In reaction to the world-wide global financial crisis of 2008, a new type of money was born. Cryptocurrencies were designed to improve on their traditional currency counterparts – pounds, euros and dollars – by being more secure, trustworthy and, crucially, independent.
Cryptocurrencies are not controlled by a central bank or government. Instead, they operate on a distributed network of computers, in a peer-to- peer arrangement.
Many internet users will be familiar with this idea. If you have used a file sharing service (to receive a music track or a movie, perhaps), then you have shared an identical copy of a file between your computer and other computers, over the internet.
Today, cryptocurrencies use the same approach, but with a financial ledger replacing the media file. The financial ledger contains a record of every transaction ever made on the network. The record is identical on every computer, listing exactly how much cryptocurrency is in circulation and who owns what.
Cryptocurrencies use encryption to ensure the system keeps track of every transaction and cannot be compromised by hackers or fraudsters.
Cryptocurrencies use a ‘blockchain’, which is essentially the distributed collection of these encrypted records. An ever-increasing, immutable database that cannot be edited, only added to.
Each cryptocurrency transaction is authorized and ‘signed’ by the sender using a combination of encrypted private and public ‘keys’. As the name suggests, users keep their private key secret, but can freely distribute their public key. Transactions can be checked using the public key without giving away details of the private key.
Groups of transactions become ‘blocks’, which are added to an ever-expanding chain of blocks, giving the technology its name. Each block has an additional layer of encryption security – the first and last pieces of code written to consecutive blocks have to match, making it impossible to retroactively revise the blockchain.
The basic details of each transaction – the unique identity of the sender, the amount of cryptocurrency to send, and the unique identity of the recipient – are broadcast to the network so each copy of the distributed databases can make a note of it.
These subtly different versions of the common database, known as ‘nodes’, are hosted by users spread across the globe. They synchronize over time in a process known as ‘consensus’ –the collective validation that a given transaction has taken place.
If a fraudster was to somehow fake a signature in order to submit a fraudulent transaction to the network, accurate versions of the database outnumber the compromised database, and effectively overrule it. The attempted transaction is therefore not incorporated into the blockchain. All of this takes place without any outside intervention.
Other defining characteristics of the current generation of cryptocurrencies includes the creation of spendable currency by ‘mining’ or ‘minting’ to help support the network and its users.
‘Node Operators’ – those users who host the distributed database – can receive micro rewards for validating transactions. Also known as ‘miners’, they do this by completing an energy- and computer-power intensive process called ‘proof of work’ (PoW) that secures the consensus system.
In a ‘proof of stake’ (PoS) system, participants holding coins ‘lock’ them for a period of time – as with a savings account or bond – and commit them to transaction validation in order to secure consensus. If the transaction is false, they lose the stake.
A growing portion of PoW-based cryptocurrencies are moving towards PoS. Bitcoin’s Lightning Network upgrade and Ethereum are examples. DasCoin is one example that is built on it.