Introduction
Like most people, I’m sure you are still trying to wrap your head around blockchain. I bet that even though you do not fully understand it, you are sure of two things — it’s the next big thing in the tech space, and you need to somehow get involved.
Many people have tried to explain what blockchain is throughout the last decade, but no one did it better than Fabricio Santos of Cointelegraph. Having been in the crypto space for quite a long time, Santon found the simplest way to explain blockchain to his family and friends.
In a medium article, Santos describes a blockchain as a series of glass boxes with content everyone can see, verify, and can’t change. All participants know where the boxes are and what they contain. Santos went on to compare the glass boxes with a crypto wallet stating, “When you open a crypto wallet, it is creating a new address in the blockchain in the form of a private key that lets you interact with the blockchain. In the same way, you are given a key to interact with the data in the glass boxes.
Simple, right? Well, for the most part, but it’s still not clear. Blockchain has far surpassed the stage of being a tech buzz word and as a crypto investor, knowing how it works is crucial when analyzing crypto projects.
Let’s take deep dive into what blockchain is and some of its main features.
What exactly is blockchain?
Blockchain is a distributed and immutable ledger that facilitates the process of recording transactions and tracking assets in a decentralized manner. A transaction can refer to the digital transfer of any type of data from one user to another within the blockchain network. On the other hand, an asset can represent any tangible or intangible asset. Virtually anything of value can be tracked and traded on a blockchain network.
How is blockchain different from a normal database?
While people can use any conventional database to store data, blockchain is very different from typical database systems.
Let’s split the word blockchain into two parts: block and chain. A block is a set of transactions processed on the network. The chain is the mechanism that links blocks chronologically to maintain consistency. The chain continues indefinitely, linking back to the first block, known as a genesis block. This way, a history of the network’s data is maintained from the start, and any change to a previous block changes all the following blocks.
In contrast, a typical database can be a simple table that organizes data according to some attributes. A typical database does not need to be arranged chronologically, and users can alter data. It’s also usually stored in centralized servers for security purposes. With blockchain, you can restrict who has access to the ledger.
How does blockchain work?
Blockchain technology enables digital data to be recorded and distributed but not edited. It stores data in blocks. Each block contains the transaction data, a hash value of the block, and the previous block’s hash value.
The data stored on the block largely depends on the type of blockchain. For instance, the Bitcoin blocks contain transaction data: the sender, receiver, and the bitcoin amount.
A block’s hash value acts as the fingerprint of the block, and since each hash value is unique, it’s used to identify a block. Blockchain links two blocks by including the previous block’s hash value to the generated block. As such, each block points back to a previous block, and altering any data on a block changes the hash value. This mechanism secures the block and makes the data immutable. If an attacker wanted to alter the data, they would have to alter every following block’s economically infeasible hash value.
In order to generate a new block, the hash value has to be created, and users need to surrender something to prove they have put in some of the value to generate the hash value. For example, users on the Bitcoin blockchain have to use computational power to generate the hash value.
Blockchain also stores data in a distributed way. The network distributes a copy of the blockchain to all nodes (computers). After processing transactions, the nodes add them to a block and append them to the blockchain.
To add a block to the blockchain, the nodes have to agree that the block is valid. To reach a consensus, various blockchain platform implements different consensus algorithms, as discussed below.
Blockchain’s history
Before Satoshi Nakamoto, the inventor of Bitcoin, there were several works about blockchain technology. One of the first documentation works was a cryptographically secured chain block as conceptualized by Stuart Haber and W. Scot Stometta in 1991. The two wanted to implement a system that kept track of documents by using timestamps and ensuring that the documents were immutable.
Another notable development in the blockchain space is when Dave Bayer partnered with Stornetta to incorporate the Merkle Tree architecture in the previous timestamped immutable data system. This previous work played a crucial role in creating a path for blockchain and cryptocurrencies.
It was not until 2008 that Satoshi implemented blockchain through Bitcoin — a peer-to-peer (P2P) decentralized digital currency with no central authority. In 2009, Nakamoto released a whitepaper that detailed how Bitcoin would function and how it would leverage blockchain. However, ever since Nakamoto left the development scene and the core developers took over, blockchain has evolved to blockchain platforms, such as Ethereum, that enable new applications outside of financial transactions.
