Introduction
Cryptocurrencies are decentralized by nature, meaning that no central authority controls them. However, to maintain security and integrity, the transactions need to be verified. In this article, we learn how a cryptocurrency transaction takes place from its request to completion.
How Do Cryptocurrency Transactions Work?
According to daily-crypto.com cryptocurrency transaction is the movement of data between two wallet addresses. Since the “data” is the currency itself, this data transfer can be seen as moving money from one wallet to another.
Let’s try to understand this with a real-world example. If you want to send money to someone through traditional means, you’d probably use a bank. You interact with the user interface and the bank handles the ledger behind the scenes. This means that the bank is the central authority that has control over your funds.
On the other hand, daily crypto transactions are transparent, secure, and decentralized. Now imagine transferring funds to your loved ones but this time, your finances aren’t controlled by a bank. This means there are no down times, no interference from middlemen, and no borders.
Why Are Transaction Verifications Important?
Transaction verification is the heart and soul of each cryptocurrency blockchain’s security. The algorithms are written in such a way that each transaction requires a validity check prior to execution.
This prevents network users from double-spending or sending more money than they have. Since these transactions are irreversible, the network makes sure that all the transactions are fully verified and valid.
What Part Does the Blockchain Play in Transaction Verifications?
Introduction to Blockchains
A blockchain is a list of these records in the form of blocks that are connected. Each block contains a list of transactions.
This can be visualized as a database that is accessible to all. To understand this better, imagine it as a spreadsheet. Everyone in the network has view access but to add data to a cell, you need permission from users who have saved an updated copy of the sheet. Once data is added to the cell after verification, it cannot be changed.
So, if all the transactions are available to see on the network, does this invade your financial privacy? Not at all. All transactions added are pseudonymous.
How the Blockchain Maintains Security
A blockchain transaction takes place between two wallet addresses. Once a transaction is initiated, it must be signed by the user making the request. Once the transaction is broadcast to the network, miners attempt to add this transaction to a block. Using this mechanism gives the following benefits in terms of security:
- Transactions are tamper-resistant as data added to the blockchain cannot be modified or deleted without network consensus.
- Besides security, the blockchain provides transparency and accountability.
- Users can view and track transaction history, including details, parties involved, and time.
- This transparency facilitates accountability and easily detects fraudulent activities.
The Heroes of Blockchain Security and Transaction Verification – Network Nodes
What Are Nodes in Cryptocurrency?
Cryptocurrency nodes are essential for a blockchain to operate. These nodes are mini servers running the blockchain operation. This node is responsible for the following:
- Keeping an up-to-date copy of the whole blockchain to avoid a single point of failure
- Forming consensus with all the other nodes in the network
- Verifying crypto transactions (if the node is a miner)
These nodes can be run on any computer with a decent processor and disk space.
Difference Between Nodes and Miners
If you’ve been in the crypto space a while, you might’ve heard the words “nodes” and “miners” being used interchangeably. This is hardly the case. While a miner is always a node, a node may or may not be a miner. Let’s explore the difference.
A node is a computer that simply helps form consensus in the network without having to verify any transaction on its own.
A miner, on the other hand, involves using a machine that lends its computing power to solve cryptographic puzzles that result in the addition of a transaction to a block. These miners are then incentivized for the computing power they lend the blockchain that indirectly secures the network. Crypto mining is a concept that is generally used in Proof-of-Work blockchain.
The Transaction Verification Process
What is the process to have a transaction verified on a cryptocurrency network? Transaction verification steps vary from chain to chain. Here, we’ll break down the steps to the absolute base lines that are similar across most networks.
Making the Transaction Request
Each transaction is initiated with a request. A user adds the wallet address of the destination wallet and signs the transaction with his private key.
Verification by Cryptocurrency Nodes
Once the transaction is broadcast to the network after initiation, the nodes verify the authenticity of the transaction to avoid any malicious activity on the chain.
Block Addition
The verified transaction is then confirmed by a majority of the subsequent nodes. If there is a consensus on the transaction’s validity, it is then added to a block along with other transactions.
Transaction Completion and Receiving Funds
The block is then added to the whole chain. This transaction now becomes a part of the immutable ledger. Once this happens the user on the other end receives the sent amount into his or her wallet.
Consensus Mechanisms Explained
Consensus mechanisms are processes that help form an agreement in a blockchain network regarding the latest state of the ledger. These algorithms help maintain the blockchain’s integrity as they require most nodes to agree that the data in the ledger is indeed verified and true.
