How Does Cryptocurrency Actually Work?
If you want to understand how cryptocurrencies work on a foundational level, you have to get a little bit familiar with blockchain technology. The blockchain is what allows for payments and other agreements to take place without the need for a third party to ascertain their legitimacy. The blockchain, in essence, is a publicly available ledger that records every transaction and guarantees through cryptography the validity of each transaction. The blockchain makes it impossible for any person or institution to alter records or deny their existence.
The Blockchain is Stronger than Traditional Transactions
Most financial transactions that don’t involve a face-to-face exchange of cash, rely on a third-party to guarantee the transaction. When someone uses a debit card to buy groceries, the grocery store trusts that the bank will transfer the money out of your account and into theirs. When you deposit money to your account via an ATM, you trust that your account will accurately reflect the deposit. When you buy a house, you pay a lot of fees to a Title company to make sure the deed to the house is in your name.
You keep a record of the transactions (maybe). The bank or financial institution keeps a record of the transactions. If there is ever a dispute as to the accuracy of record keeping, it is going to be your word versus a much more powerful player. Most of the time, in developed countries anyway, this isn’t a problem. But what if there is a computer error? What if bank employees are corrupt (i.e. Wells Fargo)? What if you lose all of your paperwork in a house fire?
Blockchain technology completely solves these problems by creating a decentralized system of record-keeping that is both always accessible to everyone, and through powerful cryptography can never be altered or corrupted. This allows transactions to take place on a peer-to-peer level without requiring a third party to validate the exchange.
But What Exactly is a Blockchain?
The blockchain is the record of every transaction ever made with a particular cryptocurrency. It’s essentially a public ledger that cannot be altered or forged. Rather than being stored in a single location and overseen by an individual, bank, government or corporation, the ledger exists on thousands of computers simultaneously.
When you make a transaction using bitcoin or another cryptocurrency, this network of computers validates the transaction and makes a record of it. Once the transaction is verified, it is combined with other transactions and the entire block of transactions is added to the ledger. This is why it’s called blockchain technology.
Miners are responsible for verifying transactions before they are added to the blockchain. They do this by using their computing power to solve complex mathematical equations that prove a transaction’s authenticity. Every time a transaction goes through, miners all over the world compete to see who can solve the problem and verify the transaction first. Mining is very energy intensive because of the level of computing power needed to solve the problems. Bitcoins (or other types) are generated during the mining process and used to reward miners for their efforts. Here’s a simplified look at how it works:
We’ve compiled some excellent videos that will help you visualize the blockchain and understand how the math actually works (even if you’re not a math geek!) It will take you less than an hour to watch all three. The first video by 3Blue1Brown is the best explanation we’ve found of how the blockchain functions. The video does a exceptional job of explaining how blockchain technology makes Bitcoin and other cryptocurrencies possible.
The second video is a more concise explanation of how Bitcoin works by the folks at SciSho. It’s only 10 minutes and gives a decent big picture overview of how things work. The third video by What Happens Next is a fascinating look at how these futuristic currencies have very ancient roots. The fourth video produced by CNBC provides a very concise explanation (2 minutes) of the differences between the blockchain technologies that lie at the heart of Bitcoin and Ethereum.