The blockchain is an invention that forever changed the face of the internet. But it’s far from reaching its full potential.
Even though it was initially developed to support Bitcoin, entrepreneurs and tech wizards found many applications for this technology.
But before we talk about that, let’s take a look at what is blockchain and how it actually works.
Table of Contents
1. What is blockchain?
As the name suggests, the blockchain is, well, a chain of blocks. In the financial world, these blocks are known as records, and in blockchain, they are linked together through cryptography.
In simpler terms, the blockchain is a fancy digital ledger.
Each record (block) in the blockchain contains a timestamp, information on transactions, and the cryptographic hash value (signature) of the previous block. This means that each block is reliant on the previous one.
Thus, the chain.
Who invented blockchain?
The first working blockchain was released in 2009, after Satoshi Nakamoto published the paper ‘Bitcoin: A Peer-to-Peer Electronic Cash System’ in 2008, and released the Bitcoin software the following year.
But that wasn’t the first time the idea of blockchain was introduced to the world.
In 1991, Stuart Haber and W. Scott Stornetta talked about linking blocks in an append-only data structure in their academic paper, ‘How to Time-Stamp a Digital Document’.
Types of blockchains
There are 3 main types of blockchains:
Public blockchains are open-source networks that anyone can join as a user, developer, or member. Every transaction on a public blockchain can be seen and examined by anyone.
One of the main advantages of public blockchains is their resistance to censorship. They are fully decentralized, and they record transactions on several computers all over the world. Thus, changing the data on the network is impossible.
Examples of public blockchains are Bitcoin, Ethereum, and Litecoin.
Private blockchains, on the other hand, place restrictions on who can join them. Also known as permissioned blockchains, they record their transactions privately, making them available to network participants only.
When compared to public blockchains, permissioned blockchains are more centralized. The entity running the chain has full control over who joins its network. This makes private blockchains ideal for businesses that want to share their data but protect sensitive information.
Examples of private blockchains include Ripple and Hyperledger.
Consortium blockchains, also known as federated blockchains, combine the best of both worlds. They are more decentralized than private blockchains but allow control over what data is public and what remains private.
Unlike private blockchains, who are controlled by one company, federated blockchains are controlled by a pre-selected set of entities/nodes.
2. How does the blockchain work?
To better explain how a blockchain system works, we will use the Bitcoin blockchain as an example.
How are new blocks created and chained together?
I mentioned earlier that each block contains a record of Bitcoin transactions. Every block on the blockchain can hold around 1 megabyte of data. After that block gets filled up, a new block is automatically created.
Let’s write down some hypothetical transactions and see what a block looks like.
Let’s say that Zeus owes Odin some money and he wants to pay him back in Bitcoin. So Zeus transfers 0.5 BTC to Odin.
Odin, like the good father he is, decides to send some pocket money to his sons, Loki and Thor.
Loki gets 0.1 BTC, but Thor gets 0.2 BTC because Odin always loved him more.
This gives us the following transactions:
T1: Zeus – Odin | 0.5 BTC
T2: Odin – Loki | 0.1 BTC
T3: Odin – Thor | 0.2 BTC
Now let’s say that all these transactions make up 1 MB of data, thus filling up a block – Block 1. This block is automatically assigned a signature – say ASG4.
This is what our first block looks like.
Now let’s create a second block.
After a legendary battle with the frost giants, Thor needs to repair his mighty hammer. So he sends it to Asgard’s Forge and pays 0.1 BTC.
Loki wants to make fun of Thor’s new dad bod, so he orders 100 cheeseburgers and a diet coke from Asgard’s version of Wendy’s. This costs him a total of 0.04 BTC.
Thus, we have the following transactions:
T1: Thor – Asgard’s Forge | 0.1 BTC
T2: Loki – Asgardian Wendy’s | 0.04 BTC
Besides these transactions, Block 2 also includes the signature of Block 1 – ASG4. Then Block 2 receives its signature based on the data it contains. Let’s say FUN27.
As more transactions happen on the blockchain, more blocks get created, each block containing the signature of the previous one. This way, Block 1 is directly linked to Block 2. Block 2 is then linked to Block 3. Block 4 to Block 5, and so on.
