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Ever wonder how bitcoin (and other cryptocurrencies) actually work?

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Bitcoin and other cryptocurrencies have recently made the news as a new and popular investment vehicle. But how do cryptocurrencies actually work?

Basically, cryptocurrencies act as the currency of a ledger of many transactions, but some problems must be addressed to establish a valid ledger.  - How do you prevent people from falsifying transactions?  - How do you ensure that people follow through with payments?  - How do you trust the ledger? 

Ledger Protocols:

  • Everyone has access 
  • Everyone pays up at a designated time 

How do you prevent people from falsifying transactions?

  • Each user generates a private (secret) and public key pair consisting of bits.
  • They can produce a signature using a function and their secret key and verify it with a public verification fee.
  • Other users cannot falsify the signature without access to the private key due to computational infeasibility - there are 2 to the 256th power possible signatures.
  • There is also a unique ID given to each transaction. 

How do you ensure that people follow through with payments?

  • Suppose that, instead of paying up at a designated time, no one ever actually is required to settle up using physical currencies.
  • No transactions with overspending can be valid. 

How do you trust the ledger?

  • Everyone keeps their own ledger. 
  • The copy of the ledger with the most computational work is taken as true.

Computational work to verify a ledger:

Background: a hash function has an output of a fixed length of bits that appears random but repeatedly gives the same output for a given input. It is computationally infeasible to determine the exact input given an output.  - Individual sections of a ledger are called blocks.  - Block creators find inputs to the hash function that yield some number of 0s at the beginning of the output.  - This input is used to verify the block of transactions.  - Block creators are given rewards for their work in the ledger currency out of “thin air,” which increases the overall amount of currency in the system.  - Reward for miners decreases geometrically over time, meaning that there will be a fixed amount of the digital currency in circulation.  - Transaction fees for miners incentivize them to include specific transactions in a given block due to restrictions in block size.  Thus, a decentralized but trustworthy ledger system is established. 

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