Look at you, well on your way to becoming a Cryptocurrency Genius! You already have a solid foundation as to what Cryptocurrency is and how transactions work so let’s get going here and give you a much deeper technical understanding of Cryptocurrencies.
WHAT ARE CRYPTOCURRENCIES?
In a post-Bitcoin world, with the existence of blockchain technology, the term “cryptocurrency” refers to digital money where cryptographic techniques are used to control the money supply and verify transactions, without the reliance on a trusted third party. Operating on a blockchain – a digital public ledger in which all the transactions conducted in a specific cryptocurrency are recorded. The term cryptocurrency is an alias – it doesn’t mean “currency that is cryptographic.” When “cars” were first introduced people referred to them as “horseless carriages” and it’s in this way that we should understand “cryptocurrencies” as an alias for “blockchain tokens.” Blockchain tokens are a technology that can be used as money, separate from fiat and commodities.
HOW DO CRYPTOCURRENCIES WORK?
Cryptocurrencies are defined by the utility of their blockchain network and these networks, in turn, are defined primarily by their respective consensus algorithms. An algorithm is a step-by-step process that defines how a problem is to be solved. A common way of describing algorithms is “algorithm = logic + control” A bit confusing? Think of it like cooking: by logic we mean ingredients and by control we mean recipes.
In a cryptocurrency context, these consensus algorithms help a cryptocurrency network decide on the order of the transactions. The two most common types of these algorithms are Proof-of-Work (PoW) and Proof-of-Stake (PoS).
In a PoW system, miners use their computer hardware to solve cryptographic puzzles that verify transactions and record those transactions into units called blocks. Whichever miner completes a block receives some blockchain tokens as compensation for the task. PoW is the original consensus algorithm that was first used in Bitcoin.
Alternatively, in a PoS system, the volume of transactions that miners can record into blocks, among all available transactions to mine, is proportional to the volume of tokens they possess, relative to all the tokens of that particular cryptocurrency.
Let’s take an even deeper look into Cryptocurrencies. Below you’ll find more detailed explanations to exactly what makes up the different terms that you’ll come across related to Cryptocurrencies
A blockchain is a public digital ledger that is distributed, chronologically-ordered, and non-reversible: it is the collective record of all transactions conducted through the network of a given cryptocurrency. In a cryptocurrency context, the blockchain prevents the issue of double spending without the need for a trusted third party. It is worth noting that blockchain is being experimented with outside of transactional applications; if the blockchain were the internet, cryptocurrencies would be like email – the first great use case of the technology.
Double spending occurs when a specific unit of currency is used to pay more than one person: Person A engages in fraud to use the same unit of money – let’s say $20 CAD – to pay both Person B and Person C. In a physical context, we can think of counterfeiting as a form of double spending. The origin of the double spending problem occurs specifically in a digital money context, where duplication completely undermines the function of money. Money relies on scarcity – increasing the money supply causes inflation and devalues every unit of the currency that you presently hold at that specific moment in time when the money supply increases. It was not until the arrival of blockchain technology, that the double spending problem was definitively resolved through a usable solution.
Broadly, a digital signature is a cryptographic tool for verifying digital documents – it fulfills in the digital sphere what your handwritten signature fulfills in the physical sphere. They both identify and authorize. In particular, your handwritten signature is something that only you can make but which anyone can verify; it is simultaneously tied to a specific document, signed at a particular place and at a specific time. Both of these core properties of handwritten signatures apply to digital signatures.
In terms of cryptocurrencies, digital signatures function to ensure that funds can only be spent by their rightful owners – this is what we mean by “verifying digital documents” in the broad definition above. The “document” is the transaction that takes place and the digital signatures verify that the transaction did indeed take place, just as a stamp on your passport verifies that you have passed through a border. In the process of verifying transactions, we inevitably ascertain who is in possession of what.
Blocks are the unit of storage for collections of transactions (records) on digital public ledgers, that is, the blockchain. The blockchain merely consists of blocks chained or linked together, where each block can be thought of like a page and the blockchain as a bound book in which the page is contained. Every block contains a hash (bookbinding), a timestamp (page number), and digital signature-based transaction data (writing on a page). Functionally, a hash connects the current block to the previous block, so it can very much be conceptualized as the binding that keeps a book together.
