While there’s no shortage of hype about cryptocurrencies, there’s a serious lack of simple, easy-to-understand information on how they work. One of the most common misunderstandings surrounding crypto is how blockchain works — or what it is.
Contents
- Introduction
- What is blockchain?
- How blockchain works
- Consensus methods
- Applications of blockchain technology
- The future of blockchain
Introduction: Blockchain – The Great Disruptor
Blockchain technology — the driving force behind cryptocurrencies — is positioned to disrupt virtually every centralized industry, such as insurance, lending, logistics, and venture capital… even day-to-day purchases.
The core concept behind blockchain is decentralization, shifting the structure of organizations away from the tightly controlled architecture of the current paradigm.
If you’re considering investing in the cryptocurrency market, it’s essential to develop a firm understanding of what the blockchain is and how it works. Many of the guides available on the blockchain today, however, are highly technical in nature and can be difficult for newbies to grasp.
Even if you’re not interested in participating in the cryptocurrency market, gaining an insight into the way blockchain technology works can help you cut through the hype surrounding ’cryptos‘ and better understand the regulatory furor they’re currently causing.
In this guide, we’ll break down the core concepts behind blockchain and present a clear explanation of how blockchain technology works, free from jargon, technical language, or confusing terms.
2. What is Blockchain?
The simplest way to understand blockchain is to first find out what problems blockchain technology aims to solve. The key issue solved by blockchain technology is centralization. To explain the issues presented by centralization, we’ll take an example from the current financial climate.
Let’s say that you’re currently travelling abroad on vacation. During your travels, you lose your wallet and run out of funds. Fortunately, you have a friend who lend you some money — let’s say $1,000.
Your friend, although wealthy and generous, is technologically illiterate and consequently relies on telephone banking to manage his finances. Your friend calls his financial institution and requests that his account manager transfer $1,000 from his account to yours. The account manager checks the bank register to ensure your friend has enough capital to facilitate the transfer, and then sends it to your account.
Centralized systems such as banks can suffer from any number of issues, such as corruption, the destruction of the storage media on which financial information is stored, and more. Relying on centralized third parties can also have a significant negative impact on society as a whole — the 2015 Greek financial crisis resulted in millions of people suddenly unable to withdraw any cash from ATMs, plunging the country into chaos.
Centralized institutions can also dictate terms to users that cannot be challenged. International wire transfers with current financial institutions, for example, are costly and slow.
Blockchain technology provides a means of creating new systems— financial or otherwise— that are immune to the issues that plague centralized organizations and platforms.
The basis of blockchain is an immutable, constantly-growing record of transactions and balances that can’t be tampered with and is completely transparent. Blockchain networks are run by ‘nodes’, or computers connected to the network that download a copy of this record and collectively participate in its maintenance and verification. We’ll explain how this works in more detail further in this guide.
Blockchain’s 5 Common Values
Blockchain technology delivers five key features that solve the issues presented by centralized systems. While blockchain-based platforms differ in their methodology and approach to the implementation of blockchain, they all share these common values.
Security – Centralized platforms are all extremely susceptible to tampering, either from outside or from within an organization. Fiat currencies can be disrupted by central banking authorities who are able to control supply rates or destroy physical documents of ownership. As blockchain technology is completely decentralized and is disrupted across all computers across the network, a blockchain system is virtually indestructible.
Transparency – Blockchain-based platforms are almost all open source in nature, which means anybody is able to analyze the code that comprises a blockchain network. This allows users of blockchain networks to trust them implicitly as code is not subject to the desires of the individuals who control a centralized system, nor is it prone to user error. Similarly, all of the transactions that occur on a blockchain network can be independently verified by anybody.
Immutability – The records that compose a blockchain system, referred to as a ledger, are protected by cryptography that is essentially impossible to crack. This property allows users to verify that transactions have taken place almost immediately without needing to trust in a third party for arbitration.
Borderless Accessibility – Blockchain technology is a truly international platform that allows anybody in the world to access blockchain-based platforms and services, regardless of location. New blockchain-based lending platforms, for example, are now providing startup capital to businesses in developing countries without the need for intermediaries.
Price & Speed – Transactions between traditional financial institutions are typically expensive, especially when international transfers are concerned, and can take days to complete. Cryptocurrencies built upon blockchain architecture can be transferred near-instantaneously and, depending on the state of blockchain network, can be sent with minimal fees.
3. How Blockchain Works
We’ve outlined the benefits of blockchain technology and the advantages it offers over centralized systems, but how does it actually work? Many newer cryptocurrency investors become intimidated when attempting to understand the specifics of blockchain operation, but gaining an understanding of blockchain basics is imperative.
