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Blockchain: what it is, how it works, and how it can be used

Blockchain: what it is, how it works, and how it can be used

What is a Blockchain?

A blockchain is a distributed ledger shared among the nodes of a computer network. Like a database, it stores information in digital format. Blockchains are most well-known for their fundamental role in cryptocurrency systems, such as Bitcoin, as they ensure secure and decentralized recording of transactions. The innovation of a blockchain is that it guarantees the fidelity and security of a data record and generates trust without the need for a third-party trustee.

One of the main differences between a conventional database and a blockchain is the structure of the data. A blockchain groups information into blocks, which contain sets of data and have a certain storage capacity. Once a block is filled, it is closed and linked to the previous block, forming a chain of data known as a blockchain. All new information that follows that newly added block is collected in a new block that will then be added to the chain once filled.

A database typically structures its data in tables, while a blockchain, as the name suggests, structures its data in linked blocks. This data structure ensures an irreversible timeline of data when implemented in a decentralized manner. When a block is filled, it becomes part of this timeline. Each block in the chain is marked with a precise timestamp when it is added to the chain.

Key Concepts

  • The blockchain is a type of shared database that differs from a typical database in how it stores information; blockchains store data in blocks that are then linked together through cryptography.
  • As new data arrives, it is inserted into a new block. Once the block is filled with data, it is linked to the previous block, making the data chained in chronological order.
  • Various types of information can be stored on a blockchain, but the most common use so far has been as a ledger for transactions.
  • In the case of Bitcoin, the blockchain is used in a decentralized manner so that no individual or group has control: all users collectively maintain control.
  • Decentralized blockchains are immutable, meaning the entered data is irreversible. In the case of Bitcoin, this means that transactions are permanently recorded and visible to anyone.

How Does a Blockchain Work?

The blockchain aims to record and distribute digital information in an immutable manner. Thanks to this technology, it is possible to create records that cannot be modified, deleted, or destroyed. For this reason, the blockchain is also known as a distributed ledger technology (DLT).

The concept of blockchain was first proposed as a research project in 1991, long before its most famous application: Bitcoin, which was launched in 2009. Over the years, blockchain has found multiple uses, including the creation of cryptocurrencies, decentralized finance (DeFi) applications, non-fungible tokens (NFTs), and smart contracts.

Decentralization of the Blockchain

Imagine a company owning a server farm consisting of 10,000 computers used to maintain a database containing all the information about its customers' accounts. This company owns a warehouse building that houses all these computers under one roof and has full control over each of them and the information they contain. However, this presents a single point of failure. What would happen if the electricity in that location was cut off? What would happen if the internet connection was lost? What would happen if there was a fire? What would happen if a malicious actor wiped everything out with a single keystroke? In any case, the data would be lost or corrupted.

What a blockchain does is allow the data contained in that database to be distributed among different network nodes in different locations. This not only creates redundancy but also maintains the integrity of the stored data: if someone tries to modify a record in just one instance of the database, the other nodes would not be modified, thus preventing a malicious actor from doing so. If a user manipulates the Bitcoin transaction record, all other nodes would synchronize with each other and easily identify the node with the incorrect information. This system helps establish a precise and transparent order of events. In this way, no single node within the network can alter the information contained within it.

Because of this, the information and history (such as cryptocurrency transactions) are irreversible. This record could be a list of transactions (as with a cryptocurrency), but it is also possible for a blockchain to contain a variety of other information, such as legal contracts, state identifications, or a company's inventory of products.

Important

To validate new entries or records in a block, the majority of the computing power in the decentralized network must agree. To prevent malicious users from validating incorrect transactions or double spending, blockchains are protected by a consensus mechanism such as proof of work (PoW) or proof of stake (PoS). These mechanisms allow for agreement even when there is no single responsible node.

Transparency

Due to the decentralized nature of the Bitcoin blockchain, all transactions can be transparently viewed by having a personal node or using blockchain explorers that allow anyone to see ongoing transactions. Each node has its own copy of the chain, which is updated as new blocks are confirmed and added. This means that if you wanted to, you could track Bitcoin wherever it goes.

For example, exchanges have been hacked in the past, where those who had stored Bitcoin on the exchange lost everything. While the hacker may be completely anonymous, the Bitcoin they have mined is easily traceable. If the stolen Bitcoin in some of these attacks were moved or spent somewhere, it would be known.

Of course, the records stored in the Bitcoin blockchain (as well as in most others) are encrypted. This means that only the owner of a record can decrypt it to reveal their identity (using a public-private key pair). As a result, blockchain users can remain anonymous while preserving transparency.

Is the Blockchain Secure?

