How Cryptocurrencies Work: From Blockchain to Digital Ownership

Understanding Blockchain Technology

Blockchain is the fundamental technology behind the creation of cryptocurrencies. A blockchain is essentially a decentralized digital ledger that documents and chronologically records transactions across a network of computers. Copies of the ledger are maintained on separate machines known as nodes.

Transactions occurring within a network are compiled into a block along with other transactions and are then verified. Once a block is verified it is permanently linked to previous blocks creating a chain. Thus, a blockchain provides a chronological record of activity which is resistant to alteration.

Due to the fact that every individual node maintains a copy of the ledger, the blockchain itself does not rely on a centralized database. Therefore, changes to the ledger are subject to verification from the entire network prior to acceptance. This approach enables the blockchain to maintain consistency among thousands of different nodes.

Transparency in blockchain systems is also another critical element. Most cryptocurrency networks enable individuals to access and view historical transaction records through the use of public blockchain explorers.

Key Characteristics of Blockchain Networks

The unique characteristics of blockchain systems differentiate them from the typical database.

1. Blockchain Systems use multiple computers to store all of the records of transactions; therefore, one computer or organization cannot control an entire blockchain system.
2. Each block contains information about the previous block by way of a cryptographic link, creating a never-ending chain that prevents tampering with the ledger.
3. New entries into a blockchain are validated by other members of the network (participants) using mechanisms of consensus to ensure that the entries being made are legitimate.
4. Once a block is placed into the blockchain, it is virtually impossible to alter, as altering would require changing each of the blocks that follow the altered block.

These attributes of blockchain systems make it possible for decentralized networks to be used as secure and reliable record keepers of value and transfer of digital assets.

Decentralization and Trust in Cryptocurrency Networks

A major difference between cryptocurrency networks and traditional financial systems is the reliance on centralized intermediaries such as banks, payment processors, etc., that hold and verify records of transactions. The decentralized nature of cryptocurrency networks replaces these intermediaries with decentralized consensus.

Decentralized Consensus is when participants in the network collaborate to verify the occurrence of events within the network. All of the transactions made within a decentralized cryptocurrency network are broadcasted to the nodes of the network for validation. The nodes verify if the sender has sufficient funds to make a valid transaction and if the transaction is compliant with the network's rules. If the transaction is compliant with the network's rules and the sender has enough funds, then the transaction will become part of a block and will eventually become a permanent entry in the blockchain.

Decentralized trust is achievable due to the combination of cryptography, game theory, and distributed computing in blockchain networks. Incentives exist for participants to follow the rules of the network, as they help contribute to the value and security of the network. This allows for cryptocurrency networks to operate with out a central governance body, yet still provide reliable record keeping of transactions.

Consensus Mechanisms: Securing the Network

Blockchain technology uses a consensus mechanism to achieve agreement among decentralized participants regarding what constitutes a valid transaction on the network. A blockchain network relies upon thousands of separate, non-centralized computer systems (nodes) to produce a single ledger. Without a consensus mechanism, a blockchain network could be unable to reliably produce an accurate ledger at each node in the network.

Multiple cryptocurrency networks employ different types of consensus algorithms; two of the most commonly employed consensus algorithms include Proof of Work and Proof of Stake.

Proof of Work

The original consensus algorithm employed in cryptocurrency networks was Proof of Work. A Proof of Work system secures a network through the creation of computational work by miners.

A miner competes to solve a series of increasingly difficult mathematical problems (puzzles), thereby creating the next block in the blockchain. The miner that first solves a puzzle will broadcast the block to the network, and all of the nodes on the network will then verify whether the computational work performed by the miner was sufficient to validate the block.

When a miner creates a valid block, it is appended to the blockchain and the miner is rewarded with the creation of new cryptocurrency units (along with transaction fees).

Creating this type of computational work is extremely resource-intensive (energy-consuming). However, because the resource-intensity of the computation required to perform this task is so high, it is also very difficult for malicious actors to successfully manipulate the blockchain.

Proof of Stake

An alternative consensus mechanism called Proof of Stake was subsequently designed to significantly reduce the energy requirements of a blockchain network, while still ensuring the integrity of the blockchain.

Unlike a Proof of Work system, a Proof of Stake system does not rely on computational work performed by validators to secure the blockchain. Instead, validators are chosen (selected) for participation in the validation process based on the amount of cryptocurrency that they hold and commit to the blockchain (the stake). When validators engage in staking, they provide a portion of their cryptocurrency holdings to serve as collateral to ensure their honest behavior in validating transactions and creating new blocks in the blockchain.

In exchange for their contributions, validators are entitled to a share of the total rewards available in a Proof of Stake system, which can include a proportionate allocation of newly-issued cryptocurrency units or a percentage of the transaction fees paid to the validator for each transaction processed on the blockchain. Because validators have a direct financial interest in the performance and reliability of the blockchain, they have a strong incentive to behave honestly and avoid engaging in any activity that may jeopardize their stake in the blockchain.

