How does digital currency 'change hands'? Crypto transactions explained.

We're all familiar with how cash changes hands. Mary gives an agreed amount of cash to John, who becomes its new owner.

Simple.

At a very basic level, most are also familiar with what's involved in transacting online. A nominated third party or payment service validates the transaction and ensures that Mary's money makes it to John's account.

But what's involved when it comes to transacting in cryptocurrency? How does digital money change hands?

First things first: the trust to transact

Transactions of any kind require trustbecause something of value is at stake. If the transacting parties are strangers, they generally ask a trusted third party -- like a bank -- to oversee the transaction to its completion.

However, cryptocurrencies are decentralised. This means that parties transact directly -- without the oversight of a third party to ensure that they deal with integrity.

Blockchain technology steps into this third party void, verifying and recording transactions as true and authentic. Further to this, the use of something called 'public key cryptography' ensures that transaction information sent via the internet remains confidential. Public key cryptography also provides certainty that the transacting parties are indeed authorised to do so.

So, despite having never met -- and with no third party overseeing the transaction -- parties seeking to transact in cryptocurrency can do so with confidence because of the security offered by blockchain technology and public key cryptography.

The maths and the technology can be trusted.

Back to Mary and John. What's involved in a cryptocurrency transaction?

How cryptocurrency changes hands

  1. Let's say Mary wants to send John five bitcoin. Her transaction message is sent via the internet to nodes (computers) in the Bitcoin blockchain network.

  2. These nodes check that the transaction is valid based on the transaction 'rules' followed by the network. This includes checking that Mary's public key decrypts the digital signature attached to her transaction -- proving that she is the authorised owner of the bitcoin being transferred.

  3. Although validated, Mary and John's transaction is still unconfirmed; it has not yet been entered in the blockchain (distributed online ledger). Their transaction is added to a pool of unconfirmed transactions.

  4. Nodes in the network group batches of unconfirmed transactions into 'blocks' in a process termed 'mining'. No pick or head torch required, blockchain mining involves a 'race' of sorts between computers. This 'race' requires nodes to find a certain number which, when combined with the contents of a block of transactions and crunched through an algorithm, results in another number (hash) that has certain predefined qualities.

This is a very difficult exercise -- and even with trillions of guesses occurring every second, it takes the Bitcoin network an average of 10 minutes to guess a correct number. Herein lies the rationale for the term, 'mining'. For their efforts in maintaining the blockchain -- not to mention the costs associated with running powerful computers capable of performing these calculations -- successful miners are handsomely rewarded. The software pays them a predetermined number of bitcoin, and they also receive any transaction fees associated with the block they mined.

  1. Once a suitable hash for a transaction block has been found, the successful miner then broadcasts their result to the rest of the blockchain network. The network checks that the newly created block is correct and starts the process all over again, seeking to mine the next block in the chain.

  2. Even though their transaction is now confirmed, Mary and John would be wise to wait until further blocks are added to the chain before acting on their transaction.

This is because each transaction block contains the hash calculated for the previous block, anchoring them in a chain-like fashion. This hash acts as a reference specific to the transactions in the block, and so tampering results in a changed hash. If one block changes, all of the hashes from that block forward must also change so that the blocks remain linked.

As more blocks are added to the chain, it becomes less likely for such tampering to succeed due to the intensive time and resources required to mine these new blocks such that the chain has integrity.

At first glance, transactions in cryptocurrencies may seem to have little in common with those of the traditional kind. However, with some very clever maths, science and technology, a.k.a. cryptography and blockchain technology, working together to create a watertight transaction environment, parties can rest easy knowing that their digital money is changing hands securely.

Interested? Find more about mining, cryptography and blockchain technology at the Cointree Learning Hub.


Credit: Laura Hawting on behalf of Cointree and reviewed by Anouk Pinchetti education consultant Blockchain Centre.