What Is Cryptocurrency And How Does It Work?

This Comprehensive Tutorial explains What is Cryptocurrency, the Technology behind it, how is it Created & how does it work, along with Bitcoin Cryptocurrency:

Cryptocurrencies are popular today especially with the success of Bitcoin as it is the first public cryptocurrency. They are important investment vehicles for many blockchain companies today.

Cryptocurrencies are favorably compared with legacy currencies like the Dollar, especially in that they can be used as a medium of exchange and store of value on blockchain and semi-blockchain networks. However, they have certain limitations such as high volatility and low adoption. 

Cryptocurrencies Tutorial

This tutorial provides a complete introduction to cryptocurrencies including the underlying technology, what they are, and their functioning. It will also dive deep into how they are manufactured and their applications.

What Is Cryptocurrency?

What is Cryptocurrency

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Cryptocurrency is digital money existing on the blockchain. This means that the transactions related to these computer-generated currencies are secured by cryptography, publicly broadcast, and are also permanently recorded. These transactions are publicly available and auditable on public blockchains.

The supply of cryptocurrency is also free of the control of any central authority since they operate on decentralized blockchain networks that rely on the consensus of several users to operate.

The below image explains the Centralized network (non-blockchain) versus Decentralized network on blockchain. Cryptocurrencies exist on a decentralized blockchain network.

Centralized network (non-blockchain)

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This differentiates cryptocurrencies from the digital versions of the Dollar, Euro, and other legacy currencies. The cryptocurrency software is run and hosted on networked computers in the decentralized network across the world and anyone can be part of this network.

However, just like ordinary currencies (also known as fiat) such as the Dollar and Euro, cryptocurrency plays the role of exchange medium and store of value, and partially as a unit of account or method to assign a value on another commodity during a transaction.

It is entirely based on code, with all its functions dictated by code, including maximum supply, how many to manufacture, how long it takes to manufacture, the amount of reward to manufacturers, and others.

There are thousands of cryptocurrencies available, starting with Bitcoin. Each has unique features differentiating it from the other. Other names that are used for crypto include tokens, digital currencies, crypto tokens, or coins.

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Characteristics Of Cryptocurrencies Versus Ordinary Currencies

Ordinary Currencies (fiat) like USD, Euro etcCryptocurrencies
Acts as medium of exchange, unit of account (way of determining the value of commodities), and a relatively predictable store of value.Acts as a medium of exchange, partially unit of account since sometimes it is treated as a commodity, and can act as a store of value, though highly volatile.
Value nearly fairly constant and predictable over time. Highly volatile with value changing often at a high measure.
Divisible to small units.Highly divisible to very small units.
Uniform for a given currency. Uniform for a given cryptocurrency.
Unlimited supply: Central banks have to keep printing without limits defined for currencies like USD and Euro. Limited supply: It is possible to control the printing of money and hence control inflation much easier without influence by other forces like governments.
Centralized, in that, they are issued by central banks, and they have permission and authorized by governments, for instance, to produce and distribute. Decentralized and used by “free of permission” since anyone can produce, acquire, distribute and use them without need of any permission from any other such as from government and central banks.
Reversible transactions after sending. 100% irreversible transactions after sending, including sending to the wrong place.
Though secured can be compromised either in paper or digital form because of security flaws and central controls. Highly secured by cryptography, using private and public keys to unlock usage. Only the person with private keys has the right to spend.
Instant transfers for domestic, some regional and a few international transactions; otherwise, they can take days to transfer Near-to-instant transfers with modern cryptos taking seconds to confirm on blockchains.
Must not be anonymous as a requirement since one must in most cases verify identity with authorities and middlemen such as banks and other financial institutions.
- Identity is a top priority in transactions.
Can totally be anonymous with blockchain enabling pseudonyms and it is possible to run crypto accounts not to be linked to real-world identities. Transactions are referred to by addresses or aliases and not real names of people.
Can have tangible versions. Example: cash.Usually works only in computers as digital versions unless the physical coins owned for prestige etc.

