A beginner’s guide to how cryptocurrencies work

One thing is certain, regardless of where you are in the cryptocurrency trend: These digital currencies are having a significant impact on the general public and don't seem to be going anywhere any time soon. Notably, El Salvador recently made bitcoin legal tender, and Eric Adams, the incoming mayor of New York, wants to make the city a hub for cryptocurrencies.

According to a recent Pew Research Center survey, nearly 90% of Americans have heard of cryptocurrencies, despite the fact that only 16% of Americans claim to have invested in, traded, or used it.

In general, proponents of cryptocurrencies and decentralized finance (where individuals can conduct financial transactions with one another without the intervention of a middleman or centralized body like a bank) contend that these platforms are transparent and anonymous at the same time, both of which are advantageous.

The foundation of all cryptocurrencies, the blockchain, is the key to realizing this ambition. Every transaction is recorded on the blockchain, which acts as a public ledger or virtual hall of records, along with the amount involved and the wallet addresses of the parties involved.

However, detractors and regulatory agencies are concerned about the potential for harm from cryptocurrencies, such as people using them for scams, money laundering, or funding illegal activities (along with the enormous carbon footprint that some of these cryptocurrencies have; according to The New York Times, Bitcoin consumes more electricity than some countries). Experts have also expressed worries about the resilience of bitcoin networks to attacks and whether some systems' designs have changed over time to become more centralized or naturally favor the wealthy.

Here is a brief explanation of the computer science underlying these systems for those who are just dipping their toes into the cryptosphere.

What cryptography is all about

This is what happens when you transmit and receive cryptocurrency, to start at the front end. Keep in mind that all cryptocurrencies, including bitcoin, are merely based on computer programs and that these "coins" are merely snippets of computer code that transfer value from one user to another rather than genuine units of currency. You need to first construct a digital wallet in order to participate in this process. There are wallet recommendations for both Bitcoin and Ethereum, and specialized exchanges like Coinbase and Gemini also provide wallets.

The algorithm powering the cryptocurrency will produce a matched private key and public key whenever you establish a new wallet. The public key can be compared to an address or bank account number, while the private key serves as ownership documentation. Where the crypto should be sent is determined by the public keys, which are a lengthy string of characters. The addresses typically only accept the cryptocurrency they are associated with (although something called cross-chain bridges and exchanges can help link up different cryptocurrencies).

According to Nicolas Christin, an associate professor of computer science, engineering, and public policy at Carnegie Mellon University, "You do not have bitcoins in your possession—you have documentation that someone previously sent you those bitcoins."

Then, you can use some of the remaining funds in your wallet to transmit money to another person's public key. The system generates a small personalized piece of code that is connected to the transaction when you sign to confirm that you want to transmit the bitcoins, locks up that value, and scrambles the code as part of a mathematical problem. The recipient will include a corresponding piece of code into the transaction when they are prepared to use the funds. The two pieces of code's compatibility can be verified by everyone on the network (using a procedure called transaction confirmation, often known as mining; more on that later). Signature verification refers to the complete process.

Without the necessary information, it's impossible to locate a missing component, but anyone can easily confirm that two pieces fit together, according to Christin. Beyond signature verification, Bitcoin has extremely limited additional computing capabilities. Initially, Satoshi Nakamoto's [the assumed name of Bitcoin's developer] ambition was to have programmable money. The issue is that Bitcoin's developers choose to freeze the functionality at their current state because of how quickly it gained popularity.

A lot of contemporary cryptocurrencies are based on the Bitcoin model. For instance, Litecoin and Bitcoin are very similar, however the puzzle element was significantly changed. They substituted a function named Scrypt for the Bitcoin mining algorithm (SHA-256), claiming that Scrypt consumes less energy. On the other side, the developers of Bitcoin Cash split out from the Bitcoin development team to create a cryptocurrency that is similar to Bitcoin but can process more transactions per second.

But Ethereum follows a different strategy. Engineers can build on its blockchain's additional "loops" functionality, which enables it to run a piece of code repeatedly. In order to run a programming instruction, Ethereum employs a mechanism called "gas" that charges the person who began the transaction a fee. As it runs, the application uses up the "gas," and when it runs out, it either finishes or shuts down.

Since they are all pieces of code, developers can use Ethereum to build a cryptocurrency (like the stablecoin DAI), mortgages, or one-of-a-kind non-fungible tokens (NFTs are links that point to digital assets within the blockchain, or to objects that sit off the blockchain). All of those are pieces of code, according to Christin, that extend Ethereum transactions.

The clever invention of adding smart contracts to their blockchain is also credited to Ethereum. The creators of Ethereum refer to these as scripts of code that "perform some operations or computation if certain circumstances are satisfied," likening the logic to that of a "vending machine." For instance, the artist can set a royalty schedule that charges a fee each time a piece of digital art is moved on the blockchain if it is contained within a smart contract.

Imagine going into a bank and asking to borrow $10 million for the day without mentioning your name, as another illustration. A red button will eventually be reached for under a desk, predicts Cornell Tech computer science professor Ari Juels. But you can actually carry out this kind of activity on a blockchain.

