What is Blockchain technology and how does it work?
September 30, 2024
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In 2008, the pseudonymous developer “Satoshi Nakamoto” published a blog post and released a white paper, in which he stated the details of Bitcoin and claimed to “have been working on a new electronic cash system that’s fully peer-to-peer, with no trusted third party.” The interesting thing, however, is that even though the idea of a digital hierarchy was mentioned earlier, way back in 1991, by an American physicist named Wakefield Scott Stornetta and an American cryptographer and computer scientist named Stuart Haber, it was Satoshi Nakamoto who brought the blockchain to life and implemented it as a digital record used for the Bitcoin transactions.
A few years later, the prospects of blockchain technology began to unfold as it started to be disassociated with Bitcoin and showed the potential to revolutionize financial and inter-organizational transactions. So, what is blockchain and how does it work?
Imagine the blockchain as an unchangeable digital record book that's shared across many computers. This special book, known as a ledger, stores transactions or data and keeps them super secure. But here's the cool part: blockchain isn't just about money – it has lots of other handy uses beyond digital currencies!
The whole story started with Nakamoto claiming in the white paper that an “e-currency based on cryptographic proof” makes money more secure and “transactions effortless,” as it does not require “to trust a third party middleman.”
To that end, Nakamoto created Bitcoin to serve as a peer-to-peer means of transaction resembling cash without the need for a central bank or any external authority to oversee and uphold the transaction record, mirroring the operational principle of physical currency. Satoshi Nakamoto was tinkering away with this whole new way of handling cash electronically; no middlemen, just direct transactions between people.
After deploying the world’s first digital currency, Nakamoto invented and implemented the first blockchain network as an unchangeable digital record book used for Bitcoin transactions.
Traditional ledgers can be easily messed with, so trusting their accuracy is tough. We've used ledgers to store info for different purposes like tracking house records and business transactions. Bookkeeping often uses double-entry accounting, which is better than single-entry but still has issues.
Public blockchains fix these issues using a new method called triple-entry bookkeeping. This makes transactions super secure by adding a third layer of verification using cryptography. This kind of blockchain also uses “consensus mechanisms”, like proof-of-work (PoW) and proof-of-stake (PoS), to keep adding new blocks. It's like a better way to do record-keeping that you can trust.
The cool thing about blockchain is that it's like a team effort where no one person gets to be the boss. Imagine if a group of friends wanted to play a game and everyone needed to agree on the rules. In the same way, blockchain needs everyone to agree that a transaction is legit. This stops any single person from having too much power, as everyone has a say, so nobody can just make up the rules all by themselves.
Also, once a transaction is written down in the blockchain, it's like carving it into stone. Nobody can change it or mess with it, which makes it hard for sneaky folks to do bad things and lie about transactions.
And here's a neat thing: to keep everything in sync, there's this process called mining. It's like a puzzle that everyone has to solve together. When they solve it, they agree on the latest stuff that happened, like a team saying, "Hey, this is what we all think is true!"
When you send Bitcoin, you pay a small fee for computers to confirm your transaction. They bundle it with others in a queue for a new block. These computers, called nodes, work together to check all the transactions. They solve a tough math problem to make a special code, called a hash.
Once they solve it, the block is added to the network. Your fee, along with others, is the reward for the miners. Each new block gets a special code using a formula with the previous block's code.
As more blocks are added, the chain gets stronger, and you can't change old records without being ignored. This chain of blocks is the secure blockchain. Each block's code depends on the previous one; each block's code is made from the previous one's info, and the cycle keeps going forever.
Public blockchains work by everyone agreeing without a bank, so consensus mechanisms help make sure transactions are real. Proof-of-work (PoW) is used in blockchains like Bitcoin and Ethereum, but Ethereum moved to a more secure and energy-efficient way called proof-of-stake (PoS) in 2022. Both mechanisms aim to agree on real transactions, but they work in their own unique ways.
Proof-of-work (PoW) is the original way to verify transactions, and it is used by Bitcoin and Ethereum blockchains as we discussed before. PoW relies on math problems only computers can solve, but there are two issues with PoW. First, it uses a lot of power and can't handle many transactions at once (only seven for Bitcoin). Second, transactions take at least ten minutes, longer when many are happening. But this is still faster than old ways of sending money globally. To fix these issues, other methods like proof-of-stake (PoS) were made.
In proof-of-stake (PoS), transactions are checked by someone called a validator, depending on how many coins he holds. They're not mining like in PoW, and there's no reward for making new blocks. Instead, they forge new blocks by locking some of their coins.
