How Cryptocurrency Transactions Work: Blockchain Explained

Cryptocurrency, a digital or virtual currency works on a network, secured by cryptography. This makes it nearly impossible to counterfeit or double-spend, and blockchain technology ensures this cryptographic security. 

Hence, if you wish to understand how cryptocurrency transactions work, you need to understand how blockchain functions.  

Most cryptocurrencies exist on decentralized networks. They use blockchain technology, a distributed ledger. This network functions via a disparate network of computers. 

When we talk about blockchains, several related concepts come to the surface— 

• Peer-to-peer transactions 
• Cryptocurrency mining 
• Consensus mechanism and many more. 

Together, these conceptual processes make up the functioning backbone of the blockchain. This systematic and collaborative functioning of blockchains enables miners to mint new cryptocurrencies, users to make transactions, and all that information to be recorded with utter security. 

By the end of this guide, you will be able to make cryptocurrency transactions and understand how the blockchain makes them happen. 

What is a Cryptocurrency Transaction? 

A cryptocurrency transaction is a transfer of cryptocurrency funds between two parties. These transactions are recorded on a public ledger called a blockchain.  

Cryptocurrency uses cryptography (a process of coding information to restrict it to a few password holders). With this process, blockchains verify and secure your transactions instead of relying on a central authority like a bank. 

The infographics below will explain the four major steps to complete a transaction— from initiation to confirmation. 

On-Chain vs. Off-Chain  

In cryptocurrency, transactions can happen in two main ways— on-chain and off-chain. 

On-Chain Transactions 

These transactions occur directly on the main blockchain network. With the help of a consensus mechanism such as Proof-of-Stake or Proof-of-Work, these transactions are validated and then recorded on the blockchain. 

Moreover, everyone present on the blockchain’s network can see these transactions. However, it cannot be changed easily. Thus, on-chain transactions are more secure. But transparent at the same time. 

One major disadvantage of on-chain transactions is that they are slow and consume high energy. Hence, they are ideal for high-value transactions. 

Off-Chain Transactions 

Off-chain transactions occur outside the main blockchain, using secondary layers or networks. They are like making a private deal and later revealing it to the public record book (the blockchain). 

Moreover, off-chain transactions are faster and cheaper. However, their lower security makes them better suited for smaller, everyday payments. 

In our guide, we will emphasize the on-chain cryptocurrency transactions based directly on blockchains.  

Major Tenets of Blockchain Cryptocurrency Transactions 

There are several major tenets of blockchain cryptocurrency transactions. Here’s a breakdown: 

Decentralization 

Unlike centralized systems, blockchain operates as a distributed ledger. This ledger is spread across a network of computers (nodes). Thus, it eliminates the need for a central authority. Moreover, this decentralization enables trustless transactions, where parties can interact without intermediaries. 

Immutability  

Once a transaction is recorded on the blockchain, it cannot be altered or deleted. Cryptographic hash functions create a unique digital fingerprint for each block, ensuring immutability.  

Moreover, attempting to alter a single block would invalidate all subsequent blocks. Thus, blockchains guarantee the integrity and security of the entire blockchain. 

Transparency  

Recording all transactions on the public ledger makes them transparent and easily auditable. However, the identities of the individuals involved in the transaction are not included. 

Security  

Cryptography plays a crucial role in securing blockchain transactions. Digital signatures verify and authorize transactions1.  

A mathematical verification certifies the transaction, resulting in a successful, secure transaction between the two network-connected parties. 

Validation 

To ensure transaction validity, nodes on the network verify transaction details, such as digital signatures and wallet balances.  

Valid transactions are held in a “mempool,” a waiting area for unconfirmed transactions, until miners or validators include them in a new block. 

Prevention of Double-Spending  

The immutability feature on blockchains prevents the double-spending of cryptocurrencies. 

It is nearly impossible for a user to spend the same funds multiple times because each transaction is recorded and verified. 

Block Creation 

Verified and validated transactions are added to the blockchain in a new block through mining (in Proof-of-Work systems) or validation (in Proof-of-Stake systems).  

Each block bears a unique fingerprint called a hash, which includes information from the current block and the preceding block’s hash. 

In a typical transaction, the sender attaches the transaction information to the recipient’s public key and gathers the information into a block. The block contains a digital signature and a timestamp and is transmitted across the network’s nodes. The transaction is completed successfully when the right individual uses their private key to match the block. 

The Role of Miners in Cryptocurrency Transactions 

Source : Bitpanda

Miners are essential to the functioning of cryptocurrency networks. They validate transactions and add them to the blockchain, which helps maintain trust and stability in decentralized finance. Miners tackle complex cryptographic puzzles using a method known as Proof of Work (PoW).  

The first miner to crack the puzzle gets to add a new block to the blockchain and earns rewards in cryptocurrency.  

Miners play a key role in ensuring the integrity and security of the blockchain by following network rules and verifying transactions to avoid double-spending.  

Their economic incentives, such as transaction fees and block rewards, motivate them to act in the network’s best interests. 

Blockchain’s Security and Transparency 

Blockchain technology greatly improves the security and transparency of cryptocurrency transactions by leveraging cryptography, decentralization, and consensus mechanisms.  

These components build trust and guard against fraud, ensuring that data remains tamper-proof and accessible only to authorized users. 

Each block in the blockchain is secured with a unique cryptographic hash, which prevents tampering and facilitates digital signatures to verify authenticity.  

By operating on a peer-to-peer decentralized network, blockchain technology eliminates the risk of single points of failure. Thus, it successfully reduces the chances of centralized manipulation.  

Transaction validation through consensus mechanisms helps deter malicious activities. The immutability of the data blocks guarantees that once a transaction is recorded, it can’t be changed, keeping everything accurate and transparent. 

That said, while blockchain offers robust security features, potential vulnerabilities remain, such as 51% attacks and issues with smart contracts.  

External factors, including the handling of secure passwords and the applications’ reliability, also affect the system’s overall security. 

Conclusion 

Understanding how cryptocurrency transactions work—and the role that blockchain technology plays—is essential for anyone looking to navigate the world of digital currencies.  

The decentralized nature of blockchain provides a level of security and transparency that traditional financial systems often lack.  

Therefore, by recognizing the differences between on-chain and off-chain transactions, we can better appreciate the unique advantages and limitations of each method.  

Whether you’re making a high-value investment or simply transferring small amounts for daily purchases, knowing how these systems function can empower you to make informed decisions.  

As we continue to explore the evolving landscape of cryptocurrency, it is important for young investors and crypto enthusiasts to keep learning. On this channel, we regularly post the latest news and guides to help you stay updated on every change in the crypto world.