- What are Cryptocurrencies?
- Pay for products
- Develop DApps
- How do Cryptocurrencies work?
- How do Cryptocurrencies work?
- Simple Method To Make $100 A Day Trading Cryptocurrency As A Beginner - Tutorial Guide
- How does Blockchain technology work?
- What is mining and how does it work?
- Long-term investment & short-time trading
- Why do Cryptocurrencies need Cryptography?
Cryptocurrencies are this revolutionizing way to send money on the internet, but is the technology behind it really that “magical”?
The big question is: How do Cryptocurrencies work?
Cryptocurrencies work by having a public ledger that records all transactions on decentralized computers all over the world.
Wallets are used to store Cryptocurrencies, and rely on Cryptography to be secure. Cryptocurrencies are pseudo-anonymous, meaning that the addresses are public, but the actual person isn’t necessarily linked to a wallet.
In this complete guide I am going to show you all the technical aspects of Cryptocurrencies and how they actually work to make “magic internet money” even possible.
Let’s get straight into the article!
What are Cryptocurrencies?
Before diving into the technological specifics of Cryptocurrencies, I would like to take a step back and show you what a Cryptocurrency exactly is.
So, basically a Cryptocurrency is a digital currency.
This means, that unlike gold coins or cash, they can’t be physically printed, but are only accessible through the internet.
Now you might say: But I have seen physical Bitcoins like the one shown in the picture below.
Yeah….but those are just souvenirs, and aren’t actual Bitcoins you can use to make transactions on the internet.
The first Cryptocurrency that was ever created is Bitcoin, which was developed by Satoshi Nakamoto.
To this date, we don’t know for sure who Satoshi Nakamoto is, since he published his invention on a Cryptography forum under the pseudonym “Satoshi Nakamoto”.
In 2011, he left the Bitcoin project, stating that Bitcoin is strong enough to stand on its own feet and can prosper without his active involvement.
Bitcoin was so revolutionizing, because it was peer-to-peer and completely decentralized.
Before, you always needed a third-party like PayPal to act as the trusted middleman and verify all the transactions.
Bitcoin eliminated that middleman by enabling anybody in the world to join his own computer to the Bitcoin network and become a miner, who help verify all the transactions that are happening on the Bitcoin network.
Okay, but what can you actually do with Cryptocurrencies like Bitcoin? What are their real-life use cases?
Pay for products
First of all, Cryptocurrencies can and are used for their original purpose, which is to use it as a digital currency and pay for goods on the internet, but also in real life.
There are already many online stores which accept Bitcoin and sometimes also other Cryptocurrencies as a payment method.
But not only on the internet, also in real-life Bitcoin is being used to pay for items.
This works, by letting customer scan a QR-code in a restaurant, cafe, or hotel for example.
This QR-Code stores the address of the wallet of the owner of the business. Customers can simply scan that QR-code with their smartphone and send the price in Bitcoins (or another Cryptocurrency) to the owner of the business.
Cool side Note: Lamborghini accepted Bitcoin as a payment method to pay for their cars early on, which is part of the reason why Lamborghinis are so “loved” in the Crypto-space, and many people who got rich off Cryptocurrencies, purchased a Lamborghini with their newly created wealth.
Many people, myself included, believe that Cryptocurrencies are an awesome invention and will solve many problems and will be of great value to the whole world.
Because of that reason a lot of people think Cryptocurrencies are a great investment opportunity, since the prices of Cryptocurrencies will most likely increase once many people start using it regularly.
While Cryptocurrencies have performed extremely well in the past decade, it is important to note that Cryptocurrencies are a very risky asset class, and that one can potentially lose just as much as one can gain.
Also, because the Cryptocurrency market is so knew, it is mostly unregulated and hacks are also a threat, if you don’t take care of your Cryptocurrencies.
Learn here, which wallets are the best to protect your precious Cryptocurrencies.
With Cryptocurrencies like Ethereum, the Blockchain 2.0 has been born, which includes the use of so-called “Smart Contracts”.
These Smart Contracts are programs and conditions that can be programmed into a Blockchain, and will be executed automatically, once the set conditions have been met.
The cool thing about the Blockchain 2.0 is, that now Cryptocurrencies can not only be used as a way to transfer money digitally in a decentralized way, but now decentralized applications, also called DApps, can be programmed upon the Ethereum Blockchain and other Cryptocurrencies, which means that applications and services can now run upon a Blockchain in decentralized way.