Bigger coin holders have more power, increasing their chances of being chosen as validators. But to keep things fair, different ways to choose validators are used, including random picking or how long they've had their coins. The cool part is that PoS is faster and cheaper.
How a Bitcoin transaction starts, gets confirmed, and becomes a part of the blockchain. Source: “The Future of Money,” Eswar S. Prasad.
Other blockchains without their own special coins have to find different ways to get everyone to agree on transactions. These ways are called “consensus algorithms”, and they're kind of like the secret sauce of blockchain, making sure everyone's on the same page. However, figuring out these algorithms can sometimes be a bit tricky, and people might not always agree on the best way to do it.
Blockchain technology is the fundamental idea or set of rules that power blockchain networks; think of it as the engine that makes digital currencies like Bitcoin function, much like how the internet enables us to use email. As we mentioned, the blockchain isn’t only about money, as it offers a range of practical applications that extend beyond digital currencies. So, there are four types of blockchain because different use cases demand different types of blockchain.
Public blockchains are like big teams of computers that anyone can join to figure out if a transaction is real or not. People who do this checking, often called “miners”, get rewarded for their efforts. To make sure everyone agrees on what's real, these public blockchains use special ways of working together. Two popular examples are the Bitcoin and Ethereum blockchains. It's like teamwork that pays off!
Public blockchains are mainly known for activities like mining and trading cryptocurrencies, such as Bitcoin, but you can also use them to make unchangeable records that show who's responsible for something, such as making sure property ownership records are legit.
Public blockchains don't rely on any one organization. Even if the group that kicked it off disappears, the public blockchain can keep going as long as there are computers in the mix. Another plus point is how clear everything is in the network. However, public blockchains also struggle to handle lots of users; as more and more people join, things tend to slow down.
Private blockchains work a bit differently. They're not open to just anyone – you need special permission from the boss, kind of like getting an invite to a private club. These blockchains are usually run by a single group, so they're kind of like having a boss who decides everything.
Private blockchains are really fast, which makes them perfect for situations where the info needs to be super secure but not for everyone's eyes. They're great for things like keeping track of supplies, showing who owns what, and even handling votes within a group.
However, it's trickier to fully trust the info since a handful of central points decide what's legit. Because there are only a few of these points, security can be weaker. If just a couple of them go rogue, it messes up the whole agreement process. Also, their source code is often kept secret and locked up. People can't check it out for themselves, which can make things less secure. On top of that, there's no hiding on a private blockchain; everything's out in the open.
When groups want the best of both private and public blockchains, they use hybrid blockchain, which mixes parts of both. This allows them to create a private system that's also partly public, and they can control who can see what info in the blockchain. In hybrid blockchains, most stuff isn't public but can be checked using smart contracts when needed. Secret details stay inside the network but can still be proven true, and even if a private group owns it, it can't change transactions. When someone joins, they can use the network, and their identity will be hidden from others, except when they do a transaction.
Hybrid blockchains are safe from big attacks, and they protect privacy while talking to outside groups. Also, hybrid blockchain transactions are quick and cheap, and it can handle lots of them. However, it’s not fully open, as some stuff is kept private. Upgrades are also hard, and people don't have a reason to join or participate.
Hybrid blockchain is handy for many things. For example, in real estate, companies can run private systems but show some things to everyone. Retail and finance can also benefit. Even medical records can be here, but they can only access them. Governments might use it too, to save info and share it safely.
They are also called Consortium blockchains, and they are like group-run permissioned blockchains. They're not controlled by one person or company, unlike private blockchains. Compared to private blockchains, they are more spread out, and a few groups are in charge instead of just one.
In terms of security and setup, Consortium blockchains are quite safe, but they're not easy to create; many groups must work together to make them work well. In these blockchains, a bunch of groups share control, which stops any one group from having all the power.
One of its use cases is banks and payments, where banks can team up and decide which nodes check transactions. However, they're not as open as public blockchains, and if a group's node is hacked, the blockchain's rules can mess things up.
In a nutshell, blockchain's diverse types and mechanisms transform the way we transact and share information. According to Precedence Research’s August report, the worldwide blockchain technology market was valued at approximately $4.8 billion in 2022, projected to reach about $2,334.46 billion by 2032, with a compound expected annual growth rate of 85.7% from 2023 to 2032. As a secure digital record book shared across computers, ensuring transparency and tamper-proof data, blockchain technology has the potential to redefine various industries and drive forward a new era of secure and efficient digital interactions.
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