The two most important characteristics of any blockchain network are security and immutability. How does blockchain technology deliver these features? Instead of providing access and control over the entire system, as is the case in traditional centralized systems, blockchain technology distributes control across all network participants— everybody who is running the software for blockchain in question.
Network participants work together to keep track of transactions and balances and to update the entire blockchain network. This record is referred to as a ‘distributed ledger‘. Participants are provided with rewards for helping to maintain the system, or are penalized for interfering with it. The first step in understanding how blockchain technology works is understanding what a distributed ledger is.
What is a Distributed Ledger?
The easiest way to understand how a distributed ledger works is to compare it to the ledger used by a traditional financial institution. Banks provide individuals with the ability to deposit capital for safekeeping and security and record all withdrawals, deposits, and transactions in a ledger.
Ledgers, while now stored digitally, are controlled by a central authority, and are thus at risk of tampering or loss. A distributed ledger functions in the same way as the ledger of a bank, but instead of being managed by the bank itself, the ledger is managed by every single network participant. This ledger is completely transparent and can be viewed in its entirety by anybody at any time.
The Risks of Distributing Ledger Management
Let’s imagine, for example, we have a bank in the bygone era of pen-and-paper ledger management that stores their ledger in an office. If a clever but unscrupulous individual were to break into this office, they would be able to edit the ledger in their favour and increase their account balance.
This individual would then be able to enter the bank the next day and simply request to withdraw funds in excess of what they had deposited. An account manager would check the ledger and believe everything was in order.
A network of banks could prevent this eventuality by sharing ledger information with one another. Let’s say the bank in the above example is a member of a group of seven banks that all share ledger information. None of these banks trust each other to keep accurate records for the entire network, so they each keep individual records.
Each bank in this example records and tracks their own transactions, but frequently sends representatives to the other banks in the network to record their transactions as well. If there was an irregularity in the ledger of one specific bank in this network it would be noticed quickly when compared to the duplicate records held by other banks.
While this system is more secure than a single bank operating alone, it still possesses a weak link. If the representatives that travel between banks were interfered with while between branches, it’s possible that their ledgers could be interfered with by a particularly organized band of thieves. Should more than half of the records be compromised in this manner the entire banking network could fail.
Securing a Distributed Ledger
A distributed ledger system could be compromised in a similar manner if network participants attempt to alter the state of the ledger in their favour. To combat this, blockchain networks employ a technique called cryptography to ensure that nobody can alter ledger records.
In our previous example, a network of banks worked together to share ledger information with one another and thus reduce the risk of tampering. To understand how a distributed ledger is secured, imagine these banks add another layer of security that makes it impossible to tamper with records while they’re in transit.
When each page of the ledger record is completed, the banks incorporate all of the values entered on it into a complicated mathematical equation and then record the sum on a separate page. When calculating the equation for each subsequent page, the sums of previous equations are included in the calculation.
This complex practice makes it extremely difficult— almost impossible— for ledger records to be tampered with. In order to tamper with the data on one page of the ledger, it would be necessary to ensure that the changes that were made match the answer to the equation at the end of each page before it. This calculation would take an inordinate amount of time and would be so resource-intensive as to render any attempt to alter the ledger ultimately futile.
The banks in our example take another step to ensure they’re protected from each other as well. In order to prevent the banks in the network from working together against their customers, banks are incentivized for agreeing upon the current state of the shared ledger system and the records therein. If banks disagree with the current state and are in the minority, they are fined, ensuring that all banks in the network are operating with the best interest of the network in mind.
The process of agreeing upon the current state of a distributed ledger system is called reaching “consensus”. We’ll now proceed to explain how our bank network example relates to blockchain technology and how consensus is achieved in a blockchain environment.
4. Consensus Methods
In our previous example we used the analogy of a network of banks to represent participants in a blockchain network. In the blockchain ecosystem, these banks are analogous to ‘nodes‘, which function as the bookkeepers of the network. Each node runs the software that powers the network, and participates in the maintenance of the distributed ledger.
Each individual node updates its ledger on a regular basis and cross references each update with every other node on the network, working in a similar manner to the way the banks in our example share ledger information. The ’blocks‘on this network are represented in our example as the pages in each bank’s ledger.
The complicated mathematical equation used by the banks in our example to prevent tampering is called ’hashing‘ in the blockchain environment. In reality this process is far more complex and far harder to reverse engineer, but ultimately operates in the same manner.
Blockchain node operators are incentivized into running nodes for the same reason a banker may want to operate a bank. In return for assisting with the maintenance of the network, node operators are provided with a small fee for each transaction processed.
