How Do Cryptocurrencies Work?

If you are just beginning to get involved in the world of cryptocurrencies, you may be wondering how they work. And although each cryptocurrency functions differently, they all follow a similar set of basic rules or protocols.

What Are Cryptocurrencies?

First and foremost, to understand cryptocurrencies, you must know what they are. Cryptocurrencies are digital assets backed by software code instead of a centralized government run banking system. A handful of cryptocurrencies are decentralized in nature, while others have more centralized qualities. Cryptocurrencies are generally used in peer to peer transactions. The main advantage of cryptocurrencies is the ability to send money to anyone at any time, day or night, because they don’t rely on human processing. One of the key value propositions of cryptocurrencies is that it is 24×7, 365 days a year. Compare that to traditional banks, which are open 8am to 5pm, Monday through Friday, except holidays.

Verifying Transactions and the Digital Ledger

The way cryptocurrencies are able to function without government oversight is thanks to their system of verifying transactions via consensus algorithms. When one person wishes to send cryptocurrency to another individual, the transaction is sent to a group of nodes which are operating on the blockchain of the senders’ cryptocurrency of choice. These nodes will work to verify the transaction, and if they come to a consensus, the transaction will be posted to the digital ledger, which is the same as saying it is completed and verified. Cryptocurrency transactions, once on the blockchain digital ledger, cannot be undone (or should not be), making them by definition immutable. This means that once you receive a cryptocurrency payment from someone, they can’t undo the transaction, nor can they send you cryptocurrency which they don’t own. 

Consensus Methods

What differentiates cryptocurrencies from one another is the method they use to come to the consensus mentioned in the paragraph above. Some blockchains, such as Bitcoin, use a method known as Proof of Work (PoW). In this method, the nodes must show POW by solving difficult math problems to verify a transaction for addition to the blockchain. Another popular method of consensus is known as Proof of Stake (PoS), and in this method, the nodes are allowed to verify transactions based on how many coins they have staked in the specific cryptocurrency blockchain. The most famous POS systems are Ethereum 2.0 (which is currently moving from POW to POS), Cardano, Stellar, and QTUM.  

There are also less commonly used consensus mechanisms such as Proof of Authority, which is centralized in nature, as certain nodes will have the automatic authority to approve transactions. There is also Proof of Importance which is a much more specified version of Proof of Stake, where stake is taken into account when nodes are chosen, but so are other factors as well, such as number of past transactions and when the nodes last transaction occurred. 

Overall, cryptocurrencies provide a quick and efficient way to process global peer to peer payments with final settlement using automated computer software code. For more information and how cryptocurrencies can be applied to your life, visit our website: staby.io.