How Are Cryptocurrencies Created/Manufactured?

Bitcoin software can be installed on multiple operating system platforms.

Bitcoin software can be installed on different operating system platforms

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Cryptocurrencies are created using computer codes and cryptography algorithms that make it possible to secure it through cryptography. That is why the name is “crypto.” Additionally, every transaction is secured using cryptographic codes.

The code, which is written by crypto and blockchain developers on the blockchain or other digital ledger technologies, dictates the maximum supply, rewards to miners, confirmation times, and other things critical to the operation of a cryptocurrency.

Different blockchains are coded with different programming languages, as shown in the below image:

Different blockchains coded with different coding languages

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The development of the crypto code usually is started by a private/public individual, group, or company of persons. It starts as a crypto project to achieve a certain result such as enable private transactions, tokenization projects (issuance of crypto tokens in exchange for real-world assets in digitized version), or with some other motivation.

Anyone can start a crypto project and cryptocurrency. Some defined amount of cryptocurrencies is generated on the blockchain after coding is done. These are distributed as defined by the project, for instance to developers, founders, public through public offerings, to project development, etc.

The organization and planning of the project is such a way to give the generated and to-be-generated crypto some intrinsic value. This is to stir long-lasting interest among the public and users willing to adopt it.

The below image enlists the top 8 cryptocurrencies by market size:

Top 8 cryptocurrencies by market size

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For instance, the person, group, or company may peg the crypto to real-world assets like gold and real estate such that it appreciates, or make it more scarce, and/or adopt and code other strategies to make the crypto more valuable. It’s upon the project initiators and strategies that differ from one project to the other.

The person, group, or company will then issue the cryptocurrencies or tokens to the public through an initial coin offering or initial exchange offering similar to initial public offering in the stock jargon.

The below image explains the process of developing a cryptocurrency project:

How Do Bitcoin And Cryptocurrencies Work?

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Usually, persons will buy the tokens or cryptocurrencies in exchange for real-world assets and money or other crypto such as Bitcoin and Ethereum. They will then keep it for speculation to allow its value to grow and sell later.

Persons or investors can do so directly to individuals interested in buying the crypto or through cryptocurrency exchanges which are organized markets for trading cryptocurrencies. Those in possession of the crypto can also use the crypto or tokens so acquired or bought to buy other goods and services with it.

List of major types of token per dimension:

 Type Description Characteristics
Technical LayerBlockchain native tokens Implemented on the protocol-level of a blockchain.- Critical to blockchain operation.
- Integral to blockchain’s consensus mechanism.
- Part of blockchain’s incentive mechanism for validators.
Examples are STEEM and BTC.
Non-native protocol tokensImplemented in a crypto-economic protocol on a blockchain.- Integral to protocol’s consensus mechanism.
- Part of the protocol’s incentive mechanism for nodes.
- Tracked on an underlying blockchain to which it is not integral
Example: ERC20 tokens on Ethereum blockchain.
App tokensImplemented on the application-level on a blockchain.- Integrated within the application.
- Part of the app’s incentive mechanism for nodes.
- Tracked on an underlying blockchain to which it is not integral.
Example is Safecoin.
Purpose CryptocurrenciesIntended to be a pure cryptocurrency.- Intended as a global medium of exchange.
- Works as a store of value.
Examples are BTC, Kin, ZEC.
Network tokens Token primarily intended to be used on a specific network, application, or system.- Token has functionality within the issuer’s system.
- Token not intended as general crypto.
Examples are GNO and STX tokens.
Investment tokens Token primarily intended to passively invest in the ensuing entity or asset.- Owners promised a share of asset value or success of the issuing entity.
- No or little significant functionality.
Examples are Neufund and DigixGold.
Underlying value Asset-backed tokensToken functions as a claim on an underlying asset.- Allows trading via IOUs without having to move the underlying asset.
- Issue responsible to hold the underlying asset.
- Introduces counterparty risks.
Example is USDT token.
Network value tokensThe token is tied to the value and development of a network. - Tied to value exchanged or generated on the network, for example, transaction fee volume.
- Closely intertwined with key interactions of network participants.
Example: Ethereum or ETH token.
Share-like tokensToken has share-like properties.- The issue promises token owners to share in the success of the issuing entity example, dividends or profit shares.
- May or may not come with voting.
- Mostly weak or no legal basis.
Example: DigixDAO.
Utility Usage tokens Token provides access to service functionality.- Gives holders of the token exclusive functionality of the service.
Example is Bitcoin.
Work tokensProvides the user with rights to contribute to a system.- Contributors must own tokens to contribute to the system.
- Network incentivizes contributions to the system via a reward system.
Hybrid tokensToken has traits of both usage and work tokens.- Token grants access to system functionality.
- The token allows owners to contribute to the system.
Examples are Ethereum and Dash tokens.
Legal StatusUtility tokens Token has clearly defined utility defined by law. - Closely tied to the functionality of the issuing network or application.
- Internal network or app currency but not necessarily trying to be a currency.
- Owners get the right to actively contribute to the system.
- Avoids security-like features.
Example is Steem.
Security tokens Token behaves like security such as happens with stocks. - Show-cases security-like features example, voting on decisions about shares, dividends, etc.
- Holders are regarded as owners.
- Little or insufficient utility.
Example is SPICE.
CryptocurrenciesThe token is pure cryptocurrency. - Token acts as a store of value and medium of exchange.
- Token not emitted by a central authority against which owners have claims.
- Currently not regarded as the lawful, functional currency.
- Not regulated by e-money laws.
Example is Litecoin.

#1) The initiators of the project, alongside node supporters and other investors in the project, will usually specify and stipulate a way of making the crypto more decentralized such that it will be adopted by as many people as possible around the world.

For instance, in addition to availing it on blockchain to facilitate this, they may offer rewards for minters who commit their computer resources in the network to support the network and mint or mine more of the units as time progresses.

The project initiators will then specify and code everything on the blockchain. For instance, the code will specify total supply, and how regular the coins are released in supply from time to time to avoid volatility and manipulation, and the algorithms that direct the networks.

#2) The code also defines the rules to be followed by these minters and miners from time to time and how the decentralized participants, using computers, will make decisions (consensus) to continue the crypto project. Hence, this way, the survival of the crypto project relies on the consensus of many people on a decentralized network.

For instance, participants who are supporting the project by becoming minters can suggest ways of continuing the project and be rewarded for it. These suggestions are voted by other minters and participants. These suggestions can also help extend the cryptocurrency as a payment option for mainstream goods and services through API integrations.

The aim is to make the consensus process as decentralized and liberal as possible but also fair to all participants.

#3) The project initiators will have a way of rewarding themselves by selling the initially created cryptocurrencies and tokens, but will also stipulate budgets for development and other activities on the network.

#4) Other tokens or crypto may evolve from the initially created crypto/token by the way of hard forks or decisions by minters, founders, etc.

Bitcoin As The First Cryptocurrency

History of Bitcoin

Bitcoin was initiated by a person or a group using a pseudonym or name Satoshi Nakamoto in 2008, as a digital currency or Internet money that is free of manipulation by central authorities or governments. Bitcoin.org was registered as a domain name on 18 August 2008.

Then, Satoshi Nakamoto, later that year, posted on a cryptographic mailing list, a link to the Bitcoin white paper as Bitcoin: A Peer-to-Peer Electronic Cash System. The paper discussed a peer-to-peer system that would be used for electronic transactions without relying on human trust.

The Bitcoin network then came into operation on 3 January 2009 with Satoshi Nakamoto mining the genesis block number 0. The Coinbase of the block carried the text “The Times 03/Jan/2009 Chancellor on brink of second bailout for banks.” This referred to the headline published on the same date by The Times and also referring to the instability of central-bank issued reserve currencies.