How do Cryptocurrencies work?
Now that you know what Cryptocurrencies are and what purpose they have, let’s get into the real question of how Cryptocurrencies actually work!
To get things started I would like to say that a Cryptocurrency is basically a public ledger, where all transactions are recorded.
Every transactions that is being made through a certain Cryptocurrency is written down on this public ledger, which means that the sending address, the receiving address, and the amount of Cryptocurrencies that were sent are all recorded publicly.
This public ledger is, of course, not stored in one computer or server, but on many decentralized computers all over the world.
These computers are also called miners, for a reason that I will get to later.
Every computer in the world can decide to join most Cryptocurrency mining networks.
This means, that for a third party to overtake and then possibly manipulate a Cryptocurrency, they would have to control more than 50% of all the computers that are mining the Cryptocurrency.
If there is at least one computer in the whole entire world mining the Cryptocurrency, it is still fully functional.
Now, individuals can send and receive transactions by having their own wallets.
New wallets can be created on any Cryptocurrency for free, and are just a random string of characters, that identify the individual wallet.
Each wallet has a public and a private key.
How do Cryptocurrencies work?
The public key is accessible to everybody on the Bitcoin network, and is used to identify the Bitcoin wallet.
The private key, on the other hand, is only known to the person who owns the Bitcoin wallet.
Anybody who has access to the private key of a certain wallet can access the funds, which is the reason why it is so important to keep your private keys of the wallets you own, as safe as possible from hackers.
Once a transaction through a certain Cryptocurrency is made, the transaction is batched together with many transactions into a block.
This block is then verified by the miners and then added to the previous blocks, forming a chain of blocks, also known as the Blockchain.
Bitcoin is often called the “currency of the dark web”, which isn’t true anymore, since there are privacy-focused Cryptocurrencies like Monero that anonymize your transactions better than Bitcoin.
Bitcoin is actually “pseudo anonymous”.
It isn’t at all anonymous, in the sense that all transactions are recorded publicly on an open ledger accessible to everybody in the world.
But on the other hand, only the addresses of the wallets are recorded, and one doesn’t necessarily know the actual person behind a wallet.
A big problem that was faced with digital money before, was the “double-spending problem”, which means that a certain amount is spent more than once, which isn’t ideal of a currency.
The internet was designed in a way to democratize information.
Simple Method To Make $100 A Day Trading Cryptocurrency As A Beginner - Tutorial Guide
This means, that it was to everybody’s advantage to let content be duplicated easily, and accessible as many times as somebody wants to.
With a digital currency, that is designed to be scarce, you want the exact opposite.
To avoid the problem of spending an amount that one doesn’t have twice or more times, the public ledger and the Blockchain were introduced.
Every time somebody wants to transact a certain amount from his wallet, the network checks the public ledger and sees if the sum of all transactions the wallet has performed in the past is greater than the amount the person wants to transacts.
If the person has the desired amount of a certain Cryptocurrency in his wallet, which can be checked by looking at the previous transactions the wallet has made, he is allowed to perform the transactions.
Another thing that makes Cryptocurrencies trusted and so “decentralized” in a way, is the fact that most Cryptocurrencies are open-source.
This means, that everybody can look at the exact source-code of a Cryptocurrency and suggest improvements and further development.
The reason why Cryptocurrencies like Bitcoin are so secure is, that they use Proof-of-Work, which I will discuss under the “mining”-section of this article.
In short, proof-of-work means, that a lot of computational power is used by many computers, which means the Bitcoin network (or that of any other Cryptocurrency that uses the Proof-of-Work algorithm) is secure.
How does Blockchain technology work?
Since the creation of Bitcoin, there has been a lot of buzz around Blockchain technology and how it is going to change and disrupt many industries.
So, to fully understand Cryptocurrencies one also needs to understand Blockchain technology and how it actually works.
So let me now show you what blockchain technology is and how it exactly works.
Blockchain technology is, as already shown above, a public ledger that holds specific amounts of data.
A Blockchain is very immutable, since all data entries are collected in blocks, that all rely on each other.
If somebody tries to tamper with a certain block, then he has to restore all the other blocks following that block as well, before the next verification happens, which in the case of the Bitcoin blockchain, has never happened before and is therefore thought to be impossible to do.
What makes the Blockchain technology even more secure and trustworthy, is that decentralized computers all over the world are storing a copy of the whole Blockchain, meaning the miners are helping to verify the new transactions.
