How Does Cryptocurrency Work?


Cryptocurrency is gaining momentum, and by now, you’re probably at least curious if it’s worth your investment effort. However, like many people, you may not know how it works, especially because crypto is substantially different from other investments you may already have.

You’re in the right place. Check out this handy guide to learn some basic cryptocurrency terminology and concepts, setting the foundation for getting started as a crypto user or investor.

How Does Cryptocurrency Work?

Cryptocurrency is a digital currency that people can spend on goods and services, although they may need to convert it to a format the merchant accepts first or connect it to a debit card to make everyday purchases. Cryptocurrency also can be used to transfer money securely and inexpensively. Some use cryptocurrency as an alternative investment to store wealth, much like gold, or as a speculative asset if they believe the price will go higher. 

Here’s a closer look at how cryptocurrency works.


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Cryptography

Cryptocurrency uses cryptographic methods to secure and verify transactions and control the generation of additional coins. 

Generally speaking, cryptography protects information from third parties by facilitating the exchange of messages only the intended recipients can read. Cryptocurrencies use cryptography to keep transactions secure, verify transfers, and control the creation of new crypto through mining.

Asymmetric encryption cryptography is an example of a type used in cryptocurrencies. It involves public and private keys. As you might guess from the name, the public key is a piece of data that gets widely distributed, typically as the address of a person receiving the cryptocurrency funds from a sender. Then, the private key is only known to its owner.

In short, someone can encrypt their data with the receiver’s public key. Their private key is the only thing that decrypts what was encrypted. The main advantage of this method is that it allows people to transfer keys over nonsecure channels. 

There’s also symmetric key cryptography, used to safely transfer the key between a sender and receiver. 

Public Keys and Private Keys

Anyone buying cryptocurrency for the first time receives public and private keys. A public key functions similarly to an email address. You can give it to others before receiving cryptocurrency from them.

On the other hand, a private key is something you should treat like a password and never share. When you make a transaction involving your public key, it’s your private key that verifies your identity. Cryptocurrency transactions do not require providing your name, address, or other standard identifying information. However, every cryptocurrency user with entries on the blockchain has a pseudonym of scrambled numbers and letters. 

Bitcoin has a public ledger. That means anyone can see which parties carried out transactions, plus when and where they happened. Although there are no names present, people see the random letter and number strings representing users’ identities. 

These specifics mean you should not count on cryptocurrencies to shield your identity. The nature of how the blockchain shows information makes it harder but not impossible to figure out who uses or owns certain crypto, provided someone feels committed enough to make an effort. 


The Blockchain

All cryptocurrency transactions permanently appear on a digital ledger called a blockchain. People are now looking at how the technology could apply to other needs, but most individuals still primarily associate the blockchain with crypto.

A blockchain is a decentralized digital ledger, or distributed ledger, meaning its data is kept in various places worldwide rather than in a single location or server or managed by any central authority. It stores encrypted information as blocks that get linked. That characteristic means the blockchain is a largely tamper-proof system that does not let anyone change confirmed transactions listed on it. 

Every chain of data has multiple blocks, and each block features three components:

  • The block’s data
  • A nonce
  • A hash

The data contained in a block varies depending on the blockchain’s primary use. In the case of cryptocurrency, a block includes transaction details about the sender, receiver, and amount. Most blocks don’t only have data about one transaction, but thousands.

The nonce (an abbreviation for “number used only once”) is a unique 32-bit whole number randomly generated during each block’s creation. The nonce automatically creates a block header hash, which summarizes any information associated with the block besides transaction data. For example, it may include the block’s creation time. Bitcoin block headers are 80 bytes long.

The hash is an extremely small 256-bit number tied to the nonce. A bit is the smallest type of data handled by computers — one bit equals 0.125 bytes. A 256-bit number can fit inside 256 bits worth of data.

Although every block has a nonce and hash, it also contains an identifier connecting it to the previous segment of the chain.

The next section explains how these components fit together. 


Mining 

Cryptocurrency mining happens when individuals use the computing power of hardware to solve mathematical problems, creating more coins and validating transactions in the process. 

In order to unlock a new block and create new coins, a miner — or rather, a miner’s computer — must solve a mathematical puzzle. They must find a nonce that will generate an accepted hash. 

Miners do this by trying to guess the block’s target hash. That’s a 256-bit number less than or equal to the block header hash. The guessing involves the miners’ computers randomly generating as many nonces as fast as possible. 

However, recall that while a nonce is 32 bits, the hash contains 256. That means there are an estimated 4 billion nonce-hash combinations for a miner’s setup to try. The first miner to solve a given puzzle correctly is rewarded with more cryptocurrency.

Once the computing setup uncovers the match, the miner has found the so-called “golden nonce.” That achievement adds another block to the chain, and the miner is rewarded with new coins. 

As of November 2021, a Bitcoin miner could earn 6.25 bitcoins (BTC) for every new block they add to the Bitcoin blockchain. That may not sound like much, but it was the equivalent of about $400,000. 

Is Crypto Mining a Worthwhile Way to Make Money?

Getting cryptocurrency by mining is not the typical way most people obtain it, especially newcomers. That’s primarily because the mining equipment is a significant investment, and only the first miner to confirm a new block gets rewarded. The computing power required to be competitive in Bitcoin mining, for example, is beyond what most individuals can access — picture warehouses full of computers set up in so-called “mining farms.” 

Mining on your own is far from a surefire way to see handsome returns for your efforts. However, one alternative that’s sometimes more profitable is to join a mining pool, which allows miners to combine their resources and share the rewards.

