This is the second in a series on the basis of crypto. You can find the first article on ‘What is crypto and what does it mean for me?’ here.
Now that you know what crypto is used for, you might be wondering ‘how does it work’?
Block, meet chain
Let’s start simple. Cryptocurrencies are built on the foundation of a technology called blockchain. It does exactly what it says on the tin - blockchain is a list of records of transactions, called blocks, that are ‘chained’ (or linked) together using cryptography.
Each one of those blocks reinforces the information from the block before, by referencing a hash generated from the previous block by using a hash function. If we lost you at hash function, let’s break that down quickly. A hash function is a one-way cryptographic algorithm that turns any message into a coded, fixed-size output.
Referencing the previous block in each new block is important because it means that every transaction record in the blockchain is linked to the one that came before, creating a permanent digital ledger of all its records. If you try to change an old block, its hash would also change , thus invalidating the entire chain.!
It’s a bouncing baby Bitcoin! Bringing new crypto into the world
New blocks can be added by anyone, but they only officially become part of the blockchain when they’re validated. This is where the decentralisation and P2P we discussed in the last article comes into play.
In other money systems, validation of transactions relies on a centralised third party. For cryptocurrencies, validation relies on a majority of nodes (users) in the P2P network agreeing to the validity of the chain. The process of validation by users in the network is rewarded with a portion of the protocol’s currency - and this is cryptocurrency mining.
There are two ways that validation on the blockchain can happen; through Proof of Work (PoW), or Proof of Stake (PoS).
In Proof of Work, special users on the network (miners) compete to solve a mathematical problem that is difficult to compute, related to the block in question. Solving this problem is designed to be computationally expensive. This means it costs electricity to solve each problem, helping add security to the network by disincentivizing bad actors due to the expenses they would incur if they tried to launch an attack. The first miner to get the correct solution and inform the network wins the reward, a portion of the currency. The block is then validated and all the ledgers are updated.
Proof of Stake removes the competition element, instead choosing a validator from a pool of people who have put up (or staked) some of their crypto into the ecosystem - a little bit like a lottery, with the staked crypto acting as lottery tickets. This means that only one person has the exclusive right to validate that block and earn the block reward. Security is enforced in Proof of Stake networks by charging miners a large penalty (called slashing), which is taken from their stake if foul play is detected by the rest of the network.
Blockchain beyond crypto
Whilst the blockchain is most commonly associated with cryptocurrency, it has myriad real-world applications, and its potential is huge. Any transaction or ledger which relies on a trusted middleman could potentially benefit from a blockchain implementation, which removes the need for the middleman and the single point of failure. Also, you may have recently heard about the rise of ‘NFT’s and their emergence in the art world, one of the most prominent examples of the blockchain in a completely new sphere. Where blockchain technology may take us next remains to be seen, but it’s as exciting as the advent of the internet was in the 90s and worth keeping an eye on!
Please remember when buying and selling crypto, your capital is at risk. Prices can go down as well as up. While we believe in crypto accessibility for all, we also know that it might not be appropriate for everyone. Please consider your personal circumstances when buying or selling crypto as the price can be very volatile. Past performance is not an indicator of future performance.
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