How does blockchain work?
Blockchain works by storing information electronically as a decentralized, distributed, immutable digital ledger shared through nodes on a computer network. You may hear the term blockchain associated with cryptocurrencies like Bitcoin or Ethereum. Blockchain technology is the cornerstone of cryptocurrency systems.
However, blockchain technology is capable of much more. This article will answer the question "What is blockchain technology," and explain how it maintains fidelity and security to enable trust among its users. We'll explain blockchain technology so you better understand it when you encounter it or decide to use it.
Introduction to blockchain
What is a blockchain? The simple way to explain blockchain technology starts with understanding "What's a blockchain?" A blockchain comprises a chain of blocks containing records of transactions. Blockchain is a decentralized record-keeping technology that provides secure and accurate data on a digital ledger. Each block is a digital collection of transactions. The storage capacity of a block depends on the blockchain platform.
For example, Bitcoin blocks can store up to one megabyte of data. An Ethereum block can store up to 45 megabytes of data. Each occurrence of a new transaction gets recorded onto the block. When a new block gets added to the blockchain, nobody can delete or change it. A blockchain network consists of thousands to millions of nodes, which are computers.
People tend to identify blockchain most commonly with Bitcoin. Many mistake blockchain and Bitcoin for being the same thing, which they are not. Bitcoin is a cryptocurrency used as a store of value for investment, transfer of funds or purchase of goods and services. Bitcoin is powered by blockchain technology, recording every single transaction. Bitcoin is one of the most well-known applications of blockchain technology. Bitcoin is the most common application of what is blockchain in crypto. However, blockchain has and continues to have more applications created throughout industries like finance, healthcare, insurance, real estate, and supply chain.
Blockchain technology can be used in various manners, from transferring cryptocurrencies to tracking products in a supply chain to recording property deeds or updating your address for all your bills, vendors and counterparties when you move.
The primary purpose of blockchain is to ensure transparent, tamper-proof and secure transactions in a decentralized manner. It allows for secure and transparent transactions between parties that may not know or trust each other. Blockchain technology enables them to agree on the state of a database without needing a third-party intermediary.
Core concepts of blockchain
Five core concepts are the foundations of blockchain. These core concepts highlight the appeal of blockchain technology to organizations, enterprises, and users around the globe. They are critical to learning Blockchain for Dummies 101. In defining blockchain, these five core concepts apply to public blockchains.
- The blockchain is secure. Each transaction in the blockchain is encrypted and linked to the previous one. It's also viewable and accessible to everyone in the network. If any transaction is changed, it would require altering all the subsequent transactions, which is computationally impractical. This helps to ensure security against tampering and fraud.
- The blockchain is immutable. This means that the record can't be deleted or changed without the consensus of the whole network. Immutability is the main design component that keeps the blockchain secure and trustworthy.
- The blockchain is transparent. Every transaction on a public blockchain, like Bitcoin and Ethereum, is available to all participants in the network who want to view them. Identities are hidden, but all transactions can be tracked and trailed. This transparency keeps the blockchain accountable. However, private blockchains are private and require authorization to access and participate. This is because of the nature of its sensitive data like medical records or more control over the information. A central entity controls private blockchains and requires authorization and permission to participate.
- The blockchain is decentralized. This means no single entity can control it. Being decentralized also means that every node in the blockchain network has a copy of the entire blockchain. The blockchain is replicated throughout a network of nodes, making it hard to manipulate and resistant to fraud, single points of failure, or censorship. The decentralized nature makes it virtually impossible for the blockchain to be entirely controlled by a single entity.
- The blockchain implements a consensus protocol. Blockchains use a consensus protocol to ensure every node has an equal count, enabling the network to agree on the state of its blockchain. Large blockchains with a diverse user community have less chance for manipulation.
The blockchain is a database that stores data, usually in the form of transaction records. The amount of data stored in a block can vary depending on the blockchain network and its purposes. A block for the Bitcoin network stores up to one megabyte of data, which can record 2,000 transactions. Transaction data includes a date, timestamp, amount per transaction and the addresses of the recipient and sender.
Smart contracts are self-executing contracts stored on the blockchain. Smart contract data automates tasks like supply chain management or escrow payments. Identity data stores information about your identity, which you can use for verification purposes to prevent fraud. Other data types can include medical records, property titles and voting records.
