How Cryptocurrencies work?

Whether you’re on the head or tail end of the cryptocurrency craze, one thing is for sure: These digital assets are hitting the mainstream hard, and don’t seem to be going away anytime soon. Notably, the country of El Salvador recently adopted bitcoin as legal tender, and New York’s incoming mayor Eric Adams is intent on transforming New York City into a hotspot for cryptocurrency. 

Although only 16 percent of Americans say they invested, traded, or used cryptocurrency, almost 90 percent have heard about it, according to a recent Pew Research Center survey. 

Advocates for cryptocurrency and decentralized finance (where people can make financial deals with one another without being moderated by a middleman or central authority like a bank) in general argue that these platforms are transparent and simultaneously anonymous—both good things. 

The key to this vision lies in a digital technology called the blockchain, which undergirds all cryptocurrencies. The blockchain serves as a virtual hall of records, or a public ledger, that records every transaction, detailing the amount as well as the sender and receiver’s wallet addresses. 

The basics of crypto, explained

To start at the front end, this is what happens when you send and receive cryptocurrency. Keep in mind that all cryptocurrencies are just based on computer programs, bitcoin included, and that these “coins” are not actually money, but clippings of computer code that transfer value from one user to another. To become a part of this process, first you have to create a digital wallet. Bitcoin and Ethereum both have recommendations on what wallet works best with their cryptocurrency, and specialty exchanges like Coinbase and Gemini also offer wallets.

Whenever you create a new wallet, the algorithm running that cryptocurrency will generate a paired private key and public key associated with it. You can think of the public key as like an address or bank account number, and the private key proves your ownership. The. public keys are a long string of characters that identify where the crypto should go. Usually, the addresses only accept the type of cryptocurrency they’re affiliated with (although something called cross-chain bridges and exchanges can help link up different cryptocurrencies). 

“You do not have bitcoins in your possession—you have proof that somebody in the past sent you those bitcoins,” says Nicolas Christin, an associate professor of computer science, engineering, and public policy at Carnegie Mellon University. 

You can then tap some of the unspent value in your wallet, and send it to someone else’s public key. When you sign to verify that you want to send the bitcoins, you generate a small personalized piece of code attached to the transaction, and the system creates a mathematical puzzle that locks up that value and scrambles the code. When the recipient is ready to spend the money, they will put a corresponding piece of code into the transaction. Everybody in the network can verify that the two pieces of code fit together (through a process called transaction confirmation, also known as mining—more on that later). This entire operation is called signature verification. 

“It’s impossible for someone to find a missing piece if they don’t have the right information, but it’s super easy for anybody to verify that two pieces fit,” Christin explains. “Bitcoin has very little additional computational abilities beyond signature verification. Satoshi Nakamoto’s [the pseudonym of the alleged creator of Bitcoin] vision was to have programmable money, initially. The problem is Bitcoin became very popular very quickly and the developers decided to freeze the features where they were.”  

However, a new upgrade released last week could open up the possibility for supporting expanded functions beyond signature verification. 

So how are other cryptocurrencies different from Bitcoin?

Many modern cryptocurrencies derive from the Bitcoin model. For example, Litecoin is in many respects similar to Bitcoin, but the puzzle component was slightly altered. They replaced the mining algorithm (called SHA-256) that’s used in Bitcoin with a function called Scrypt, which they claim takes less energy to run. On the other hand, the creators of Bitcoin Cash branched off from a team that was working on Bitcoin to make a Bitcoin-esque cryptocurrency that can process more transactions per second. 

Ethereum, however, takes a different approach. Its blockchain has an added feature called “loops,” which allows it to repeatedly run a piece of code, and engineers can program on top of it. Ethereum uses a mechanism called a “gas” that charges the person who initiated the transaction a fee to run a programming instruction. The program burns up the “gas” as it runs, and when it’s out of gas, the program either completes or terminates. 

Developers can build a cryptocurrency on top of Ethereum (like the stablecoin DAI), create mortgages, or unique non-fungible tokens, since they’re all pieces of code. “All of those are pieces of code that are extensions of Ethereum transactions,” says Christin.

Ethereum is also credited with the nifty innovation of integrating smart contracts onto their blockchain. Ethereum’s developers describe these as code scripts that “performs some actions or computation if certain conditions are satisfied,” comparing the logic of the code to how a “vending machine” works. If a digital art NFT lives inside a smart contract, for example, the artist can create a royalty schedule that accrues a fee every time the art is transferred on the blockchain. 

Or, as another example, imagine walking into a bank and asking to borrow $10 million for the day without telling anyone your name. “Somebody’s going to be reaching for a red button under a desk somewhere,” says Ari Juels, a professor of computer science at Cornell Tech. “But you can actually do something like this on a blockchain.” 

You would borrow money using a smart contract, and you use it to do whatever you want to do. Typically, it’s used for arbitrage, where you buy and sell tokens at profit. Then, you pay back the loan, and all of that is contained in a single transaction. “The way that blockchains work, if you fail to pay back the loan, the whole transaction can just be aborted,” Juels says, “which means that it’s as though you never borrowed the money to begin with.”

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