What Is Blockchain and How Does It Work?
Key Takeaways
Blockchain is a digital ledger that securely records transaction data across a distributed network of computers.
Blockchain ensures data integrity through its immutable nature via cryptography and consensus mechanisms, meaning once information is recorded, it cannot be altered retroactively.
Blockchain forms the backbone of cryptocurrency networks like Bitcoin and Ethereum, and is instrumental in fostering transparency, security, and trust in various sectors beyond finance.
Introduction
Blockchain technology has transformed industries, especially finance, by introducing a decentralized, transparent, and secure way of managing data and transactions. While it began as the foundation for cryptocurrencies like Bitcoin, its applications have grown to include supply chain management, healthcare, voting systems, and much more.
What Is Blockchain?
A blockchain is a special kind of database. It’s a decentralized digital ledger that’s maintained by a distributed network of computers. Blockchain data is organized into blocks, which are chronologically arranged and secured by cryptography.
This structure ensures that the data is transparent, secure, and immutable. It’s virtually impossible to change data stored in a block after the block is confirmed and added to the chain. The decentralized structure also removes the need for a central authority. Blockchain transactions can happen between users without the need for intermediaries.
There are different types of blockchains with varying degrees of decentralization. Still, the term blockchain usually refers to a decentralized digital ledger used to record cryptocurrency transactions.
Brief history of blockchain
The earliest model of a blockchain was created in the early 1990s when computer scientist Stuart Haber and physicist W. Scott Stornetta employed cryptographic techniques in a chain of blocks as a way to secure digital documents from data tampering.
Haber and Stornetta inspired the work of many other computer scientists and cryptography enthusiasts, eventually leading to the creation of Bitcoin as the first cryptocurrency powered by blockchain technology. Since then, blockchain adoption has grown significantly, and cryptocurrencies are now a global phenomenon.
While blockchain technology is often used to record cryptocurrency transactions, it’s suitable for recording many other types of digital data and can be applied to a wide range of use cases.
Key features and benefits of blockchain
Decentralization: Information is stored across a network of computers (nodes) rather than a single central server. Big decentralized networks like Bitcoin are highly resistant to attacks.
Transparency: Most blockchains are public, meaning all participants have access to the same database. Transactions are visible to all participants.
Immutability: Once data is added to the blockchain, it cannot be altered without network consensus.
Data security: Cryptography and consensus mechanisms ensure robust protection against data tampering.
Efficiency: Blockchain can enable faster and cheaper transactions by removing the need for intermediaries. Transactions are processed in near real-time.
What Is Decentralization in Blockchain?
Decentralization in blockchain refers to the idea that the control and decision-making power of a network is distributed among its users rather than controlled by a single entity, such as a bank, government, or corporation.
In a decentralized blockchain network, there’s no central authority or intermediary that controls the flow of data or transactions. Instead, transactions are verified and recorded by a distributed network of computers that work together to maintain the integrity of the network.
How Does Blockchain Work?
At its core, a blockchain is a digital ledger that securely records transactions between two parties in a tamper-proof manner. These transaction data are recorded by a globally distributed network of computers (nodes).
When Alice sends Bob some bitcoin, the transaction is broadcast to the network. Each node authenticates the transaction by verifying digital signatures and other transaction data. Once the transaction is verified, it's added to a block along with other transactions. We can think of each block as a page of the digital ledger.
Blocks are chained together using cryptographic methods, forming the blockchain. The process of verifying transactions and adding them to the blockchain is done through a consensus mechanism, a set of rules that govern how nodes on the network come to an agreement about the state of the blockchain and the validity of transactions.
Blockchain in a Nutshell
1. Transaction recording
When a transaction is initiated (e.g., transferring cryptocurrency), it is broadcast to a network of nodes. Each node validates the transaction using predefined rules.
2. Block formation
Validated transactions are grouped into a block. Each block contains:
Data (e.g., transaction details)
A timestamp
A cryptographic hash: A unique identifier created by running the block’s data through a hashing algorithm.
Previous block's hash: This is what links blocks together, forming the chain.
3. Consensus mechanism
To add a block to the chain, participants in the network must agree on its validity. This is achieved using a consensus algorithm, such as Proof of Work (PoW) and Proof of Stake (PoS). We will discuss both in more detail soon, but here is a brief summary:
Proof of Work (PoW): Used by Bitcoin, PoW requires block validators to use computational power to solve complex problems.
