How Cryptocurrency Transactions Work: A Comprehensive Guide
Cryptocurrency Transactions: The Basics of Digital Value Exchange
Cryptocurrency is a form of exclusively digital value, free from the control of any person, company, or government.
Unlike traditional currencies, which allow you to redeem your digital account balance for physical bills, cryptocurrency transactions are simple data entries recorded on a distributed, immutable ledger, called a blockchain.
On popular blockchains such as Bitcoin, Ethereum, and Algorand, no cryptocurrency is actually exchanged between people. Instead, ownership data associated with both parties’ cryptocurrency wallets is updated on the blockchain each time a transaction is processed.
Blockchain technology allows these types of transactions to be proposed, and recorded by a global network of volunteers, called “nodes.” These computers work together to ensure unanimously that only valid transactions are made and stored immutably in the ledger.
Essential Components for Sending a Cryptocurrency Transaction
Before examining the step-by-step process of creating, issuing, verifying, and processing a cryptocurrency transaction, it is important to understand the individual elements that make these types of peer-to-peer transactions possible.
Three basic components are needed to complete a crypto payment:
A cryptocurrency wallet
A blockchain network
Cryptocurrencies to pay for the blockchain transaction/gas fee
Understanding Cryptocurrency Wallets: Hot vs. Cold Wallets
Hot wallets are computer programs that are downloaded to desktop computers, mobile phones, or other smart devices. They are connected to the Internet at all times and allow users to receive and transfer funds quickly.
Cold wallets are hardware devices, such as specialized USB sticks, that must be manually connected to a smart device to make or receive transfers. Unlike hot wallets, cold wallets are not connected to the Internet at all times. While many people find cold wallets less convenient than hot wallets, they are considered to be significantly more secure.
Unlike paper notes in traditional wallets, cryptocurrencies are not actually stored in a cryptocurrency wallet. Cryptocurrency holdings are recorded on the blockchain and access to those funds is controlled through a wallet. A cryptocurrency wallet stores the addresses used to interact with your allocated funds on the blockchain. If the keys are lost, access to the funds associated with the wallet is also lost.
In every wallet, one will find both public and private keys destined for the distinct cryptocurrency. Keys are an essential part of a cryptocurrency wallet and are used to:
Provide evidence of who the funds belong to which has been placed on the blockchain
After: Use of digital signatures and approvals of outgoing transactions
Create public wallet addresses
The Creation of Public and Private Keys: A cryptographic process is defined here as a step by step procedure of converting plain text into cipher text and vice versa through the use of cryptographic algorithms to provide security in communications.
In fact, public and private wallet keys are entwined basically by a certain type of one-way logical formula. They are derived out of each other; specifically, the private key is used to formulate the public key. The ECC or Elliptic Curve Cryptography is one of the most often utilized public key cryptography methods mainly utilized to derive keys for all cryptocurrency wallets including bitcoin ones.
A unique feature of these keys is that the owner of the respective wallet is the only one capable of creating the public key associated with this wallet and proving ownership of the funds. From section 2, it can be seen how cryptography makes it almost impossible to determine the private key from the public key.
To make it easier to understand, let us analyze an example that relates to this paradigm. Let me illustrate this with an example, suppose you have a number that is a million digits long. From that million-figure number, one has to recall a specific pair of two numbers, which were added together to come up with that figure. Even for such a fundamental problem as the one described above, implementing all the multifaceted solutions would mean trial and error to arrive at the appropriate combination.
Though, once the solution is found I can with a few keystrokes or a mouse click or another button press prove to anyone in the world that the solution came to the same correct answer. After all, it would take only a pinch more of extension to each put the numbers and verify that it corresponds to a millionth digit.
The difficulty of finding a solution and the ease with which it can be verified once found form the crux of cryptocurrency transactions. Notably, it is this use of cryptography that enables cryptocurrency transactions to work reliably, securely, and profitably.
ECC will take it further than this, with a complex system of lines that go through a special kind of curve on a chart. Each time the line passes through the curve, it changes course perpendicularly, and so on. The public key, in this case, is the first and last point that crosses the line after a secret number of times.
The private key, in this case, is the secret number of movements made to get from point A to the last point on the curve.
Generating a Cryptocurrency Wallet Address: The Role of Cryptographic Hashing
In this case, aside from the public and private keys, we also have the cryptocurrency wallet address.
Now, to generate this address, what you do is to use precisely that very public key — remember the public key was generated off of the private key?, and plug it into a cryptographic hashing algorithm. This is another type of one-way mathematical algorithm that takes any input and converts it into a fixed-length random string of alphanumeric code called a “hash.”
Hash codes could be said to be “unique” and “deterministic.” In other words, each entry creates a completely unique hash code that is the exact same value each time it is run through the algorithm.
As with public and private keys, it is impossible to look at a hash and know which entry created it.
This hash, which serves as the address of a cryptocurrency wallet, is what users share to receive incoming cryptocurrency transactions.
Private and Public Keys’ Storage Solutions: Hot Wallets vs. Cold Wallets
Hot wallets are so called because they store the keys online in the wallet software itself.
On the other hand, this also makes users vulnerable to attacks from cyber-criminals.
