What is a cryptocurrency and how does it work?

A digital version of the cash might be the future of money - potentially putting aside traditional payment methods. The cryptocurrency industry matures every month and more and more people want to create their own digital currency.

There are thousands of different cryptocurrencies on the market. And the process of building your own cryptocurrency can be time-consuming and needs effort.

The first and the most important step in your journey of creating a cryptocurrency is understanding what is cryptocurrency and how it works! A cryptocurrency is a digital payment form that can be exchanged in the real world. It also relies on public-key cryptography for making transactions secure and verifying the assets’ transfer.

Blockchain is the thing most cryptocurrencies rely on. It is simply a chain of blocks. And the block itself is a data structure that contains information (transactions). Every block has its own hash, and it also has a hash of the block that goes before it in the chain. Each hash is a unique identifier, like someone’s name. It is as simple as a line of people, where a person knows his own name and the name of the person behind him, and this line is stored and can be recreated.

What is a cryptocurrency and how does it work?
What is a cryptocurrency and how does it work?

Every transaction and block need this identifier (hash), so we can identify it. To calculate the hash a cryptographic hash algorithm is used, for example, Bitcoin uses an algorithm called SHA256. Data in each transaction or block determines the hash, so if anything is changed, for example, the amount in a transaction, its hash will be changed too.

Another very important thing to remember is that blockchain technology and cryptocurrency rely on decentralization. It means that there is no central point of control, but there is a peer-to-peer network.

A bank is a good example of a centralized system. It stores all your data and money in its own database, which they verify independently. But in a decentralized system, such as a peer-to-peer network (P2P), all responsibilities of verifying and storing data are distributed among the people. Talking about blockchain, any member of the P2P network has a copy of a full blockchain. Multiple nodes store this open data, and that’s what makes it a distributed ledger.

If you need to add a new block to the blockchain, every member verifies whether it is okay to add a new block to the chain and add it to their own blockchain’s version. If 50% of the network agrees on this change, then it is a consensus or majority agreement. After consensus about the blockchain’s new version, this new version will become the accepted blockchain.

If someone changes the data in the blockchain, their version will be different from the accepted version by the majority of the network, and she/he will not be able to get this change onto the real blockchain.

Bear in mind that if someone changes some data in the blockchain, the block's hash will be changed too, breaking the chain. For example, someone changes the value of a transaction for giving them more money and this will break the chain.

However, if all blocks’ hashes were recalculated in the chain, then a valid blockchain could be made again, including their tampered data. This process is possible with a computer that can easily recalculate a block's hash value and the hash value of previous blocks in seconds.

To make sure something like this doesn't happen, the technology of blockchain relies on a proof-of-work algorithm.

What is a cryptocurrency and how does it work?
What is a cryptocurrency and how does it work?

The simplest way to understand this is to imagine 3 variables: x, y and z. We are given the value of z, don’t know the value of y, and we have to find a value of x, so that x * y = z. For solving this, we start with guessing any value for x, for example, 1. We multiple 1 * y and the output we get is if this value is equal to z. In this case, if it doesn’t, we try another value or x, for example, 2. We multiply 2 * y and see whether it equals z. And this process is done to every possible value of x until we get our x * y = z right. The name of this process is brute force. In this process, every attempt is computed until the correct answer is computed. Once the right value for x is found, it is stored in the block that affects its hash (making it correct).

Just keep in mind that this is a very simple basic example and wouldn’t be used because it is too fast to solve. But the main idea is that a proof-of-work algorithm ensures that rewriting the whole blockchain isn’t worthwhile because we have to find out the value of ‘x’ for every block and it would take a very long time.

This process of solving proof-of-work for making a new block for cryptocurrency is called mining.

To sum up, the key characteristics of cryptocurrency here is a short breakdown:

  • Cryptocurrency is a virtual currency that is designed for working as a medium of exchange. You can buy it with traditional money and use it for buying traditional and virtual goods and services.
  • Cryptocurrency’s most important feature is decentralization. The need for certifying asset ownership is eliminated by a distributed ledger, which makes transactions transparent and eliminates fraud.
  • Proof-of-work is a method to secure the cryptocurrency’s ledger.
  • Blockchain is public, so anyone can become a node and join the ledger.

In our next article, you can find out more about creating your own cryptocurrency! We also offer development expertise in cryptocurrency and cutting-edge integration from the line of blockchain services.

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