All blockchains must agree on the current state of the ledger by reaching consensus, but there are many different consensus methods present in the blockchain ecosystem.
3 Most Common Consensus Methods
Proof of Work
The most frequently used consensus method at this point in time is ‘Proof of Work‘. This consensus method is used by Bitcoin, and is thus the first method to be established. Proof of Work, or PoW, can be likened to the mathematical equation that must be solved to encrypt each page in the bank ledgers from our previous example.
The purpose of this complex equation is to ensure that each participating node exerts a significant amount of energy in order to solve it. In Proof of Work consensus, these equations are extremely difficult, and thus require vast amounts of processing power and electricity.
Each node in a Proof of Work blockchain can be considered to be ’racing‘ the other nodes to find the correct answer to this equation, which will then finish the ’page‘, or block. The node that announces the correct answer first is provided with a ’block reward‘, which commonly comes in the form of the blockchain’s cryptocurrency.
The process of solving these blocks is called ’mining‘. Nodes that choose to mine in Proof of Work blockchain networks are called ’miners‘. In order to ensure the answers provided are correct and are in accordance with the current state of the ledger, miners who announce different answers to those working on the same block are rejected.
As mining requires a relatively large amount of electricity, miners do not want their solution to be rejected, and are thus incentivized to contribute correct answers, assisting with the maintenance of the ledger.
A Proof of Work system is virtually immune to tampering unless a miner or a group of miners dedicated to disrupting the network control more than 51% of the total processing power dedicated towards it. Even if a group did control a majority of nodes it would be extremely difficult to tamper with past transactions and functionally impossible to alter transactions beyond a few blocks.
Processing power is extremely important when mining Proof of Work networks. As a general rule the more processing power a miner is able to dedicate to mining, the more likely it is that they’ll be able to solve the block first and thus receive the block reward. Many miners choose to pool their resources together into a ’mining pool‘ that spreads the block reward for solved blocks across all members.
The complexity of blocks in a Proof of Work network can be adjusted to regulate ’block difficulty‘. If blocks in a Proof of Work network are taking too long to solve, the block difficulty can be reduced. If blocks are solved too fast, difficulty can be increased. Changing block difficulty determines how often a new ’page‘ is created in the ledger, a process referred to as ’block timing‘.
Some examples of Proof of Work blockchain networks include Bitcoin, Litecoin, and Bitcoin Cash.
Proof of Stake
Proof of Stake is a consensus method that doesn’t involve mining at all. Instead of relying on the incentivization of miners to ensure all network participants are dedicated towards maintaining the integrity of the ledger, Proof of Stake networks must hold an amount of equity in the network, referred to as ’Stake’.
In a Proof of Stake network, nodes are selected to process transactions without needing to solve any complex equations. Other nodes in the network are selected to verify the integrity of the block that’s solved. To prevent participants from attempting to tamper with the network, nodes must lock up, or ’stake‘ an amount of cryptocurrency that is forfeited if any irregularities are detected.
This method ensures that individuals operating Proof of Stake nodes are financially invested in the network and are thus committed to operating with integrity. The more currency a node stakes in this kind of blockchain network, the more likely it is that it will be selected to create the next block and thus claim transaction fees.
Proof of Stake systems typically boast faster transaction confirmation times and more transactions per second than Proof of Work systems. Notable Proof of Stake blockchains include NXT and Peercoin. Ethereum, the second largest cryptocurrency by market cap, is also planning on shifting from Proof of Work to Proof of Stake in the near future.
Proof of Importance
Proof of Importance operates in a similar manner to Proof of Stake consensus in that nodes are required to stake crypto in order to participate. Instead of simply selecting the node to create the next block based on stake size, however, Proof of Importance networks select nodes based on their ’importance score’.
This score is calculated not only on the amount of cryptocurrency staked in the network, but also on how much the node uses the network and how often they contribute. Nodes that help to facilitate the most transactions are ranked with high important scores.
This consensus method encourages the use of cryptocurrency on the blockchain as a currency as opposed to a means of storing value, and is highly scalable. NEM is a good example of a Proof of Importance blockchain.
PART 5: Applications of blockchain technology»
5. Applications of Blockchain Technology
Now that we’ve covered how blockchain technology works and how different blockchain networks tackle the issue of maintaining the ledger, it’s time to examine how blockchain can impact the world around us.
The most obvious application of blockchain technology is as a means of transferring or storing value as cryptocurrency. The transparent and immutable nature of blockchain networks, however, has the potential to disrupt everything from supply chain management to legal systems, or create completely autonomous Internet of Things economies.