Mining and Staking in Practice

Mining and staking provide two ways of creating trust in the Blockchain community.

Mining is performed by powerful computers that make thousands of calculations per second to prove the legitimacy of the blockchain and allow it to work properly.

Staking is when you put your cryptocurrency at risk (by locking it) to help prove that a certain series of transactions took place. The longer you participate in helping to validate transactions, the greater your chances of earning rewards.

When mining, the miner receives both an allowance of new coins plus a portion of the transaction fee charged to the user who sent the coin(s) being mined.

When staking, the reward is given out to the validator in proportion to the amount of cryptocurrency they choose to stake, as well as the amount of time they have committed to participating in the validation process of each block.

The primary purpose of both methods is to create a situation where a participant's economic interests are aligned with good behavior in a decentralized network.

Digital Assets and Token Supply Models

Many digital currencies are considered a type of digital asset, or token, because they are a unit of value that exists solely in a digital format. Each token represents a specific set of rights that are defined by the rules of the blockchain protocol on which the token is built.

Each cryptocurrency will have a token supply model that defines how new tokens will be created and released into circulation and/or how many total tokens may ultimately exist.

For example, some blockchains have a fixed supply limit for their tokens; i.e., there will never be more than 21 million Bitcoins available for circulation. This fixed supply helps to support Bitcoin’s position as a scarce digital currency.

In other cases, the token supply increases gradually and predictably through time using an inflationary model; i.e., tokens are continuously added to the supply as the network grows.

A cryptocurrency's token supply model greatly influences how the public views the potential long-term value of the currency. Currencies that have a clear and predictable issuance schedule tend to draw significant interest from investors who see the currency as a means to store value digitally.

Types of Digital Assets

Several types of digital assets exist in the cryptocurrency market place.

• Native cryptocurrencies (also known as base coins) are the native coin of a particular blockchain. Most blockchains use native cryptocurrencies to pay for transaction costs.
• Utility tokens give users access to certain services or applications running on top of a blockchain platform.
• Governance tokens grant users a vote to shape the future of a particular protocol based on its community's needs.
• Stablecoins stabilize their prices by pegging them to traditional currencies such as the U.S. dollar or other financial instruments.

These categories show that the purpose of the digital asset varies depending upon what service or application it supports.

Public and Private Keys: The Foundation of Digital Ownership

Ownership of cryptocurrency is controlled by cryptographic key pairs which allow users to manage the flow of money (i.e., send, receive, etc.) without needing to reveal their personal identities.

There are typically two major parts to each user's wallet: a public key and a private key.

A public key works much like a mailing address. A public key can be shared with others allowing them to send cryptocurrency to your wallet. Many wallets will take a public key and create a shortened version called a wallet address.

A private key works much like a password and is the key to proving you own the assets stored at the address created by your public key. Whoever has control of a private key can authorize transactions using that private key.

Therefore, keeping private keys secure is very important because if you lose your private key you also lose the ability to have access to the funds associated with that private key.

How Transactions Are Verified

When a user sends some type of cryptocurrency to an address, there are several processes happening in the network at the same time.

• A user will sign a transaction using their private key (this proves that they have the authority to use the funds).
• A transaction is sent out to the network. Each node on the network verifies both the transaction's signature and whether the sender has enough money in their account.
• If verified, a group of transactions are bundled together in a block that is added to the blockchain once a majority of the nodes agree on this addition.
• Once a transaction is confirmed, it is now an unchangeable entry in the permanent public ledger (blockchain) which prevents reversal.

The whole process allows for secure transfer of ownership of digital assets from one owner to another.

Factors That Influence Cryptocurrency Price Volatility

Price volatility is a common characteristic of cryptocurrencies. Prices may rapidly increase or decrease as a result of numerous interrelated factors.

A large factor that impacts price is market sentiment. News regarding the development of technology related to a particular cryptocurrency, news regarding a change in regulations affecting the sale of the cryptocurrency, or even information regarding adoption by major institutions, all of these will shape participants' views on the potential future value of a particular digital asset.

Another important factor that influences price volatility is liquidity. Digital assets that trade less frequently may exhibit larger price movements as a result of larger trades taking place.

Finally, price behavior is impacted by the amount of network activity occurring in a given blockchain. As the number of people utilizing a blockchain increases so does the demand for its native token. Users must pay transaction fees in order to make purchases using the token.

The Expanding Cryptocurrency Ecosystem

Blockchain technology is still evolving as researchers, developers and business entities continue to find new applications for decentralized systems.

There are today thousands of digital assets (also known as cryptocurrencies), hundreds of exchanges and a world wide community of developers and users which all contribute to an environment where financial transactions can be completed through a decentralized system with no central authority or intermediary.

An understanding of how Blockchain works; consensus mechanisms; wallets and digital assets will provide you with a base to navigate this area of digital finance.

Cryptocurrencies have become an ongoing experiment in digital finance and that the underlying blockchain technology continues to evolve as new concepts and applications are developed and adopted by various industries.