The chain in blockchain is created by the hashes – the connective tissue of blockchain technology – which link every block to the chronologically previous block. We can think of the sequential linking as a chain. It’s also possible to conceive of each block as a numbered page and the blockchain in its entirety as a book.
Functionally, hashes are cryptographic math: a hash algorithm takes a data input of any size and produces a fixed-length hash. In a cryptocurrency context that data consists of the transaction history up until that point of time, embodied through digital signatures. Thus, with hashes chaining the digital signatures together, we are able to record all the transactions that take place, forming chains of blocks (that is, chains of records).
Block size is the size of the batch of updates to a given cryptocurrency’s public ledger – it represents the limit to the rate at which information is recorded into the blockchain. Roughly speaking, a cryptocurrency’s blockchain network data needs to be downloaded and verified in real time by miners. The amount of data needed to be downloaded and verified is proportional both to the hardware system requirements (CPU, memory, bandwidth) and to the number of transactions that can be processed. Thus, a larger block size means that more data needs to be downloaded and verified in order to keep up with the network, simultaneously requiring more advanced hardware and enabling more transactions to be processed.
The block size is important for two reasons: (1) determining the base level entry point for participating as a miner in a cryptocurrency’s blockchain, and (2) determining the number of transactions that can be processed by a cryptocurrency’s blockchain. Think of block size as the digital version of box sizes when moving between apartments and houses. The box size determines both how strong you have to be to carry the box (system requirements) and how much can be contained in each box (number of transactions).
The labor performed by the computer hardware of nodes in a blockchain network, running a given consensus algorithm like PoW or PoS, is the solving of cryptographic proofs. In cryptography, we take plain text, like “The weather is nice,” and pass it through a cipher that is used to both encrypt and decrypt our message. Without getting too involved in how ciphers work, the plain text example “The weather is nice” would get changed to something like “Uif xfbuifs jt ojdf”
A simple cipher would be something like “If “A” is equal to 1 and “Z” is equal to 26, where the numerical value of each letter is equivalent to its place in the alphabet, add 1 to the numerical value of a letter and display the letter that corresponds to the new numerical value except for “Z” which will restart at 1.” When we apply this cipher to “The weather is nice” we get the ciphertext “Uif xfbuifs jt ojdf” – “T” becomes “U,” “h” becomes “i” and so forth.
We ensure that a system is cryptographically secure by showing that for any pair of messages – encrypted or not encrypted – the probability that they came from the same cipher is identical. Another way of saying this is that a ciphertext – an encrypted message – must reveal nothing about the message.
Now, this is where we finally come to cryptographic proofs, which is a process centered around comparing messages and their respective ciphertexts. In a cryptographic proof, we take Message1 and Message2 and we encrypt them by passing them through a cipher to get Ciphertext1 and Ciphertext2, respectively. We have “proven” our cryptographic process when Ciphertext1 and Ciphertext2 cannot be distinguished, such that a potential adversary looking to decrypt them cannot trace them back to Message1 and Message2. This process of encryption is performed through public keys and the eventual decryption process requires the use of private keys.
HOW DO CRYPTOCURRENCIES WORK? | PUBLIC KEYS & PRIVATE KEYS
Public keys are used to encrypt messages into cryptographic messages; private keys are used to decrypt cryptographic messages into human-readable messages. In cryptography, public keys and private keys came into existence first as a means to communicate securely over insecure channels (that is, channels where unwanted parties could potentially listen to the messages being communicated). The original problem with cryptographic keys – before the private/public distinction emerged – was the difficulty of communicating the key itself, over an insecure channel. The key is what deciphers an encrypted message and so there is a great irony in sending a key over an insecure channel, which would compromise any encrypted messages sent afterward. With this in mind, our current approach to cryptographic keys is a paired method, where the public key is used to encrypt messages and the private key is used to decrypt messages. Only you should know your private key – hide it well – while everyone can access your public key. Consequently, without having to agree to a key beforehand, anyone can send encrypted messages to you through your public key. Your private key is then able to decipher the encrypted messages.
How is this relevant to cryptocurrencies? Replace the word “message” with “transaction” and the importance should be evident: public and private keys are used to coordinate the ownership and trading of cryptocurrencies within a blockchain network.