Blockchain technology achieves security and decentralized trust in several ways. To begin with, new blocks are always stored linearly and chronologically. That is, they are always added to the "end" of the blockchain. After a block has been added to the end of the blockchain, it is extremely difficult to go back and change the contents of the block unless the majority of the network has reached a consensus to do so. This happens because each block contains its own hash, along with the hash of the previous block and the aforementioned timestamp. Hash codes are created by a mathematical function that transforms digital information into a string of numbers and letters. If this information is changed in any way, the hash code also changes.

Suppose a hacker, who also operates a node on a blockchain network, wants to modify a blockchain and steal cryptocurrency from everyone else. If they were to modify their single copy, it would no longer be aligned with everyone else's copy. When everyone else cross-references their copies with each other, they would see this copy sticking out, and the hacker's version of the chain would be discarded as illegitimate.

Succeeding in such an attack would require the hacker to control and simultaneously modify 51% or more of the copies of the blockchain so that their new copy becomes the majority copy and, therefore, the agreed-upon chain. Such an attack would also require a huge amount of money and resources, as they would have to redo all the blocks because they would now have different timestamps and hash codes.

Due to the size of many cryptocurrency networks and their rapid growth, the cost of carrying out such an endeavor would likely be insurmountable. Not only would it be extremely expensive, but it would also likely be futile. Doing such a thing would not go unnoticed, as network members would see such drastic changes to the blockchain. Network members would then split off into a new version of the chain that was not affected. This would cause the value of the attacked version of the token to collapse, rendering the attack ultimately useless, as the malicious actor would have control of a worthless asset. The same would happen if the malicious actor attacked the new Bitcoin fork. It is built this way because participating in the network is much more economically incentivizing than attacking it.

Bitcoin vs. Blockchain

The blockchain technology was first outlined in 1991 by Stuart Haber and W. Scott Stornetta, two researchers who wanted to implement a system where document timestamps could not be tampered with. But it was only nearly two decades later, with the launch of Bitcoin in January 2009, that blockchain had its first real-world application.

The Bitcoin protocol is built on a blockchain. In a research paper introducing the digital currency, the pseudonymous creator of Bitcoin, Satoshi Nakamoto, described it as "a new electronic cash system that's fully peer-to-peer, with no trusted third party."

The key thing to understand here is that Bitcoin simply uses blockchain as a means to transparently record a ledger of payments, but blockchain can, in theory, be used to immutably record any number of data points. As discussed earlier, this could be in the form of transactions, votes in an election, inventories of products, state identifications, property deeds, and much more.

Blockchain vs. Banks

Blockchains have been hailed as disruptive forces in the financial sector, particularly for payment and banking functions. However, banks and decentralized blockchains are very different.

To understand the differences between a bank and the blockchain, let's compare the banking system with the blockchain implementation of Bitcoin.

  • Opening hours: Banks have set hours and are closed during holidays, while the blockchain is open 24/7.
  • Transaction fees: Banks charge different fees depending on the transaction, while Bitcoin has variable transaction fees set by users.
  • Transaction speed: Banks can take up to 72 hours to settle transactions, while Bitcoin can take as little as 15 minutes.
  • Know Your Customer (KYC) rules: Banks require customers to provide identification, while anyone or anything can participate in the Bitcoin network anonymously.
  • Ease of transfer: Banks require government-issued identification and a bank account, while Bitcoin only requires an internet connection and a mobile phone.
  • Privacy: Bank account information is stored on private servers and can be compromised, while Bitcoin can be as private as the user desires.
  • Security: Bank account information is only as secure as the bank's server, while the security of Bitcoin depends on the user.
  • Approved transactions: Banks can deny or freeze transactions, while Bitcoin users can transact as they see fit.
  • Account seizures: Governments can easily seize bank accounts, while it is more difficult to seize Bitcoin when used anonymously.

How Are Blockchains Used?

The Bitcoin blockchain is known for storing data on monetary transactions. However, there are over 10,000 different cryptocurrency systems that use blockchain to reliably store data on other types of transactions.

Some major companies like Walmart, Pfizer, AIG, Siemens, and Unilever have already adopted blockchain. For example, IBM has created its Food Trust blockchain to track the path of food products from their origin to their destination.

But why do this? The food industry has experienced numerous cases of contamination from E. coli, salmonella, and listeria, as well as risks of accidental contamination. In the past, tracing the source of these problems took weeks. Thanks to the blockchain, producers can track the path of their food products, identify any issues, and trace back to the source of contamination. This saves lives. This is just one example of blockchain use, but there are countless other possible applications.

Banking and Finance

Perhaps no industry would benefit more from integrating blockchain technology than the banking sector. Financial institutions operate only during business hours, typically five days a week. This means that if you try to deposit a check on Friday at 6:00 PM, you may have to wait until Monday morning to see that money credited to your account. Even if you make the deposit during business hours, the transaction can still take anywhere from one to three days to be verified due to the volume of transactions banks have to handle. In contrast, the blockchain never sleeps.

