How Does Cryptocurrency Work? A Complete Guide

Updated Time : January 26, 2024
How Does Cryptocurrency Work A Complete Guide

Table of Contents

It is no wonder for anybody diving into the world of digital currencies; many wonder- how does cryptocurrency work

It’s a question that demands a clear and comprehensive answer. Here, we’ll unravel the complexities behind cryptocurrency, shedding light on its intricate workings.

You’re in the right place if you’ve ever been curious about the mechanisms powering these virtual coins or have a penchant for delving into tech topics.

Join us to learn all about it.

What is Cryptocurrency?

Cryptocurrency, often called ‘crypto’, is a revolutionary form of digital currency. Unlike the tangible money we’re accustomed to carrying in our wallets, cryptocurrency exists solely in the virtual realm. 

However, this doesn’t limit its utility. While its primary function serves online transactions, there are instances where you can use it for tangible purchases, too.

According to Statista, there are over 425 million cryptocurrency users worldwide. The surge in its adoption has been remarkable, with figures skyrocketing from 5 million users in 2016, marking an increase of over 8,000%. 

This tremendous growth parallels the emergence of crypto exchanges, wallet applications, and enterprises embracing cryptocurrency payments.

Types of Cryptocurrency 

Cryptocurrencies can be categorized into two main types: coins and tokens. Whether virtual, digital or tangible, coins operate like traditional money and possess distinct blockchains. 

On the other hand, tokens reside on pre-existing blockchains and can function as a medium of exchange and a representation of asset ownership.

Cryptocurrency Examples

Bitcoin, as the pioneering cryptocurrency, holds the distinction of being the most widely traded. Following closely in terms of value and utility is Ethereum, recognized for its capacity to handle intricate transactions.

Beyond these giants are many other popular cryptocurrencies, often termed ‘altcoins’. Notable mentions in this category include Cardano, Solana, Dogecoin, and XRP.

Advantages of Cryptocurrency

Cryptocurrency offers several benefits over traditional forms of currency.

Some of these advantages include:

  • Privacy: Cryptocurrency transactions don’t require disclosing personal information, safeguarding you from potential identity theft and other fraudulent activities.
  • Security: Your investment remains safe, irrespective of governmental instabilities.  In other words, they have Cryptographic Security.
  • Global Reach: Cryptocurrencies are universal, eliminating the need to navigate or pay foreign exchange rates. However, it’s essential to note that they aren’t legal in all countries.
  • Freedom from Bank Restrictions: Unlike traditional banking systems, with cryptocurrencies, you aren’t bound by limitations such as ATM withdrawal caps.

Disadvantages of Cryptocurrency

While cryptocurrency offers various benefits, it’s essential to be aware of its downsides.

Some of the disadvantages include:

  • Volatility: Cryptocurrencies are known for their price fluctuations. The value of a cryptocurrency can swing dramatically in a short period, leading to significant financial gains or losses.
  • Irreversible Transactions: Once a cryptocurrency transaction is made, it cannot be reversed. This absence of a safety net can be problematic if a mistake occurs or fraudulent activity occurs.
  • Legal and Regulatory Issues: Cryptocurrencies operate in a gray area in many countries, with some governments banning or heavily regulating their use. This can pose user challenges and limit the adoption and utility of specific cryptocurrencies.
  • Security Concerns: Even though blockchain technology is usually safe, some cryptocurrency exchanges have been attacked by hackers, causing significant losses for those who invested.

How Does Cryptocurrency Work?

Cryptocurrency functions on a few foundational principles and technologies:

Blockchain

At the heart of every cryptocurrency lies the blockchain. It’s a distributed public ledger that records all transactions. This ledger is maintained and updated by all participants in the cryptocurrency network. 

Blockchain and cryptocurrency are intricately linked, but they differ in many ways as well. Check out our blog about the differences between cryptocurrency and blockchain to learn more.

Creation – Mining

Cryptocurrencies come into existence through a process known as mining. Miners use computational power to solve complex mathematical challenges.

Successfully solving these problems results in the generation of new coins.

Cryptographic Wallets

Once you’ve acquired cryptocurrency through mining or purchasing from brokers, you need a place to store it. This is where cryptographic wallets come into play.

They allow users to hold, spend, and manage their digital assets.

Ownership and Transactions

Owning cryptocurrency doesn’t mean you have a physical entity. Instead, you possess a digital key.

This key permits you to shift a specific value or unit from one individual to another, bypassing the need for a centralized authority or third-party involvement.

Evolution and Future Potential

Although Bitcoin, the pioneer of cryptocurrencies, was introduced in 2009, digital currencies and blockchain applications are still blossoming. As technology advances, we can anticipate a broader adoption and integration of blockchain.

This includes the potential for trading various financial instruments like stocks, bonds, and other assets using this groundbreaking technology.

Do you want to know what the future holds for cryptocurrencies? If yes, then take a look at our latest article about the future of cryptocurrency.

