How does cryptocurrency work?

Cryptocurrency is a decentralized digital money that is based on Blockchain technology. You might have heard of the popular versions of crypto such as Bitcoin and Ethereum, but as the market grows, there are now 1,600 of cryptocurrencies in supply as of 2018. Today, the number stands at 1,9000 and continues to grow.

How does cryptocurrency work? 

Cryptocurrency is any form of digital or virtual currency that uses cryptography to secure transactions. It has gained immense popularity as transactions leverage blockchain technology and the cryptocurrencies themselves are created with cryptographic techniques, which give cryptocurrency its secure, decentralized and nearly-anonymous qualities.

In turn, making transfers of funds between individuals ‘peer-to-peer’, meaning transactions are conducted in a distributed system of nodes (known as computers or machines) so users can send or receive payments from anywhere around the world without the need of a central authority or other intermediary. 

Let’s go deeper into how cryptocurrencies work by first looking at some basic terminology. 

What is a blockchain? 

A blockchain is a shared, immutable public ledger or database that records encrypted blocks of data (or transactions), chains them together with the chain of previous cryptocurrency transactions. Finally, distribute them across a global network of computer systems. 

Especially for cryptocurrencies, whose main function is to act as a medium of exchange, their transactions are stored on a blockchain.

When transactions of cryptocurrency take place, they are submitted on the blockchain to be confirmed. 

How are cryptocurrencies created?

Cryptocurrency units are created through mining. Mining a process that involves using computer power to solve complicated mathematical problems that confirms cryptocurrency transactions and generates new units of cryptocurrency.

When a user transfers his funds from his crypto wallet, the transaction is encrypted with an electronic signature or a cryptographic signature. The electronic signature provides a mathematical proof that the sender and his wallet is valid. 

When the transactions occur, cryptocurrency miners will compete to be the first to decrypt the block containing the encrypted transaction data. The transaction data includes the current time, transaction IDs (hashes) or addresses, how much cryptocurrency is transacted and the time of transaction. 

Once a block is decrypted and validated by a majority of nodes in the blockchain network, the block is added to the public ledger that is blockchain and data becomes immutable.

Miners are incentivized to resolve blocks because each time they validate transactions, new units of cryptocurrencies are generated as rewards for them. This mining process gives value to the cryptocurrencies and is known as a proof-of-work (PoW) system.

However, the race to resolve blocks requires intensive computer power and electricity - a process that generating Bitcoin relies on, which is criticized widely as being a negative environmental impact. As such, the proof-of-stake (PoS) system has emerged as an alternative and growing in popularity. The second largest cryptocurrency Ethereum is currently undergoing a transition to adopt the PoS system. 

With PoS, validators, instead of miners, are in charge of validating transactions on the Blockchain. The validators ‘stake’, or temporarily lock up a certain amount of cryptocurrency as collateral within a communal safe to gain a chance at participating in validating transactions. Like miners, validators get rewarded with cryptocurrency for their contribution. However, if the validator proposes adding a block with inaccurate data, their collateral gets destroyed or reduced to penalize their dishonesty. Solana, Terra, Avalanche and Cardano are the top cryptocurrencies that use proof-of-stake systems. 

How can you use cryptocurrency? 

When Bitcoin was first launched, it was used as a medium of exchange, which people can use to buy regular goods and services. These goods and services include buying a cup of coffee, computer, or even real estate. The first item bought with Bitcoin was two pizzas, and was exchanged for 10,000 BTC, the equivalent of US$ 372 million in today’s market, on May 22, 2010. 

You can buy a range of goods and services with cryptocurrency now in the e-commerce sector including Shopify, Square, WordPress.com, Newegg.com, Etsy.com, and Overstock.com, physical stores that accept crypto credit cards such as BitPay, Crypto.com, Shift Card, ShakePay, high-ticket items like real estate and luxury goods, some restaurants, insurance from AXA, Premier Shield Insurance, gold at JM Bullion and other cryptocurrencies that might rise faster in value than buying a product or service. 

To make a payment with cryptocurrency today, you’ll need a cryptocurrency wallet. The main types of crypto wallets are ‘hot wallet’ and ‘cold wallet’. A hot wallet is connected to the internet and allows immediate transactions and is usually in the form of a crypto exchange such as Coinbase or a mobile app like MetaMask. 

On the other hand, a cold wallet allows users to store cryptocurrency offline in a physical device that generates its own private keys and is more effective in storing crypto long-term, also known as ‘hodling crypto’. It is also safer from online attacks compared to hot wallets. 

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