What is a cryptocurrency and how does it all work?

“Crypto” has been a buzzword in the past few years, and you have probably heard this word unless you have been living under a rock. In simple words, cryptocurrency is a digital mode of payment or, say, a digital currency that is not controlled or circulated by a government central bank like fiat currencies. 

In this guide, we’ll try to be concise about the concept of cryptocurrencies and how they work in a comprehensive but easy manner.

What is a cryptocurrency?

Cryptocurrency is a digital asset or currency that does not rely on banks or centralized institutions for transaction verification. Transactions details of cryptocurrencies are stored in a public ledger. 

Cryptocurrencies are stored in digital wallets (online or offline). The term “cryptocurrency,” as the name suggests, uses cryptography techniques or encryption methods to validate transactions. This implies that complex coding is used to store and send transaction data between different wallets and all public ledgers on that blockchain. This high level of encryption is aimed at the security and safety of the data.

Most people we know, who are interested in cryptocurrencies support them because of their speculative nature rather than their sophistication and applications in the financial world. Bitcoin was the first cryptocurrency that surfaced around 2009 in a whitepaper by an alias “Satoshi Nakamoto” (The real identity of the person behind Bitcoin is still a mystery).

You can find a full list of trending crypto currencies and what most of the retail group are talking about over at SwaggyStocks’ trending crypto tracker.

How do cryptocurrencies work?

Any layman can say that cryptocurrencies work on blockchain technology without having a grasp on what blockchain actually is. Let’s walk you through the fundamentals of blockchain.

Blockchain

Blockchain is basically a process of storing information. This digital record of transactions is then replicated and distributed throughout the blockchain’s computer network. The interesting part is that it is nearly impossible to edit or hack the system. 

Blockchain, as the name suggests, is a set of blocks linked together in the form of a chain. Each block holds a certain number of transaction details, and once a block is full, a new block is created and connected to the previous block. 

Distributed Ledger Technology (DLT) is a digital database replicated and distributed throughout the blockchain network. The interesting part is that the DLT is not centralized. This means it is not controlled by an individual but a network of computers. Blockchain is a kind of DLT in which transactions details are stored with an irreversible cryptographic signature. This cryptographic signature is known as a hash.

Therefore, to disrupt a blockchain network, hackers would have to modify this information on all the nodes where that information has been replicated and stored, which is nearly impossible, in theory, of course. 

How does Blockchain work?

A transaction must go through many essential phases before it can be stored on the DLT or blockchain. 

Authentication

Although the innovative blockchain network tends to work without any central regulatory authority, all transactions must be validated.

This is accomplished by using cryptographic keys, which are strings of data (similar to passwords) that recognize users and grant them access to the system.

Every participant on the blockchain has their own private key as well as a public key. The private key is not visible to anyone else except the owner of that wallet, while the public key is visible to everyone. These keys combined help to process a transaction with a digital signature. 

Authorization

Once the participants have agreed to process a transaction, it must be authorized before storing its details on the blockchain. A consensus mechanism is used for this purpose. Basically, the consensus mechanism is the process that decides whether to add a transaction on the blockchain or not. 

The two most prominent consensus mechanisms are as follows:

1. Proof of Work

Proof of Work (PoW) refers to a consensus mechanism that forces the network’s computers to solve a complex mathematical problem. This process is also called mining, and in return, miners are frequently rewarded with cryptocurrency. However, mining is a challenging task. It necessitates computational power that requires a significant amount of electricity. 

Due to the high costs of energy consumed in PoW, blockchain networks started using the Proof of Stake (PoS) mechanism. 

2. Proof of Stake

In this consensus mechanism, participants must stake the cryptocurrency in the blockchain to participate in the validation process. Consequently, this saves a significant amount of computational power or the power consumed. 

Blockchain technology has now grown to use Smart Contracts, which set a criterion. These smart contracts automatically execute and validate transactions when specific criteria are met.

Now that we know how cryptocurrencies work let’s see how and where one can store his cryptocurrency. 

Where can you buy and store cryptocurrency?

Like other assets, cryptocurrencies can be bought, sold, or exchanged through brokers and crypto exchanges. The cryptocurrencies stay on a blockchain, and the wallet software allows you to interact with the blockchain’s balances. The wallet itself stores addresses and lets its owner transfer them to other addresses while allowing others to see the balance stored at any particular address. 

Most cryptocurrency wallets enable users to send, receive, and store cryptocurrency. Some contain a function that allows you to acquire and spend cryptocurrency. However, some crypto wallets provide extra functionality such as coin/token exchanging, staking for a defined return, and access to dApps (decentralized apps) built on blockchain networks.

Are cryptocurrencies safe?

Cryptocurrencies, unlike fiat currencies, are limited in amount and cannot be printed like traditional paper currencies. Therefore, the factor of inflation is diminished in this case. 

In contrast to government-owned fiat currencies, the value of cryptocurrencies is totally determined by their supply and demand. This might result in huge fluctuations that result in large gains or losses for investors. Furthermore, crypto investments are subject to significantly less regulatory oversight than traditional financial instruments such as equities, bonds, and mutual funds.

Wrapping up

Cryptocurrencies have shown practically no price correlation with other conventional financial markets such as stock markets. Therefore owning some can help diversify one’s portfolio. But, before investing in a cryptocurrency, make sure you know and understand the reason for your speculation and, most importantly, the risks involved. 

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