Cryptography explained: What it is and how it relates to cryptocurrency

Unlike traditional currencies, decentralized digital assets lack third-party backing institutions to oversee security. As a result, they rely on advanced encryption techniques, or cryptography, to ensure the validity of each exchange and ward off threats. Although cryptography isn’t unique to cryptocurrency, it’s fundamental in protecting blockchain networks, maintaining data integrity, and safeguarding privacy.

In this guide, we'll explore the concept of cryptography andits role in securing blockchain networks, highlight key cryptographic methods such as asymmetric encryption and hash functions, and explain how these technologies underpin cryptocurrency systems like Bitcoin (BTC).

What is cryptography? Understanding the basics

Cryptography is the science of securing information. It employs mathematical techniques to encrypt data, ensuring only those with authorized access can interpret it. While often associated with modern-day IT, cryptography has ancient roots, dating back to times when rulers like Julius Caesar encoded confidential messages for trusted individuals. 

In today’s digital world, cryptography involves converting human-readable information (plaintext) into an unreadable format (ciphertext) and vice versa (more on that below).

What purpose does cryptography serve in today’s world?

Cryptography is essential for safeguarding digital data and preventing unauthorized access from malicious actors. Without the security that cryptographic systems provide, online privacy would be at significant risk, making it easier for hackers to compromise sensitive information.

Cryptography serves several key purposes:

• Protects sensitive data: Cryptography acts as a protective barrier between authorized users and malicious actors who attempt to steal, alter, or misuse digital data. This layer of protection ensures that users can communicate online with confidence.
• Verifies user identity: Cryptographic protocols not only secure data but also verify the identity of individuals involved. This verification process helps maintain data integrity and prevents issues such as data corruption.
• Protects online privacy: Cryptographic methods obscure sensitive details, ensuring that personal information remains hidden from unauthorized parties. This level of privacy protection is crucial for securely handling online transactions.
• Prevents double-spending: In the cryptocurrency space, specifically, cryptography ensures that tokens can’t be used more than once. By adding verification layers and ensuring secure transaction records, cryptography helps maintain trust in the legitimacy of a cryptocurrency’s ledger.

How cryptography works: Algorithms, keys, and hash functions

Cryptographic technologies are multifaceted and vary across different protocols, but their core function is to encrypt and decrypt – or scramble and unscramble – data. Again, only authorized parties with the necessary tools can interpret cryptographically protected data within a secure channel.

To do this, cryptography relies on a combination of mathematical algorithms and "keys.” Cryptographic algorithms convert readable data, known as plaintext, into unreadable ciphertext, while keys are the tools that decrypt the data. There are two main types of encryption: symmetric and asymmetric. In symmetric encryption, the same key is used to encrypt and decrypt data, while asymmetric encryption requires two distinct keys – one for encryption and another for decryption.

For added security, many cryptographic systems incorporate hash functions, which transform readable input data – such as a password, file, or transaction data – into a fixed-length string of characters known as a "digest." Hash functions are essential for ensuring data integrity, as they generate unique, irreversible digests tied to the input data. This not only makes tampering with the original data extremely difficult but also streamlines the verification process, allowing systems to quickly confirm that the data remains unchanged.

How does public key cryptography work in cryptocurrency? 

Public key cryptography (PKC) is a type of asymmetric encryption widely used in cryptocurrencies. In this system, users possess two linked cryptographic keys – one public and one private – each serving different functions. The public key can be shared openly to receive digital assets, while the private key remains confidential, providing the holder exclusive access to their assets.

When transferring cryptocurrencies from a digital wallet, the private key is required to prove ownership of the assets and to generate a unique “digital signature” that verifies each transaction. While the public and private keys are mathematically related, encryption ensures that it’s impossible to reverse-engineer the private key from the public one. This design makes safeguarding the private key crucial, as anyone with access to it can control the digital assets tied to the wallet.

An example of cryptography in cryptocurrency: What type of cryptography does Bitcoin use?

Bitcoin’s pseudonymous founder, Satoshi Nakamoto, didn’t invent cryptography but was the first to implement it in a peer-to-peer (P2P) platform for virtual currency. At the core of Bitcoin’s design is the Elliptic Curve Digital Signature Algorithm (ECDSA), which generates cryptographic key pairs – a private key and a mathematically related public key using the secp256k1 curve. When users send BTC, they sign the transaction with their private key, and the wallet broadcasts this signature to the decentralized Bitcoin network for verification using the public key.

The combination of ECDSA for transaction verification and Secure Hash Algorithm 256-bit (SHA-256) for proof-of-work (PoW) mining forms Bitcoin's robust security foundation. While ECDSA handles cryptographic key generation and transaction authentication, SHA-256 secures transaction blocks during PoW mining, ensuring network integrity and resilience against attacks.

Miners (node operators) use SHA-256 to solve computational puzzles by incrementing a nonce (a value in the block header) and repeatedly hashing the block's data, aiming to generate a hash with the required leading zeros. The first miner to do so adds the next block to Bitcoin’s blockchain and earns BTC rewards.

Bitcoin's algorithm automatically adjusts the mining difficulty every 2,016 blocks (roughly every two weeks) to maintain the steady production of one block every 10 minutes, regardless of fluctuations in mining power.

Why is cryptography important to cryptocurrency? 

Cryptography and cryptocurrency go hand in hand – without cryptography, cryptocurrencies would be vulnerable to security breaches, making it impossible to ensure transaction privacy, data integrity, or protection from fraud.

The advanced mechanisms that cryptographic technologies use – such as asymmetric encryption, public and private keys, and hash functions – make it possible to confirm cryptocurrency transactions on public networks while maintaining user privacy and avoiding counterparty risks. 

In essence, cryptography instills integrity in blockchain technology. While cryptocurrency users can't consult banks or other intermediaries in case of disputes or fraud, they trust that their transactions are secure thanks to the cryptographic mechanisms underpinning decentralized networks.

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Disclaimer: This post is informational only and is not intended as tax advice. For tax advice, please consult a tax professional.