How does cryptocurrency work?

Cryptocurrencies have become a hot topic for debate; heard by most people but understood by few. One can have a hard time finding a major Bank, Accounting firm, Software company or Government that hasn’t researched Cryptocurrencies or started a ‘Blockchain’ project. Looking beyond the noise in the press releases, many people often fail to understand the basic concept of Cryptocurrency.

Cryptocurrency started when Satoshi invented Bitcoin in 2008 as a ‘peer-to-peer electronic cash system’. To enable a digital cash transfer, one needs a payment network with accounts, balances and transactions. A major problem every payment network must solve is the prevention of ‘double spending’; essentially, prevent one entity from spending the same amount twice. Traditionally, this is done by a central server that keeps records of all the balances.

In a decentralized network, ie; one used in cryptocurrencies, one does not have this server, rather, every single entity of the network does this job. Every peer in the network needs to have a full list with all the transactions in order to facilitate future. If the peers on the network disagree about even a single balance, all transaction chain is halted.

To illustrate a typical transaction using Cryptocurrency, we’ll look at the transactions on the network the transaction is a file that says Person A gives say, 10 Bitcoin to Person B and the transaction is signed digitally by Person A. Once signed, the transaction is broadcasted to the network, and can be seen by everyone on the network, though its legitimacy still ‘unconfirmed’. After a specific amount of time, the transaction gets confirmed.

The duty of ‘confirming’ transactions is assigned to ‘Miners’. Miners take transactions, stamp them as ‘legitimate’ and spread them in the network. After a transaction is confirmed by a Miner, every user has to add it to its database and the transaction becomes part of the blockchain.

For confirming transactions, the Miners are rewarded with cryptocurrency. To become a Miner, one needs to use some of their computer’s power to qualify for the task. Essentially, every Miner competes to solve a cryptographic ‘puzzle’. Finding a solution entails a Miner confirming the transaction and adding it to the blockchain. Incentivising Miners by paying them in Cryptocurrency ensures a network of independent users, maintaining the legitimacy of the transaction history.

Cryptocurrencies are the key to the complex digital cash problem of maintaining integrity and consensus across independent and potentially malicious users. And though the technology isn’t free of flaws, it is still promising and is surely to be of increasing importance in the times to come.