Proof of Stake (PoS): Used by newer blockchains like Ethereum, where block validators are chosen based on their stake in the network.
4. Chain linking
Once validated, the block is added to the blockchain. Each subsequent block references the previous one, ensuring a tamper-proof structure. In other words, for a new block to be validated, it must use the previous block identifier.
5. Transparency
Another feature of blockchain is its transparency. Anyone can generally check a blockchain’s data, including all the transaction data and block data, on public websites known as blockchain explorers.
For example, you can see every transaction that’s ever recorded on the Bitcoin network, including the sender and receiver’s wallet address, the amount of the transfer, and much more. You can also trace all Bitcoin blocks all the way back to the first block, known as the genesis block.
Blockchain Cryptography
Cryptography is key for the blockchain to maintain a secure, transparent, and tamper-resistant record of transactions. For example, hashing is a crucial cryptographic method used in blockchains. It’s a cryptographic process that converts an input of any size into a fixed-size string of characters.
The hash functions used in blockchains are generally collision-resistant, meaning that the odds of finding two pieces of data that produce the same output are astronomically small. Another feature is called the avalanche effect, referring to the phenomenon that any slight change in the input data would produce a drastically different output.
Let's illustrate this with SHA256, a function used in Bitcoin. As you can see, changing the capitalization of the letters caused the output to be dramatically different. Hash functions are also one-way functions because it’s computationally infeasible to arrive at the input data by reverse engineering the hash output.
Input data
SHA256 output
Binance Academy
886c5fd21b403a139d24f2ea1554ff5c0df42d5f873a56d04dc480808c155af3
Binance academy
4733a0602ade574551bf6d977d94e091d571dc2fcfd8e39767d38301d2c459a7
binance academy
a780cd8a625deb767e999c6bec34bc86e883acc3cf8b7971138f5b25682ab181
Each block within a blockchain securely contains the hash of the preceding block, establishing a robust chain of blocks. Anyone wanting to alter one block would need to modify all the succeeding blocks, a task that is not only technically challenging but also prohibitively costly.
Another cryptographic method widely used in blockchain is public-key cryptography. Also called asymmetric cryptography, it helps establish secure and verifiable transactions between users.
This is how it works. Each participant has a unique pair of keys: a private key, which they keep secret, and a public key, which is openly shared. When a user initiates a transaction, they sign it using their private key, creating a digital signature.
Other users in the network can then verify the transaction's authenticity by applying the sender's public key to the digital signature. This approach ensures secure transactions because only the legitimate owner of the private key can authorize a transaction, and everyone can verify the signatures using the public key.
What Is a Consensus Mechanism?
A consensus algorithm is a mechanism that allows users or machines to coordinate in a distributed setting. It needs to ensure that all agents in the system can agree on a single source of truth, even if some agents fail.
Consensus mechanisms ensure that all nodes in the network have the same copy of the ledger, which contains a record of all transactions.
When tens of thousands of nodes keep a copy of the blockchain's data, some challenges can quickly arise, including data consistency and malicious nodes. To ensure the integrity of the blockchain, there are various consensus mechanisms that govern how network nodes reach an agreement. Let's take a closer look at the major consensus mechanisms.
Types of Consensus Mechanisms
What is Proof of Work?
Proof of Work (PoW) is a consensus mechanism used in many blockchain networks to verify transactions and maintain the integrity of the blockchain. It's the original consensus mechanism used by Bitcoin.
In PoW, miners compete to solve a complex mathematical problem in order to add the next block to the blockchain. In a process known as mining, the first miner to solve the problem is rewarded with cryptocurrency.
Miners must use powerful computers to solve mathematical problems, mine new coins, and secure the network. This is why the mining process requires significant amounts of resources (computational power and energy).
What is Proof of Stake?
Proof of Stake (PoS) is a consensus mechanism designed to address some of the drawbacks of Proof of Work (PoW). In a PoS system, instead of miners competing to solve complex mathematical problems to validate transactions and add new blocks to the blockchain, validators are chosen based on the amount of cryptocurrency they "stake" in the network.
The stake represents the amount of crypto held by validators as collateral. Usually, PoS validators are randomly selected to create new blocks and validate transactions based on the size of their stake. They are rewarded with transaction fees for creating new blocks and as an incentive to act in the best interest of the network. If they act maliciously, they risk losing their staked crypto.