By integrating blockchain technology into banks, consumers can see their transactions processed within seconds or minutes, the time it takes to add a block to the blockchain, regardless of holidays or the time of day or week. With blockchain, banks also have the opportunity to exchange funds between institutions more quickly and securely. In the stock trading industry, for example, the settlement and clearing process can take up to three days (or more for international trading), which means that money and shares are locked up for that period of time.

Given the magnitude of the amounts involved, even the few days the money is in transit can entail significant costs and risks for banks.

Currencies

Blockchain forms the basis for cryptocurrencies like Bitcoin. The US dollar is controlled by the Federal Reserve. In this central authority system, a user's data and currency are technically at the discretion of their bank or government. If a user's bank is hacked, their private information is at risk. If a user's bank fails or the user lives in a country with an unstable government, the value of their currency may be at risk. In 2008, several failing banks were saved - in part using taxpayer money. These are the concerns from which Bitcoin was conceived and developed.

By spreading its operations across a network of computers, the blockchain allows Bitcoin and other cryptocurrencies to operate without the need for a central authority. This not only reduces risk but also eliminates many processing and transaction fees. It can also provide those in countries with unstable or underdeveloped currencies or financial infrastructure with a more stable currency with more applications and a wider network of individuals and institutions to do business with, both domestically and internationally.

Using cryptocurrency wallets as savings accounts or as a means of payment is particularly significant for those who do not have state identification. Some countries may be torn apart by war or have governments that do not have proper infrastructure to provide identification. Citizens of such countries may not have access to savings or brokerage accounts - and thus have no way to securely store their wealth.

Healthcare

Healthcare providers can leverage blockchain to securely store their patients' medical records. When a medical record is generated and signed, it can be written into the blockchain, providing patients with proof and certainty that the record cannot be changed. These personal health records could be encoded and stored on the blockchain with a private key, so that they are only accessible by certain individuals, ensuring privacy.

Smart Contracts

A smart contract is computer code that can be embedded in the blockchain to facilitate, verify, or negotiate a contractual agreement. Smart contracts operate under a set of conditions that users agree upon. When those conditions are met, the terms of the agreement are automatically executed.

For example, suppose a potential tenant wants to rent an apartment using a smart contract. The landlord agrees to provide the tenant with the apartment door code as soon as the tenant pays the security deposit. Both the tenant and the landlord would submit their respective parts of the agreement to the smart contract, which would hold and automatically exchange the door code for the security deposit on the lease start date. If the landlord fails to provide the door code by the lease start date, then the smart contract refunds the security deposit. This would eliminate fees and processes typically associated with using a notary, a third-party mediator, or lawyers.

Supply Chains

As in the example of IBM Food Trust, suppliers can use blockchain to record the origin of the materials they have purchased. This would allow companies to verify the authenticity not only of their products but also of common labels such as "Organic," "Local," and "Fair Trade."

As reported by Forbes, the food industry is increasingly adopting the use of blockchain to track the path and safety of food along the journey from producer to consumer.

Voting

As mentioned earlier, blockchain could be used to facilitate a modern voting system. Voting with blockchain could eliminate electoral fraud and increase voter participation, as tested in the November 2018 midterm elections in West Virginia.

Using blockchain in this way would make votes nearly impossible to tamper with. The blockchain protocol would also maintain transparency in the electoral process, reducing the personnel needed to conduct an election and providing officials with near-instant results. This would eliminate the need for recounts or any real concern that fraud could threaten the election.

Advantages of Blockchain

Today, every blockchain can have different pros and cons. This is because blockchain is a highly versatile tool that can be adapted to the needs of each individual application. Therefore, it does not make sense to define specific pros and cons as they are not applicable to all blockchains.

However, the advantages that we can identify as more generic are:

  • Improved accuracy by eliminating human intervention in verification
  • Cost reduction by eliminating third-party verification
  • Decentralization makes it more difficult to manipulate the blockchain
  • Transactions are secure, private, and efficient
  • The technology is transparent
  • It offers an alternative banking system and a way to protect personal information for citizens of countries with unstable or underdeveloped governments

Historical Accuracy

Transactions on the blockchain network are approved by a wide network of computers, thus eliminating most human intervention in the verification process. This leads to a reduction in human errors and ensures an accurate record of information. Even if a computer on the network were to make a calculation error, the error would only occur on one copy of the blockchain. To spread to the rest of the blockchain, the error would have to be made by at least 51% of the computers on the network, an almost impossible chance for a large network like Bitcoin's.

