Cryptocurrencies have been experiencing exponential growth in the past few years. It all started in the year 2008 after the inception of Bitcoin, invented by an anonymous person or group that goes by Satoshi Nakamoto’s name (whose identity hasn’t been revealed to this date). This article will provide you with an insight into the working of Cryptocurrencies.
I will try to use simple analogies so as to provide to help the reader get hold of the idea behind Bitcoin (or any other cryptocurrency). However, the actual working of this is much more complicated. I will not go into the prospects of investing in the cryptocurrency market except for the fact that they are notoriously volatile.
Cryptocurrency can be defined as a digital currency where the transactions and records are maintained by decentralized ledger using cryptography.
What do we mean when we say Bitcoin has a decentralized ledger?
To start with, let us introduce two characters, Ashish and Alex. Now, Alex transfers say Rs 100 to Ashish via bank. The bank which has been maintaining records of these account holders, reduces Rs 100 from Alex’s account and puts it into Ashish’s account. Here the bank does the work of record-keeping of transactions (i.e., maintaining ledgers). A central authority authenticates the records maintained by the banks.
However, in the case of Bitcoin, this record of transactions is not maintained by one single authority, and anyone can take up the task of keeping records of transactions (They are called ledgers). These ledgers keep track of all the transactions happening through Bitcoin. However, why would one decide to maintain records? What ensures all the records are identical? These will be answered further into the text.
How does this system of record-keeping work?
Now, if Alex transfers Rs 100 to Ashish via Bitcoin, he broadcasts this to all the ledgers (the record-keepers) about the transaction. These ledgers add this transaction to their records.
In doing so, Alex will have to make three announcements:-
- His account no.
- Money to be transferred
- Ashish’s account no.
Isn’t revealing account number risky? Also, what ensures that Alex indeed does the broadcast about the transaction?
Here comes the role of cryptography. Alex maintains two keys for his account. A private key and a public key. Alex keeps the private key to himself, which he uses to make transactions. The public key is what is sent to all the ledgers. The public key functions as a signature of Alex (authenticating that the person transferring the money is indeed Alex). The public key can only be activated by a private key (which means that it cannot be forged or replicated). However, it is almost impossible to predict the private key with a public key in hand. This allows Alex not to reveal his account no. (Private Key) and at the make sure that it is indeed Alex that is broadcasting the transaction (Public Key).
What ensures all the records are identical and foolproof?
The question arises as to what ensures that the order of transactions maintained by each ledger is identical. There might be network delays at some places, which can lead to the jumbling of the order of transactions.
For example, there are two transactions taking place
- Unni transfers Rs 50 to Raghul
- Raghul transfers Rs 60 to Siri
So what ensures that the maintained records by all the ledgers are identical?
The solution to the problem lies in mathematics. Let us compare the order of data received by ledgers Ledger 1 and Ledger 2.
Unni transfers Rs 50 to Raghul.
Raghul transfers Rs 60 to Siri.
Raghul transfers Rs 60 to Siri.
Unni transfers Rs 50 to Raghul.
In layman’s terms, each ledger (which is basically a computer) will be given a maths problem to solve associated with each entry. Whichever ledger solves the maths problem first, the entry of that ledger will be fed into all the other ledger.
For e.g., if Ledger 1 solves the problem associated with the transfer of money from Unni to Raghul before Ledger 2 solves the problem related to the transfer of funds from Raghul to Siri; then the entries of all the ledgers will be updated as:-
Entry 1: Unni transfers Rs 50 to Raghul (this is from ledger 1)
Entry 2: Raghul transfers Rs 60 to Siri (this can be from ledger 1 or 2, whoever solves it first. It is possible that ledger one may solve the problem of second entry even before ledger 2 solves the problem of first entry)
Strictly speaking, the math problem is basically reverse guessing a hash function (Bitcoin uses SHA256 function, which was developed by the US national security agency). There is no known inverse of this hash function, and the computer has to find the inverse of a value through trial and error. This can take billions of guesses and requires an immense amount of computing. On average, it takes about 10 minutes for a computer designed for SHA256 to crack this function.
To help the reader get a feel of what exactly happens:-
Consider a function y = x2 + 20x + 3
The inverse of this function is pretty obvious; however, let us say the computer does not know the inverse of this function. So, the computer will be given the question say – for what value of x is y = 9704?
Now, the computer starts by assigning different values to x and cross-checking the obtained y.
F(0) = 3 (which is not equal to 9704)
F(1) = 24 (which is not equal to 9704)
F(89) = 9704 (which is equal to 9704)
This will go on until x = 89. The computer has performed this calculation 90 times in this example. However, in relation to the hash function, this can go up to billions of times.
Also, this maths problem is not random. What the math problem depends on:-
- Details of the transaction
- The solution of the math problem associated with the previous transaction
This means that the solution to this math problem will be associated with the next transaction. This creates a chain, where each unit of this chain contains a record of the transaction as well as a link to the next unit in the chain. This makes tampering with a single unit of the chain (i.e., transaction record) futile as all the subsequent entries will then have to be modified. This technology is called blockchain technology.
Why do people maintain ledgers?
As mentioned above, maintain ledgers requires an immense amount of computing. Immense money is consumed on hardware and electricity to keep these computers running. So why do people maintain ledgers?
The answer to this is that these ledgers are rewarded a certain amount of Bitcoins for solving every problem. It is like a race between the ledgers to solve the problem, and the one that does so will be awarded a certain amount of Bitcoins. Therefore, the majority of the ledgers are located in China, where the electricity is cheap.
In our previous example, let us say the award for solving each problem is one bitcoin. Then ledger one is awarded one bitcoin for solving the problem associated with entry 1. Another Bitcoin will be awarded to the one who solves the problem related to entry 2.
This also means that the number of Bitcoins in the economy is increasing. Therefore these ledgers, who do all the computational work, are also called miners as they bring new Bitcoins into the system. These are analogous to the miners of gold when it was used as a currency.
However, these problems get more challenging, and the amount of reward to solve a problem diminishes as more Bitcoins are mined. There is an upper limit on the number of bitcoins that can be mined, which is 21 million. Nearly 15 million Bitcoins have been mined to date. However, it is predicted that the last Bitcoin will be mined by the year 2140. This restricted flow of bitcoins into the economy ensures that it is not devalued against other currencies. In the present date, 1 Bitcoin is valued at 27, 31,513.76 rupees.
Some concerns surrounding cryptocurrencies
- The market for cryptocurrency is pretty volatile.
- Lack of recourse – once payment is made, it cannot be reverted in case of fraud.
- It is prone to cyber-attack risks. There are multiple cases of Cryptocurrency companies filing for bankruptcies because of losses suffered due to cyber-attacks.
- Since the transaction does not go through a central agency, it is used for illicit activities. One can hide his/her true identity easily.
- The government cannot control the monetary supply of cryptocurrencies. This is a handicap on the policy tools presents with the government to control inflation etc.