But what if someone decides to alter the data in Block 1?
Let’s say that Loki, mischievous as he is, wants to cause some trouble. He changes the amount of Bitcoin Thor got from Odin from 0.2 to 0.3. This way, Thor will have to account for money he didn’t receive.
And here’s where things get complicated. Now that the data in Block 1 is different, the signature, which is generated based on the data in the block, changes automatically. So instead of ASG4, the new signature becomes, let’s say, ERR2.
Given that this signature is included in Block 2, the string of data also changes, thus altering the signature of Block 2 from FUN27 to OOPS42.
This triggers a domino effect where every signature of every block in the chain is changed. Once users realize that someone tries to change the data in the blocks, they reject the changes and shift the blockchain back to their previous valid version.
So how are signatures created?
To be honest, the process itself is pretty complicated. Most of this still sounds like black magic to me, so I’ll be staying out of the super-technical stuff.
But in simple terms, a cryptographic hash function (a complex algorithm) takes a string of data (the transactions in the block) and converts it into a unique 64-digit string. There are several such hash functions online that you can play with – we’ll be using this one for our example.
By adding the data from our first block in the hash generator, we get the following string:
If a single character in the input data changes, the output will be completely different. So if Loki changed that 0.2 BTC to 0.3 BTC, our output will be this:
This is why the integration of the signature of Block 1 (ASG4) into the data of Block 2 makes it impossible to alter the blockchain. The signature of each previous block is used to create the signature of the next one.
So where does mining come in?
Contrary to popular belief, crypto mining isn’t about creating new Bitcoin.
Miners compete with each other to validate the transactions in every block, making sure that each block on the chain fits certain criteria.
But to understand how all of that works, we first need to talk about nonces.
Nonces are a variance added by the blockchain to each block. Their only purpose is to change the hash output (signature) of a block, without altering the data of the transactions. The nonces are added because every signature of every block needs to start with a specific number of leading zeroes.
Miners then need to find the value of the nonce to validate the transactions and add the new block to the blockchain. There is no formula to calculate the value of the nonce. It is simply a process of trial and error.
And generally, the more computational power you have, the faster you can test various nonces, and thus find the right value.
3. Decentralization of Blockchain
Now that we have a clear picture of what the blockchain is and how it works, let’s talk about one of its key aspects – decentralization.
Decentralization is one of blockchain’s most commonly encountered concepts. A decentralized blockchain means that there is no central point of control for the whole network. Instead, the network is stored in several locations throughout the world.
Vitalik Buterin, the co-founder of Ethereum, separates decentralization into 3 different types:
- Architectural (de)centralization – how many physical devices is a system made up of?
- Political (de)centralization – how many individuals or organizations control those devices?
- Logical (de)centralization – is the whole network monolithic and organized, or chaotic and disorganized?
Using these types, he then classifies various technologies and institutions. He defines the blockchain as politically decentralized, architecturally decentralized, but logically centralized.
What about DLT?
Many believe that blockchain and distributed ledger technology are one and the same thing. But that isn’t quite right.
Distributed Ledger Technology is a decentralized technology that stores its databases in several locations, on several devices, owned and controlled by different individuals or organizations.
The main difference between the two is that DLT is a technology, and the blockchain is a type of DLT.
The decentralization of distributed ledgers aims to end the need for a central authority that processes or validates the transactions on the network. This reduces the risk of the system to be compromised in an attack.
4. So how does blockchain fit into cryptocurrency?
Blockchain’s role in the crypto industry is pretty straightforward – it records and validates transactions. This allows the crypto world to remain anonymous, increases its security and helps it remain transparent and immutable.
But what does a crypto transaction look like?
Let’s go back to our earlier example.
For Zeus to send those 0.5 BTC to Odin, he first needs a wallet that can hold Bitcoin.
- Zeus opens his wallet and inputs Odin’s public key together with the amount he wants to send.
- He then types in his private key to confirm the transaction.
- Hermes, who is a miner, charges 0.00005 BTC to include the transaction in the blockchain. Think of this as a shipping fee, which is automatically included in the final amount.
