Blockchain, ‘the next big thing after the Internet’ is on everyone’s lips today. In this article, we will answer the questions “What is blockchain?” and “How does blockchain work?”
We will also explain the distinctive features of the technology and explore its potential use-cases. Let’s fill the gaps!
To understand the technology at the basic level, let’s see why they call it “blockchain”. The name means “chain of blocks”. Each block represents a unit of digital information stored in the distributed public database (ledger).
The most important things a beginner should know about blockchain:
Here are a few things beginners should know about blockchain technology.
These were the basic principles to keep in mind. If some of them make no sense to you right now, don’t get discouraged. We will deal with them later in greater detail.
Now, let’s explain how blockchain works, for beginners.
Let’s explore how blockchain works, step by step.
Imagine, you want to send 1 BTC to your friend X.
To understand how it is possible, we have to explain the basic features of blockchain.
Blockchain networks are decentralized by nature. To understand what it means, we will juxtapose them with centralized systems you are familiar with.
In a centralized system, the idea is simple — some authority is in charge of making, storing and updating records. For instance, your bank is responsible for keeping your financial data and has control over it. Under certain circumstances, the bank authorities share your information with the government or pass it to their business partners. Theoretically, they are able to tamper with this data, delete it, restrict your access to it, or lose it to hackers.
In a decentralized blockchain-based system your data does not sit in one place and no one controls it. In a way, it belongs to all the members of the network as they all store these records on their computers. As there is no central entity to control the process, the peers interact directly. A and B do not need any banks, payment systems or law offices to send and receive money, grant ownership rights or make other agreements.
The complete history of the network transactions is available to any user. It’s the ‘single source of truth’ which everyone can view anytime, but no one can change or delete. Due to its distributed nature, a blockchain network would be extremely difficult to compromise. You can ‘correct’ a central database without being noticed. But it’s impossible to do when the data is spread across many independent computers.
When experts speak about blockchain pros, they often mention it is ‘transparent’. At the same time, many people believe Bitcoin is a perfect financial tool for illegal activities, due to its anonymous nature. Who is right?
There is no controversy here: blockchain ensures both transparency and privacy.
We will use a real-life example to explain it.
Again, you are sending 1 BTC to your friend X.
You broadcast the transaction to the network and every node gets to know about it. Miners check and verify it. Then, they have it added it to the next block. This chain of events takes place in full sight of the whole network community. This is what we mean exactly when we call blockchain ‘transparent’.
Ok, and what we mean when we say blockchain is ‘private’?
Using the example above, your transaction record does not get linked to the real identities of the sender and receiver. The viewers will not see “Alice sent 1 BTC to Xavier”. Instead of the names, they will see a long string of random characters (your public address), time and amount sent.
Thus, blockchain manages to kill two birds with one stone. People may see the transactions made by a certain public address, but they don’t know who stands behind it, physically.
IMPORTANT: In the case of Bitcoin it’s possible to track down your real identity using your public address and IPs. For this reason, they often call it ‘pseudo-anonymous’.
If you are seeking 100% anonymity, there are so-called ‘privacy coins’. The most famous of them is Monero. It uses three special technologies to hide the names of both the sender and recipient, as well as the amount sent.
Simply explained, immutability means that once you put something into the blockchain, you cannot put it out. Neither can you (or anyone) change it.
It’s one of the main advantages of blockchain over centralized systems where you have to rely on people who might betray your trust. In a blockchain network, trust is ensured by cryptography and math.
We have already talked about hash, a unique block identifier. A hash is created using a special cryptographic function. It transforms input texts of various lengths into a string of code of fixed length.
An input text, containing the new block transaction data and the hash of the previous block in the chain, is run through a special algorithm. For Bitcoin, the SHA-256 algorithm is applied. No matter how long your input text is, you always get an output hash of 256 characters.
It’s impossible to tamper with the blockchain-stored data because Block 10 always links to Block 9 (includes its hash). Which, in its turn, links to Block 8, and so on. To make the slightest modification, you have to deal with a huge amount of data and spend a lot of resources. No trophy is worth such a waste of time, money and energy.
On the physical level, any blockchain network is a collection of nodes. They are individual computers connected to each other. As we have said, in a blockchain there is no central server to manage, control and update the database. This load is distributed across multiple peers. When you join the community, you get the full version of the blockchain and start running a node.
Once all the peers agree a new block is ok and can be added, every node updates its copy of the blockchain. To decide if this new block is good or bad, the nodes use consensus — a special set of rules. Consensus makes it possible to achieve agreement on the value of the newly added data.
All nodes are equal, according to the main principle of blockchain, which is a peer-to-peer system. They have the same rights but may differ in their functions. For instance, you can run a light or full version of blockchain (light or full node), or take part in mining.
Running a lightweight (or light) node means you don’t download the complete version of the blockchain, only the block headers. Light nodes use a simplified method of transaction verification and depend on the full nodes.
Running a full node requires a certain amount of spare computing resources. Full nodes are used to fully validate transactions and blocks. They are necessary to support the functionality of the whole blockchain network.