Using a smart contract, you could borrow money and utilize it anyway you pleased. For arbitrage, you typically buy and sell tokens at a profit. The loan repayment process follows, and it all happens in a single transaction. According to Juels, "blockchains work in such a way that if you fail to repay the loan, the entire transaction may just be aborted, which means that it's as though you never borrowed the money in the first place."

Let's further draw back the blinds now: Any cryptocurrency system needs a mechanism to add new currencies to the network and a way to keep track of where each coin has been and is currently located in the public ledger in order to function.

However, since all of these cryptocurrencies are peer-to-peer in nature, no single organization handles all of this, unlike a regular bank. Instead, the entire network of participants is in charge of managing the system, which is why they must reach some sort of agreement on whether transactions are genuine or invalid. On the blockchain, each transaction must be validated. A block is made up of a group of transactions, while a chain is made up of numerous blocks.

According to Juels, "the blockchain offers you a different trust paradigm." The rules are extremely clear, and transactions may be carried out in a precise, programmatic manner.

To carry out those two common goals, many cryptocurrencies employ a range of techniques. The majority of cryptocurrencies, including Bitcoin and Ethereum, use the proof-of-work method to do this. Even while all users have the opportunity to ultimately determine whether the transaction was genuine, only one user can be chosen to take the lead in the validation, add the transaction to the blockchain, and earn a reward. New currencies are introduced into the system through these awards. This process is also referred to as mining. The users, known as miners, must first compete with one another to solve a cryptographic challenge whose difficulty increases in direct proportion to the number of people attempting to solve it. An algorithm creates the puzzle. The only way to solve it is to attempt a variety of numbers, and powerful computers or processors can test a larger variety of numbers more quickly and are therefore more likely to find the right solution.

With Bitcoin, there are only a finite number of bitcoins in circulation (21 million), and mining rewards diminish with time. Despite this, miners are still rewarded since they can take a cut of the transaction fee. "One vote per CPU was Bitcoin's ultimate goal. That finally has been undermined," claims Juels. People are taking part in the system by employing specialized mining devices. As the competition for bitcoin increased, people constructed and destroyed specialized devices, consuming massive amounts of electricity and producing mountains of garbage.

According to Juels, "Proof-of-work still operates on the fundamental idea of requiring a resource investment in order to participate in the system to mine blocks."

Proof-of-stake systems, on the other hand, need token staking as a resource investment in order to join, similar to making a security deposit that is refunded once the network has approved the transactions you added to the blockchain. A staker who is online at the moment is randomly selected by the system to validate transactions and collect rewards. Theoretically, it ought to use less energy as it doesn't involve solving puzzles.

According to Juels, your contribution to the Bitcoin system is inversely correlated with the amount of processing you perform. It is proportionate to the amount of bitcoin you have in the system under a proof-of-stake system.

According to him, "both proof-of-work and proof-of-stake systems often function in a fashion where the rights to produce the next block are selected arbitrarily in a form of lottery where your chances of winning the lottery are proportionate to your resources."

Ethereum claimed to be switching to a proof-of-stake system, although this shift has not yet taken place. Proof-of-stake is now being used by several cryptocurrency projects, each of which has its own variant. For instance, Cardano employs the "Ouroboros" proof-of-stake mechanism, which combines stake delegation with stake pools. Additionally, Solana, a blockchain on which you can also create smart contracts and other decentralized applications, combines proof-of-stake with the proof-of-history consensus process to include timestamps in transactions.

Proof-of-stake is quicker and uses less energy, but many experts worry about its stability and entry restrictions. "In theory, you can just start mining with your laptop for bitcoin. You wouldn't succeed, but you can enter the system without making any kind of prior resource investment, says Juels. "For these proof-of-stake systems, in order to join, you must either purchase some coins or receive the coins at the start of the protocol. Some individuals find it objectionable that they must first acquire coins in order to participate, but it is necessary.

As an alternative, a cryptocurrency project called the XRP ledger utilizes a consensus system that is essentially democratic—unlike proof-of-stake or proof-of-work—but validators are not compensated.

There is still another idea to understand. In a proof-of-storage scenario, also referred to as a proof-of-space scenario, you commit a certain amount of space for network storage. "At first, the plan was for digital preservation—we wanted to record everything so that we could at least make good use of the disk space. It seems to be less necessary than we initially believed," adds Christin. Digital preservation is necessary, but it doesn't scale as quickly as a currency would. According to Juels, these systems might be beneficial for storing data from NFTs. Filecoin is a project that is putting this idea to the test.

Despite progress with major financial systems like PayPal, Mastercard, and Robinhood, the future of cryptocurrencies is still up in the air because of impending government rules that may fundamentally alter the ecosystem and the community. Additionally, the value of cryptocurrencies like bitcoin is still unstable and entails dangerous investments. Regardless of where the future of cryptocurrencies goes, it is undeniable that the widespread use of this cutting-edge technology has already compelled major financial institutions to change the way they view how people want to interact with money and each other.