Although there are many separate types of digital currency, the underlying mechanics behind them all are essentially the same. That said, once you wrap your head around the basics, you should have a decent idea of how each digital currency operates.
Here’s a step-by-step breakdown of how digital currencies work, plus the technology that makes them possible…
Digital Currency Networks: Blockchain
The biggest (and most difficult to grasp) element of how digital currencies work is their blockchain networks. But before we go any further to discuss how these networks operate, we need to make an important clarification.
There is a distinct difference between Blockchain cryptographic protocol (uppercase ‘B’) and the respective blockchain (lowercase ‘b’) networks of each digital currency.
See, the Blockchain protocol was developed and released by the creators of Bitcoin. And although Blockchain is the technology on which all digital currencies are built, it is not tied or affiliated to any particular digital currency.
However, when we talk about the blockchain of a specific currency, we’re referring to a singular implementation of the Blockchain protocol. That implementation is what actually creates a digital currency.
In simple terms, the Blockchain protocol allows digital currencies to be created and used as viable forms of money. That’s because it provides a framework for creating digital items that are:
- Unique and non-duplicable
- Non-repudiable and impossible to “double spend”
- Scarce and limited in supply
- Durable and immutable
- Divisible and uniform
Without the Blockchain protocol, making a digital currency would be impossible. The individual blockchain networks of each digital currency are essentially different incarnations of that protocol.
In other words, all digital currencies are created, stored, and exchanged on their own separate blockchain networks – all of which are built using the foundational Blockchain protocol.
To summarize once more for clarity, the Blockchain software is like a universal blueprint that makes digital currencies possible, but it’s not a currency in and of itself. But when that blueprint is used to build a blockchain network, a digital currency is born.
Creating & Exchanging Digital Currency: Mining
So once a digital currency is created, how in the world do people obtain and use it? On top of that, how can we eliminate the chance of fraud and manipulation across the millions of transactions happening between users?
The Blockchain protocol addresses both of these concerns through a process called “mining.”
See, a digital currency’s blockchain network is a public ledger of all transactions of that currency that have ever occurred. New transactions are grouped into ‘blocks.’ Each block is confirmed and validated by multiple users throughout the network, before being added at the end of the chain. Every user has their own copy of this public ledger, and it’s constantly updated.
Miners have the responsibility of confirming all the transactions inside a new block, so the block can be sealed and recorded on the public blockchain ledger.
To confirm a block, miners compete with one another to make something called a hash, a unique sequence of cryptographic information based on:
- The transaction data inside the block being confirmed.
- The result of complex mathematical formulas.
- The previous hash of the last block on the chain.
Once miners complete a hash, the new block is confirmed and the hash is stored alongside it. As a reward for each new hash/confirmed block, miners receive new units of the network’s currency.
To regulate the currency supply and control inflation, the Blockchain software protocol makes it increasingly difficult for miners to generate hashes and confirm new blocks as the network grows in size.
This system guarantees transparency, accountability, and stability for networks and their currencies.
Storing Digital Currency: Wallets
We’ve discussed what makes digital currencies possible, where they come from, and how they’re exchanged. Now let’s talk about how they’re stored…
When digital currencies are mined on their blockchains or transferred between users, they must be stored until their new owner is ready to use them. That’s where digital currency wallets come into play.
Wallets are simply pieces of software capable of housing digital currencies securely for an indefinite period of time.
All digital currency wallets have a public key and at least one private key.
The simplest way to understand the public key is to think of it like an anonymous address. When you send or receive digital currency, that address is recorded on the public ledger for your transaction. Everyone can see it, but it contains none of your personally identifiable information. It simply documents your wallet’s location on the blockchain network.
The private key, on the other hand, is seen by nobody but the wallet’s owner. It contains the cryptographic information needed to authorize transfers out of the wallet, and it should never be shared. Private keys are often secured through encryption and backed up in hard copy on paper.
However, nothing matches the security of a multi-signature wallet, which utilizes multiple private keys stored in separate locations – and requires the signature of two keys for every transaction.
For most BitIRA customers, Digital IRA investments are held in multi-signature wallets through our proprietary wallet solution. These wallets are held on custom hardware devices that are personal to each customer, and locked in cold storage inside a state-of-the-art depository. We are so confident in the security of our wallet solution that all assets of BitIRA customers are fully insured.
To learn more about how cryptocurrencies work, contact BitIRA and one of our Digital Currency Specialists can explain in more detail. Or, if you’re ready to enter the growing digital currency market with a Digital IRA, your Specialist will explain the process step-by-step and remain available to answer any questions.