Mining normally implies running a full node, too. A miner is a node that creates new blocks, while other nodes just validate the information. We will return to blockchain mining later in this article.
The basics made clear, we now come to the technology applications.
You apply blockchain in several big ways. We have outlined them below.
Blockchain-based money transactions involve different cryptocurrencies. The biggest and oldest of them is Bitcoin, but there are many others. Such transfers are very safe, extremely cheap and fast.
The distributed ledger technology (DLT) makes it possible to code any agreement as a smart contract. When certain conditions are met, something happens automatically.
Blockchain can verify information about property ownership, rights, identities, etc. The important thing is that no one is able to alter or steal it. Want to know who owns the house you plan to buy or create the piece of music you’d like to use for your video? Find this data in the blockchain and contact the author/owner directly.
The DLT improves the way people and companies communicate with each other, share information and resources, raise and distribute funds and coordinate their work.
The most obvious blockchain application is cryptocurrency. The current finance system far from perfect and needs reformation. It is especially true for cross-border money transfers — they are expensive, slow and involve too many intermediaries. The systems like SWIFT make things smoother, but they cannot compete with blockchain networks in terms of price and speed.
A modern customer is comfortable with the Internet and mobile apps. Smartphones and PCs are affordable for most of us. Information travels very fast. People just don’t understand why it takes banks so long to move money between accounts, and why it costs so much. Bitcoin and other cryptocurrencies seem to be an up-to-date solution to this problem.
Since BTC was launched in 2009, the number of cryptocurrency wallets has been growing. By the end of September 2019, it had reached over 42 mln.
Ok, and what a typical Bitcoin user looks like? According to surveys, over 70% of BTC users are male, and most of them (58%) are rather young (18 — 34 years old). Why these people buy crypto assets? The top two reasons are a lack of trust in national governments/banks and a hope for greater returns in the future. As you see, both are pretty universal.
Cryptocurrency is the most popular use-case of blockchain. Thus, it would be interesting to see how it works.
In a nutshell, almost any cryptocurrency is “an electronic cash system that’s fully peer-to-peer, with no trusted third party.” What does it mean, in comparison with ‘normal’ money?
Traditional currencies are issued by governments and regulated by them. A government may decide to print more money, in case of need. Fiat money (for instance, the USD) used to be backed by gold and then by trust.
Cryptocurrency supply is fixed. Crypto transactions are verified by the nodes. They agree on if these transactions may or may not become a part of the blockchain. Issuance of new coins happens through the process called mining. The time has come to consider it in detail.
Mining is the process of adding blocks to blockchain and creating new coins. We will consider it using the Bitcoin network as an example. It applies the PoS (Proof-of-Work) consensus protocol.
In the BTC network, if a computer wants to add a new block to the chain and get the reward, it has to provide the so-called ‘Proof-of-Work’. You prove to the system that you have solved a math problem with a cryptographic hash function, related to the new block data. This ‘work’ is necessary to authorize the transactions.
Solving such a puzzle is a very difficult task. In fact, the odds of finding the right answer were as low as 5.8 trillion by February 2019. Thus, you need to have enough computational resources at your disposal. It means investing in powerful and expensive mining hardware and paying huge electricity bills. It makes a hacker attack too costly — just imagine the number of resources you would waste to affect multiple blocks.
Nowadays, many people see mining as a way to get additional income. But it’s not as easy and profitable as it was years ago. Miners compete with each other to earn newly created BTC or other coins. To win them, they have to upgrade their hardware constantly. More processing power guarantees more ‘guessing’ attempts per second.
With time, the difficulty of the network (and mining in it) increases, as more new blocks join the chain. Besides, every 210,000 blocks an event called ‘Bitcoin halving’ happens, when the mining reward gets reduced by half. The next halving is due in May 2020.
As a result, solo mining is not profitable anymore if you deal with older cryptos like Bitcoin. It would be smarter to join a mining pool, where they split the reward among all the participants. In the long run, this model ensures a more stable income.
To understand how blockchain works, you should know what public and private keys are and how they are different from each other.
The main rule of any cryptocurrency user is not to share their private key with anyone and keep it in a safe place. If someone knows your private key, s/he becomes the co-owner of your money. Your public key, on the contrary, may be shared with everyone you want. That is why they are called public.
The best way to explain the difference between public and private keys is to compare the first to your email address and the second to your email password. You give your email address to all the people you want to contact. Print it on your business card. You broadcast it through social media and other channels if you seek feedback from a wider audience. It’s safe to share because you have your account protected by a unique password.
This password is your private key, and we do hope you don’t share it with anyone. If you do, these people can read the messages in your inbox and reply to them. They can send messages on your behalf and delete the ones they don’t like. They can change your account settings and preferences.
In a blockchain context, people need to know your public key to send you cryptocurrency. To be the only one who sends, receives and owns it, you keep your private key safe. The public key encrypts messages, and the matching private key decrypts it.
Public and private keys look like long strings of random characters.
To sum it up, your private key represents your right to own and manage the digital funds. If you lose control over it, you lose control over your cryptocurrency. Your public key may be available for everyone, just like your contact details.
