How do cryptocurrencies work? The heart of any cryptocurrency is a public ledger that establishes ownership by anonymously recording who owns what amount of the currency. A network of computers validates every transaction by performing computations that prove they have done the work, and receive new coins in return. Two essential features of cryptocurencies are mining (the creation of cryptocoins) and the block chain (a public ledger of transactions). Mining The cash currencies we are familiar with – the U.S. dollar, the Euro, the British pound – are created by central banks. Governments can print predetermined amounts of their currency and release them into circulation. By contrast, cryptocurrencies are mined by users who typical rely on a mining program to solve sophisticated algorithms in order to release blocks of coins that can go into circulation. Mining is a democratic event: no individual can simply press a button and generate unlimited coins. Instead, everybody buys the same mining software and competes equally when digging for new coins. The more coins mined, the more difficult it gets to release new blocks and get new coins. That is how the algorithm has been devised — to ensure that not all coins can be mined instantly and to allow the currency to stabilize over time. For many cryptocurrencies, there is only a limited amount of time when
coins can be mined. Once that time expires, no more coins can be created. Coin generation typically starts out fast and gets progressively slower until the final coins are issued. Coins appreciate in value if there are more requests by buyers than there are offers by sellers. This would suggest that as the network expands and more users compete for a similar number of coins, the price of each coin rises. The Block Chain This is a widely distributed digital ledger that contains the entire transaction history of the overall money supply of the cryptocurrency. The ledger is maintained by a decentralized network of computers. As the name implies, the ledger is a chain of blocks. Each block contains a set of transactions with information including the sending addresses, the receiving addresses and the number of the cryptocoins exchanged between them. When combined with cryptographic techniques, the block chain allows two important aspects of a transaction to be fulfilled: proof of ownership and proof that the funds have not been doublespent. Proof of ownership is established by a digital signature – a sort of account number – and a private signing key – which acts as a password. To ensure funds are not being double-spent, transactions are only deemed to be complete when they appear in the blockchain master ledger. Transactions are added there in blocks and are verified by various “nodes” of the system. The node that verified the block first is rewarded with newly created cryptocurrency – which is how new coins are added to the money supply.
Once a transaction is recorded, it cannot be reversed (to prevent the double-spending problem) Everyone has the same blockchain and therefore access to the recorded transactions; this is unlike owning a currency note which will not reveal the past transactions made using the currency. Many cryptocurrencies today can be exchanged, at variable exchange rates, for major world currencies, such as the U.S. dollar or Japanese yen, in special online markets. In December, one bitcoin was worth roughly $750, up from about $450 a year earlier.