How do cryptocurrencies work?

Bitcoin blocks connecting to each other.

Often referred to as virtual or digital currency, crypto works differently from the traditional systems that we’re used to. Unlike these systems, no one entity, like a Government or a bank controls it. Crypto is decentralised. So, how does it work? It relies on a technology called the blockchain. Let’s have a look at how the blockchain works, and how it allows cryptocurrencies to operate.

What is the blockchain?

The blockchain is a decentralised and distributed ledger. It’s powered by a vast network of interconnected computers that work together to record and secure entries made into it.

As the name suggests, you can imagine the blockchain as a chain of digital blocks. Each of these blocks contains a list of transactions linked together in a chronological order, creating an immutable and transparent record of activity. Every participant in the blockchain network can access a copy of this ledger, ensuring that information is not stored in a single location susceptible to manipulation.

Reaching consensus on the blockchain

In traditional industries like finance, centralised authorities play a pivotal role in overseeing transactions and maintaining records. 

In blockchain technology, there is no centralised authority, so all transactions must be approved by the majority of participants in the ecosystem through a consensus mechanism. Participants in the blockchain effectively must collectively agree on the validity of transactions, eliminating the need for a central authority. 

There are two main types of consensus mechanism:

Proof of Work (PoW): this method requires digital validators (or miners) to solve complex mathematical problems to validate transactions. They compete with one another and once solved, the transaction is validated and a new block is added to the blockchain. The resource-intensive nature of PoW ensures the security and integrity of the network as it would be incredibly expensive and ultimately unprofitable to game the system.

Proof of Stake (PoS): this replaces the competitive mining process with a more cooperative approach. Validators, holding a certain amount of cryptocurrency as collateral (staking), confirm the validity of transactions through cryptographic algorithms. Once this confirmation is obtained, the new block is added to the existing blockchain. If the transaction is fraudulent, you are penalised either by having some of your stake removed or simply not receiving any reward.

Transactions on the Blockchain

All crypto transactions are recorded on the blockchain as a result of either of these consensus mechanisms. When a user initiates a transaction, it is broadcast to the network. Nodes on the network then verify the validity of the transaction through the chosen consensus mechanism.

Once validated, the transaction is grouped with others to form a block that is added to the existing blockchain, creating a permanent and immutable record.

Investing in cryptocurrency may result in the loss of capital as the value can fluctuate.

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