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How Cryptocurrency Work?

Functionally, most cryptocurrencies are variations on Bitcoin, the first widely used cryptocurrency. Like traditional currencies, cryptocurrencies’ express value in units – for instance, you can say “I have 2.5 Bitcoin,” just as you’d say, “I have $2.50.”

Several concepts govern cryptocurrencies’ values, security, and integrity.

Block Chain

A cryptocurrency’s block chain is the master ledger that records and stores all prior transactions and activity, validating ownership of all units of the currency at any given point in time. As the record of a cryptocurrency’s entire transaction history to date, a block chain has a finite length – containing a finite number of transactions – that increases over time.

Identical copies of the block chain are stored in every node of the cryptocurrency’s software network – the network of decentralized server farms, run by computer-savvy individuals or groups of individuals known as miners, that continually record and authenticate cryptocurrency transactions.

A cryptocurrency transaction technically isn’t finalized until it’s added to the block chain, which usually occurs within minutes. Once the transaction is finalized, it’s usually irreversible – unlike traditional payment processors, such as PayPal and credit cards, most cryptocurrencies have no built-in refund or chargeback functions, though some newer cryptocurrencies have rudimentary refund features.

During the lag time between the transaction’s initiation and finalization, the units aren’t available for use by either party. The block chain thus prevents double-spending, or the manipulation of cryptocurrency code to allow the same currency units to be duplicated and sent to multiple recipients.

Private Keys

Every cryptocurrency holder has a private key that authenticates their identity and allows them to exchange units. Users can make up their own private keys, which are formatted as whole numbers between 1 and 78 digits long, or use a random number generator to create one. Once they have a key, they can obtain and spend cryptocurrency. Without the key, the holder can’t spend or convert their cryptocurrency – rendering their holdings worthless unless and until the key is recovered.

While this is a critical security feature that reduces theft and unauthorized use, it’s also draconian – losing your private key is the digital equivalent of throwing a wad of cash into a trash incinerator. While you can create another private key and start accumulating cryptocurrency again, you can’t recover the holdings protected by your old, lost key.

Wallets

Cryptocurrency users have “wallets” with unique information that confirms them as the temporary owners of their units. Whereas private keys confirm the authenticity of a cryptocurrency transaction, wallets lessen the risk of theft for units that aren’t being used. Wallets used by cryptocurrency exchanges are somewhat vulnerable to hacking – for instance, Japan-based Bitcoin exchange Mt. Gox shut down and declared bankruptcy after hackers systematically relieved it of more than $450 million in Bitcoin exchanged over its servers.

Wallets can be stored on the cloud, an internal hard drive, or an external storage device. Regardless of how a wallet is stored, at least one backup is strongly recommended. Note that backing up a wallet doesn’t duplicate the actual cryptocurrency units, merely the record of their existence and current ownership.

Miners

Miners serve as record-keepers for cryptocurrency communities, and indirect arbiters of the currencies’ value. Using vast amounts of computing power, often manifested in private server farms owned by mining collectives comprised of dozens of individuals, miners use highly technical methods to verify the completeness, accuracy, and security of currencies’ block chains. The scope of the operation is not unlike the search for new prime numbers, which also requires tremendous amounts of computing power.

Miners’ work periodically creates new copies of the block chain, adding recent, previously unverified transactions that aren’t included in any previous block chain copy – effectively completing those transactions. Each addition is known as a block. Blocks consist of all transactions executed since the last new copy of the block chain was created, usually a few minutes prior.

The term “miners” relates to the fact that miners’ work literally creates wealth in the form of brand-new cryptocurrency units. In fact, every newly created block chain copy comes with a two-part monetary reward: a fixed number of newly minted (“mined”) cryptocurrency units, and a variable number of existing units collected from optional transaction fees (typically less than 1% of the transaction value) paid by buyers. Thus, cryptocurrency mining is a potentially lucrative side business for those with the resources to invest in power- and hardware-intensive  mining operations.

Though transaction fees don’t accrue to sellers, miners are permitted to prioritize fee-loaded transactions ahead of fee-free transactions when creating new block chains, even if the fee-free transactions came first. This gives sellers an incentive to charge transaction fees, since they get paid faster by doing so, and so it’s fairly common for transactions to come with fees. While it’s theoretically possible for a new block chain copy’s previously unverified transactions to be entirely fee-free, this almost never happens in practice.

Through instructions in their source codes, cryptocurrencies automatically adjust to the amount of mining power working to create new block chain copies – copies become more difficult to create as mining power increases, and easier to create as mining power decreases. The goal is to keep the average interval between new block chain creations steady at a predetermined level – for instance, Bitcoin’s is 10 minutes.

Finite Supply

Although mining periodically produces new cryptocurrency units, most cryptocurrencies are designed to have a finite supply. Generally, this means that miners receive fewer new units per new block chain as time goes on. Eventually, miners only receive transaction fees for their work.

This has yet to happen with any extant cryptocurrency, but observers predict that the last Bitcoin unit will be mined sometime in the mid-22nd century, if current trends continue. Finite-supply cryptocurrencies are thus more similar to precious metals, like gold, than to fiat currencies – of which, theoretically, unlimited supplies exist.

Cryptocurrency Exchanges

Many lesser-used cryptocurrencies can only be exchanged through private, peer-to-peer transfers, meaning they’re not very liquid and are hard to value relative to other currencies – both crypto- and fiat.

More popular cryptocurrencies, such as Bitcoin and Ripple, trade on special secondary exchanges similar to forex exchanges for fiat currencies. (The now-defunct Mt. Gox is one example.) These platforms allow holders to exchange their cryptocurrency holdings for major fiat currencies, such as the U.S. dollar and euro, and other cryptocurrencies (including less-popular currencies). In return for their services, they take a small cut of each transaction’s value – usually less than 1%.

Cryptocurrency exchanges play a valuable role in creating liquid markets for popular cryptocurrencies and setting their value relative to traditional currencies. However, exchange pricing can still be extremely volatile – Bitcoin’s U.S. dollar exchange rate fell by more than 50% in the wake of Mt. Gox’s collapse, for instance.

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