  • The first Bitcoin client was released on 9 January 2009 and hosted by SourceForge. Hal Finney, a programmer who downloaded the software the same day, used the software to receive 10 Bitcoins from Satoshi Nakamoto. This marked the world’s first Bitcoin transaction.
  • Before Bitcoin, David Chaum, and Stefan Brands had developed issuer-based e-cash protocols. Adam Back also developed the Hashcash scheme for spam control based on Proof of Work. Wei Dai had created b – money, a Bitcoin predecessor before Bitcoin, and which was the first proposal for distributed digital scarcity based cryptocurrencies.
  • Nick Szabo whose bit gold was a direct precursor of Bitcoin architecture, although it was never implemented. The proposal investigated the use of Byzantine fault-tolerant protocol to store and transfer Proof of Work solutions. Hal Finney had also developed reusable proof of work system.
  • Wei Dai and Nick Szabo became huge supporters of Bitcoin.
  • Individuals negotiated the value of first Bitcoins via the Bitcoin Forum. Some of the first notable transactions of Bitcoin included a purchase of pizza from Papa John’s on which 10, 000 BTC were spent.

Today, the Bitcoin peer-to-peer money is run by supporters in virtually every country around the world. It is used to buy and sell goods; as a store of value and traded on many cryptocurrency exchanges.

Although volatile, the price of Bitcoin has so far attained a maximum of $20,000 per single Bitcoin in 2017.

How Do Bitcoin And Cryptocurrencies Work?

How Do Bitcoin And Cryptocurrencies Work

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It is very easy to use Bitcoin without understanding the technical details. You only require installing the software wallet on your computer and mobile phone, and then you can buy Bitcoin on crypto exchanges to either sell it for profit and/or to store.

(i) Downloading a wallet and generating an address

To send, sell, or buy Bitcoin, a wallet address is required. Generating a wallet address is not difficult. Most wallets, on downloading, allow generating a wallet address automatically.

A user can then share this wallet address with other users who want to send or sell crypto. These wallets also allow the user to download and save a private key or seed-word that can restore it if deleted wrongfully or when a password is lost.

The below image example shows free crypto wallet works for mobile and PCs:

Downloading a wallet and generating an address

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(ii) Sending and receiving

A Bitcoin wallet allows a user to send, store, and receive Bitcoins, but technically stores private and public keys. The private and public key secures cryptocurrencies through cryptography encryption.

#1) During the send transaction, the user will assign crypto to the receiver’s public key which is associated with the receiver’s wallet address that the sender is using.

Sending cryptocurrencies

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#2) The receiver then uses its private key to claim ownership by authenticating their wallet and decrypting data related to the corresponding public key where the crypto was assigned. The transaction received can be seen on the wallet’s history of transactions or blockchain explorers such as Blockchain.

The below image is an example of a Blockchain explorer showing a completed transaction. Senders and receivers can use explorers to confirm that amount has been sent and received.

Blockchain explorer showing a completed transaction

Both the private key and the public key used to authenticate the transaction are cryptographically associated with the wallet address.

Another aspect of cryptocurrency working is the creation of a digital signature. The digital signature works in the same way that like a signature on a document, to prove the validity and authenticity of the source.

#3) Hence, a cryptocurrency cannot be copied. The user who sends a transaction uses their private key to create this digital signature, and thus creates a mathematical proof that the crypto was sent from his wallet. It also prevents copying of the transaction or crypto.

(iii) Mining and confirmation of the transaction

Once the sender broadcasts the transaction to the blockchain network, the nodes, through the mining process confirm the transaction meets the criteria pre-coded on the blockchain.

The nodes confirm that the transaction is coming from a verifiable source, and other details, for instance, that the user has enough spendable balance. The nodes then mine the transaction by adding it to the block and then to the previous blocks on the blockchain.

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Commercial crypto mining rigs:

Commercial crypto mining rigs

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The user will then receive the Bitcoins on their wallet through the address they have provided to the sender. The receiver can only spend the Bitcoins by authenticating with their private key, which confirms that he/she is the actual owner of the wallet where the Bitcoins were sent.