There are certainly cases where crypto mining is extremely profitable for participants. A pair of siblings reportedly makes $30,000 every month with their mining efforts. That’s not the norm, though. 

As a beginner, the wisest and safest way to participate is to consider building a diversified portfolio to enjoy better protection from inevitable market fluctuations.

Anything from media hype to investor sentiment can make cryptocurrency prices soar and plummet just as fast. Plan to stay in cryptocurrency investing for the long haul and try not to panic over those sudden changes. Then, you can think about mining new coins once you get the hang of things. 


Cryptocurrency Wallets 

One of the main advantages of the public-private key system discussed above is that it allows you to access your cryptocurrencies at any time over an Internet connection. You’ll store your crypto in a special digital wallet that keeps the virtual currency and facilitates transfers to and from other parties. 

So-called “hot” wallets connect to the Internet, while “cold” wallets do not. For example, app-based wallets such as those offered by Coinbase, Electrum, or Mycelium are always hot. 

However, some people opt for cold wallets. They’re not as convenient for transferring coins, but because they do not have a constant Internet connection, there’s a much lower risk of hackers or other malicious parties exploiting them in cyberattacks. 

The most common kinds of cold wallets look like small USB drives. You briefly connect them to a computer for transaction purposes. Another, less common type of cold wallet involves simply writing your wallet address and password on a piece of paper that you store in a secure place, such as a safe.

When choosing your cryptocurrency wallet, think about how many types of cryptocurrencies you want it to hold. Many hot wallets can store hundreds of popular cryptocurrencies. However, the cold wallets you plug into a computer are typically less broadly compatible and may only keep a few dozen crypto varieties. Finally, remember that you can download many hot wallet apps for free. In contrast, some hardware-style cold wallets cost at least $100. 


Cryptocurrency Exchanges 

One of the most common ways to buy cryptocurrency is through an exchange. Think of it as a platform that lets you buy and sell different digital currencies. You can also choose between centralized and decentralized crypto exchanges. 

Centralized Cryptocurrency Exchanges

Coinbase, Kraken, and Gemini are a few of the many centralized cryptocurrency exchanges serving investors in the United States. They function as intermediaries between buyers and sellers, allowing people to trade crypto or buy and sell it for fiat money (currencies, such as the U.S. dollar, deemed to be legal tender by a government entity). 

Moreover, centralized exchanges hold users’ private keys. This approach removes the risk of losing access to your funds by forgetting the associated key details. However, if a centralized exchange gets hacked, you could lose your cryptocurrencies. 

Centralized cryptocurrency exchanges must abide by strict regulations mandating their operations. After choosing one, you’ll go through a process similar to setting up a brokerage account. It involves verifying your identity and submitting the required documents. 

Next, you’ll set up a payment account so your funds are deposited into a bank account or onto a debit or credit card. After that, you’re all set to make cryptocurrency purchases through the exchange.

Decentralized Cryptocurrency Exchanges

There is no intermediary in a decentralized exchange, so buyers and sellers engage directly with each other. They’re not yet as popular or widespread as centralized exchanges, but that could change in the next several years. 

For example, decentralized exchanges appeal to some people because they don’t share information with third parties. Users do not have to prove their identity as they do with centralized exchanges. Individuals also retain their private keys while interacting with decentralized exchanges. 

Decentralized exchanges have setups similar to the blockchain, too. There is no single entity storing all the associated information. Thus, people consider decentralized exchanges much less vulnerable to hacking. 

Uniswap, Compound, and Venus are a few examples of decentralized exchanges. 

As someone just getting started with cryptocurrency, you’ll likely find centralized exchanges more accessible and easier to use. However, it’s still worth knowing the differences between the two if you decide to branch out and try both types later. 


Staking

The model that requires miners to correctly solve the hashing puzzles described above is called the proof-of-work (PoW) model. An alternative method of verifying and validating transactions is the proof-of-stake (PoS) model. 

The PoS model allows people to participate in staking by committing chosen quantities of crypto coins to the cryptocurrency protocol. A proof-of-stake protocol randomly selects from the pool of people who have staked coins to act as validators. The more coins a person pledges to the protocol, the higher their chances of being selected for confirming transactions. 

Each blockchain using the PoS model sets rewards for people chosen as validators. Those parties then earn the promised amount of crypto coins. 

Many people like adding staking to their investment strategies because it allows you to generate passive income from your cryptocurrency holdings.

What Are the Advantages of Crypto Staking?

Crypto staking lets you earn interest on your cryptocurrency holdings. The amounts could total as much as 20% per year, depending on the blockchain and its specifics. You can also choose how much you want to stake by using centralized exchanges offering that service.

You still possess the coins put aside for staking. Additionally, you can unstake them later. However, staking your coins may prevent you from selling them during a specified period.

It’s relatively easy to get started with staking. As mentioned earlier, PoW mining requires a significant investment in computing equipment or joining a mining pool. Staking gives you an alternative with a much lower barrier to entry. The only requirement is that you hold some cryptocurrencies that support it. Ethereum 2.0, Tether, and Polkadot are a few of the many coins currently available to stake. 

If you choose to try staking, take the same care as with other investments. Although staking is an increasingly popular and accessible strategy, it carries risks. Staked coins that experience a sudden drop in value could suffer losses that outweigh the interest you earn. 


Final Word

You now know many of the terms and concepts most frequently associated with cryptocurrencies. Before investing in them, consider learning some of the pros and cons of this investment option. The more informed you are, the easier it will be to make a confident decision about whether it’s time to add crypto to your investment strategies.



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