If you want to truly understand how cryptocurrency works, then you need to learn the ins and outs of the blockchain.
Blockchain technology is the foundation of any crypto activity. It’s worth diving into its background, mechanisms, and future potential if you’ve ever found yourself wondering, “Wait, how does cryptocurrency work?”
Our article covers the following:
On the most simple level, a blockchain is literally a chain of blocks or records that create a digital ledger.
Using cryptographic algorithms, each block is secured and bound to each other similar to a linked list.
Blockchain networks have no central authority; the intention of blockchain networks is to create democratized systems where users can verify for themselves whether or not a transaction on the chain is legitimate.
The information is open for anyone and everyone to see. No third parties are required.
Since it's a shared and immutable ledger, any applications built on the blockchain are transparent, auditable, and permanent.
In 1991, Stuart Haber and W. Scott Stornetta created a cryptographically-secured chain of blocks where no one could tamper with the timestamps of documents. In 1992, they upgraded their system to incorporate Merkle trees—described below—that enhanced efficiency and allowed more documents to be collected on a single block.
Bitcoin—the first blockchain network—launched on January 3, 2009, and it’s run continuously without security incidents since that date.
The founder of blockchain technology as we now know it is an anonymous person, or group of people, known as Satoshi Nakamoto.
In October 2008, Satoshi published the white paper Bitcoin: A Peer-to-Peer Electronic Cash System, which outlined a proposal of the mechanics we now commonly refer to as Bitcoin's blockchain.
Another popular blockchain, Ethereum, was founded by Vitalik Buterin and announced at the North American Bitcoin Conference in January 2014. The Ethereum Network officially launched on July 30, 2015. Ethereum expanded on Bitcoin’s technology by adding smart contracts and speeding up transaction times.
But the blockchain’s history and evolution haven’t stopped with Ethereum and Bitcoin. Numerous projects have cropped up to address some of the deficiencies of Bitcoin and Ethereum by adding new features—different consensus algorithms, quicker transaction speeds, lower transaction fees, and increased levels of privacy—all by leveraging the capabilities of blockchain technology.
Consensus algorithms are mechanisms used to add new blocks to the chain while maintaining reliability and trust between all unknown peers in the network.
The consensus protocol makes sure that every new block being added is the one and only version of truth agreed upon by all the nodes in the network.
There are many different consensus algorithms, the most popular being proof of work (PoW) and proof of stake (PoS).
Merkle trees, also known as binary hash trees, are data structures that allow users on the blockchain to verify a single transaction at a time without having to download the entire blockchain.
A Merkle tree hashes each transaction together in a given block to make one root hash. If a transaction inside the block is altered, the generated hash no longer matches the root, and the network rejects the incorrect block.
Each block includes the Merkle root; the nodes that validate the blockchain run the Merkle root hashing algorithm to compare against the block’s published hash. If the two hashes match, the transaction is valid.
For example, let’s say a Bitcoin block had four transactions: A, B, C, and D. Each transaction would be hashed—hash A, hash B, hash C, and hash D. The transactions are paired together, two at a time, to create hash AB and hash CD.
The process completes to form the Merkle root—hash ABCD. If a bad actor attempted to alter the transaction history, and claim the block contained transactions A, B, C, and E instead, the network would know something was wrong—hash ABCD obviously doesn’t equal hash ABCE.
Blockchain nodes act as servers in a decentralized network. Full nodes store a copy of the entire blockchain and use it to validate transactions and maintain the consensus between other nodes. They are also able to create new blocks.
Light nodes, which connect to full nodes to obtain and validate any necessary chain information, don’t store a copy of the chain; they query the network’s current status to see which block is last and broadcast transactions for processing. A downloaded wallet—described below—is an example of a light node.
To add a block on the chain in the PoW consensus algorithm, each participant, or miner, must compete to solve a puzzle using their computer’s processing power.
The first miner who gets the right answer mines the block and collects the block reward.
Bitcoin and Litecoin use this method for their blockchains.
It’s well-proven that PoW algorithms offer a high level of security.
Since it’s impossible to know which node will mine the next block, it’s more difficult for bad actors to attack a single miner and interfere with the block-creation process. Since anyone with the correct equipment can participate, it’s difficult and costly to control enough mining power to disrupt a healthy mining network.
There are two core, underlying issues with PoW:
PoW networks can require hundreds of thousands of computers to perform billions of calculations per second; the rate of these calculations is known as hash power. Those calculations require electricity generated by power plants that cause pollution.
The tragedy of the commons refers to an economic issue where people have incentives to consume, but risk total overconsumption. In other words, the continued use of resources results in a detriment to all individuals.
In reference to blockchain technology, a tragedy of commons refers to a future point in time when there will be fewer bitcoin miners available due to shrinking block rewards as a result of Bitcoin halving events. Most of the rewards earned will come from transaction fees, which could also diminish over time as users opt to pay lower fees for these transactions.
Staking cryptocurrency is an essential part of maintaining PoS blockchains like Ethereum 2.0.