Cryptocurrency vs. Traditional Currency

Cryptocurrency is just a new addition to the world of transactions. Here’s the comparison table for Cryptocurrency vs. Traditional Currency:

AttributesTraditional CurrencyCryptocurrency
ProductionProduced by government in paper bills and coinsNot produced by any government
Physical FormCan be carried physically or stored in a bankExists only in digital form
Backed byBacked by governmentNo government, bank, or financial institution backing
StorageHeld in banks or financial institutionsStored in a digital wallet
Insurance against LossInsured by banks against lossNo recourse in the event of a loss

What is Cryptographic Security?

Cryptographic security is like a digital guardian that keeps information safe and hidden from prying eyes. It uses special codes, like secret languages, to lock up data, making it impossible to understand without the right key.

Just as you wouldn’t want strangers reading your diary, cryptographic security ensures that only the people with the secret code can access and understand the information. It’s like a protective shield for your digital secrets.

If you are interested and want to know more about Cryptographic Security, you can look into our blog about it!

Cryptography vs. Encryption: Guardians of Cryptographic Security

Cryptography acts as the mastermind behind secret codes, securing digital transactions with a cloak of confidentiality and integrity.

Encryption, its trusted ally, is the practical wizardry that transforms our readable messages into these secure codes, ensuring only the intended recipients can decode them.

These dynamic duos work harmoniously in cryptographic security to protect our digital world from unauthorized access and prying eyes. But they are often confused as the same.

Do you want to learn more about the core differences between cryptography and encryption? Then, you must read our blog illustrating the distinguishing factors between cryptography and encryption!

Types of Cryptographic Security

The types of cryptographic security determine how information is encrypted and decrypted, and they play a crucial role in safeguarding data from prying eyes and malicious intentions. 

1. Symmetric Cryptography (or Symmetric Key Encryption)

Symmetric cryptography is a private conversation between two people using a secret language they only understand. Here, the same ‘secret’ (known as a key) is used to both lock (encrypt) and unlock (decrypt) information. 

Since the same key is employed for both tasks, this key must remain secret. If someone else learns this key, they can both lock and unlock the conversation.

A popular method that uses symmetric cryptography is the Advanced Encryption Standard (AES).

2. Asymmetric Cryptography (or Public Key Encryption)

Imagine a mailbox with a slot and a lock. Anyone can drop a letter through the slot (public key), but only the person with the key can open the mailbox and read the letter (private key). 

Asymmetric cryptography works similarly. It uses two keys: a public key to lock (encrypt) the data and a private key to unlock (decrypt) it.

RSA is a well-known algorithm that employs this method, named after its inventors Rivest, Shamir, and Adleman.

3. Hash Functions

Think of hash functions as unique digital fingerprints. No matter how long a document or message is, a hash function will produce a fixed-size string or ‘hash’ from it. 

The beauty of these functions lies in their uniqueness; even a tiny change in the input will result in a completely different hash. Also, it’s incredibly challenging to work backward from the hash to get the original data.

A widely used hash function is SHA-256, which is part of the SHA-2 family.

4. Digital Signatures

Digital signatures are the electronic equivalents of handwritten signatures or stamped seals. They are unique to the document and the signer, providing a two-fold verification: proving the document’s origin and confirming that it hasn’t been tampered with. 

Creating a digital signature typically involves the blend of asymmetric cryptography (for the unique signature) and hash functions (to ensure the document remains unchanged).

If you are interested in learning about these types in a more detailed way, please check out our comprehensive guide on different types of cryptography.

Cryptographic Techniques

From online banking to sending personal messages, cryptographic techniques work silently in the background, giving us the peace of mind we need in this interconnected era.

There are many Cryptographic Techniques available. They are:

  • Encryption: Converts readable data (plaintext) into an unreadable format (ciphertext) using a key.
  • Decryption: Converts the unreadable format (ciphertext) back into its original readable form (plaintext) using a key.
  • Key Exchange: Securely exchanging cryptographic keys over a public channel. Example: Diffie-Hellman key exchange
  • Authentication: Verifying the identity of a user, system, or entity.
  • Digital Signatures: Provides proof of the origin, identity, and status of an electronic document, transaction, or message.

To understand the role of cryptographic techniques, specifically in cryptocurrency, look at our comprehensive guide about the different types of cryptographic techniques.

How to Buy Cryptocurrency: A Step-by-Step Guide

Buying a Cryptocurrency is easier than you think. Here are 3 steps for you to follow:

Step 1: Choosing a Platform

Before diving into cryptocurrencies, you must decide on the right platform to purchase. Here are some features for Traditional Brokers:

  • Offer both cryptocurrency and other financial assets like stocks, bonds, and ETFs.
  • Generally have lower trading costs.
  • Might have limited cryptocurrency-related features.

