How Cryptocurrencies Work (and Why They’re So Popular)

bitcoin person touching smartphone

While the meteoric rise of digital currencies like Bitcoin and Dogecoin have been widely documented in the news, the highly technical mechanics behind them may seem opaque. Even US lawmakers preferred to speak in general terms with crypto experts during consecutive House and Senate hearings in December.

“What would you say to people who say, ‘This doesn’t seem like a new financial system per se, but really an extension, or maybe an expansion, of our current system?'” asked Rep. Alexandria Ocasio- Cortez to the panel. at the December 8 hearing in the Chamber.

“What I believe we are seeing is a new open infrastructure layer of the Internet: a missing layer of the Internet that is designed around value exchange and economic coordination and that is rooted in immutable data,” Circle CEO Jeremy Allaire replied.

Ultimately, you don’t need to accumulate encyclopedic knowledge of blockchain programming to meaningfully understand cryptocurrency. A fascinating picture emerges by asking the simplest questions about these unique digital assets:

What is a Blockchain?

A blockchain is a series of encrypted units of information. Before being added to the chain, each “block” goes through an algorithm that produces an encrypted identifier.

“In Bitcoin, it’s called a hash function,” says Xi Wu, a cryptocurrency expert and assistant professor at the Haas School of Business at the University of California, Berkeley. “It’s like a box. You insert the information and it comes out with a string of numbers and letters that is not immediately understandable.

The identifier of the block that precedes it is included in each block, thus creating a chain of encrypted information with a defined sequence.

Cryptocurrency has attracted over 100 million users largely due to the promise of highly secure transactions – the first level of this protection is created by the encryption process. If someone decides to go back to a previous block and change the information to their advantage (for example, you had to add a few zeros to inflate your account balance), this would change the encrypted identifier and therefore “break” the block and all the following. . Essentially, a single digit change could corrupt the entire system.

Like any currency, cryptocurrencies rely on a community of people who agree that they have value. While traditional currencies like the US dollar are produced and regulated by a central bank, cryptocurrencies are produced and regulated by the community that uses them: a copy of the blockchain is stored simultaneously on the personal computers of users around the world . “The fundamental structure of cryptocurrency is a network,” says Wu. “The underlying technology works like a network economy.”

This network provides the second level of security. If someone attempts to modify any piece of information in the blockchain (even if they cleverly cover their tracks), all other computers on the network will reject the modification via an algorithm that reaches consensus.

Come to a consensus

Although all cryptocurrencies operate on a blockchain network, they differ in the mechanism by which consensus is reached. In traditional cryptocurrencies such as Bitcoin, the consensus algorithm is called proof of work. This process requires individuals on the network called “miners” to lend their computer’s processing power to the validation process. When a new block comes forward, these devices compete to find an arbitrary number, called a “nonce”, that can unlock the algorithm. Once the nonce is found, the block is integrated into the blockchain and the miner is rewarded with a certain amount of money.

“Whoever solves the puzzle gets the reward for validating that information,” Wu says. “Then the information is stored on the network and will be distributed to all nodes, or terminals.”

As reviewers have noted, the proof-of-work consensus mechanism comes with a extremely high energy cost. Researchers at Judge Business School, University of Cambridge estimate that the Bitcoin network annually consumes more electricity than the entire Ukrainian country.

Enter the second most common consensus mechanism: Proof of Stake. Instead of competing to solve a puzzle, validators are asked to provide a fixed amount of currency as collateral in order to validate a transaction and receive a transaction fee. This method has much lower energy costs than its counterpart and is currently progressive in from the developers behind the popular Ethereum cryptocurrency.