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Chapter 2:  Cryptocurrencies

How Does Cryptocurrency Work?

Interesting Fact:
Did you know that cryptocurrencies and crypto transactions are considered to be an improvement over traditional banking institutions and conventional money transfer methods?
9 minutes

In this section, I’m going to tell you how does cryptocurrency work!

Nowadays, cryptocurrencies seem to be all around us - we trade crypto, transact in crypto, send it to our friends and relatives, buy and sell goods and services for crypto, and can even borrow and lend it out, too!

As we perform all of those processes, though, do you ever think about what’s going on in the background? I’ll let you in on a little secret - there’s a lot of stuff happening, with every single transaction! So, then - let’s figure out how cryptocurrencies ACTUALLY work!

In this section, we’re going to dive deep into the question of how does cryptocurrency work. Specifically, we’ll explore what makes cryptocurrencies unique, what happens during a transaction, and why these questions are something you should even care about, in the first place.

So, let’s get to it!

How Does Cryptocurrency Work? (Explained with Animation)

Video Explainer

Video Explainer: How Does Cryptocurrency Work?

Reading is not your thing? Watch the "How Does Cryptocurrency Work?" video explainer

How Does Cryptocurrency Work? (Explained with Animation)

How Does Cryptocurrency Work? (Explained with Animation) How Does Cryptocurrency Work? (Explained with Animation)

What Makes Cryptocurrencies Unique?

In order to really get a grasp on what is cryptocurrency and how does it work, you need to first understand the underlying technology that crypto is built upon - blockchains. This is, evidently, something that I’ve explored thoroughly in a separate section. If you still haven’t read it, do so - it will help you get a better understanding of what we’re talking about today!

That being said, for the context of this section, we’ll focus on one of the key functions of blockchain technology - automated and immutable bookkeeping.

How does cryptocurrency work: What makes cryptocurrencies unique?

You see, a blockchain is simply a huge digital database. You can think about it as multiple boxes, being connected by a single chronological chain. Each box holds information about the transactions that you perform, and the chain helps with keeping everything organized and, well… Chronological!

This is the very first thing that makes cryptocurrencies unique - the fact that each cryptocurrency is based on a blockchain, and that all transactions that involve cryptocurrencies are recorded on the said blockchain, too. For a visual example, you can imagine it as a bank - every money transfer and credit card transaction that you make is recorded by your bank!

Now, admittedly, cryptocurrencies and crypto transactions are widely considered to be an improvement over traditional banking institutions, and default money transferring methods. One of the biggest reasons why that’s the case is just that - transparent and immutable bookkeeping.

Traditional banks can run into a wide array of troubles, when it comes to managing the personal information of their customers. Data breaches, power outages, and good, old-fashioned human error are just a few things that can go wrong! With blockchains generally being completely transparent and decentralized, all of these aforementioned issues are, admittedly, non-threatening.

How does cryptocurrency work: Traditional banking problems.

Then, there’s the anonymity aspect, too. With your traditional banking institutions, anonymity is out of the question - you have to identify yourself, be transparent about where your money is coming from, who you’re sending your money to, and so on. So, if you have a friend named Tim, and want to send him some money, you’ll need to tell the bank WHY you’re sending your money to Tim, as well as make sure that Tim isn’t a suspicious individual who would be involved in some shady business.

Now, sure, that’s an exaggeration, but you get the idea - with traditional banks, everything is pretty strict, in this regard. With crypto, though, it’s somewhat the opposite - the same blockchain technology behind cryptocurrencies aims to preserve your anonymity!

Specifically, this is done with the help of cryptocurrency wallets. Each wallet has a unique code associated with it - it’s called a “public wallet address”. When you transact with crypto, while all of the information is stored on the blockchain and is public for everyone to see, all that anyone will see is your wallet address sending an X amount of cryptocurrency to Tim’s wallet address.

In other words, no one will know that it’s YOU sending the crypto to TIM.

How does cryptocurrency work: Public wallet address.

One last point that I’d like to stress, when it comes to cryptocurrencies and how they work, is the fact that there are multiple different crypto projects, as well as blockchains out there. Each of these crypto projects have their own, special functions, and many of them have very unique working models, too.

That is to say - in this section, we’re focusing on the general aspects of how does crypto work, from the perspective of cryptocurrency transactions.

That’s the general gist of things, as far as the unique features of crypto technology are concerned. As you might expect, there’s a lot more to cover, in this regard, but as I’ve mentioned earlier, it’s something for a different section, altogether. So, if you’re not familiar with any of the concepts that we’ve discussed, up to this point in the section, check out other sections on our Crypto 101 Handbook - it covers each and every single of those topics, in-depth!