Blockchain is not limited to cryptocurrency and the world of finance.
Potentially, the technology is beneficial for many industries, and there are three big reasons for it.
Below we list some sectors and industries we could reform due to blockchain solutions integration.
Imagine an Uber, or Airbnb, or eBay-like service but without any central authority/intermediary. Now the web service charges you a considerable fee for ‘matching’, identity verification, insurance, dispute management, etc. In a blockchain system, you will be able to sell, buy, rent or share everything in a P2P manner. You will only have to pay a small infrastructural fee for processing your transaction. It is much better than giving away a fixed percentage of the amount involved in the deal.
Originally, blockchain was a libertarian technology. Nevertheless, it can improve the ways central bodies work, too. Today, the biggest challenges governments face are the lack of public trust, data security issues, inefficiency, and too much paperwork. The services of government officials cost way more than they should. Too much money is wasted because of outdated and complicated procedures. Everything takes longer than expected — for the same reason.
Blockchain facilitates many processes by eliminating unnecessary papers, steps, and intermediaries. It may be the way to restore people’s trust in their governments. When every record is stored in an immutable distributed ledger and everyone can track the history of all the transactions, it leaves no space for corruption.
On the other hand, the blockchain technology can make citizens comply with the rules and regulations. For example, it prevents corporations and individuals from falsifying important data or bribing government inspectors, who ‘correct’ databases.
The security of supply chains is a problem of major importance. It is especially true for the healthcare industry: we have to track the origin of drugs to be sure they are not counterfeit. If we store the product-related records in a distributed ledger, we would be able to follow their way from the factory to the store. It would be easy to check the authenticity of foods, drugs, supplements, cosmetics, diamonds, luxury bags, etc. Also, we could be sure that labels like ‘organic’ or ‘made by local farmers’ reflect reality.
A blockchain-based voting system prevents election frauds, registered in many countries. Transparency and immutability it ensures would help restore public trust in the electoral process and motivate more people to vote. So far, several states have tested this innovative voting model. The pioneer was Sierra Leone.
A single ‘source of truth’ that may be accessed by authorized professionals from anywhere in the world makes healthcare much more doctor and patient-friendly. Currently, there are many databases owned by different medical institutions reluctant to share this information. Also, there is a problem with counterfeit or stolen drugs. It means huge money loss for the industry and serious risks for consumers. According to The World Health Organization, around 30% of all drugs, sold in Africa, Asia, and Latin America are fake.
What will happen if we transfer all the medical records to a blockchain network? Your doctor will have all the necessary info at hand. You won’t have to make all these tests anew if you change clinics. Patients or doctors won’t be able to manipulate data to have bigger insurance payouts. As a result, there will be fewer frauds. Finally, patients will have control over their personal medical information. Now hospitals and clinics own it, meaning they are free to share, change or sell it.
In a centralized database, property titles are vulnerable to fraud. These records are created and checked manually. Therefore, they may contain errors. If someone seeks to take your land or house from you, they can use such errors to challenge the legitimacy of your ownership. Or they can ‘pull some strings’ to tamper with records.
What if we keep the property titles in a distributed ledger? It guarantees the safety and authenticity of the information, reduces paperwork and helps reconcile property disputes. Georgia and Honduras are already experimenting with blockchain-based land registries. So far, the results are optimistic.
The DTL may also be applied in many other sectors. They include insurance, gaming and gambling, shopping, disaster management, and environmental control, crowdfunding, charity, art business, etc. As the technology goes mainstream, the list will expand.
What is blockchain explained simply?
It is an internet-based distributed ledger where verified transaction records are stored.
Why they call the ledger ‘distributed’?
Because it is not a central database, but a network of individual computers. The updated copy of the blockchain is distributed among all the computers (nodes).
What are the main features of blockchain?
By nature, any blockchain system is decentralized, transparent and immutable. No central body controls it, everyone can view the history of transactions made, no one is able to change it.
What is a node?
Any computer in a blockchain. Nodes can be full (storing the complete version of blockchain) and light (storing the uncomplete or light version of it). Running a full node is essential to support the system.
What is blockchain mining?
Mining is the process of transaction data validation. It implies solving complicated math puzzles. Once this puzzle is solved, a new block is created and added to the blockchain. The miner who did it gets rewarded with the newly released coins.
How does blockchain work, for a user?
You make a transaction in the network and broadcast it. When miners check and validate it, it’s added to the next block and becomes a part of the blockchain. After it, it becomes unchangeable and irrevocable.
What are the benefits of blockchain?
Blockchain is a peer-to-peer system. It promotes direct interaction between users and eliminates intermediaries. Thus, it streamlines many complicated processes, reduces the amount of paperwork and saves a lot of money. It also makes data manipulation almost impossible.
What is blockchain used for?
The most popular application is cryptocurrency. Most people associate this term with Bitcoin.
Are there other applications for it?
Blockchain is applicable to many sectors, including healthcare, supply chains, voting, real estate, environment protection, governing, etc.