- The transaction is then validated by nodes, timestamped, and added to their version of the blockchain.
- Odin finally receives the 0.5 BTC.
At the moment, more than 300,000 BTC transactions are confirmed each day. You can watch all the transactions as they happen on blockchain.com.
Contrary to popular beliefs, crypto wallets don’t actually store your crypto coins. Instead, they help you make transactions, track your balance, and most importantly, store your public and private keys.
Your public key is like your bank account number. You share it with others so they can make deposits into your account.
Your public key is generated from your private key.
Your private key, on the other hand, is like a security code. You’re the only one who should know it. Otherwise, people will able to confirm transactions on your behalf. And without it, you won’t be able to confirm the transactions or withdraw money.
5. Benefits of Blockchain
Blockchain technology comes with a multitude of benefits, which can have a significant impact on the way businesses perform as well as on the satisfaction of their customers.
All the information stored on the blockchain is permanent. No one can change it, and no one can remove it. This allows businesses and individuals to efficiently and easily trace all their transactions.
But changing data on a blockchain isn’t impossible. It’s just very, very difficult.
And while immutability sounds like an excellent idea (and often is), it also can cause several problems to a business. What if, by accident, sensitive data gets published on the blockchain?
The only solution to fix this is by convincing the other parties involved in the blockchain to have a “fork” – split the blockchain into 2 paths, and move the database to one of them. But doing this on a public blockchain is next to impossible.
Yet such problems are usually avoided through blockchain’s design nature, which separates sensitive and identifying information.
Most of the data on the internet is controlled by 4 giant companies – Google, Microsoft, Amazon, and Facebook. Every picture or video you saved in the cloud or posted online, every voice message or email you ever sent, your purchasing habits, and your location history are all stored on their servers.
All information on the blockchain, including transaction details, is encrypted. A public key can’t be traced back to a specific user or company, thus preventing the tracking of purchasing habits.
In today’s world, security is one of the most important aspects of every technology.
A report shows that on average, a hacker attack is carried out every 39 seconds. Credit cards, identities, and classified information get stolen on a daily basis. This leads to billions of dollars of losses each year.
But since the blockchain is a decentralized system, it has no single point of failure.
The information is stored on countless computers connected to the network, so carrying out an attack is nearly impossible. To take control of the network or to alter information stored on the blockchain you would have to attack all the network’s devices all at once.
This would need a lot of work and computational power and would prove pointless, as carrying out an attack on the whole network would cause the value of the cryptocurrency to plummet.
Ultimately, the investment required to carry out such an attack would be larger than its eventual benefits.
The blockchain allows you to remain anonymous. Nobody can track your purchases or your spending habits and link them to your personal information so they can later monetize it. Unless they know for sure which public address is yours.
But even so, a system built fully on blockchain technology won’t store cookies or personal information. And this is exactly why the Bitcoin exploded in popularity on black markets and the dark web.
The main difference between Bitcoin and banks is that Bitcoin’s fees are flat. Banks usually charge a percentage of the transferred sum, which can range from 1% to 4%. This means that on a transfer of $10,000, the bank can charge anywhere between $100 and $400.
On the other hand, Bitcoin transactions charge a flat rate, but it is based on the market value. At the time of publishing this article, the transaction fee was $0.71. The highest transaction fee was $55.16, on December 22, 2017. That’s still lower than 1% of a $10,000 transaction.
No financial control from the government
Banks and governments can freeze an account without any notice if they consider it necessary. Countless people have their accounts frozen each day, without understanding why.
In a blockchain network, the only person who has access to your funds is yourself. Well, and anyone who has your private key (nobody else should though). The government, your national bank, or any other institution can’t access your funds or track your transactions without knowing your private and public keys.
This means that you are in full control of your money, and no institution is able to take that away from you without your consent.
The blockchain is a pretty big thing.
The technology that powers it saw an explosion in popularity in 2017 due to cryptocurrencies, but that is slowly changing. Blockchains get developed publicly and privately by many businesses and individuals. And that happens because of their enormous potential.
Blockchain technology has the power to completely change the way our society works.
It can completely disrupt the way the banking system works, support e-governments, and promote the usage of green energy.