Cryptocurrencies, and more specifically Bitcoin, have been one of the first use cases for blockchain technology. That’s why most people may have heard about Bitcoin more than they have about the underlying blockchain technology.
This post gets into more detail about how cryptocurrencies use blockchain technology, how they operate, and how they’re generated, as well as some crypto geek terms you can impress your dates with.
Table of Contents
Explaining Basic Terms in the Cryptocurrency Process
Cryptocurrencies are also known as digital coins, but they’re quite different from the coins in your piggy bank. For one thing, they aren’t attached to a central bank, a country, or a regulatory body.
Here’s an example. Say you want to buy the latest version of Cryptocurrency All-in one For Dummies from your local bookstore. Using your normal debit card, this is
what happens:
- You give your card details to the cashier or the store’s point-of-sale system.
- The store runs the information through, essentially asking your bank whether you have enough money in your bank account to buy the book.
- The bank checks its records to confirm whether you do.
- If you do have enough, the bank gives a thumbs-up to the bookstore.
- The bank then updates its records to show the movement of the money from your account to the bookstore’s account.
- The bank gets a little cut for the trouble of being the middleman. Now if you wanted to remove the bank from this entire process, who else would you trust to keep all these records without altering them or cheating in any way?
Your best friend? Your dog walker? In fact, you may not trust any single person.
But how about trusting everyone in the network?
Blockchain technology works to remove the middleman. When applied to cryptocurrencies, blockchain eliminates a central record of transactions. Instead, you
distribute many copies of your transaction ledger around the world. Each owner
of each copy records your transaction of buying the book.
Here’s what happens if you want to buy this book using a cryptocurrency:
- You give your crypto details to the cashier.
- The shop asks everyone in the network to see whether you have enough coins
to buy the book. - All the record holders in the network check their records to see whether you
do. (These record holders are called nodes, and are explained later in this
chapter.) - If you do have enough, each node gives the thumbs-up to the cashier.
- The nodes all update their records to show the transfer.
- At random, a node gets a reward for the work.
That means no organization is keeping track of where your coins are or investigating fraud. In fact, cryptocurrencies such as Bitcoin wouldn’t exist without a whole network of bookkeepers (nodes) and a little thing known as cryptograph
What is Cryptography?
Shhh. Don’t tell anyone. That’s the crypto in cryptography and cryptocurrency. It means “secret.” In the cryptocurrency world, it mainly refers to being “anonymous.”
Historically, cryptography was an ancient art for sending hidden messages. (The term comes from the Greek word krypto logos, which means secret writing.) The sender encrypted the message by using some sort of key. The receiver then had to decrypt it.
For example, 19th-century scholars decrypted ancient Egyptian hieroglyphics when Napoleon’s soldiers found the Rosetta Stone in 1799 near Rosetta, Egypt. In the 21st-century era of information networks, the sender can digitally encrypt messages, and the receiver can use cryptographic services and algorithms
to decrypt them.
What does Napoleon have to do with cryptocurrencies? Cryptocurrencies use cryptography to maintain security and anonymity. That’s how digital coins, even though they’re not monetized by any central authority or regulatory body, can help with security and protection from double-spending, which is the risk of your
digital cash being used more than once.
Cryptography uses three main encryption methods
» Hashing: Hashing is something like a fingerprint or signature. A hash function first takes your input data (which can be of any size). The function then performs an operation on the original data and returns an output that represents the original data but has a fixed (and generally smaller) size. In cryptocurrencies such as Bitcoin, it’s used to guess the combination of the lock of a block. Hashing maintains the structure of blockchain data, encodes people’s account addresses, and makes block mining possible. You can find more on mining later in this post.
» Symmetric encryption cryptography: Symmetric encryption is the simplest method used in cryptography. It involves only one secret key for both the sender and the receiver. The main disadvantage of symmetric encryption is that all parties involved have to exchange the key used to encrypt the data before they can decrypt it.
» Asymmetric encryption cryptography: Asymmetric encryption uses two keys — a public key and a private key. You can encrypt a message by using the receiver’s public key, but the receiver can decrypt it only with their private key.
Nodes
A node is an electronic device that does the bookkeeping job in the blockchain network, making the whole decentralized thing possible. The device can be a computer, a cellphone, or even a printer, as long as it’s connected to the Internet and has access to the blockchain network.
Mining
As the owners of nodes (see the preceding section) willingly contribute their computing resources to store and validate transactions, they have the chance to collect the transaction fees and earn a reward in the underlying cryptocurrency for doing. This process is known as mining, and the owners who do it are miners.
Let me make something clear: Not all cryptocurrencies can be mined. Bitcoin and some other famous ones can. Others, such as Ripple (XRP), avoid mining altogether because they want a platform that doesn’t consume a huge amount of electricity in the process of mining; power usage is one of the issues with blockchain. Regardless, for the most part, mining remains a huge part of many cryptocurrencies to date.
Here’s how mining works: Cryptocurrency miners solve cryptographic puzzles (via software) to add transactions to the ledger (the blockchain) in the hope of getting coins as a reward. It’s called mining because of the fact that this process helps extract new cryptocurrencies from the system. Anyone, including you, can join this group.
Your computer needs to “guess” a random number that solves an equation that the blockchain system generates. In fact, your computer has to calculate many 64-character strings or 256-bit hashes and check with the challenge equation to see whether the answer is right. That’s why it’s so important that you have a powerful computer. The more powerful your computer is, the more guesses it can make in a second, increasing your chances of winning this game. If you manage to guess right, you earn Bitcoins and you get to write the “next page” of Bitcoin transactions on the blockchain. Head to Book 6 if you’re interested to
learn more.
Because mining is based on a form of guessing, for each block, a different miner guesses the number and is granted the right to update the blockchain. Whoever has the biggest computing power combined, controlling 51 percent of the votes, controls the chain and wins every time. Thanks to the law of statistical probability, the same miner is unlikely to succeed every time. On the other hand, this game can sometimes be unfair because the biggest computer power will be the first to solve the challenge equation and “win” more often.
Proof of work
If you’re a miner and want to actually enter your block and transactions into the blockchain, you have to provide an answer (proof) to a specific challenge. This proof is difficult to produce (hence all the gigantic computers, time, and money needed for it), but others can very easily verify it. This process is known as proof of work, or PoW.
For example, guessing a combination to a lock is proof to a challenge. Going through all the different possible combinations to come up with the right answer may be pretty hard, but after you get it, it’s easy to validate — just enter the combination and see whether the lock opens! The first miner who solves the problem for each block on the blockchain gets a reward. The reward is basically the incentive to keep on mining, and it motivates the miners to compete to be the first one to find a solution to mathematical problems. Bitcoin and some other mineable cryptocurrencies mainly use the PoW concept to make sure that the network isn’t easily manipulated.
This whole proof-of-work concept has some downsides for blockchain technology. One of the main challenges is that it wastes a lot of computing power and electricity just for the sake of producing random guesses. That’s why new cryptocurrencies have jumped on an alternative wagon called proof of stake (PoS), covered in the next section.
Proof of stake
Unlike PoW, a proof-of-stake (PoS) system requires you to show ownership of a certain amount of money (or stake). That means the more crypto you own, the more mining power you have. This approach eliminates the need for the expensive mining extravaganza. And because the calculations are pretty simple to prove, you
own a certain percentage of the total amount of the cryptos available. Another difference is that the PoS system offers no block rewards, so the miners get transaction fees. That’s how PoS cryptos can be several thousand times more cost-effective than PoW ones. (Don’t let the PoS abbreviation give you the wrong idea.)