How Cryptocurrency Works and its Future

Cryptocurrency is an encrypted decentralized digital currency transferred between peers and confirmed in a public ledger via a process known as mining. It is a digital or virtual currency that uses cryptography for security. It is organic in nature i.e. it is not issued by any central authority, rendering it theoretically immune to government interference or manipulation. Being decentralized means having no server or central authority. Cryptocurrency is actually a subset of digital currency. The anonymous nature of cryptocurrency transactions makes them well suited for a host of nefarious activities, such as money laundering and tax evasion.

The first cryptocurrency that came into existence was Bitcoin, which was launched in 2009 by an individual or group known under the pseudonym “Satoshi Nakamoto”. Thereafter due to Bitcoin’s success and popularity, many other competing cryptocurrencies came up like - Litecoin, Namecoin, PPcoin, Ethereum, Ripple, Monero, etc. These virtual currencies are collectively referred to as Altcoins. Satoshi Nakamoto never intended to invent a currency. In late 2008 on 09 January 2009 Satoshi announced that he has developed – “A peer-to-peer Electronic cash system called Bitcoin to prevent double-spending and is completely decentralized with no server or central authority.

The crux about Satoshi’s invention was that he successfully found a way to build a decentralized digital cash system, which many attempted to create in the 90’s, but failed. After trying all the centralized attempts, which failed Satoshi tried to build a digital cash system, which is not centralized but is like a peer-to-peer network for file sharing.

There are various speculations about Nakamoto’s identity, as the cryptocurrencies increase in number, popularity and notoriety. Though his true identity has not been uncovered, it is believed that the value of Bitcoins under his control may have exceeded $1 billion in 2013.

Advantages of cryptocurrency

Cryptocurrencies makes it easier to transfer funds between two parties & the transfers are facilitated using public and private keys ensuring security. These fund transfers are done with minimal processing fees, thus allowing the users to avoid the higher amount of fees charged by most banks and financial institutions for wire transfers.

Bitcoin uses block chain to store an online ledger of all the transactions that have ever been conducted and this ledger is copied across all the computers running the Bitcoin software. Many experts see this - Block chain to have various uses in technology like - online voting, crowd funding, lowering transaction costs and making the payment process more efficient.

Disadvantages of cryptocurrency

Since cryptocurrencies are virtual and have no central repository, a digital cryptocurrency balance can be wiped out simply by a computer crash if a backup copy of the holdings does not exist. Moreover, as the prices are based on demand and supply, the rate of exchange of a cryptocurrency with another currency can fluctuate widely.

Cryptocurrencies are not immune to the threat of hacking. For instance, in Bitcoin’s history, it has been subjected to many thefts, including a few that were more than $1 million in value.

Bitcoins

A cryptocurrency like Bitcoin consists of a network of peers. Every peer has a record of the complete history of all transactions and thus the balance of every account. A transaction in Bitcoin is like a file that says, “Harry gave x - bitcoins to Ron”, and is signed by Harry’s private key. After being signed, the transaction is broadcasted to all the peers in the network. The transaction is known almost immediately to the whole network but it gets confirmed only after a specific amount of time. After a transaction is confirmed it cannot be reversed, and it becomes a part of an immutable record of historical transactions called as – Block chain.

Only miners can confirm transactions and this process is called mining. In other words, mining is the process of confirming transactions and add them to a public ledger. In order to add a transaction to the ledger, the “miners” must solve an increasingly complex computational problem (like a mathematical puzzle). Mining is open source, so anyone can become a miner. Miners verify the transactions, mark them as legit and spread them in the network. After a miner confirms a transaction, every node has to add it to the database and then it becomes a part of the Block chain. Once a block is added to the ledger i.e. as it becomes part of the block chain, all correlating transactions become permanent and a small transaction fee is added to the miner’s wallet as a reward and this process creates new bitcoins. Since there is no central authority in cryptocurrency, it needed some kind of mechanism to prevent any kind of abuse from any particular party. Suppose if someone creates thousands of peers and spreads forged transactions then the network would break immediately. Therefore, to prevent this to happen “Satoshi” had set the rules that the miners will have to invest some work resources of their computers to qualify for the task of mining. They were required to find a hash (a product of cryptographic function) that connects a new block with its predecessor. This is called the proof-of-work system, which gives value to the coins. Most cryptocurrencies use a proof-of-work system which uses a hard to compute but easy to verify computational puzzle to limit exploitation of the mining process. (It is like a really hard to solve “captcha” that requires lots of computing).

In Bitcoins, it is based on the SHA-256 Hash algorithm. The SHA-256 algorithm is the basis of a cryptologic puzzle that the miners compete to solve. After finding the solution, a miner can build a block and add it to the block chain and as an incentive receives some Bitcoins. As the difficulty of this puzzles increases gradually with the amount of computer power the whole miner’s invest, there is only a specific amount of cryptocurrency tokens that can be create in a given amount of time. This is a part of the consensus created by “Satoshi” that no peer in the network can break. Thus, the consensus keeping process is secured by strong cryptography. They are not secured by any person or organization but by math.

