Cryptocurrency is an encrypted, decentralized digital currency transferred between peers and confirmed in a public ledger via a process known as mining.
Below, we take a simplified look at how cryptocurrencies like bitcoin work. First, lets review the basics and essentialsof cryptocurrency, and then we will do an overview of theother properties that have made cryptocurrency what it is today.
TIP: If the page below feels overwhelming, please see: how does cryptocurrency work (for beginners). Meanwhile, if you are mainly interested in trading, investing in, or using cryptocurrency, see how to trade cryptocurrency (for beginners). This page provides an overview of the mechanics behind cryptocurrency.
To understand how cryptocurrency works, youll need to learn a few basic concepts. Specifically:
Public Ledgers: All confirmed transactions from the start of a cryptocurrencys creation are stored in a public ledger. The identities of the coin owners are encrypted, and the system uses other cryptographic techniquesto ensure the legitimacy of record keeping. The ledger ensures that corresponding digital wallets can calculate an accuratespendable balance. Also, new transactions can be checked to ensure that eachtransaction usesonlycoins currentlyowned by the spender. Bitcoin calls thispublic ledger a transaction block chain.
Transactions: A transfer of funds between two digital wallets is called a transaction. That transaction gets submitted to a public ledger and awaits confirmation. Wallets use an encrypted electronic signature when a transaction is made. The signature is an encrypted piece of datacalled a cryptographic signature and it provides a mathematical proofthat the transaction came from the owner of the wallet. The confirmation process takes a bit of time (ten minutes for bitcoin) while miners mine. Mining confirms the transactions and adds them to the public ledger.
Mining: Mining is the process of confirming transactions and adding them to a public ledger. To add a transaction to the ledger, the miner must solvean increasingly-complex computational problem(like a mathematical puzzle). Mining is open source so that anyone can confirm the transaction. The first miner to solvethe puzzleadds a block of transactions to the ledger. The way in which transactions,blocks, and the public blockchain ledger work together ensure that no one individual can easily add or change a block at will. Once a blockis added to the ledger, all correlatingtransactions are permanent, and they add a small transaction fee to theminers wallet (along with newly created coins). The mining process is what gives value to the coins and is known as a proof-of-work system.
Although there can be exceptions to the rule, thereare some factors(beyond the basics above) that make cryptocurrency so different from thefinancialsystems ofthe past:
Adaptive Scaling: Adaptive scaling means that cryptocurrencies are built with measures to ensure that they will work well in both large and small scales.
Adaptive Scaling Example:Bitcoin is programmed to allow for onetransaction block to be mined approximately every ten minutes. The algorithm adjusts after every 2016 blocks (theoretically, thats every two weeks)to get easier or harder based on how long it took for those 2016 blocks to be mined. So if it only took 13 days for the network to mine 2016 blocks, that means its too easy to mine, so thedifficulty increases. However, if it takes 15 days for the network to mine 2016 blocks, that shows that its too hard to mind, so the difficulty decreases.
Other measures are included in digital coins to allow for adaptive scaling including limiting the supply over time (to create scarcity) and reducingthe reward for mining as more total coins are mined.
Cryptographic: Cryptocurrency uses a system ofcryptography (AKA encryption) to control the creation of coins and to verify transactions.
Decentralized: Most currencies in circulation are controlled by a centralized government so their creation can be regulated by a third party. Cryptocurrencys creation and transactions are open source, controlled by code, and rely onpeer-to-peer networks. There is no single entitythat can affect the currency.
Digital: Traditional forms of currencyare defined by a physical object (USD existing as paper money and in its early years being backed by gold for example), but cryptocurrency is all digital. Digital coins are stored in digital wallets and transferred digitally to otherpeoplesdigital wallets. No physical object ever exists.
Open Source: Cryptocurrencies are typically open source. That means that developers can create APIs without paying a fee and anyone can use or join the network.
Proof-of-work: Most cryptocurrencies use a proof-of-work system. Aproof-of-work schemeusesa hard-to-compute but easy-to-verify computational puzzleto limit exploitation of cryptocurrency mining. Essentially, itssimilar to a difficult to solve captcha that requires lots of computing power. NOTE: Other systems like proof-of-work (such as proof-of-stake) are also used.
Pseudonymity: Owners ofcryptocurrencykeep their digital coins in an encrypted digital wallet. A coin-holders identificationis stored in an encrypted address that they have control over it is not attached to a persons identity. The connection between you and your coinsis pseudonymous rather than anonymous as ledgers are open to the public (and thus, the ledgers could beused to glean information about groups of individuals in the network).
Value:For something to be an effective currency, it has to have value. TheUSdollarused to representactual gold. The gold was scarce and required work to mine and refine, so the scarcity and workgave the gold value. This, in turn, gave the US dollar value.
Cryptocurrency works similarly regarding value. In cryptocurrency, coins (which are nothing more than publicly agreed on records of ownership) are generated or producedby miners. These miners are people who runprograms on specializedhardware made specifically to solve proof-of-work puzzles. The work behind mining coins gives them value, while the scarcity of coins and demand for them causes their value to fluctuate. The idea of work giving value to currency is called a proof-of-work system. The other method forvalidating coins is called proof-of-stake. Value is also created when transactions are added to public ledgers as creating a verified transaction block takes work as well. Further, value comes from factors such as utility and supply and demand.
If at this point, you feel a little bit confused,dont worry and dont give up.Understanding the concepts that are fundamental to cryptocurrency is a challenge. One explanation works for some people, and a different explanation works of others. We all learn in different ways.
The trick with cryptocurrency is not getting worried if you dont understand it at first each new video, explanation, orarticle that you learn fromwill make your understanding of cryptocurrency clearer until, eventually, it clicks.
To learn more, visit some of the other, more technical pages on our site to dive deeper into the inner-workings of cryptocurrency. You can also watch informational videos about the howcryptocurrency works such as the one below.
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How Does Cryptocurrency Work? - CryptoCurrency Facts