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How Does Cryptocurrency Actually Work



A Cryptocurrency (or digital currency) is a digital asset designed to work as a medium of exchange in which encryption techniques are used to regulate the generation of units of currency and verify the transfer of funds, operating independently of a central bank. Examples of cryptocurrencies are Bitcoin (BTC), Ethereum (ETH), XRP (XRP) etc.

Bitcoin: A Peer To Peer Electronic Cash System

Bitcoin is a digital currency, a distributed, worldwide and decentralized. Unlike traditional currencies such as dollar.

Commerce on the Internet has been rely almost exclusively on financial institutions serving as trusted third parties to process electronic payments. The costs and the payment uncertainties are the major problems, no mechanism exists to make payments over a communications channel without a trusted party.

A peer-to-peer version of electronic cash system allows online payments to be sent directly from one party to another without a financial institution.  Digital signatures were made for the solution of this problem, but the main advantages shall be lost if a trusted third party is still required to prevent double-spending(The risk that a digital currency can be spent twice). Using a peer-to-peer network was the solution to the double-spending problem. The network timestamps transactions have been made by them in an ongoing chain of hash-based proof-of-work, forming a record that can not be changed without redoing the proof-of-work. The longest chain not only serves as proof of the sequence of events witnessed, but proof that it came from the largest pool of CPU power.  As long as a majority of CPU power is controlled by nodes that are not cooperating to attack the network, they\’ll generate the longest chain and outpace attackers. The network itself requires minimal structure. Messages are broadcast on a best effort basis, and nodes can leave and rejoin the network at will, accepting the longest proof-of-work chain as proof of what happened while they were gone.

A Peer To Peer (P2P) Network

In peer to peer network, many peers(or group of computers) are linked together with equal permissions and share resources. Each computer acts as a node. Files can be shared directly within the group without having a central server. Each computer becomes as a server as well as an client of itself.


Multiple computers connected together via universal serial bus or via internet to transfer files.





We can define an electronic coin as a chain of digital signatures.  Each owner transfers the coin to the next by digitally signing a hash of the previous transaction and the public key of the next owner and adding these to the end of the coin.  A payee can verify the signatures to verify the chain of ownership.


The problem of course was that the payee can not verify that one of the owners did not double-spend the coin. A common solution was to introduce a trusted central authority, or mint, that will check every transaction for double spending.

Without a trusted third party, the solution to this problem was that the payee should have proof that at the time of each transaction.

Timestamp server

The solution for this problem was the timestamp server. A timestamp server works by taking a hash (SHA256) of a block of items to be timestamped and widely publishing the hash, such as in a newspaper or Usenet post. The timestamp proves that the data must have existed at the time, obviously, in order to get into the hash. Each timestamp includes the previous timestamp in its hash, forming a chain, with each additional timestamp reinforcing the ones before it.





Proof-of-Work (PoW) is the original consensus algorithm in a Blockchain network. PoW is a central part of cryptocurrency and blockchain. Mining is a process of generating Proof-of-Work. In technical terms, mining can be called inverse hashing. A miner determines a number that can be used only once.



The steps to run the network are as follows:

  1. New transactions are broadcast to all nodes.
  2. Each node collects new transactions into a block.
  3. Each node works on finding a difficult proof-of-work for its block.
  4. When a node finds a proof-of-work, it broadcasts the block to all nodes.
  5. Nodes accept the block only if all transactions in it are valid and not already spent.
  6. Nodes express their acceptance of the block by working on creating the next block in the chain, using the hash of the accepted block as the previous hash.


That’s how cryptocurrency works, and the cryptocurrency or the blockchain would be a better option than a physical currency or going through the third party.The number of cryptocurrencies are available on the Internet after Bitcoin (2009), about 1600 new currencies have existence on the internet and also growing rapidly.




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