The decentralized fashion of Blockchain technology allows for many individual computers to reach consensus, without being controlled by one central authority.
This means, that whenever a new data entry wants to come into the Blockchain, let’s say a new transaction, all the decentralized computers (miners) run some sort of program, that automatically checks if it is allowed to add that data entry.
In Bitcoin’s case, the miners check if the person trying to send a certain amount of Bitcoins, possesses these Bitcoin in the first place, by looking at the previous transactions in the ledger.
If the majority of the decentralized computers agree that the data entry is valid, it is added to the Blockchain.
On the other hand, if most of the computers say that the data entry is fraudulent, it will be rejected form the network and will not be allowed to get into the Blockchain.
Another important thing is, that all the individual data entries are connected to each other in some way, since every time somebody wants to make another data entry, the network has to check the previous entries, which are all blocks forming a chain, the Blockchain.
So, in order to connect these individual blocks to each new block that is added to the Blockchain each block contains the hash of the previous block.
So, basically, all the data entries that were made in the previous block are converted into a hash, which is a uniquely identifiable string of characters for any amount of text.
This hash of the previous block is then added to the next block, so each block is pointing to the block behind it, until you get to the first block that was ever created, also known as the “genesis block”.
So, now that you know what the Blockchain is and how Blockchain technology works, let me show you some of the awesome advantages and use cases that it brings to our world.
First of all, Blockchain technology can be seen as a big blessing for large central authorities, since they do not have to run all those central severs anymore and deal with all the management of all the computers.
Instead, with Blockchain technology, they can offer the same value to their customers, if not even a great value, by letting decentralized computers manage and run their servers.
This can reduce cost for the business, and can also improve the speed and reliability of their services.
Also, the Blockchain is very resistant to any attacks and hacks, since the ledger of any Blockchain is distributed across many different computers and for a hack to work successfully, one has to hack more than 50% of all the computers that are verifying the network, instead of only one computer, as it is the case in a centralized system.
Also, thanks to cryptography, the whole system is very well protected against malicious actors, and Bitcoin’s Blockchain, for example, didn’t experience any hack till this date.
And another very cool thing about having a Blockchain is, that all data entries are publicly recorded on a public Blockchain.
This means, that everybody can track and follow specific data back in time, and since the Blockchain is always stored on many decentralized computers all over the world it creates a perfect place to analyze data that is still recorded from years back.
What is mining and how does it work?
Mining is a big part of what make a Cryptocurrency work the way it does.
I have already told you about how mining is used to verify all the transactions that go through any particular Cryptocurrency, but there is actually more to it.
Mining has 2 very important tasks.
The first one, as already discussed above, is to verify all the transactions that go through a certain Cryptocurrency.
Without that consensus users would not be able to agree who has how much money.
But the other important thing that mining accomplishes is the controlled creation of new coins.
Most Cryptocurrencies out there, like Bitcoin, are issuing new coins in a mathematically controlled way.
In Bitcoin, the miners create new Cryptocurrencies approximately every 10 minutes, and as the years progress, less and less new Bitcoins will be created.
It is estimated that the last Bitcoin ever to be mined will be in the year 2140.
(So we will probably never experience that moment, but maybe our children or grandchildren😉)
So, to explain to you mining in general better, I would like to show you the exact process of Bitcoin mining, and how it works, since many Cryptocurrencies work similar to Bitcoin.
Bitcoin miners first take all the transactions out there, and check if they are valid.
Long-term investment & short-time trading
This means, they look at the last transactions of a certain wallet and see if it has enough Bitcoins to perform that kind of transaction.
Then, all the transactions are bundled together in a block.
To make the block linked together to the previous blocks, the hash of the previous block is added to the block.
This makes the block point back to the previous block, which makes sure that the blocks are sorted in the correct order.
Afterwards comes the hard part of mining Bitcoin.
This is where the Proof-of-Work algorithm comes in.
Now all the Bitcoin miners in the world are trying to find a magical text and number, that when hashed, returns the certain hash.
But why does Bitcoin require miners to waste electricity and computational power on “useless” calculations, you might ask?
For the simple reason that the process of adding new blocks to the Blockchain must be very costly and time-intensive, or otherwise the Blockchain wouldn’t be secure, and vulnerable hackers.
Don’t understand why?