Here are some features of Cryptocurrency Exchanges:

  • Specialized platforms with a focus on trading various cryptocurrencies.
  • Offer features like different crypto wallets, interest-bearing accounts, and more.
  • Typically charge asset-based fees.

Step 2: Funding Your Account

Once you’ve picked your platform, you must put funds into your account to start trading. Here are some Payment Options:

  • Most platforms allow fiat currency (like USD, GBP, or EUR) deposits using debit or credit cards.
  • Some platforms might not support credit card transactions due to cryptocurrencies’ associated risks and volatility.
  • Other payment methods can include ACH transfers and wire transfers.

Here are some Factors to Note:

  • The availability and processing time of deposit methods differ by platform.
  • Deposits might take varying times to clear based on the method chosen.
  • Be aware of potential fees, including deposit, withdrawal, and trading fees. These can differ based on the platform and payment method.

Step 3: Placing an Order

With a funded account, you’re ready to buy or sell cryptocurrencies. Here is the Buying Process:

  • Navigate to your chosen platform’s web or mobile interface.
  • Opt for “buy” and select the order type (e.g., market order, limit order).
  • Input the quantity of cryptocurrency you wish to purchase.
  • Confirm and place your order.

Here is the Selling Process: Similarly, for selling, navigate to the “sell” option, choose the order type, specify the amount you want to sell, and confirm the transaction.

Remember, cryptocurrency trading carries inherent risks. Always conduct thorough research and consider seeking advice from financial professionals.

How to Store Cryptocurrency?

Once you have purchased cryptocurrency, you must store it safely to protect it from hacks or theft.

Here is how you can store it:

How to Store Cryptocurrency

Step 1: Purchase Cryptocurrency

Before you even think about storing cryptocurrency, you must get some first. You can buy these digital coins from places called cryptocurrency exchanges or brokers.

Think of them as online shops for digital money. Now, it’s super important to pick a trustworthy exchange because you want your buying process to be safe and hassle-free.

Step 2: The Importance of Secure Storage

Imagine you’ve just bought some digital money called cryptocurrency. Now, just like you’d want to keep real money safe from thieves, you must also keep this digital money safe.

The online world has a lot of digital “pickpockets” and “burglars.” 

So, to protect your digital money, you use something called a cryptocurrency wallet. Think of it like a digital safe or locker where your money is kept hidden from these bad guys.

Step 3: Choose Your Preferred Wallet Type

Every individual’s needs vary, and so does the choice of their cryptocurrency wallet. Consider cryptocurrency wallets like purses or wallets for your digital money. Some are physical gadgets you can hold, while others are just software on your computer or phone. 

Now, some places where you buy or trade these digital currencies, called exchanges, have built-in wallets where you can keep your money. It’s like a store giving you a pouch to hold the things you buy. But not every store offers that pouch, so always check if they do!

Step 4: Familiarize Yourself with Wallet Options

The cryptocurrency world often throws around terms like “hot wallets” and “cold wallets.” They might sound perplexing to the uninitiated, but these terms essentially denote the nature of the wallet’s connectivity and storage mechanism.

Hot Wallet Storage

Think of a hot wallet like a purse or wallet that is always open and connected to the internet. It’s a digital tool that keeps the secret codes (cryptographic keys) safe for your online money or assets. 

Because they’re always online, they’re handy for people who trade often. But this also means they can be at risk from online hackers. A cool thing about them? They don’t have extra charges so that they can save you money.

Cold Wallet Storage

Cold wallets are like a super-secure safe in a fortress where you store your most precious items. In the digital world of cryptocurrencies, there’s something similar called a “cold wallet.” Some people also call them “hardware wallets.” 

Instead of being online, they work offline on special electronic gadgets that hold the keys to your digital money. Because they’re not connected to the internet, it’s hard for online hackers to get to them.

But, just like some high-end safes can be expensive, many of these cold wallets come with a cost.

Crypto Wallet

Step 5: Make an Informed Decision

With the knowledge of both hot and cold wallets, it’s time to evaluate your needs. If convenience and frequent access are your priorities, a hot wallet might be your ally. 

However, if you’re looking at long-term storage with an emphasis on security, cold wallets stand out as the obvious choice. Regardless of your pick, always ensure you back up your wallet, and for added security, maintain multiple copies in different, secure locations.

Final Word

The cryptocurrency world might seem tricky, but it’s about finding the right safe spot for your digital coins.

Think of wallets like choosing between a handy pouch or a sturdy safe. 

Here, you have learned about how does Cryptocurrency work. So, no matter your pick, always keep your coins secure.

As you continue your crypto adventure, remember to stay smart and safe. Happy storing!

Picture of Shahria Emon

Shahria Emon

Emon, a blockchain enthusiast and software development expert, harnesses decentralized technologies to spur innovation. Committed to understanding customer needs and delivering bespoke solutions, he offers expert guidance in blockchain development. His track record in successful web3 projects showcases his adeptness in navigating the complex blockchain landscape.

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