Other popular consensus mechanisms
Proof of Work and Proof of Stake are the most common consensus algorithms, but there are many other types. Some are hybrids that combine elements from both systems, while others are different methods altogether.
For example, delegated Proof of Stake (DPoS) is similar to PoS, but instead of all validators being eligible to create new blocks, token holders elect a smaller set of delegates to do so on their behalf.
On the other hand, in Proof of Authority (PoA), validators are identified by their reputation or identity rather than the amount of cryptocurrency they hold. Validators are selected based on their trustworthiness and can be removed from the network if they act maliciously.
What Are the Different Types of Blockchain Networks?
Public blockchain
A public blockchain is a decentralized network that is open to anyone who wants to participate. These networks are typically open-source, transparent, and permissionless, meaning that anyone can access and use them. Bitcoin and Ethereum are examples of public blockchains.
Private blockchain
A private blockchain, as the name suggests, is a blockchain network that is not open to the public. Private blockchains are typically run by a single entity, such as a company, and are used for internal purposes and use cases.
Private blockchains are permissioned environments with established rules that dictate who can see and write to the chain. They are not decentralized systems because there is a clear hierarchy of control. However, they can be distributed in that many nodes maintain a copy of the chain on their machines.
Consortium blockchain
A consortium blockchain is a hybrid of public and private blockchains. In a consortium blockchain, multiple organizations come together to create a shared blockchain network that is jointly managed and governed. These networks can be either open or closed, depending on the needs of the consortium members.
Instead of an open system where anyone can validate blocks or a closed system where only a single entity designates block producers, a consortium chain sees a handful of equally powerful parties acting as validators.
The rules of the system are flexible: visibility of the chain can be limited to validators, visible to authorized individuals, or visible to all. If the validators can reach a consensus, changes can be easily implemented. As for how the blockchain works, if a certain threshold of these parties behave honestly, the system won't run into problems.
What Is Blockchain Used For?
While blockchain technology is still in its infancy, it already has use cases in many different industries. Some of the most common current applications of blockchain technology include:
1. Cryptocurrencies
Blockchain technology was developed to support the creation of cryptocurrencies, which use blockchain as a secure and decentralized ledger for recording transactions.
While traditional cross-border transactions involve intermediaries and high fees, blockchain enables faster, cheaper, and more transparent international transfers. Apart from its store of value property, many use Bitcoin and other cryptocurrencies for global remittance.
2. Smart contracts
Smart contracts are self-executing contracts that can be programmed to execute automatically when certain conditions are met. Blockchain technology enables the creation and execution of smart contracts in a secure and decentralized manner.
One of the most popular applications of smart contracts is for decentralized applications (DApps) and organizations (DAOs), which are a big part of decentralized finance (DeFi) platforms. DeFi platforms leverage blockchain to provide financial services like lending, borrowing, and trading without traditional institutions. This democratizes access to financial tools.
3. Tokenization
Real-world assets (RWA) such as real estate, stocks, or art can be tokenized (converted into digital tokens on a blockchain). This can improve liquidity and broaden access to investment opportunities.
4. Digital identity
Blockchain can be used to create secure and tamper-proof digital identities that can be used to verify personal information and other sensitive data. This could become increasingly important as more of our personal information and assets move online.
5. Voting
By providing a decentralized, tamper-proof ledger of all votes cast, blockchain technology can be used to create a secure and transparent voting system that eliminates the possibility of voter fraud and ensures the integrity of the voting process.
6. Supply chain management
Blockchain technology can be used to create a ledger of all transactions within a supply chain. Each transaction (or group of transactions) can be recorded as a block on the blockchain, creating an immutable and transparent record of the entire supply chain process.
Closing Thoughts
Blockchain technology offers a secure and transparent way to record transactions and store data. It’s a technology that is revolutionizing industries by bringing a new level of trust and security to the digital world.
Whether enabling peer-to-peer transactions, creating new forms of digital assets, or facilitating decentralized applications, blockchain technology opens up a world of possibilities. As the technology continues to evolve and gain wider adoption, we can expect more innovative and transformative use cases to emerge in the coming years.
Further Reading
What Is Cryptocurrency and How Does It Work?
What Is a Stablecoin?
What Is Cryptocurrency Mining and How Does It Work?
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