It’s possible that blockchain technology could deliver us into a future in which your smart fridge is able to autonomously order your groceries and governmental officials are elected through completely transparent blockchain-based voting platforms. For now, however, we’ll take a look at the ways in which blockchain technology is shaping the world around us right now.
Cryptocurrency
The disruptive nature of blockchain technology is most apparent in the explosion in the value of cryptocurrency over the last few years. Bitcoin and other high market cap cryptocurrencies are the first currencies that are truly global. Unlike traditional fiat currencies, cryptocurrencies are free from the economic health of issuing countries.
The recent Venezuelan economic collapse that occurred in Q4 2017 illustrated the power of cryptocurrency as a method of transferring and storing value outside of failing fiat currency systems. With the Venezuelan Bolivar worth less than the fictional currency used in the popular online role playing game World of Warcraft, Venezuelan nationals turned to Bitcoin and other cryptos to protect their capital.
The quick transaction times offered by blockchain technology along with the relatively low fees cryptocurrency can offer has made Bitcoin, Ethereum, and other cryptocurrencies highly popular alternatives to traditional fiat currency.
It’s now possible to purchase everything from domain names to real estate and even high-end sports cars with cryptocurrency. The rate of cryptocurrency adoption is rapidly increasing, with KFC Canada recently making it possible to buy fried chicken with Bitcoin. Expedia now makes it possible to book your next holiday with Bitcoin— you can even book a trip to space with Virgin Galactic using Bitcoin.
Decentralization
While cryptocurrency is a powerful application of blockchain technology, the future of blockchain is likely to be decentralized services. By allowing peers to connect to and do business with one another without the need for a trusted third party, blockchain technology is set to heavily disrupt hundreds of different industries.
Airbnb, for example, disrupted the traditional booking industry by allowing property owners to create their own listings and manage their own bookings, revolutionizing the way travelers find short-term accommodation.
Blockchain technology, however, makes it possible to decentralize absolutely anything. The finance and lending industry is currently being challenged by blockchain-based peer-to-peer lending platforms, while platforms such as SiaCoin and Factom are decentralizing the storage industry. The Israel-based Golem platform makes it possible for individuals to lend their processing power to a decentralized supercomputer.
Decentralizing services and platforms via blockchain technology not only reduces overhead and middleman fees, it also enhances security and strength while at the same time increasing productivity.
Crowdfunding
One of the most controversial elements of the blockchain ecosystem is the practice of generating startup capital through cryptocurrency. The decentralized nature of blockchain technology makes it possible for any new business or platform to offer investors the opportunity to contribute capital towards their development, regardless of location.
The most common method of blockchain-based crowdfunding is through initial coin offerings, or ICOs. Initial coin offerings are typically used to launch blockchain-based platforms that will use a native cryptocurrency token. Investors are offered the option to purchase these tokens before the platform is launched at a discounted rate, thereby providing development capital to the creators of the project and potentially generating profit when the tokens increase in value.
As the cryptocurrency environment is largely unregulated, the ICO market is currently the subject of intense scrutiny from regulatory bodies around the world. Notably, the price of Bitcoin dropped significantly in 2017 when the Chinese government placed a temporary ban on all cryptocurrency trading in an attempt to curb rampant ICO speculation.
Initial coin offerings are a highly effective method of generating startup capital outside of the stagnant venture capital system, but they’re plagued by a number of issues due to their lack of regulation. As the blockchain environment matures and more agile iterations of the ICO model are devised — such as Vitalik Buterin’s ‘DAOICO‘ model — blockchain-based crowdfunding should prove to be extremely disruptive.
The Internet of Value
High profile venture capitalist William Mougayar refers to blockchain technology as “the second significant overlay on the internet, just as the web was the first layer back in 1990”. While cryptocurrencies and decentralization are certainly exciting applications of blockchain tech, one of the most interesting benefits it offers is the ability to transfer value as information.
Blockchain technology not only allows for the instantaneous transfer of currency, but also makes it possible to instantly exchange assets such as stocks, intellectual property, securities, or even digital certificates that represent physical items, such as gold or other precious metals. It’s even possible to tokenize scientific discoveries, music, or in-game items on blockchain.
By facilitating the creation of legally binding certificates of ownership over virtually anything, blockchain technology is dramatically improving liquidity in all asset classes. This effect is set to reduce the presence of middlemen and third parties in business, and could potentially eliminate lawyers altogether.
AI and Autonomous-Machine Economies
The Internet of Things is beginning to converge with blockchain technology, presenting extremely promising opportunities for automation. Also referred to as the IoT, the internet of things is comprised of everything from smart fridges to smart cars and allows the devices we use every day to represent themselves digitally or be interacted with via the internet.