Cost Reduction

In general, consumers are accustomed to paying a bank for transaction verification, a notary for document signing, or a minister for performing a wedding. However, the blockchain eliminates the need to rely on third parties for verification and, consequently, reduces related costs. For example, business owners have to incur a small fee every time they accept credit card payments because banks and payment processing companies have to handle those transactions. In contrast, Bitcoin has no central authority and has limited transaction fees.

Decentralization

The blockchain does not store its information in a single central location but spreads it across a network of computers. Each time a new block is added to the blockchain, every computer on the network updates its own copy of the blockchain to reflect the change. This spreading of information across a network, rather than storing it in a single central database, makes the blockchain more difficult to manipulate. If a hacker were to obtain a copy of the blockchain, only that copy would be compromised, not the entire network.

Efficient Transactions

Transactions made through a central authority can take up to several days to complete. For example, if you deposit a check on a Friday evening, you may not be able to see the funds in your account until Monday morning. While financial institutions operate only during business hours, typically five days a week, the blockchain operates 24 hours a day, seven days a week, and 365 days a year. Transactions can be completed in seconds or minutes and considered secure after a few hours. This is particularly useful for cross-border transactions, which usually take much longer due to time zone issues and the need for all parties to confirm payment processing.

Private Transactions

Many blockchain networks function as public databases, meaning that anyone with an internet connection can access a list of the network's historical transactions. While users can view transaction details, they do not have access to the personal information of the users who made them. It is common to think of blockchain networks like Bitcoin as anonymous, but they are actually only pseudonymous.

When a user makes a public transaction, their unique public key is recorded on the blockchain, but not their personal information. If a person has purchased Bitcoin on an exchange that requires identification, their identity is still associated with their address on the blockchain, but a transaction, even if associated with a name, does not reveal any personal information.

Secure Transactions

After a transaction is recorded, it must be verified for its authenticity by the blockchain network. Thousands of computers on the blockchain rush to confirm that the purchase details are correct. Once a computer validates the transaction, it is added to the blockchain's block. Each block on the blockchain contains a unique hash, along with the unique hash of the previous block. When the information in a block is changed in any way, the hash code of the block changes, but the hash code on the next block remains unchanged. This discrepancy makes it extremely difficult to make changes to the information on the blockchain without being detected.

Transparency

Most blockchains are fully open-source software. This means that their code can be viewed by anyone, allowing auditors to verify the security of cryptocurrencies like Bitcoin. Additionally, there is no authority controlling the code of Bitcoin or its modifications, which means that anyone can propose changes or updates to the system. If the majority of the network's users agree on the validity and usefulness of the new version of the code with the update, then Bitcoin can be upgraded.

Providing Accessible Banking Services to All

One of the major advantages of blockchain and Bitcoin is their ability to be used by anyone, regardless of ethnicity, gender, or cultural background. According to the World Bank, approximately 1.7 billion adults worldwide do not have a bank account or a way to store their money or wealth. Most of these people live in developing countries, where the economy is still developing and primarily based on cash.

People who earn little money, often in cash, have to store this physical money in hidden places in their homes or elsewhere, leaving them exposed to theft or gratuitous violence. The keys to a Bitcoin wallet, on the other hand, can be stored on a piece of paper, on a cheap mobile phone, or even memorized if necessary. For most people, these options are probably easier to hide than a small stack of cash under a mattress.

In the future, blockchains could offer solutions not only as a unit of account for wealth storage but also for storing medical records, property rights, and a variety of other legal contracts.

Not Just Bitcoin

The cryptocurrency Bitcoin is undoubtedly the most famous and highest-capitalized blockchain today. However, there are many other modern blockchains that are gaining more and more space for the realization of more complex applications than simple value storage. Among these, we find:

  • Ethereum, the second-largest blockchain in the world, which focuses on creating decentralized applications and smart contracts.
  • Binance Smart Chain, on the other hand, offers greater speed and scalability compared to other blockchains, allowing for more efficient decentralized applications.
  • Algorand is a blockchain that focuses on security, scalability, and sustainability.
  • Cardano is known for its modular structure and attention to decentralized governance.
  • Filecoin and Arweave enable decentralized data storage and secure file sharing.

Each of these blockchains has unique features and specific advantages, offering a wide range of opportunities for the realization of innovative decentralized applications.

In Summary

Blockchain technology is finally attracting attention thanks to Bitcoin and cryptocurrencies, but it offers many other practical applications already being implemented and explored. The buzzword on every investor's lips is blockchain, which promises to make business and government operations more accurate, efficient, secure, and cost-effective, with fewer intermediaries.

It is no longer a question of whether traditional companies will adapt to blockchain technology, but when. Today, we are witnessing the proliferation of NFTs and asset tokenization, and the coming decades will be a significant growth phase for blockchain.