I happen to think the creation of cryptocurrency (and more importantly, the blockchain) is one of the most important innovations of the last twenty years. Given that, I believe it’s important to know what the building blocks of cryptocurrency technology are, how they work, why they have been designed the way they have, and what it all means for users of it.
If you already know how this works you can just skip ahead to the links.
Bitcoin is simply an encrypted electronic signature that states you have a particular quantity of Bitcoin, much like a dollar bill is simply a piece of paper stating that you have a particular quantity of tender worth that amount. Instead of being backed by the government, Bitcoin’s value is backed by a decentralized network.
Everyone on the network carries Bitcoin’s value in a public ledger called the blockchain. The blockchain is comprised of a series of math problems bundled into blocks. But it’s easier to think of the blockchain ledger as being a list of all accounts of all the members within a network. Each member can see what’s in each account at all times, and each member must agree that the value of each accounts is valid in order for the account to be used to transact something.
In order to make a transaction, the originating account must tell the whole network about it: what the transaction amount is, and which account that stored value is going to. Because all account information is public, everyone on the network can verify that the originating account has the value necessary to make the transaction. (This is different than legacy financial systems, in which a single central entity (the bank) determines if your account has the necessary funds, and then updates its private ledger to decrease the sender’s account’s value and increase recipient’s account value by the amount of the transaction, plus any fees the bank collects.)
Once everyone verifies this information, the transaction is confirmed and the change in stored value on the originating account and target account is updated in everyone’s copy of the ledger (you can also have multiple target accounts).
This keeps going until a particular block is filled up, at which point the block is sealed with a special code that everyone agrees on and is constructed from the information within that block, and the value of that code is then used to begin the construction of a new block on the ledger. In other words, each subsequent block on the chain relies on the verifiable value of the preceding block. This ensures that none of the transactions can be tampered with, since you would have to rewrite all the blocks prior to the most recent one if you wanted to create a fraudulent transaction. Once a block is sealed it remains on the chain forever, and every piece of information in that block also remains on the chain, and can be verified by anyone on the network at any time.
The process of sealing the block is called mining, or hashing. In very simplified terms, it’s just a means of converting one string of information into another string in such a way that it can be easily verified but nearly impossible to predict. This is the essential nature of encryption, and the crux of the blockchain’s ingeniousness.
For members of a network to agree that something has not been tampered with, they all need to be able to check the veracity of a given output given an expected behavior of a calculation, but it also needs to be difficult–if not impossible–to predict a calculation’s outcome (otherwise a member of the network could create phony transactions).
Hashing algorithms take a lot of computing power to solve the encryption puzzles needed to seal a block. It makes sense, then, that the creator of Bitcoin built in a financial incentive to do so (otherwise no one would have reason to spend their own computing resources to do the work of sealing a block). This incentive, or reward, comes in the form of a certain number of “coins” created by the network upon the completion of a block. Whoever seals the block gets that reward.
Because the total number of coins that will ever be created has been capped at 21 million, the value of the coins is somewhat immune to inflation. And because these cryptographically created coins, which are really just tokens of shared value, can be spent on the network, it makes sense to refer to them as cryptocurrency. All cryptocurrencies work on the general principles described above, with variations in execution, but the blockchain is the necessary foundation of it all.
If you have the time and prefer video, this explanation by a preeminent expert in the crypto field is pretty great. It explores game theory, the information arms race, and decentralized, trust-less networks. Well worth your time.