Key elements of a blockchain
Decentralized nature of blockchain
Blockchain aims to transfer control and decision-making from centralized authorities to a distributed network of different nodes. Blockchain delegates these services to the nodes rather than having a central authority or organization governing the framework. Transactions on the blockchain are also peer-to-peer.
Blockchain achieves decentralization by reducing the level of trust that participants must place in each other. It also deters a user’s ability to exert control over the network in ways that may degrade the network.
To enforce trust, blockchain implements consensus algorithms used to determine the governance framework. In simple terms, the consensus is a decision-making process for the network to agree on the state of the blockchain. Think of it as a voting system, where 50%+ votes determine how the network will run.
There are various algorithms, but the most popular ones are Proof-of-Work and Proof-of-Stake.
Proof-of-Work (PoW)
Simply put, PoW is what cryptocurrency miners must show, and show the fastest to win the right to append a block to the blockchain. Crypto miners are nodes on the network that add transactions to block, verify transactions, and append the blocks to the blockchain.
The work in this concept is solving a highly complex math problem, and the proof is the solution to the problem, referred to as a nonce. A nonce is a number only used once added to a hashed (encrypted) block. Since it’s only used once, it guarantees that any transaction in a block cannot be processed twice, in what is known as double-spending.
Before miners add a block to the blockchain, they need to verify the transactions and ensure they are valid. In short, this aims to ensure that everyone is on the page regarding the status of the ledger. If a transaction is deemed invalid, the nodes will invalidate it. So if a hacker wanted to process a fraudulent transaction, they would have to have control of over 50% of the network, which is very expensive.
Miners are incentivized with block rewards so that they can act honestly and ensure the network runs as it’s intended to.
Popular blockchain networks using PoW include Bitcoin, Dogecoin, Litecoin, and Monero.
Proof-of-Stake (PoS)
PoS, on the other hand, is a consensus mechanism where the accounts with the most significant stakes in the network determine the governance of a network. Here node accounts, known as validators, with a substantial stake in the cryptocurrency coins are randomly selected to create new blocks and validate transactions.
To further enhance decentralization, PoS allows accounts with small balances to pool them through a stake pool to stand a chance to participate in the governance process.
Validators are incentivized with block rewards so that they can act honestly and ensure the network runs as it’s intended to.
Popular blockchain networks using PoS include Ethereum Consensus Layer, Cordano, Cosmos, and Algogrand.
Immutable records
Before we dive into blockchain immutability, we need to understand the basics of cryptography in the blockchain.
A cryptographic hash function – is a computation and mathematical algorithm that takes in data as input and outputs a unique string of characters, a checksum.
The Checksum is a string of numbers, letters, and characters that serve as a digital signature for the data being hashed by the hashing function. The Checksum of each data input is different, and the slightest change to the input changes the Checksum entirely in what is known as an avalanche effect.
The key utility with a hash function and the Checksum value is that it cannot be reverse-engineered, meaning it’s impossible to work backward from the Checksum to determine the input data.
The hashing process of any newly generated block always includes the meta-data of the previous block. Moreover, each transaction verified by the blockchain contains a timestamp embedded in the block to help the network arrange transactions and blocks chronologically. This links all the blocks together from the genesis block, making it impossible to manipulate or delete data.
Source Developers Fluree
If an attacker attempts to tamper with a block’s data, the subsequent blocks will break since the hash values have changed. The nodes can quickly identify such a case because the miners or validators nodes will invalidate all the changes.
When added to decentralization, cryptographic hash functions also add a layer of security. As no central authority can alter any data on the blockchain, cryptographic hash functions ensure that nodes on the network cannot alter the data for their benefit.
A Distributed and Transparent ledger
Blockchain is a distributed ledger that shares replicates, and synchronizes transaction data among the network members. This means that each node in the network has an updated copy of the ledger.
Source Corporate Finance Institute
After miners or validators generate and validate a block they append it to the blockchain. After that, they broadcast the block to the network, and each node updates its ledger really fast. This enables nodes to keep track of the ledger’s state and adds to the ledger’s security by eliminating a single point of failure or attack. If one of the nodes crashes or is compromised, other nodes will still have a copy of the ledger.
The shared information is also easily verifiable and accessible to anyone through a block explorer. A block explorer is an online blockchain web application that shows the details of all the transactions on a particular blockchain network.
Using a block explorer, you can view all transactions from the genesis block, view the transaction history of a particular digital wallet, explore unconfirmed transactions or even go through all your transaction and the fees you paid for each transaction.