(iv) Records and transaction tracking

The Bitcoin wallet then allows tracking of all the transactions relating to the private keys generated on it. It allows transparency of transactions with all the history visible publicly.

Plus these data are immutable or the storage is permanent on the blockchain. Any user can trace the status of the transactions, whether confirmed, rejected, or pending.

Secondly, the blockchain public ledger allows Bitcoin to calculate wallet balances and spendable balances. In a nutshell, most of the cryptocurrencies work in a similar way to Bitcoin.

Applications Of Cryptocurrencies

Applications of blockchains

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#1) Low-cost money transfers

Cryptocurrencies are considered as of low cost in sending a large amount of money that costs only a small fraction compared to legacy fiat. This is useful for both domestic and international transfers. The low cost associated with crypto is because there are no middle-men for these transactions. Usually, banks and financial institutions act as middlemen in legacy finance, charge fees to complete these transactions.

#2) Instant cross-border transactions

Even domestic cryptocurrency transfers are instant on most blockchains taking only seconds to minutes, but the largest obvious beneficiary is cross-border transactions. Traditionally, these transactions take up to days to complete.

It is applied in sending, receiving, storing, and trading funds in places where regulation does not allow cross-border transactions or dealing with cross-border institutions under legacy banking. This is because no government in any country can freeze or censor crypto.

#3) Payment of goods and services in merchant stores such as websites

#4) Investing in early-stage startups

New startups can issue tokens and cryptocurrencies to investors who can contribute their resources to support the startups. The startup can use the money to develop its goals while investors can hold the crypto and earn profit from such growth or sell the crypto in a secondary market. The crypto or tokens can be directly pegged to company assets such that the latter will influence the price at a later date. 

#5) Making private transactions

Anonymous private transactions are needful and not an option in many instances in both individual and organizational settings. Some cryptocurrencies such as Monero, ZCash, and PIVX are designed to allow private transactions. They can conceal amount, sender, recipient, and other details such as time of sending.

#6) Sending non-cash remittances

Some cryptocurrency networks allow users to store, send, receive, tokenize, monetize and transact non-monetary remittances such as mobile data top-ups, bill payments, etc.

  • Cryptocurrencies can also be applied similarly to loyalty points to reward users in a given business relationship.
  • These are also used to enable non-monetary economies such as computer storage. Using peer-to-peer blockchain-based storage, users can rent out storage spaces to others on a peer-to-peer basis. This is cheaper, more secure, and more reliable than the cloud-based storage alternatives.

#7) Tokenizing of funds, assets, and instruments

Cryptocurrencies are divisible to micro-units. This allows the tokenization of assets where the value of token or crypto is pegged to the crypto assets. This allows trading of non-monetary assets in the traditional settings.

For instance, people can tokenize real estate, stocks, funds, and other assets and trade them on the blockchain without borders and market limits using legal security tokens.

Tips on using cryptocurrencies:

Apart from avoiding investing in cryptocurrency scams, some cryptocurrency projects survive better and become more profitable than others. This depends on the leadership and crypto-economics of the project.

Crypto economics dictate consensus, incentivization, and decentralization mechanisms. Hence it affects global adoption of the project, and survival of the project via integration to other systems such as payment networks.

Conclusion

Compared to legacy currencies like Euro and Dollar, cryptocurrencies are the decentralized meaning of a public network of participants which decides and agrees on their operation and development through consensus. They are non-censorship, in that no authority directs or manipulates or can stop them.

Cryptocurrencies exist only in code but mostly start as entire lifecycle projects dedicated to promoting their usability, adoption, and value.

We saw that cryptocurrencies are secured with cryptography, consensus, decentralization, and immutability of data. The success of a cryptocurrency mainly depends on its crypto-economics. Good crypto-economics make it more favorable for more people to invest their energy and resources in promoting them rather than in spoiling and destroying them.