What Happens During a Crypto Transaction?

Now that you’re familiar with the unique features of cryptocurrencies, in general, it’s time to check out how does crypto work, transaction-wise - specifically, what happens when you perform a cryptocurrency transaction. For consistency’s sake, let’s stick to the same example I gave earlier - you sending some crypto to Tim.

How does cryptocurrency work: What happens during a crypto transaction?

Also, let’s say that you’ve decided to send Bitcoin to Tim - evidently, this would work the same with most other cryptocurrencies out there, but Bitcoin is probably still the simplest example.

So, in order to perform this transaction, you will need to have a cryptocurrency wallet, with BTC inside of it. Most wallets work the same - you enter the receiver wallet address, the amount of crypto that you’d like to send, and pass a few confirmations.

Now, as soon as you send that BTC, your transaction will be submitted to the network. In the case of Bitcoin, it will need to be verified, in order to be confirmed. This is the core security measure that’s employed by blockchain technology - it’s called a “consensus algorithm”, and it helps keep the cryptocurrency network secure and fraud-resistant.

It’s a really intimidating-sounding term, but what it boils down to is a method of how the blockchain confirms the validity of a transaction. Different blockchains use different methods, and with Bitcoin, the consensus algorithm is called “Proof-of-Work”.

Have you ever heard the term “cryptocurrency miner”? Well, this is what Proof-of-Work refers to - miners are people who employ their computers (or other special devices) to earn cryptocurrency for them! Miners earn crypto for confirming transactions happening on the blockchain - such as your transaction, where you send Tim your Bitcoin.

As you might imagine, this is an entire, huge topic, in of its own! For now, though, just keep in mind what I said earlier - when you perform the transaction, it’s placed in a queue, on the blockchain, and awaits confirmation. Now, if your transaction is legitimate, it will receive all of the required confirmations, and the Bitcoin that you’ve sent will reach Tim’s wallet in no time.

On the flip side, if you decide to “trick the system”, and try to perform some sort of a hacker-like faulty transaction, it will get denied, pretty fast - that’s the magic of consensus algorithms and blockchain security!

You should be aware of this entire process if you’re looking at how does investing in cryptocurrency work, as well. As you purchase crypto, or perform any other transactions, many of those processes will be happening in the background!

All of that being said, that’s essentially how crypto transactions work! Mind you, as we’ve established earlier, each cryptocurrency is going to have this process look a bit different from the other. Especially nowadays, with so many new blockchain projects constantly springing up, all around. The premise, though, will remain the same, either way!

Why Should You Know How Cryptocurrencies Work?

So, then - now that you have a general idea of how cryptocurrencies work, it’s also worth addressing the “why” - specifically, why it’s important to know this, in the first place!

How does cryptocurrency work: Why should you know how cryptocurrencies work?

Naturally, since you’re reading this, you do probably already have some reasons of your own. However, the point that I want to emphasize is that EVERYONE should learn about crypto - how it works, what happens during transactions, and so on.

The biggest reason for why that’s the case is pretty simple, actually - with crypto becoming as popular as it is, it’s being integrated into our everyday lives! While the integrations are still very slow, I urge you to think about it - the simplest example would be major payment gateways, such as PayPal and Visa starting to accept and perform cryptocurrency transfers.

Following that, if you understand how cryptocurrencies work, you will also have a much better chance of protecting yourself from potential scams and hacking attempts. No malicious individual or organization will be able to come in and trick you, since you will already understand the differences between a normal cryptocurrency transaction, and some shady dealing happening in the background.

Lastly, learning about how cryptocurrencies work is also one of the very first steps that you can take when it comes to studying the crypto world, as a whole! Cryptocurrencies, and the blockchain technology behind them, are some of the core, essential elements that make up the entire industry.

This is very true if you want to look into how does the crypto market work, or even how does investing in cryptocurrency work, as well! When you understand the technology behind crypto, and what happens during transactions, you’ll be much better-equipped to start your investment journey!

All that you need to do in order to understand the importance of crypto tech is take a look at DeFi, or decentralized finance. It’s a new-and-emerging form of finance, and one that already houses some huge investors, and incredible amounts of money. Well, no matter if it’s a cryptocurrency lending platform, a gambling game based on blockchain technology, or some sort of a wallet project, everything essentially boils down to the very fundamentals of how cryptocurrencies work!