How Does Cryptocurrency Work?
If you have no clue what a crypto is, or how it works, this article will explain the basics on how cryptocurrency works. The process is a bit complex and we will try to make it easy for you.
We have all heard the story of the programmer who bought two large Papa John’s pizza for 10000 bitcoins. This happened on May 22, 2010.
The price of the 10000 bitcoins at that time was around $30. Currently, the same number of bitcoins is worth over $100 Million! Are you surprised? That’s how much crypto has evolved and grown in less than 10 years.
The main purpose of this article is to expand your knowledge about cryptocurrency trading, explain its functioning so that you even you can start trading them.
This entire article will cover the elemental points of how cryptocurrency works. We will discuss about cryptocurrency exchanges, crypto trading, as well as cryptocurrency mining.
What Is Cryptocurrency?
Cryptocurrency is a decentralized digital currency. Encryption techniques are used to generate and verify the crypto transactions.
It is decentralized because no government or single organization has control over the price movements of these crypto assets.
Instead, a peer-to-peer network is the medium of crypto transaction from one place to another place. There is no intermediary while transferring money. No central bank or financial firms are involved with the cryptocurrency transaction.
Let’s have a look at the peer-to-peer network.
When two or more computers are connected with each other and ready to share resources or information without connection with other servers is known as a peer-to-peer network.
It is a networking system that is broadly used in the block-chain network. In block-chain, a peer-to-peer network is
“In which interconnected nodes (a point in a network or diagram at which lines or pathways intersect or branch) or peers share resources amongst each other without the use of a centralized administrative system.”
You have full control over your assets. The transaction record is kept on a public ledger. This public ledger is called the blockchain.
Blockchain is a decentralized digital public ledger where a record of every crypto transactions is stored.
It is called blockchain because its structure resembles blocks which are connected by chains.
The block contains transactional information such as the date and time of the transaction, and the amount transacted.
It also contains information about the participants involved in the transaction. Instead of the real names, the digital signatures are stored.
Thus anonymity of the users are maintained in a blockchain. Each block is unique from other blocks with the help of a unique code named ‘hash‘.
The ‘chain’ is blockchain refers to the public database which can be accessed by anyone. The blocks containing the digital information is stored here.
Anyone can check the authenticity of the transactions and hashes as all information is public.
It contains the transactional data and the hash information of the current and previous block but it never stores the IP address of the owner.
Thus, by looking at the blockchain, you can find out the number of transactions carried out, and the amount, but you can’t trace the participants in the transaction.
How Does Cryptocurrency Work?
Like previously mentioned, a peer-to-peer network is used for crypto transactions.
The transaction completes when funds or amount transferred from one digital wallet to another digital wallet.
People store the digital ‘coin’ in a secure software called cryptocurrency wallet.
A common beginners misconception about cryptocurrency is that is is physical and resembles a coin. In reality, it is a digital currency and you can’t touch or feel it.
This digital wallet is also used for sending digital currency for personal as well as business purpose.
There are hardware wallets that are considered safer than its software counterpart. As the soft wallets generate private keys on the internet, it isn’t considered 100% safe.
For securing a crypto wallet, there are two keys; one is a private key and another one is a public key.
To transfer funds, you need to use the public key or public address. To secure your own wallet from outsiders or hackers, you need to have your own private key.
Therefore, you should never share your private key with anyone. Let’s explain the transfer of crypto funds using an example.
Bob needs to make a crypto payment to Mike. He decides to send 0.003 BTC (Bitcoin) to Mike. Bob logs into his wallet and clicks on the send button. Next he enters the public wallet address of Mike and enters the amount to be sent.
Remember that Bob needs to have this amount in his balance for the transaction to happen. He then hits send the transaction happens instantaneously.
Mike receives this amount immediately in his wallet without any issues. Crypto transactions are fast and secure.
After this process, the transaction news is broadcasted into the crypto network and this record is stored in the public ledger. To record into the public ledger, there is a process maintained by users called mining.
In the public ledger, traders keep track of each transaction from various corners of the world. There is zero possibility to change the information from blocks.
The transaction amount is public, meaning anyone can see your last transaction as the same time your wallet balance. However, the sending process is encrypted.
The sender and the receiver mainly announce some information before sending or receiving funds.
The following information is visible to everyone involved in the transaction.
- Account holder name
- wallet address of the person who is going to receive the funds
- The amount to be transferred.
Crypto vs Bank Transfer Fees
The great thing about transactional fees in crypto is that it is very minimal (usually less than 0.1%). This is far lesser than the bank transfer fee.
For example, when transferring funds via bank, consider the following example:
To send $10000 internationally via bank transfer, you’d need to pay $500 (roughly) as outbound fees and the receiver would pay $80 as inbound transfer fee.
The receiver receives $9500 and the total transfer fee amounts to $580. The whole process could take up to a few days.
Alternatives to bank transfer such as money transfer service could cut down the transfer cost to roughly around $100.
Now consider the crypto situation. If this same amount ($10000), were to be send in cryptos, the transfer cost would be about $0.5 or 50 cents.
It would cost nothing if the transactions happened using the same hardware wallet. And this transaction happens instantly so there is no waiting time.
Thus you can realize, how fast and reliable crypto is compared to traditional fiat.
Purchasing goods through bitcoin or other cryptos is now prominent in almost every country.
As this is decentralized by nature, people are starting to realize the advantages crypto holds over the traditional currencies.
Cryptocurrencies are now used to carry out even the smallest of transactions.
How Do Crypto Exchanges Work
Cryptocurrency exchanges are online platforms where you can trade and exchange one cryptocurrency for another.
