It’s a revolutionary solution that doesn’t stop amazing people. However, many are wondering how cryptocurrency works and what’s so special about a coin that isn’t really a coin.
Cryptocurrency isn’t made of gold or any other physical commodity we the people find precious and therefore, valuable. It has nothing to do with central banks and fractional reserve money. And it doesn’t rely on any of the known fiat currencies such as the dollar, euro, pound or yen.
So how come 1 Bitcoin currently exchanges for over $7,000?
How cryptocurrency works in the simplest possible words
Say you want to send 50 cents to some charity via an online payment system. Even if it were possible, first, it would take 3-5 business days for a receiver to actually see the money. Second, when all fees are deducted, the receiver will get only 20 cents because roughly 30 cents will be taken for processing the payment.
In other words, the third party (the payment processing company and/or card issuer) will take 30 cents to confirm that:
- A) You really did send the money and
- B) You didn’t spend it twice
Now, imagine the payment system where those 50 cents are received almost instantaneously without generating any additional costs such as payment processing fees. The receiver gets the exact 50 cents you originally sent.
That’s cryptocurrency on the blockchain technology. And it doesn’t really matter whether you are sending 50 cents to charity or $1,000,000 to your sister; the transaction will be completed in a blink of an eye with negligible costs.
How does cryptocurrency work on the blockchain technology?
Mike wants to send 5 Bitcoins to Melissa. He takes his crypto wallet, enters Melissa’s receiving address and hits ‘SEND.’ 10 minutes later, Melissa sees those 5 Bitcoins in her wallet.
What happened during those 10 minutes?
The moment Mike hit the ‘SEND’ button, he informed the peer network that the new transaction was taking place. The network knows that it is Mike who is sending the payment because Mike’s wallet contains two encrypted identity keys, private and public.
This is where the fun starts.
The network of peers (everyday people like you and me) starts solving the mathematical problem, unique for Mike’s transaction. Whoever solves it first, adds a new block to the chain, confirming the transaction. Ergo, the blockchain technology. It’s also the moment when Melissa receives those same 5 coins.
As a gratitude for such a self-less maintaining of the blockchain ledger, the miner who solved the mathematical problem receives a small fee in that same cryptocurrency. But that fee is nowhere near the minimum fee you pay to the banks, credit card issuer or the online payment processing service such as PayPal.
What prevents the same miner from collecting fees over and over again?
Cryptocurrency transactions use 256-bits hash encryption, originally designed by the US Department of Defense. On average, it takes 10 minutes for the computer to solve the mathematical problem. Thus, every 10 minutes, a new block is added to the chain.
During those 10 minutes, millions of other transactions occur almost simultaneously so it’s both mathematically and physically impossible for a single miner to take control over the network.
What prevents a hacker to reverse engineer the result once the mathematical problem is solved?
That same 256-bits encryption. The result is always the same, but the possible number of equations that lead to that result are many while only one is the true mathematical problem set for a specific transaction (block).
For example, in Mike’s case, the mathematical problem was: 1+2+3+4=10.
Now, even if the hacker hacks into the block and discovers the result, it would be impossible to figure out the right “equation” in under 10 minutes. As you know there are over a hundred of different ways to come to that result using just the simple math.
Why under 10 minutes? Because once the block is added to the ledger, game’s over. The transaction is confirmed and every other block that tries to conflict or counter the original one will be ignored.
What prevents you from sending those same 5 coins to two different addresses at the same time?
The blockchain ledger. It’s impossible to trick the network because the exact time the transaction is entered into the rest of the information inside the block and if you try to execute another one, it will just be ignored.
That’s also one of the greatest challenges in modern payment processes which has successfully been solved by the blockchain technology.
What makes the network and what is the blockchain ledger?
The blockchain ledger is the record of all blocks ordered chronologically.
The network is made of ordinary Joe’s and Jane’s who are using their computers to maintain the ledger. They do that because of the incentive that comes in a form of a small fee from every successfully completed block.
Conclusion
And that’s how cryptocurrency work. We find it valuable and have faith in it. That’s basically all a commodity or currency needs to be considered valuable enough to be the part of the market exchange. If you want to learn more about cryptocurrency, check out Cryptocurrency Institute.