PoS uses an economic incentive model to secure a network and verify transactions; it creates a financial motivation for people to take certain actions—a reward for validating legitimate transactions, or a fine for validating illegitimate transactions. Investors are required to own a minimum amount of a crypto asset to become a validator and stake independently.
To learn more about crypto staking, please read our previous article.
PoS algorithms are much more energy efficient than PoW, and they’re less prone to 51% attacks.
A consensus mechanism becomes subject to a 51% attack when more than 50% of the computational power is held by an individual or group of individuals. These larger groups could coordinate to validate false transactions, and destroy users’ faith in the validity of the blockchain data.
Although it would be difficult and expensive to accumulate 51% of a reputable digital coin, a miner with a 51% stake isn’t likely to attack a network where they hold a majority share. It’s not in their best interest.
If the value of the cryptocurrency falls, their holdings would also fall. On a PoS blockchain, a majority stake owner has more personal incentive to maintain a secure network.
In terms of security, PoS consensus algorithms aren’t as well-proven and time-tested as PoW.
Even though PoS networks might be less susceptible to 51% attacks, they could still allow validators with large holdings to have excessive influence on transaction verification, and make it less of an equitable ecosystem. Also, some PoS networks require locking up staked coins for a certain period of time, which could leave owners susceptible to price fluctuations in the market.
Transactions on a blockchain are validated using public-key cryptography.
Transactions are sent via an application called a wallet, then stored in temporary memory pools before they’re moved to mining pools and validated.
Blockchain transactions are validated using public-key cryptography, also known as asymmetric encryption; it’s a framework that uses both a private and a public key, as opposed to the single key used in symmetric cryptography. The public key is derived from the private key.
The public key is used by the sender to encrypt information, while the private key is used by the recipient to decrypt it, typically using a RSA algorithm.
Each account owner in the network has to create a public/private key pair. Private keys are a 256-bit number between 0–2^256. With such a huge range of numbers, it’s statistically infeasible for 2 people to get the same keys—there are 10⁷⁷ keys available.
A wallet is an application that serves as a user interface. It shows your balance and asks for permission to send funds. It tracks incoming and outgoing transactions, sums up spendable currency, and creates and signs transactions on the user’s behalf.
A user specifies the transaction amount and destination address. Then, the wallet constructs a transaction and signs it with a private key. In seconds, the transaction is passed through every node in the network and verified.
Every participant in the network checks the validity of transactions. If a transaction fails any of the criteria, such as double-spending, it’s ignored by the participant entirely. Otherwise, the participant keeps your transaction in a temporary memory pool, often called a mempool for short.
Miners construct a candidate block by aggregating transactions off the mempool. Once a transaction reaches a miner, the recipient will see the new transaction in their wallet and store a copy of it indefinitely. However, it will temporarily appear with zero confirmations.
Depending on fees, the transaction is eventually included in a block that gets solved. It gets broadcast through the network and everyone stores it on their local blockchain. Then the transaction will have one confirmation—one valid block accepted by the network.
The block creation process continues, and as more and more blocks build on top of the block where the transaction was confirmed originally, it gains additional confirmations. When a transaction reaches six or more confirmations, it’s considered fully confirmed. The more confirmations elapse, the harder it becomes to invalidate a transaction with an attack.
The amount of time a transaction sits in the mempool can vary based on the duration of the next block being mined and the number of transactions currently waiting in the mempool. Bitcoin mines blocks about every 10 minutes; typically, if a transaction sits in the mempool for longer than 48 hours, it will be dropped and the funds will return to the spender.
If the mempool becomes full, the nodes will set a minimum threshold for the transaction fee. Any transactions currently in the mempool below that threshold are removed. The sender would have to re-submit their transaction with a higher fee to get it back into the mempool.
If your transaction seems to be stuck in the mempool, you can initiate a replace-by-fee (RBF) action. The RBF mechanism allows you to re-submit your original transaction with a higher fee. The new transaction will get picked up and mined while the original transaction is discarded.
If a group of crypto miners want to combine their computational power, they’re able to form a mining pool.
Each participant contributes their processing power toward the effort of finding the next block. If someone is successful, they receive the block rewards and distribute them amongst the members of the pool proportional to their processing power.
As mining cryptocurrency has become more popular, it’s grown more difficult for individuals to mine individually. Mining pools increase the chances of profitability and also require less hardware and electricity costs in terms of individual participants.
Blockchain technology is gaining in popularity because there’s a lot of distrust with current, legacy systems.
The internet is only becoming a bigger part of our daily lives, and blockchain technology helps push us towards a new internet with more transparency and decentralization.
There are endless possibilities for the application of blockchain technology.
NFTs are gaining popularity for digital art, gaming, real estate, and tracking the authenticity of physical goods.
DeFi platforms are growing quickly and offer easy access to financial transactions previously allowed only by large banking institutions with high barriers to entry.
Voting, digital identity, and the wide-scale use of cryptocurrency for daily transactions are all picking up speed in our digital world. Blockchain technology truly is a platform that allows for extensive development and multiple use-cases.
If you’re interested in more crypto education, please read our articles: