Cryptocurrencies are de-centralised digital currency token that are freely transferrable within its network of users.
Cryptocurrencies in their current form, are regulated not by a central authority like a ‘Reserve bank’; but collectively by the network.
The basic idea behind the creation of cryptocurrencies is to bring into existence a payment system that moves away from the traditional banking system by allowing peer-to-peer transfer of money over the internet without routing transactions through a bank’s server.
The cryptocurrency tokens are software codes representing some form of monetary “value”.
Block Chain Technology:-
Block Chain is the principal technology used to validate transactions within the cryptocurrency network and to secure the network.
A block-chain is an inter-connected chain of transaction records that is distributed across the network.
A ledger is a record of transactions. In a block-chain multiple transaction records are compiled to form a single block of data. The block is then mathematically validated by solving a hash function and added to the last existing block (of data) – thus forming a chain.
Hashing:-
Hashing is a method of calculating a relatively unique fixed-size output (called a message digest, or just digest) for an input of nearly any size or type (e.g., a file, some text, or an image). Even the smallest change of input (e.g., a single bit) will result in a completely different output digest. [Source]
See example below:
| Input Text | Output Hash Value (SHA-256) |
| 1 | 0x6b86b273ff34fce19d6b804eff5a3f5747ada4eaa22f1d49c01e52ddb7875b4b |
| 2 | 0xd4735e3a265e16eee03f59718b9b5d03019c07d8b6c51f90da3a666eec13ab35 |
Each validated block is represented by a unique hash value. Any tampering with the block data subsequent to validation will produce a completely different hash result and hence easily detected.
The block-chain records are then replicated across the network (of computers) making it almost impossible for anyone to tamper with the transaction records.
Chaining of Blocks:-
Blocks are chained (linked) together with each block containing the hash of the previous block, thus forming the blockchain. If a previously published block were changed, it would have a different hash. This in turn would cause all subsequent blocks to also have different hashes since they include the hash of the previous block. [Source]
Distribution of Blocks:-
Block-chain networks achieve security by distributing the block-chain across the network. Thus, every computer within the network has a record of the chain of block. These computers are known as “nodes”
Security:-
We know that a change in one block would lead to a change in the hash function of that and all subsequent blocks.
Since every node within the network has a record of the chain of Blocks, any mismatch in a block series data (identified by a change in hash functions of the blocks) can quickly be detected and replaced by the “correct” block series as identied by the majority of network nodes.
This is better understood with the help of an example. Let us assume you draw up a ledger of transaction records and then make multiple copies of the ledger and store them in different locations.
If anyone with unscrupulous intentions, gains access to one of those locations and modifies the transaction records in the ledger stored, you can still determine the correct state of balance by accessing the ledgers stored in other locations.
This is how security is achieved within the block-chain network.
Digital Wallets and Cryptography:-
A fundamental technology used by blockchain networks is the public/private key cryptography. The technology uses a pair of keys: a public key and a private key that are mathematically related to each other.
Each user is assigned a key combination: a private key and its corresponding public key. As the name suggests the private key is kept secret by the owner and used to digitally sign documents. Public keys can be made available to a third party and can be used by them to verify signatures generated with private keys.
In a block-chain network, the private and public keys are stored in a person’s wallet. To transfer cryptocurrency tokens to another person, the transferor has to specify the wallet ‘address’ of the transferee. The wallet address is derived from the recipients’ public key.
In a transfer of cryptocurrency tokens, the sender’s private keys are used to digitally secure the transactions.
How a Cryptocurrency Network Operates:-
A cryptocurrency network supports peer-to-peer transfer of cryptocurrency tokens in a de-centralised environment.
In this section, we explore how transfers of cryptocurrency tokens are effected within the network with the help of an example.
For our hypothetical example, let us assume a crypto-currency network with its own cryptocurrency token. Let us name this token F-Coin.
There are multiple participants in F-Coin Network. Each of the participants have a digital wallet (downloaded onto their computers) where they store their F-coin tokens.
We also know that a person’s private-public key combinations are stored in the wallet.
Let us now assume that ‘A’ a participant in the F-Coin networks wants to transfer 1 F-coin to ‘B’.
Under the traditional setup, A would raise a transfer request with A’s Bankers who would then verify the authenticity of the transactions (known as transaction validation) and process the payments (transaction verification).
Under the cryptocurrency network setup, A places the transfer request with the network.
This is where the network ‘nodes’ come into the picture.
Transaction Validation:-
We already know that the network nodes have a record of all block-chains within the network.
Once a network node receives a transfer request (a.k.a transaction request) it checks whether the cryptocurrency tokens are digitally signed – which proves that the transfer request has originated from a valid source.
Once validated, the node will propagate the transaction to other nodes in the network who will propagate it further till the time the transactions are picked by special nodes called ‘Mining Nodes’.
Transaction Verifications:-
The special mining nodes pack multiple validated transactions into data ‘blocks’ by solving a computational problem to achieve a target hash value and add them to the existing block chain.
The mining nodes bring the ‘blocks’ into existence and keep the block-chain running.
Once a new block is added to the chain, the record of the new block is propagated across the network and all the transactions (transfers) within the block get verified i.e processed.
Incentives for Transaction verification a.k.a Mining Fees:-
We know that creating a ‘block’ requires the solving of a computational problem which requires significant investment in hardware and consumes a lot of machine resources and electricity.
In order to incentivise mining nodes to keep verifying transactions by adding new ‘blocks’ to the chain, the network rewards miners in the form of transaction fees and new cryptocurrency tokens.
In the traditional banking setup, transactions fees are borne by the recipient. For example if you pay for your new suit with the help of a credit card, the card company will deduct a fee before crediting the proceeds to merchant account.
Under a cryptocurrency setup the transaction fees are borne by the sender.
Mining for New Cryptocurrency Tokens:-
While transaction fees are one way of rewarding the miners, the network also rewards the miners with new cryptocurrency tokens for each block added to the chain.
This is how the network brings new cryptocurrency tokens into existence.
The process of bringing new blocks into existence is known as mining for its similarities with mining for commodities in the real world. To mine for gold, we need to dig deep into the earth’s surface – a process which consumes energy.
Similarly, cryptocurrency miners also earn new cryptocurrency tokens by solving computational problems to add a new block – which also requires the consumption of energy.
Some cryptocurrency networks like the Bitcoin have a limit on the number of cryptocurrency tokens that can be brought into existence by mining. Others like the Dogecoin have no limit on this number.
More on Digital Wallets and Cryptography:-
In a verified transaction, cryptocurrency tokens are delivered to the recipient’s’ wallet address. We know that the wallet address is derived from the recipient’s public key.
Once delivered, the cryptocurrencies sit in the recipient’s wallet as unspent tokens. To spend the tokens (i.e to transfer the tokens to someone), the user has to use the corresponding private key to unlock the tokens.
If the private key is lost, the tokens are also lost forever.
The public-private key cryptography prevents theft by preventing anyone from gaining an unauthorised access to the tokens.
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A word of note. The presentation is intended to explore the basic functionalities of block-chain and crypto-currencies. This should not be construed as an advice to invest in cryptocurrencies. In fact, I would advice you against investing in cryptocurrencies.
You can read my article on why you should never invest in cryptocurrencies.
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