Let me explain:
Every time a new block is added to the Bitcoin Blockchain, miners all across the world are using computational power and electricity cost over a long period of time, to be the first one to find the right number and text, that when hashed, returns a specific hash.
The first miner to find that hash, gets to add the new block to the Blockchain and receive the Bitcoin mining reward, which consists of a certain amount of Bitcoins, and the transaction fee every user pays when performing a transaction.
Now, but what if a hacker wants to change a certain transaction in a block that is, let’s say, 5 weeks old.
He can surely do that, but the impossible thing (until now, at least) is to calculate all the hashes for the transactions after that block before the next block gets added, which is approximately every 10 minutes.
So, if adding a new block to the Blockchain was not time-intensive, every hacker could just go to an old block, and change some transactions in his or her favor.
But to get accepted in the network again, he doesn’t not only have to calculate the block that he wants to change again, which means to use all that computational power and electricity, but also do the same for all the blocks after that, since all the blocks are linked together.
And he or she has to do all that in less than 10 minutes, which is quite impossible to do, and for that reason (because of the strength of the Proof-of-Work algorithm) Bitcoin has not been hacked or tampered with before and is therefore a very trusted Blockchain.
Now, before I dive into the nitty-gritty of cryptography in Blockchain, I would like to tell you some more things about the mining difficulty.
Again, to simplify my explanation, I will explain the concept of mining difficulty with Bitcoin, as most other Cryptocurrencies use a similar method.
So, the goal of the Bitcoin network is to add a new block to the Blockchain every 10 minutes.
But how do you determine how fast computers are going to solve the Proof-of-Work algorithm?
Simple: By increasing or decreasing the difficulty of how easy/hard it is to solve the Proof-of-Work algorithm.
So, if more miners join the Bitcoin network and a block gets solved every 8 minutes, because there is more computational power available, the mining difficulty will re-adjust after 2016 blocks.
Then, the mining difficulty will get higher, so the blocks will be solved again every 10 minutes.
On the other hand, if a lot of miners decide to leave the Bitcoin network, and now it takes 14 minutes to solve a block, the mining difficulty will re-adjust again and it will become easier to solve the Proof-of-Work, so the blocks will get solved every 10 minutes again.
If you want to learn everything about Bitcoin mining in detail, check out this comprehensive guide.
Why do Cryptocurrencies need Cryptography?
As the name already suggests, Cryptography plays a big role in Cryptocurrencies.
But why, and where is Cryptography used exactly in Cryptocurrencies?
Bitcoin uses the SHA256 hashing algorithm, which uses 256-bit encryption.
It was originally developed by the NSA to encrypt information.
But what is a hash, and why is it useful?
Basically, a hash allows you to create a unique fingerprint for a text, that is only working in one-direction.
This may sound complicated, but bare with me for a second.
Let’s say you want to hash the text “Hey123” using the SHA256 hashing algorithm.
Using a SHA256-tool I get that the hash for that text is “88d415096deac447e898011e33c8b7c8ac9ea01aed0dc06a03036f5826adbaab”.
The cool thing about this is, that by only having the hash, without knowing the text, it is quite impossible to know what the original text is.
Now, this is very important for online security and passwords in general, but in Cryptocurrencies and Bitcoin specifically this is very important, in order for the Proof-of-Work algorithm to work properly.
In order to solve a block, a miner has to find a certain text, that when hashed by the SHA256 algorithm, returns a hash with a certain amount of zero’s at the beginning of the hash.
Since hashing is only a one-way street, the miners have no better chance to find the right hash than just by guessing random text and numbers, which requires a lot of computational power and electricity, and then to find a hash, that has more zeros at the beginning, than the mining difficulty requires it to be.
When the mining difficulty increases, miners have to find a hash, that has more zero’s at the front.
These hashes are rare, and take longer to find.
The same is also true in the opposite direction. When the mining difficulty lowers, miners have to find hashes with a lower number of zero’s in front of them, which are more common and require less computational power to find.
To sum it up, I would like to say that there are many important components that make Cryptocurrencies work like we know them today.
From having a public ledger, to wallets, to miners, everything makes sure that Cryptocurrencies are fully-functional networks that allow for transactions to happen and even decentralized applications to be built on top of them.
Now I would like to turn it over to you: What did you learn today from this article?
Maybe you learned about the hashing algorithm Cryptocurrencies use, or how mining difficulty works?
I am looking forward to hearing from you in the comments below.
Thanks a lot for reading all the way to the end of this long article, and I wish you a great day!