The private and public keys of a cold wallet are stored offline on the physical device.
Therefore, it is practically impossible to attack cold wallets over the Internet. Now, the drawback is that every time a user wants to make a transfer, they have to connect their cold wallet to a computer or smart device.
While this issue is less of a problem for the long-term holders who trade very infrequently, it does develop as a headache for more active traders who keep on transferring funds from one address to another.
Processing Cryptocurrency Transactions on a Blockchain Network
Overview of Blockchain Technology
Anyone in the world can participate in managing a public blockchain network, as long as they have access to the Internet and a smart device. Most blockchain networks take steps to “decentralize” the platforms and ensure that no one person or central authority can take control of the blockchain ledger.
Users who voluntarily take the time to become active participants in a blockchain network are known as “nodes.” Nodes can perform various functions, such as maintaining a complete history of transactions or carrying out the very important task of validating data.
What is a Blockchain? Understanding the Virtual Chain of Data
Think of a blockchain as, well, a virtual chain of boxes (or “blocks”), inside each of which is some quantity of data. For cryptocurrency networks, this data is mostly transactional information: who has transferred what, to whom, and at what time.
As new transactions are issued to the network, new blocks must be created, filled with the new data, verified, and added to the chain.
All blocks added to the blockchain are permanent and immutable, so it is impossible to go back and change the information stored in the finalized block. That’s why data validation is so important. Every piece of information about transactions has to be checked by the nodes in the network, which all have to agree on something for valid transactions to pass.
Since there is no one central authority implementing the network, the validation system is automatic to default on agreeing to all the nodes that new data added to the blockchain has been committed. This system, which is applied in block chain networks, especially in Bitcoin to mine valid transactions, prevents other people from injecting fake transactions into the network.
Simply put, this is a mechanism for reaching an agreement.
While different blockchains cope with the problem by various styles of consensus mechanisms, all of them are trying to achieve the same goal: maintaining accurate ownership and transaction information.
To this day, proof of work and proof of stake remain the most widely used systems in the cryptocurrency space.
Understanding Transaction Fees in Cryptocurrency Payments
Namely, every user of any given cryptocurrency has to pay a certain premium in exchange for its service known as a transaction fee. Sometimes, this is referred to as a gas fee, due for his or her payment to get processed.
Now, since we have explained the various components making up the process of a cryptocurrency transaction, let us look at how a payment works from start to finish.
These could vary depending on the blockchain and how congested it is at that very moment.
Some cases allow users to add a tip to the transaction fee to encourage validators to help them quicker by placing them over others in the queue.
Step-by-Step Guide to Creating and Signing a Cryptocurrency Transaction
It’s also worth pointing out that nearly all of the steps mentioned in this list are done automatically by the underlying code of the Bitcoin protocol and by the nodes on the network. All the Bitcoin user has to do is enter the amount of crypto they want to send, copy and paste the recipient’s public wallet address, and hit send.
The process of sending a transaction consists of three phases:
Transaction
Issue
Settlement
Below is an example of the different phases that take place in the Bitcoin blockchain. This process is what allows Bitcoin to function as a peer-to-peer electronic money system.
Transaction
Olivia receives her public wallet address and shares it with Marcos.
Marcos takes the address of Olivia’s public wallet and creates a transaction message that contains information about the intended transaction: where Marcos’ bitcoin comes from, where it goes, how much change should be returned to Marcos in the form of UTXO, and the amount of the associated fee.
After generating this transaction message, it is subjected to a cryptographic hashing so that it is reduced to a number of characters that are fixed.
Marcos encodes the above hash code with his private key in order to produce a signature for the particular transaction. In this manner, Marcos is also letting Olivia and the rest of the blockchain network know that he initiated the transaction and has not been altered in the process.
Marcos sends the plain text of the transaction and the digital signature to Olivia.
Marcos sends the plain text of the transaction and the digital to Olivia.
Olivia then activates the same cryptographic hashing algorithm to hash the actual transaction messages and check if it matches before the declared hash value.
The two hashes should match thus proving beyond doubt that Marcos was the one who sent the transaction and it was not in any way corrupted as it was being transmitted across the network. Replacing or altering any of the transaction details means the hash created will be an entirely new string and let the network know that someone tried to alter it.
Issue
Once Olivia has been able to verify that the transaction that Marcos has sent her is valid, she must broadcast it to the network so that all nodes can verify this information.
The transaction message and digital signature are initially sent to up to eight nodes. Each node then transmits that information to up to seven other nodes on the network.
This process continues until all nodes in the blockchain network separately receive and verify the transaction.
A memory pool stores pending or unconfirmed transactions after verification by all nodes on the network.
Settlement
Depending on the type of consensus mechanism the underlying blockchain uses, a single validator node is selected to propose a new block full of transactions from the mempool.
For validators that follow the proof-of-work mechanism, once a successful validator is selected in the mining process, other nodes in the network must confirm that the validator has won the hashing competition before it can propose a new block.
After the block organism refers to the one with the transaction from Marcos to Olivia it forms an individually confirmed transaction. This means that after this block is generated in the blockchain, every subsequent block increases Marcos’s confirmation of his transaction. Additional rounds of confirmations help increase the certainty of the transaction’s accuracy on the network.
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