Pseudonymity

Owners of the cryptocurrency keep their digital coins in encrypted digital wallet with an encrypted address, which is not attached to a person’s identity. Thus, the connection between the owner and the coins is pseudonymous rather than anonymous as the ledger is open to the public.

Though cryptocurrency exists in the digital world and is different from the general currency it can be divided into smaller units, just as the rupee, which can be broken into paisa and the dollar into cents. In the case of bitcoins, the smallest unit to which it can be broken is called – “Satoshi” which is named after “Satoshi Nakamoto”.

As the block chain increases in size with the increase in number of transaction, it becomes more difficult for the attackers to disrupt it. Hence, the computational power required to reverse a block chain is very high and so this discourages the small-scale attacks to happen.

In Bitcoins, the balances are kept using public and private keys, which are long string of numbers and letters linked through the mathematical encryption algorithm that was used to create them. The public key (just like a bank account number) serves as the address which is published or visible to the world and to which others may send bitcoins. The private key (just as an ATM PIN) is meant to be kept secret and only used to authorize Bitcoin transmissions.

To make use of digital cash we need a - payment network with accounts, balances and transactions. The major problem that every digital payment network has to solve is the problem of Double-spending. It is prevented usually by a central server, which keeps records about the balances.

However, in a decentralized network, we don’t have this kind of central server. So, here every peer in the network needs to do this job i.e. they need to have a list with all transactions to check if the future transactions are valid or is an attempt to Double-spending. But now again there is the problem that how can all the peers in the network have a consensus about these records. If the peers of the network disagree about only one single, minor balance, then everything might get broken. Thus, they will need to have an absolute consensus. Generally, a central authority decides about the correct state of the balance and declares consensus. So, now the question is how can a consensus be achieved without a central authority?

Nobody did know the answer to this question until “Satoshi” emerged out of nowhere and proved that it was possible to achieve consensus without a central authority.

Double spending

It is the risk that a digital currency can be spent twice. Double spending problem is unique to the digital currencies as digital information can be reproduced relatively easily. Physical currencies don’t have this problem as they cannot be easily replicated and the parties involved in a transaction can immediately verify the bonafides of the physical currency. With digital currency, there is a risk that the holder could make a copy of the digital token and send it to a merchant or another party while still retaining the original. This was a matter of concern initially with Bitcoin. However, Bitcoin has a mechanism based on transaction logs to verify the authenticity of each transaction & prevent double spending.

In Bitcoins, all the transactions are included in a shared public transaction log (Block chain). This mechanism ensures that the person or party spending the bitcoins really owns them and also prevents double-spending and other frauds to happen.

The block chain of verified transactions is built up over time as more and more transactions are added to it. Bitcoin transactions take some time to verify because the process of verification involves complex algorithms that take up a great deal of computing power. It is therefore, very difficult to duplicate the block chains because of the immense amount of computing power that would be required to do so.

Hackers have tried using various methods like out-computing the block security mechanism or using a double-spending technique that involves sending a fraudulent transaction log to a seller and another to the rest of the Bitcoin network. These attempts by the hackers have met with only limited success and in fact, most Bitcoin thefts so far have not involved double-spending but rather have been due to users storing bitcoins without adequate safety measures.

Litecoin

Litecoin was launched in the year 2011. It is an alternative cryptocurrency based on the model of Bitcoin. “Charlie Lee”, a MIT graduate and former Google engineer, is the Litecoin’s creator. Litcoin differs from Bitcoin in factors like faster block generation rate and the use of – scrypt as a proof-of-work scheme (instead of SHA-256 as in Bitcoin).

BITCOIN TRANSACTION PROPERTIES

1. Fast and global: Transactions are very fast and are confirmed instantly.

2. Irreversible: All the transactions after confirmation are considered irreversible. Nobody can reverse or undo those transactions.

3. No Permissions: Anybody can use cryptocurrencies. It is just a software that can be downloaded for free. There is no gatekeeper.

4. Pseudonymous: Bitcoins are received on addresses, which are of 30 random characters, and these addresses cannot be connected to any real world identity of users.

5. Secure: Public and private keys secure cryptocurrencies and only the owner of the private key can send money.

BITCOIN MONETARY PROPERTIES

1. Controlled supply: Most cryptocurrencies have a limit on the supply of their tokens. In Bitcoins, the supply will decrease in time and probably would reach its end of supply in around 2140.

2. No debt but bearer: It takes away the control of the central banks take on inflation or deflation by manipulating the monetary supply.

Conclusion

For the future, many feel cryptocurrency as a hope that facilitates exchange, which is more transportable than hard metal and is something that will remain outside the influence of the central banks and governments.