A good example is Etherscan, an Ethereum block explorer that lets you track all the transactions on the Ethereum network. This feature plays a big role in making blockchain transparent.
Anonymity on the blockchain
One of the key features that make cryptocurrency attractive is anonymity. Although blockchain transactions are more traceable than cash transactions, some crypto projects are designed with anonymity and privacy in mind.
Instead of using your personal information to identify you, blockchain uses what is known as a wallet address or public key. It acts as your email address or bank account number. Your wallet address is a collection of random numbers, letters, or characters that might resemble 1GVY5eZvtc5bA6EFEGnpqJeHUC5YaV5dsb. So when sending a document or cryptocurrency, you would need the receiver’s wallet address to know where to send the funds.
When you open an account with a digital wallet, a wallet address will be automatically generated. Each wallets address comes with a corresponding private key that acts as your password. In most cases, it’s a combination of random words that let you log in to your digital wallet or authorize transactions.
While blockchain networks like Bitcoin allow you to track transaction data, other networks like Monero keep everything anonymous. Participants cannot use block explorers to liken wallet addresses to transactions. As such, this makes a network like Monero anonymous and Bitcoin pseudonymous.
Faster transaction settlement
Traditional banking systems and financial institutions are quite slow. It can sometimes take days to process simple transactions after finalizing all the settlements. This is because of the intermediaries involved in each step of the transaction.
Blockchain enables faster transactions by eliminating intermediaries. Its architecture allows for peer-to-peer transactions processed in minutes, if not seconds. Moreover, blockchain also uses consensus algorithms that provide trusted real-time verifications of transactions.
Source Euro Money
Types of blockchains
Blockchain networks are built in various ways depending on what a business wants to achieve. They can be a public, private, consortium, or hybrid blockchain.
Public blockchain
Source Priyanka Patil Medium
Public blockchains are permissionless and utterly decentralized. They allow anyone to join the network, and all nodes have equal rights to access the blockchain, create new blocks, and validate blocks of data.
Currently, public blockchains are mostly used for exchanging cryptocurrencies. You may have come across popular public blockchain protocols like Bitcoin, Litecoin, Ethereum, or Monero.
Private blockchain
Private blockchains are blockchain networks that are governed by a single organization. Here, a central authority determines which nodes can provide the network and the rights of each node in the network.
Although consensus algorithms are implemented on private blockchains, the governing entity still has total control of governing the blockchain. Private blockchains are partly decentralized because public access to the network is restricted. Unlike public blockchains, private blockchains can choose to keep transaction data private and have no transaction fee.
Most entities use private blockchain networks for business-to-business data or virtual currency exchange. Good examples are Ripple and Hyperledger.
Consortium blockchain
In contrast to a private blockchain, a consortium blockchain is governed by organizations rather than one entity. Therefore, they enjoy more decentralization and higher security levels.
Like private blockchain, it also offers higher levels of privacy since the information from the checked blocks is hidden from public view. However, anyone who is a member of the network can access it.
Hybrid blockchain
Hybrid blockchains are controlled by a single entity but with some oversight from the public blockchain, which is needed to perform certain transaction validation. Hybrid blockchains limit who is authorized to engage in the network and perform transactions. To join the network, you have to receive an invitation or authorization.
Source Foley & Lardner LLP
Blockchain vs Bitcoin
Whenever people talk about bitcoin or blockchain, they generally consider them to be the same thing because Bitcoin was the first blockchain application. Although bitcoin, like other cryptocurrencies, runs on a blockchain, they are two different concepts.
Let’s have a look at what sets them apart:
| Basis of comparison | Blockchain | Bitcoin |
| What is it? | A distributed and decentralized ledger | A peer-to-peer digital currency |
| Application | To enable a low cost, and secure environment for peer-to-peer transactions | It aims to simplify and increase transaction speed without any central authority |
| What data is transferred | Easily transfer anything from digital currencies to assets. | Limited to facilitating transactions and trading as a currency |
| The scope | of Blockchain is highly flexible, and various applications can be developed on top of it. | Its scope is only limited to transactions. |
| Status | Because various enterprises use blockchain, they must adhere to KYC and other regulations. | Bitcoin prefers anonymity; therefore, even though we can see the transactions in the ledger, they are just characters that cannot be traced to the parties involved. |
You can learn more about Bitcoin here [Link to “What is Bitcoin” article]
Beyond Bitcoin: The role of smart contracts
While bitcoin is the most recognized digital asset, it’s just one asset class among many others to evolving financial services globally. Ever since the advent of Bitcoin hit the airwaves, a plethora of applications have cropped up, all of which seek to leverage the principles and capabilities of blockchain technology.