You can also exchange crypto for fiat or the other way around.
Some exchanges only deal in cryptos while others deal with both crypto and fiat. You need to setup an account with the exchange to start crypto transactions.
Crypto can be bought and sold peer-to-peer or there can be cryptoucurrency brokers where the transaction happens between the broker and the customer.
The broker sets the price for these cryptos. It is slightly higher than the market price where they earn a premium.
Before starting the trade, for novice traders, it is compulsory to choose a reputed and regulated exchange platform and a broker.
In the crypto market, users often use the direct exchange platform or peer-to-peer exchange because this platform is suitable for both decentralized and centralized crypto coins.
As I mentioned before, you need to have a crypto wallet to perform your trading.
To implement trading you have to consult with trusted and regulated brokers. Brokers are working as third party and then help traders to perform their trading.
To execute the exchange process you need to have an account and secure password for that account. The customer places an order into the exchange platform.
The information of the transaction directly goes to the crypto wallet. Here, traders sometimes use “Hot” wallet to perform trading and sometimes use “Cold” wallet.
The ledger keeps all track of the transaction or that particular exchange report. It is necessary to mention that, “Hot wallet” is less secure than the “Cold Wallet” or “Cold Storage.”
Here cold refers to offline/hardware wallets that we mentioned earlier, and the hot wallet is the software wallet.
We will now discuss information regarding on how cryptocurrency mining works.
How Does Cryptocurrency Mining Work
There are thousands of cryptocurrency available. All are unique and have some use-case to them. Some cryptos are decentralized and some are centralized (controlled by a central authority).
The trading method is similar for all of them but for mining, there are few differences, which we cannot overlook. Let’s explain what mining is:
In cryptocurrency, mining refers to the process where an individual or a group of individuals, use dedicated mining rigs or computers to solve complex mathematical equations in order to validate a block of transactions.
These equations are a part of the encryption process so that no outsider gets access to the sensitive data.
The first person/group to solve these equations and complete the validation of the block transactions receives a ‘block reward’.
In return, the miners receive the cryptocurrency that they have validated as proof-of-work.
So bitcoin miners validating blocks of transactions will receive bitcoins as block rewards. This is how miners make money.
Bitcoin was the first cryptocurrency and hence it was the first crypto to be mined. Bitcoin mining is the process to release new bitcoin by solving complex mathematical problems.
Evolution Of Crypto Mining
The earliest mining was done using only a CPU of a computer. This method was quickly outdated and if currently, it would take you decades of CPU mining to even earn a single bitcoin
After a year or so, GPU (Graphical Processing Unit) mining was introduced where a computer’s GPU power would be utilized for mining.
GPU mining was vastly superior to CPU mining with more than 30 times increase in the mining speed.
Both CPU and GPU mining are time consuming as well as expensive as it uses a lot of electricity.
As time progressed and the block reward reduced, dedicated crypto mining rigs were introduced. These are also known as ASIC (Application Specific Integrated Circuit) rigs.
These rigs were specifically designed for mining crypto and hence, their hardware was optimized to maximise the crypto mined.
Mining rigs proved to be far more efficient than any other previous mining methods and is the current gold standard used by miners worldwide.
In addition, there are cloud mining companies that mine on behalf of you for a fee. This way you won’t have to own any hardware and still earn cryptos.
Complexity Of Crypto Mining
If you think you can mine cryptocurrencies by solving these mathematical problems manually, it will take you many years or even your entire lifetime to mine an insignificant amount of crypto.
For example, to mine bitcoin, miners have to guess a specific single number from a 64 bit hexadecimal number. That sounds almost impossible, doesn’t it?
The hexadecimal definition in mathematical term is
“Hexadecimal (also base 16, or hex) is a positional numeral system with a radix, or base, of 16. It uses sixteen distinct symbols, most often the symbols 0–9 to represent values zero to nine, and A–F (or alternatively a–f) to represent values ten to fifteen.”
The reward is now 12.5 bitcoin for mining one block and this reward amount will be the same until 2020. From 2021, this will be halved to 6.25.
The three current mining methods are described below:
There are few mining applications available in the marketplace. You can simply download those mining app and start making money from that. It is easier to mine through those apps.
To run your application, you need to give Bitcoin wallet address and they will send your reward directly to your wallet.
The more powerful the device is, the more bitcoin transaction it will able to process with the help of your necessary command.
As we stated before that there are a few third party mining websites available in the cryptocurrency marketplace. You have to pay the amount to mine Bitcoin and other cryptocurrencies.
This website refers to a cloud-mining website. You have to purchase a contract to mine bitcoin. Your account will be able to mine bitcoin depending on your paying amount.
The minimum contract length is a year. Some mining website will pay you on a daily basis and some will pay you weekly basis. The payment will directly go to your crypto wallet.
Those who are interested to invest in cryptocurrency mining will need to purchase an ASIC mining hardware.
These rigs are expensive and it takes a lot of electricity to mine crypto.
Depending on where you live, mining can be a profitable way of livelihood.
Cryptocurrency is the hottest trend in the world of trading and finance. It is slowly replacing fiat as the preferred form of payment system.
It is digital, fast, secure, and free from any central regulation. Although it has been more than 10 years since the first crypto (Bitcoin) was introduced, the world of cryptocurrencies is still new to many.
In this article, we have tried to give you a basic idea on cryptocurrencies and how they work. More and more use-cases of crypto are being discovered and hence crypto’s importance cannot be undermined.
When choosing a crypto broker or exchange, make sure it is reputed and has a large customer base. Love it or hate it, you cannot avoid crypto in the upcoming future.
Check out our crypto section for more educational articles on crypto.