This article was contributed by Mary A. Callahan who is a freelance journalist working for CEX.io.
As time goes by, the cryptocurrency industry is getting more mainstream traction. Eventually, almost everyone in the world will be required to understand the technology that drives this financial paradigm.
In this article, we will try to outline the most important mechanisms in crypto. This should allow you to understand how BTC to USD trading works. In addition, you will learn about crucial concepts that secure and allow crypto assets to be transferred seamlessly between users.
How Does Blockchain Work?
Blockchain is the technology that allows cryptocurrencies to exist. Pioneered by Satoshi Nakamoto and their Bitcoin whitepaper in 2008, blockchain is a decentralized peer-to-peer network that uses a public digital ledger.
On a blockchain network, every transaction is immutably recorded on a public ledger, accessible to anyone. These transactions are then organized in blocks and connected with each other through cryptography. Hence, the name of the technology: blockchain.
This allows for a trustless system, where transactions are entirely public and cannot be tampered with. The actions on the blockchain are confirmed by a network of decentralized nodes that follow strict code rules.
Moreover, an important feature of blockchain is that transactions are strictly without intermediaries. Consequently, every transaction is between two users, with each participant being the sole custodian of their assets.
But how is this possible? How does blockchain manage to create this trustless assets exchange system without having to rely on third-party custodians? The answer — consensus mechanisms.
What Is a Consensus Mechanism?
A consensus mechanism is an algorithm that allows the nodes to reach an agreement that the transactions on the network are authentic. Since the system is decentralized, consensus mechanisms provide the nodes with a set of rules to follow to verify the veracity of the network.
At the creation of a new block, the nodes will go through this algorithm and ensure that every transaction reaches its destination. Moreover, they will check that there haven’t been any asset double spending occurrences.
At first, there were only a handful of consensus mechanisms widely used in the crypto industry. However, over time, masterminds have pushed the tech further along to allow for better scalability, security, and/or decentralization.
Proof of Work
Initially popularized by Bitcoin, Proof of Work (PoW) is an algorithm that allows computers called miners to reach a consensus and produce new blocks and coins. These specialized machines need to complete a mathematical puzzle (hash) that will determine the next block.
The miner that manages to guess the result right, receives the transaction fees from the block as well as the newly minted coins. The major tradeoff is that miners require enormous amounts of energy to run.
Proof of Stake
Unlike PoW, Proof of Stake (PoS) doesn’t require miners to compete for the next block by solving puzzles. Instead, nodes need to stake a certain minimal amount of the network’s token and lock it on the blockchain.
Staking then allows the nodes to participate in the consensus mechanism and receive rewards from transactions.
Proof of Importance
Proof of Importance tries to improve upon the original PoS concept by giving each node a different level of importance in the network. Introduced by NEM, the nodes in a PoI network receive a score that gives them more or less power in the consensus.
However, unlike in PoS, where the criteria is the amount of staked tokens, PoI protocols rang the nodes following additional factors. These include the number of tokens, number of transactions carried out, longevity in the network, activity clusters, etc.
Proof of Capacity
Proof of Capacity (PoC) is similar to PoW, although with the difference that PoC algorithm calculations are not carried out in real-time. Instead, the miners use the concept of “Plotting” where solutions are calculated upfront and stored on the miners’ hard drives.
The goal behind this mechanism is to reduce energy costs and provide a more eco-friendly alternative to mining.
Proof of Authority
Proof of Authority is an algorithm that allows certain nodes to reach consensus by providing work in the network. Similar to PoI, only a designated number of nodes can participate in creating blocks. However, in this case, nodes are chosen arbitrarily and given access to the consensus in the network.
This more centralized approach allows developing projects to slowly increase their trusted node partners over time.
What Are Encryption Methods?
Every blockchain relies on some key concepts that usually overlap across different networks. These encryption methods ensure that transactions remain secure and trustless.
Public and Private Keys
The private and public keys are crucial concepts in blockchain technology. This pair of cryptographic keys allows each user to access, receive, and spend assets on the network.
- The private key acts as a way to sign transactions and prove ownership of your assets.
- The public address allows users to send assets and locate them on the blockchain.
In layman’s terms, the private key acts as your bank card pin number, whereas the public key acts as your account number.
Digital Signatures
Digital signatures are a flawless security method that uses a combination of private and public keys to verify transactions. By pairing the private and public keys during the signing, digital signatures prevent any type of forgery or fraud.
Hashing
Hashing is a cryptographical method that converts a string of characters, regardless of length, into a unique output. This means that the combination of the private and public keys will always result in a unique hash. But more importantly, this hashing can be reversed only by the holder of the private key.
Explore New Opportunities with Crypto
Hopefully, this article has provided you with sufficient material to get basic knowledge about the most important crypto mechanisms in the industry. Remember, crypto is a vast subject and will require more deep dives to fully understand it. However, this initial information should give you a solid basis to be able to investigate further.
About the author
Mary A. Callahan is a freelance journalist at CEX.io. She started her career as a finance intern but later decided to try social media marketing in the fintech niche. This is when she determined to reconsider her approach to writing (Mary has a Master’s Degree in Journalism) and explore the crypto ecosystem. As she also has a Bachelor of Science in Economics, Mary combined her two passions — writing and finance. Now she is an expert in Bitcoin-related topics. Mary joined our team to write articles about blockchain security and regulations in different countries, as well as Bitcoin purchase guides.
Last Updated on January 9, 2024 1:50 pm CET