Vitalik Buterin is among the growing list of developers who felt that Bitcoin did not achieve its full potential when leveraging blockchain. Concerned by its limitations, Buterin developed Ethereum — a P2P blockchain protocol that was malleable and flexible enough to support additional functionalities. One of the core aspects of Ethereum was the introduction of smart contracts.
What are Smart Contracts?
Smart contracts are simply programs stored on a blockchain that automate the execution of an agreement so that all participants can be certain of the outcome without the need for any intermediaries. Since they are developed on the blockchain, smart contracts inherit the features of blockchain technology.
Smart contracts work by following an “if/when…then…” model that is hardcoded on a blockchain. In short, smart contracts execute certain actions when certain pre-determined conditions have been met. The action can include releasing funds to a wallet address, verifying transactions, or even changing the ownership status of a digital asset.
Unlike typical contracts, smart contracts are implemented in several ways. They can be issued as digital assets, also known as tokens, non-fungible tokens, or NFTs, or a simple agreement that terminates when the pre-set conditions are met.
Many cryptocurrency companies and startups deployed smart contracts to issue their digital tokens traded on exchanges. On Ethereum, this is achieved through an ERC-20 token standard.
Moreover, the blockchain has evolved to support smart contracts that digitally represent assets through NFTs. An NFT is a digital asset that is used to represent real-world assets like art, music, or in-game assets.
Learn more about the Ethereum blockchain here [Link to “What is Ethereum” article]
Criticism of blockchain technology
Most blockchain enthusiasts see blockchain as a solution that will soon replace and automate a great part of traditional financial services database systems and eliminate intermediaries across many industries. While this is a possible reality, it’s probably far from becoming the norm.
Scalability Issues
Blockchains are not scalable like centralized systems. For anyone who has used the Bitcoin network, you know that transaction speed depends on network congestion. When there are a lot of transactions being processed, the transaction speed reduces significantly.
Immutable data
Data on the blockchain is immutable. It is quite clear that the financial industry greatly benefits from immutability. However, it is not ideal in cases where attackers have compromised the security of a financial institution. This is because any fraudulent transactions cannot be reversed. This is mostly the case with the Bitcoin blockchain. Moreover, anonymity in such a case may also play to the disadvantage of a crypto project as it cannot track the attackers.
Blockchain requires an advanced skillset
While blockchain is a revolutionary technology, implementing and managing a blockchain project is difficult. It requires thorough knowledge from the team involved to even go through some minor applications.
51%+ attack on a blockchain network
Blockchain technology is considered more secure than typical database systems, however this does not mean that it’s completely secure. There are various ways the blockchain network can be compromised. For instance, if a single entity were to gain control of more than 51% of a network, they would gain total control. By doing so, they can modify the network to function according to their interest.
Most blockchains are not interoperable
Last but certainly not least, most blockchain platforms are not interoperable. As mentioned above, there are various types of blockchain platforms, each trying to solve a certain problem uniquely. Although these blockchains might benefit from working together, their core blockchain code does not allow them to. However, different blockchains are developing bridges, a combination of smart contracts that facilitate interoperability and transaction between blockchains.
Closing thoughts
Blockchain technology has come a long way since its first successful application in 2008 with the development of Bitcoin.
As Robert Schwertner points out, “I see the future of blockchain technology very bright… We will get rid of cash faster, which anyway is so old-fashioned, and away we paid 2000 years ago, it’s long overdue.”
Schwertner also states that although the internet helps us transfer information, it has one limitation, we cannot transfer value in a trustless and secure way across the internet. This is where blockchain comes in. Within blockchain technology, code is everything. The lows of a project are hardcoded into a smart contract and executed simultaneously in a decentralized and peer-to-peer manner.
So far, we have witnessed blockchain expand to integrate a plethora of applications like NFTs, decentralized finance applications, and industry-specific applications.
Disclaimer: For information purposes only. Not investment or financial advice. Seek professional advice. Digital assets involve risk. Do your own research.
