How does digital currency work?

As you may already be aware, there many digital currencies in existence today. Despite the many differences that separate each, the fundamental technology that drives them all is the same. While this may seem complex at first, understanding the basics will give you a sound understanding of how digital currency works today.

In this article, we will discuss the revolutionary technology that drives cryptocurrencies, and how it all works when you put everything together.

Fundamental Network: The Blockchain

The biggest stumbling block for people starting to learn about cryptocurrencies is the blockchain. In IT terms, a blockchain is a cryptographic protocol – and it first appeared in 2009 along with Bitcoin.

Bitcoin’s biggest revolution, therefore, is the invention of the Blockchain, or the original cryptographic protocol. Although this term is still not widely understood outside of technological circles, it is poised to transform the way in which we do many things in business and finance in the future.

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Today, you will often see people refer to blockchain and Blockchain. The former is for all cryptocurrency blockchains, while the latter (capitalized) refers only to Bitcoin’s Blockchain. One easy way to remember this distinction is that Bitcoin is always capitalized, too. So, what’s the big difference? The key is understanding that Bitcoin introduced the Blockchain, but does not own it.

In other words, while Bitcoin’s anonymous creators invented Blockchain technology, it is not proprietary to Bitcoin – instead, it is an open source protocol. This means that creators of other digital currencies, such as Ethereum or Ripple, use blockchain protocols to implement new cryptocurrencies and blockchains, much like a web developer uses HTML and CSS coding to create websites. The underlying technology is the same and will create a similar end product, but the final result is designed and tweaked to meet different needs, ideas, and functions.

The Blockchain protocol as introduced by Bitcoin introduced a new era of currency to the world – cryptocurrencies that could be used in place of traditional money such as the US dollar. Blockchain technology essentially made it possible to create new digital currencies that are:

  • Unique and non-replicable
  • Non-repudiable, eliminating double-spending
  • Limited in supply, leading to scarcity
  • Durable and immutable
  • Divisible and uniform

Just as it is impossible to make websites without HTML, it would be impossible to create cryptocurrencies without a blockchain in place. No matter which cryptocurrency you are using, each uses an adaptation of blockchain technology. It is on this blockchain that the coins or tokens are created, stored, and exchanged, with every movement recorded on a public ledger, which could be compared to that which an accountant uses.

Blockchain technology made cryptocurrency possible, but it is important to remember that this does not make blockchain a cryptocurrency: it is the code that blockchain developers use to create and develop digital currencies, among other uses of the protocol.

As the technology is so young, many of these other uses have not even been explored yet, making this an exciting, futuristic technology poised to transform the world around us: This is only the beginning!

The Creation and Movement of Cryptocurrencies: Mining

It’s all very well creating a digital currency – but how do people acquire them, or even use them? More to the point, how can people make safe, yet anonymous transactions without being subjected to fraud or manipulation from other equally anonymous actors?

Blockchain’s answer was to introduce the concept and process known as mining.

While you may imagine a miner hacking away deep underground at the rocky earth in search of valuable resources, it’s a little different with the blockchain! In fact, the mining is all done by computational power – when Bitcoin was first introduced, anyone could mine it on their home laptop. No matter what blockchain you look at, it has a public ledger that records every action that has taken place on a network.

These actions are all recorded and validated by miners who work on each transaction on the blockchain. As blockchains can grow very large in size, they are divided into smaller, more manageable blocks, which the miners work on.

Any transaction made worldwide will fit into one of these blocks; once a block is completed, it is added to the end of the blockchain and a new one is started. As you might expect, the ledger is constantly updating, and all users have access to it.

Miners on a blockchain work to confirm each block and the transactions it contains. This is done through raw computer power, in which a hash (a cryptographic puzzle) is solved. Typically, a hash contains:

  • Transactional data within the current block
  • Complex math formula to be solved
  • The prior last block’s hash

Once a hash is solved and completed, the latest block is confirmed – and the miners are rewarded with a defined number of units of that specific blockchain’s technology – such as Bitcoin on the Bitcoin Blockchain, or Ethereum on the Ethereum blockchain.

As the most established digital currency, Bitcoin regulates its supply and manages inflation by increasing the difficulty of its blockchain as it grows. This makes it harder for miners to abuse their position at the same time, offering an accountable and stable system for currencies that values transparency above all.