In this article, we will look at how cryptocurrencies work in principle, from transactions to data storage. Since bitcoin is the first and most famous cryptocurrency, I will focus on it in this article.
When people use the words Bitcoin and blockchain as synonyms it is not true. But people still do so, it’s a popular misconception.
Bitcoin is not just a coin, it is also a protocol that is based on blockchain technology. A protocol is a set of rules by which members of a network communicate with each other. For example, part of the Bitcoin protocol governs how private and public keys should be managed, how mining occurs, how transactions are confirmed, and so on. Ethereum, waves, neo, ripple and some other cryptocurrencies have a similar protocol to Bitcoin.
This protocol, like Bitcoin and Ethereum, includes the definition of a coin, which is usually named after the protocol. This coin is what makes using the protocol interesting for people. It is used to reward people who “mine” or mine to add blocks to the blockchain and, more importantly, to buy something from each other.
Tokens, on the other hand, are in the third layer of the architecture. They exist thanks to smart contracts, which in turn work thanks to protocols (the second layer). Ethereum is currently the most popular protocol for creating smart contracts and tokens. Bitcoin’s protocol, on the other hand, ultimately does not allow for the creation of tokens because it does not support the creation of smart contracts.
A safe alternative to traditional banks
To understand cryptocurrencies well, let’s first understand how blockchain and conventional client-server architecture works.
The basic concept of this architecture is that the client (user) makes an http request to the server, and if everything is fine, the server sends the client a web page as a response. The web page itself usually contains data from some centralized database.
The very fact that all information is stored centrally, on one (conventionally) server, which is controlled by a bank or company, is a huge problem. Even more, the fact that all information is stored on one server increases the chance that the server will be hacked. This, in turn, jeopardizes the privacy of your data.
Blockchain solves two big flaws that are inherent in traditional client-server architecture – privacy and data security. Blockchain is a distributed and immutable storage, in addition all transactions in it can be monitored.
Let’s take this definition apart piece by piece. Distributed means that information is stored on a network of computers. This eliminates the need to have centralized servers. You can think of this storage as a ledger that keeps a list of all the transactions that occur on the blockchain. This vault is immutable, once information is in it, it cannot be deleted or changed from there.
Transactions on the blockchain are pseudonymous, you can see other people’s transactions but you don’t know who exactly is behind them, you can’t change the data that is contained in the transaction. Some cryptocurrencies allow you to encrypt the data in a transaction or even require you to do so.