Anatomy of the blockchain
Let's go through a breakdown of blockchain defined by its components. As mentioned earlier, a blockchain is a distributed database comprised of a series of sequential blocks. Each block contains data like the record of a transaction. Every new transaction gets added to the block. A block can contain up to one megabyte of Bitcoin transactions, approximately 2,000 transactions.
A transaction is the record of an exchange between parties. Transactions are represented by digital signatures, which miners verify. Miners are machines that compete with other miners to solve complex computations. The first miner to solve the math problem gets to add the next sequential block to the blockchain and receives a reward. Nodes are computers connected to the blockchain network that can act as miners. Nodes replicate a record of the blockchain and verify transactions.
Validators validate new transactions and blocks in a proof-of-stake (POS) Bitcoin network. They first have to stake a specific amount of cryptocurrency depending on the blockchain network, which comes with the risk of losing it. They receive newly minted cryptocurrency for their work, which helps to secure the network and enable the growth and support of the blockchain network.
How transactions work
Now that you can answer the question "What's blockchain?" let's move on to the next question: How does the blockchain work?
Here's how blockchain works in a typical transaction. A transaction is viewed as a digital record for the transfer of ownership of an asset from an owner to another party. Transactions get recorded, shared and verified in a decentralized manner by all the nodes on the network, ensuring security, transparency and immutability.
Transaction process
To initiate the process, a sender creates a transaction request comprised of the sender's address, the recipient's address, the amount of the transaction and the sender's digital signature. The request gets broadcast to a network of computers.
The block receives a unique identifier called a cryptographic hash. The hash is created using the transaction data unique to the block and includes the prior block's hash. Miners compete to solve a complex math problem. The first miner adds the transaction to a block, which broadcasts to the network. This consensus mechanism is called proof-of-work.
Transaction verification
Other miners and validators or nodes in the blockchain network will verify the transactions, including the validity of the details and status of the participants. Common consensus mechanisms are either proof-of-work or proof-of-stake. Once verified, the transaction is added to other verified transactions on a block. Once most nodes reach a consensus that the block is valid, the block gets added to the blockchain. This process updates the nodes with their copy of the blockchain. Adding the block to the chain completes the transaction and can't be changed.
Smart contracts
Smart contracts contain automatic self-executing instructions via programming code to trigger when certain conditions are met. Smart contracts can automate many tasks, including completing agreements, transferring or purchasing assets, and creating new cryptocurrencies.
Due to their additional complexity, smart contracts are more expensive to execute. A smart contract transaction only gets executed when specific conditions are met. The transaction is initiated, verified and recorded on a new block on the blockchain. When the trigger is contingent on external information, it can use third-party services, called Oracles, to gather the information, relaying the external data to the smart contract.
Like regular blockchain transactions, smart contract transactions are immutable and permanently recorded on the blockchain. It's essential to make sure the contract coding is perfect. You can't change smart contracts but can design them with upgrade patterns or proxy contracts to allow for updates.
Security and consensus in blockchain
Security and consensus are two core concepts that make blockchain technology so appealing. While the blockchain design makes hacking extremely hard, hackers tend to exploit other areas outside the blockchain, like digital wallets.
Cryptography for security
Cryptography is the key method of securing data on the blockchain. Cryptography is a general term describing all the techniques to secure data from unauthorized access. Encryption is a type of cryptography that transforms data into an unreadable format using mathematical algorithms. Encryption makes the data unreadable for unauthorized users during transmittal or storage. Encryption protects data, while cryptography secures transactions on the blockchain.
Consensus mechanisms
Consensus mechanisms or protocols require majority approval to add a block to the blockchain. There are two types of consensus mechanism.
- Proof-of-work (POW): POW is popularly known as mining. It's a competition between miners to solve complex mathematical equations and add new blockchain blocks. The first miner to solve the math problem receives new cryptocurrency. POW can be energy intensive due to the heavy load on computer power and electricity, making it more expensive. POW has more decentralization. Bitcoin uses the POW consensus mechanism.
- Proof-of-stake: POS requires validators to take their cryptocurrency before validating blocks. The higher the amount of cryptocurrency, the greater the chances of being able to validate the block. POS is less expensive, but it also has the potential for validators to lose their stake. POS also has the potential for validators to collude or even attack the network. POS has less security and is less decentralized. Ethereum uses the POW consensus mechanism.
Cryptography is still highly secure unless an entity achieves 51% of the nodes, which is impractically expensive. Most hacking incidents don't happen on the blockchain but rather with outside components that can access the blockchain. For example, hackers can hack third-party apps like Oracles. They can also hack smart contracts if there is a flaw with the coding and digital addresses.