Since these algorithms only require the majority to respond, the consensus can be formed even if some nodes in the network are down. Now, there are a few different types of consensus mechanisms used in the crypto space, all designed to perfect the security and integrity of blockchain networks.
Proof of Work (PoW)
Proof-of-Work is a consensus mechanism that incentivizes miners to validate the network by contributing their computing power. Each transaction comes with a cryptographic puzzle linked to it. Validating this transaction requires computing power depending on the difficulty of the network. The ultimate objective is to create a system where nodes in the network get a better chance to add a block and get rewarded for the “work” done.
With a lot of nodes acting in the best interests of the network, an attack on the network would require an unrealistically huge number of resources. So, we can infer that as a proof of work network grows, it becomes more secure due to the added difficulty and the increased requirement for computing power.
Proof of Stake (PoS)
Proof-of-Stake (PoS) emerged in 2012 as a notable alternative to Bitcoin’s Proof of Work (PoW) consensus mechanism.
Unlike PoW, PoS replaces miners with validators, prompting interested entities to stake a substantial portion of the network’s currency to propose and add new blocks to the blockchain.
Security in PoS networks is established through aligned incentives, as validators with significant stakes are naturally inclined to operate in good faith, ensuring the integrity and reliability of the network. Dishonest activity in the network can result in the removal of the validator from the network with their staked amount lost.
Other Consensus Algorithms
The advancement of blockchain technology also comes with a need for better security. So, according to the use case, projects have introduced other types of consensus mechanisms as well. Some of these mechanisms are modified versions of PoW and PoS, others cater to specific use cases. These include:
- Delegated Proof of Stake
- Proof of Authority
- Proof of Activity
- Proof of History
- Proof of Capacity, etc.
Risks Associated with Blockchain Transactions
Scalability
Scalability is the biggest issue that has persisted throughout the crypto age. This is an issue inherent with blockchain technology due to the following reasons:
- Block size
- Time required to achieve consensus
Bitcoin has a block size of 1MB that can roughly fit over 2000 transactions. With a fixed block time of 10 minutes, this puts a technological limit on the transactions per second. The centralized alternatives, like Visa, process tens of thousands of transactions per second.
Security Risks
Consensus mechanisms require 51% of the network to accept a transaction once it’s verified. So, if a malicious actor were to get a hold of 51% computing power of the network, they might be able to manipulate the block by adding false transactions.
Although carrying out a 51% attack is extremely expensive, Ethereum Classic blockchain saw one of these security breaches back in 2020. However, at the current difficulty level, attacking bitcoin would require billions of dollars to achieve the 51% hash rate.
Another security issue related to crypto transactions is that if you’ve initiated a transaction to a false address, the immutability of blockchain prevents you from getting your funds back. So, always be sure where you send your money.
What’s Next?
Scalability Solutions and Faster Transactions
Recently, there has been a great deal of innovation with regard to scaling blockchains to bring up the transaction-per-second limits. Developers have worked to create Layer 2 networks that reduce the load of blockchain by assisting with transaction approvals through bundling or side chains. Polygon, Arbitrum, StarkWare, and Optimism are some of the popular projects working on these scaling solutions.
The result? Faster transactions with lower costs. The idea is to create a decentralized financial system that is on par with the traditional alternatives.
The Future of Crypto and Blockchain
Crypto and blockchain are still in their infancy and there’s a long way to go. Decentralized applications still have issues related to UX that make them harder to use compared to normal mobile applications, but this is a comparison for another day.
There are still gaps in consensus mechanisms and true randomness has not yet been achieved. Apart from that, users still have to juggle with long wallet addresses that create fear of error. So, solutions that cater to a better user experience coupled with AI are what will bring more traction to crypto ecosystems. In the long run, the experience of digital currencies will attract the world’s leading institutions and enterprises, and the wave has already started.
Conclusion
There is no doubt that decentralized systems have come a long way. Blockchain technology has enabled financial systems that are fast, secure, and decentralized. While we may see some gaps here and there, it is important to understand that this is a new technology. So, issues like low TPS for bitcoin and high gas fees in Ethereum are already being worked on by corporations worldwide.
Lastly, the increasing competition and the window of opportunity have created millions of cryptocurrencies in the digital asset space. This competition also creates a healthy environment that fosters innovation and growth and brings the idea of a perfect blockchain solution closer than expected.
