The Basics of Cryptocurrency and How it Works
Cryptocurrency is a digital currency recorded in a ledger of accounts and transactions between peers using a system of verification and encryption.
Transactions are made by sharing public passwords attached to a private and encrypted digital wallet. Each password relates back to a “block” of transactions on a digital ledger (called a blockchain) and represents X amount of digital coins.
To rephrase the above in simple terms: cryptocurrency is essentially a digital ledger of transactions, secured by cryptographic codes, that acts as a decentralized currency, which can be exchanged between peers by sharing public passwords that relate back to digital wallets.
How Does Cryptocurrency Have Value?
Just like any other currency, from the US dollar to the money in your Paypal account, currency primarily has value because we all agree it has value. Meanwhile, secondary factors include: a limited supply, a demand for it, use-value in an economy that accepts it in terms of exchange-value, because there is work behind it, etc.
The same is true for cryptocurrency. It has little inherent use-value, with the same being true for bank credit in a bank account, but it none-the-less has value in the modern economy.
We agree it has value (for whatever set of reasons), thus it can be traded for other things with value (such as real world goods and services).
With that in mind, although it is like centrally-backed state-issued fiat currencies in many ways, there are notable differences. The main differences being it isn’t backed by a central government, it isn’t regulated by a central bank, and you can’t use it to pay your taxes (it isn’t legal tender).
Labor Theory of Value and Cryptocurrency: It takes a work to confirm cryptocurrency transactions, secure a cryptocurrency network, and to mint new coins. Specifically these things take the “hash-power” of miners (who confirm new transactions and in the process secure the system and create new coins). That work isn’t for nothing. The work produces a secure ledger and secure digital decentralized currency usable on the internet anywhere in the world (so the value also represents the value of having a sort of decentralized digital bank, accountants, and system of digital currency). When we take wheat and turn it into bread, the work done adds value to the final product. Bread has more value than wheat on the market. When we take computers from around the world and turn them into a network that secures and creates a decentralized peer-to-peer one world digital currency, that has value. Learn more about the labor theory of value.
Cryptocurrency Is Decentralized
Unlike traditional currencies, cryptocurrency is decentralized. Instead of one entity (such as a bank or central government) controlling the creation of money and keeping track of the ledger and accounts, each member of the community (each account holder) contributes to a single, public ledger of transactions and each member can create money through confirming transactions.
When a transaction is made, the spender and receiver each use a unique digital signature. A digital signature uses a public key (to create a signature and to send money to) and private key (used by others to verify the signature) that can be used to legitimize the transaction. This helps ensure that transactions are recorded correctly and that the spender owns the money they’re trying to spend. Time Stamping helps to ensure that the order of transactions is chronological. This is done by placing a group of transactions in a “block” that gets appended to the coin’s ledger. Everything in that block is considered to happen at the same time. Once a block is recorded, it is permanent and publicly visible.
Adding Transactions to the Ledger Is “Mining”
The entity that verifies the transaction and adds it to the ledger is called a “miner”. This is because when a transaction is added to the ledger, new coins are created and given to the entity as part of the fee (garnering the nickname “mining”).
To learn more about what mining is and how it works, visit our page on The Basics of Mining Cryptocurrency.
Example of Transferring Cryptocurrency
One of the best ways to learn about cryptocurrency is to see a real-world example. Let’s say Joe wants to buy a Pizze from Jane with a hypothetical cryptocurrency called FactCoin. Bellow, we’ll go through each of the steps that makes this possible.
Step 1: Joe and Jane Make a Transaction
In order for Joe to transfer 1 FactCoin, he sends out a transaction to every member of the FactCoin Network. In simple terms, this is a message to everyone with FactCoin accounts stating that he is transferring 1 FactCoin to Jane. To keep their identities safe, Joe use unique, encrypted codes that act as IDs for his FactCoin account and Jane’s FactCoin account. These accounts are often called addresses. Usually Joe and Jane will be using software to enable these transactions and to manage their accounts called a cryptocurrency wallet.
Step 2: FactCoin Miners Verify the Transaction
Everyone in the FactCoin network will receive the transaction that Joe sends out. Then, all of the FactCoin Miners – special members of the network who invest computational effort into verifying FactCoin transaction – compete to add that transaction to the ledger.
In order to add that transaction, they have to solve a complex math problem with the help of computers (this prevents Joe or Jane from being the one to write and record the transaction). The first one to solve the problem sends out a message to everyone who owns that coin type and declares that the transaction has been added. Everyone in the community then updates their ledger.
Step 3: Jane Gives Joe a Pizza
To be safe, Joe and Jane wait until the transaction is complete before exchanging the real world product or service, this helps avoid some potentially scamm-y things (like double spending) that can happen between the initial message and the confirmation of the transaction. The process usually takes about 10 minutes.
Once the transfer is recored in the ledger, the transaction is permanent. There is no way to recover lost funds or funds transferred in error. Jane gives Joe the pizza that he has now paid for, and the process is complete!