Practical applications
There are many applications for blockchain technology, and developers are building out more applications daily.
Cryptocurrencies
Cryptocurrencies are the most widely used application for blockchain technology. There are thousands of cryptocurrencies. Cryptocurrency is a store of value for investment, speculation or purchases. Unlike stocks and bonds, cryptocurrency is treated more as property than an actual, legitimate currency. They can be as risky and speculative as penny stocks.
Bitcoin is the most widely used cryptocurrency as it has penetrated the mainstream. Cryptocurrencies continue to swell with interest even as Bitcoin exploded to $69,000 before collapsing to $15,460 from 2021 to 2022. Cryptocurrencies can be hard to short sell. They are also rife with fraud and pump-and-dump schemes like the FTX cryptocurrency exchange scandal, including the FTT crypto collapse, which fell from over $80 to less than $1 per token. Cryptocurrencies don't usually pay dividends and are considered risky for long-term investing.
Supply chain
Blockchain technology enables more accountability with supply chains as it can track the journey of goods. Its decentralized nature enables all participants and counterparties to view the immutable record of transactions for products to ensure accountability. End-user customers can also track the sourcing of goods to ensure authenticity. Any disruptions in the supply chain can alert participants rapidly with complete transparency. It improves the efficiency of the supply chain while helping to cut down on fraud.
Non-fungible tokens (NFTs)
NFTs are digital assets stored in the blockchain. These assets can range from digital art to in-game items and collectibles. NFTs can represent ownership of digital assets. The NFT craze peaked in 2021 with the sale of Beeple, Everydays: The First 5,000 Days, which sold for $69.3 million in 2021.
Smart contracts in industries
Most industries can use smart contracts. Financial services smart contracts enable automated financial transactions like loan payments or trade orders. Real estate smart contracts can record property titles and automate the buying and selling homes to speed up transactions. You can use them to automate healthcare and supply chain functions to improve efficiencies. Smart contracts can also expedite cross-border payment processing, meaning trade settlements can happen instantaneously on the blockchain.
Healthcare
Medical records can be stored and shared securely on the blockchain. The decentralized nature enables a single source of truth to be accessible by any provider or healthcare facility. This can improve healthcare and cut down on fraud. However, since medical records and health data are sensitive, it's practical to warrant using private blockchains to thwart unauthorized access while being secure and transparent.
Future of blockchain
Blockchain technology is in its infancy. There are ever-growing applications for blockchains to power automation and improve processes. More enterprises and governments are accepting and adopting blockchain as it gets more recognition. Here are some potential future applications and possibilities of blockchain technology.
- Metaverse: The Metaverse is also in its early stages. The clunky nature of headsets and expensive hardware barriers to entry has caused the hype to die down. However, the metaverse plans to continue growing its virtual world, potentially becoming a work, entertainment and commerce hub for people around the work powered by the blockchain.
- Decentralized autonomous organizations (DAOs): Another blockchain example is DAOs. Smart contracts power these organizations with self-executing blocks that trigger when conditions are met. They have the potential to disrupt the way businesses are operated and managed.
- Decentralized finance (DeFi): DeFi enables consumers to access financial services without needing a financial institution, broker or bank. Smart contracts would automate most or all of the processes for various financial services, including lending, borrowing, repayments, wealth management, insurance and trading. Blockchain technology makes DeFi applications more secure, efficient and transparent.
Private blockchains
Most of the information provided applies to public blockchains like Bitcoin and Ethereum. However, enterprises are partaking in private blockchains due to sensitive data, control and security risks. These utilize the same technology but have stricter access and are not decentralized. A network administrator often provides access and permissions and monitors activity. While private blockchains have centralized, limited access, with low transparency relative to your access, they have more security, privacy and faster performance than public blockchains.
The future of blockchain remains bright
Critics frequently dismiss blockchain technology as a niche sector for coders and conspiracy theorists. Most new technologies are. However, many of the world's largest financial institutions, such as JPMorgan Chase & Co. NYSE: JPM, are investing in blockchain technology.
The reasons are simple: many more consumers are concerned about the privacy and security of their information. Plus, blockchain technology has exposed the ability for cross-border transactions to move more swiftly.
For these reasons and more, blockchain technology is not only not going away, but it will likely become a mainstream part of our lives soon.
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