How does Cryptocurrency Work

Cryptocurrencies are slowly but surely entering the mainstream. While the jury is still out on their long-term merit, we can address some basic questions. Let's start with precisely how cryptocurrencies work.

For the sake of this article, we'll focus on Bitcoin---the most famous, most used, and most valuable of all cryptocurrencies at this time. Other cryptocurrencies do have features that distinguish them from Bitcoin. But the fact is that almost all cryptocurrencies build on foundations similar to that of Bitcoin.

Here are a few critical questions that this explanation will address:

  • What is a cryptocurrency, in simple terms?

  • How do we store cryptocurrency?

  • How do we track cryptocurrency? How are account balances updated? And how are transactions measured?

  • How do we verify crypto transactions? Isn't it easy to hack a "digital-only" currency?

  • What's up with all the unique language? "Blockchain" and "mining" and "proof of work"---what does it all mean?

Bitcoin is software. That software tracks a digital-only currency. There’s no physical currency, no real coin you can hold in your hand.

Individual people use digital wallets to “store” their Bitcoin. These wallets have a unique bitcoin address and are secure. One can access their wallet via unique passwords, called keys. Using their private key, a person can authorize a transfer of Bitcoin from their wallet to another wallet.

In this way, Bitcoin wallets are similar to bank accounts. Each account has a unique ID, and each unique ID has a certain amount of currency (dollars or Bitcoin) associated with it. People can authorize transfers from their accounts to other accounts (people, businesses, other bank accounts, etc.).

How do we record these transactions? Via “the blockchain.” The blockchain is a distributed ledger, similar to a spreadsheet. When you see “blockchain,” think about a spreadsheet. The blockchain records every Bitcoin transaction that’s ever occurred.

The blockchain is maintained and monitored by multiple people all over the globe. These monitors are called “nodes.” Nodes keep a record of the blockchain and validate new “blocks” that are added to the chain (we’ll discuss “blocks” in a bit).

Whereas a bank monitors its ledger, cryptocurrency blockchains are typically monitored by many separate individuals. Banks, therefore, are centralized authorities. They maintain their books and control the money. Cryptocurrencies, including Bitcoin, are decentralized, meaning many different people each control a copy of the ledger.

New Bitcoin transactions are bundled into "blocks" and added to the blockchain---just like adding a new row onto a spreadsheet. But how do all the various “decentralized” copies of the ledger stay in sync? And how can we be sure that we're adding genuine transactions onto the blockchain? Couldn't it be easy to "hack" and add a billion dollars to your account?

Not quite.

To provide validity to new blocks, "proof of work" must be submitted that solves a complex cryptographic puzzle. This puzzle-solving activity is called “mining.”

All miners compete to solve the puzzle, but only one miner can win. That miner provides their solution, or proof of work, to the puzzle.

The many nodes on the network then verify that the solution is mathematically correct. This puzzle solution acts as proof that the new transaction is legitimate, not hacked. This collective action also keeps the nodes in sync with one another on the state of the ledger. Each node then adds that new block onto the end of the blockchain, verifying the transactions therein. The winning miner gets a prize---they win a little bounty of Bitcoin!

And then the process starts all over again for the next block: more transactions, more verification, more puzzles, more mining, more updating of the blockchain.