Blockchain platforms are beginning to make it possible for IoT devices to both communicate and trade with one another. that imagines a world in which IoT devices will be able to use IOTA tokens to autonomously purchase or sell goods and services without the need for human intervention, creating a ‘machine economy‘.
Let’s imagine that self-driving electric cars become commonplace. Using IOTA, an autonomous smart car would be able to use a decentralized transport aggregator to earn IOTA. While not delivering passengers, this smart car could park in an automated parking garage, paying in IOTA. Similarly, the same vehicle would be able to identify the closest charging station that offers the best price, navigate to the station and connect automatically, and then pay in— you guessed it— IOTA.
PART 6: The future of blockchain»
6. The Future of Blockchain
Over the last year the world has experienced a massive shift in the perception of blockchain technology and cryptocurrencies. Governments around the world are exploring the potential impact of blockchain tech, while internet giants such as Facebook and Google are beginning to invest heavily in its potential applications.
Cryptocurrencies have deepened their utility as a viable payment method, while the massive spike in Bitcoin value has catalyzed a media frenzy. We’ll now break down what the future holds for blockchain technology.
Increased Adoption Rates
Demand for high value cryptocurrencies has surged over the last year. There are now more than 250,000 merchants worldwide that accept cryptocurrency as a payment method, a number that is expected to increase with the rapid rise in popularity of the Ripple blockchain-based payment platform.
Financial heavyweight Goldman Sachs has recently weighed in on Bitcoin’s rapidly increasing adoption rates with Zach Pandl, the co-head of foreign exchange and emerging markets strategy, stating that “Cryptocurrencies may offer viable alternatives in countries and corners of the financial system where the traditional services of money are inadequately supplied”.
With mainstream news media following Bitcoin price fluctuations closely, cryptocurrency has never been more visible to the public at large, paving the way for widespread consumer adoption.
Heightened Regulatory Control
Cryptocurrencies have now become too large for regulatory bodies to ignore. Many governments around the world have adopted an assertive stance to the blockchain revolution, while others have welcomed the disruptive technology with open arms.
The growing internet of value is in dire need of sensible regulation, such as the $3 billion ICO market. The U.S. Securities and Exchange Commission has taken a balanced position on the ICO market, while other governments— such as China— have committed to a short-sighted approach in attempting to curtail cryptocurrency trade altogether.
The next year will likely bring a more nuanced perspective to the regulatory table, with most forward-leaning governments assuming a cautious but open-minded perspective on blockchain technology.
National Cryptocurrencies
In 2017, several countries around the world led the way in exploring the possibility of a government-backed cryptocurrency. Russia, Dubai, and China have all announced the potential of fiat cryptocurrencies, but not all of these propositions are a transparent adoption of the core tenets of blockchain technology.
Venezuela has recently announced the development of an oil-backed cryptocurrency called the Petro, while Israel is currently considering the creation of a Crypto-Shekel in order to reduce Israeli reliance on cash.
Over the next year, expect forays into the blockchain environment by Singapore, South Korea, Japan, Canada, Switzerland, India, and Estonia.
Institutional Investors
Until recently, Wall Street investors and investment banks have neglected the blockchain ecosystem. With the launch of Bitcoin futures on the Chicago Board Options Exchange and the Chicago Mercantile Exchange, however, the growing crypto market has begun to capture the attention of institutional money.
Widespread institutional investment in blockchain networks has only just begun, and is expected to increase dramatically in the near future.
Large-Scale Societal Impact
The future of blockchain technology presents many new use cases, with distributed energy platforms and peer-to-peer energy trading taking the lead in the developmental race. Platforms such as Spectral Energy in The Netherlands and Grid+ in the U.S. are currently leading the way in decentralized sustainable energy.
Marketplaces such as Veridium are now making it possible to trade tokenized carbon credits, assisting enterprises in balancing their carbon footprint through sustainable supply chain management. It could be that that the future killer app of Blockchain technology isn’t currency, but is the protection of the environment we live in.
Final Thoughts
While blockchain technology may appear complex at first glance, the basic architecture of any blockchain can be understood by keeping the core concepts presented in this guide in mind. As blockchain technology advances, use cases will become more complex, but the core tenets of decentralization, transparency, security, and immutability will remain the same.
Users should be aware that if they click on a cryptocurrency link and sign up for a product or service, we will be paid a referral fee. This in no way affects our recommendations, which products we choose to review or our advice which is the sole opinion of the authors.
The opinions provided in this article are those of the author and do not constitute investment advice. Readers should assume that the author and/or employees of Grizzle hold positions in the company or companies mentioned in the article. For more information, please see our Content Disclaimer.