If you’ve paid attention to Bitcoin or cryptocurrency in general in recent years, you’ve no doubt heard about the “blockchain,” the technology used to power these currencies.
Many news sources will breathlessly talk about the blockchain and the potentials it holds, but few will actually define what it is. This is a shame because blockchain technology is what defines cryptocurrency, and while you don’t need to be an expert on it to buy or sell crypto, a basic overview of it will help you make better crypto investing decisions.
Defined in short, a blockchain is a list of blocks (digital records) that are linked through cryptography. (1) The blockchain forms the heart of Bitcoin and every other cryptocurrency; indeed, blockchain technology is what makes cryptocurrency a viable concept, ensuring its resilience and longevity in an unstable marketplace.
If you’re unsure about investing in cryptocurrency, understanding how the blockchain works will allow you to better comprehend the value of Bitcoin and other crypto.
Blockchain technology was invented in 2008 by pseudonymous computer programmer Satoshi Nakamoto as part of the development of Bitcoin. (2) While blockchain technology had been theorized and experimented with as early as 1991, Nakamoto’s implementation of it was the first one that was stable enough to be used as the basis of a cryptocurrency.
A blockchain can be thought of as a digital ledger, one that is virtually impossible to tamper with. Each block in a blockchain consists of a cryptographic hash of the previous block, a timestamp, and relevant transaction information. (3) Each block is linked to the ones preceding and following it, hence the “chain.” When a transaction occurs on the network, a new block is created and added to the blockchain, with every computer connected to the blockchain verifying it for authenticity.
Blockchains are managed through peer-to-peer networks using a single protocol in which all computers connected to said blockchain share in its functioning and upkeep. (4) This means that every system that participates in the use of a particular cryptocurrency—wallets, exchanges, and merchants, for example—is connected to that currency’s blockchain.
Every interaction between users is recorded on the blockchain in such a fashion that blocks cannot be altered after the fact without altering all subsequent blocks. This requires a majority consensus from all other blockchain users, effectively rendering fraud and theft impossible due to the expense and time necessary to seize control of a large network.
The invention of blockchain technology is what made the creation of Bitcoin and other cryptocurrencies possible. Fiat currencies, the currencies that most people use in their day-to-day lives, are backed by central authorities that give them security and value. For example, the U.S. dollar is backed by the federal government, while the euro is backed by the European Union.
No such authority exists for cryptocurrencies, which compensate through decentralized security via the blockchain. In order to modify a transaction on the blockchain (to invalidate a transaction or steal money, for example), an individual user needs to obtain a consensus from the other users, which is extremely difficult to do. (5) This allows currencies like Bitcoin to avoid double-spending—where users are able to spend units of currency more than once—and other issues that prevented effective cryptocurrency development.
Another advantage of blockchain technology is that it is completely transparent. All transactions that occur on a given currency’s blockchain are recorded, logged, and visible to anyone who seeks that information out. (6) While there are some cryptocurrencies such as Monero that are capable of anonymizing the identity of individuals in transactions, most crypto transactions can be viewed publicly, allowing for open use of the currency.
The blockchain’s nature as a decentralized, secure system means it has the potential to disrupt world business by simplifying it. Many existing online business models rely on providing middleman services between two people who wish to engage in a financial transaction. For example, PayPal is a payment processor that connects merchants to customers, taking a small fee as its cost for transferring money via their platform. With blockchain technology, however, customers and merchants can deal with each other directly, with the blockchain ensuring the integrity of their transaction; hence, PayPal’s role is made obsolete.
The same goes for services such as Uber and Airbnb. Using the blockchain, it is possible for someone who wishes to rent out their property to connect with prospective customers without the need for a service such as Airbnb. Middleman services essentially act as guarantors of the transactions they handle; with the blockchain, the system itself guarantees the transaction.
The potential for blockchain technology to revolutionize business in this manner has attracted attention across the world. For example, in the Eastern European nation of Georgia, all real estate has been added to the Bitcoin blockchain to make transactions faster and more transparent. (7) In 2016, IBM opened a blockchain research center in Singapore to study potential uses for the technology. (8) Banks and other financial institutions have also begun researching ways to use blockchain technology to improve their business models.
Finally, blockchain technology allows for fast and easy distribution of content over the Internet. While the original purpose of the blockchain was to allow for fast and secure peer-to-peer currency transactions, it can easily be adapted to serve as a low-cost content distribution system. Because every transaction on a blockchain is validated and processed by all machines connected to it, sending information over the Internet at little to no cost becomes easy.
Much in the same way that blockchain makes middleman services such as PayPal obsolete, content providers such as Netflix could potentially be made obsolete. Since files sent via a blockchain are embedded in the structure of the blockchain itself, there is no need for applications such as iTunes or Spotify, as the files can simply be sent peer-to-peer, akin to file-sharing programs, albeit legal. (9)
While Bitcoin was the first major use of the blockchain, the technology has already been adapted in ways that can facilitate all of these uses. Most notably, Ethereum, one of the top competitors to Bitcoin, introduced the concept of “smart contracts,” which helped extend the blockchain technology into everything from securing medical records to speeding up financial transactions in the mainstream banking world. (10) Websites such as Steemit and DLive allow users to create content (blog posts or video streams) using blockchain technology, which dramatically lowers costs compared to traditional content platforms.
In short, blockchain technology is revolutionizing the world. From its origins as the backbone of Bitcoin and other cryptocurrencies, it is rapidly being expanded into every sphere of life. It is no stretch to say that in the near future, the vast majority of business transactions, from buying groceries to paying rent, will involve blockchain technology in some form or another.
1. Is the blockchain safe to use? This is the number one concern of anyone engaging in financial transactions: security. There is no such thing as a 100 percent secure system, as any computer system can be hacked or abused given enough time and resources. However, the blockchain’s consensus-oriented design makes hacking it nearly impossible. Because every block must be validated by every other machine connected to the blockchain, any unauthorized changes must be approved by a majority of users on the network, which is extremely unlikely to happen due to the massive amounts of money and coordination it requires. While some blockchains are less secure than others, blockchain technology itself is one of the most resilient technologies out there when it comes to fraud and malfeasance.
2. How many blockchains exist? There’s no way to definitively answer this question because new blockchains are being created all the time. Additionally, while many blockchains are publicly accessible, there are also a great many private blockchains that are not accessible via the wider Internet. In general, there are three types of blockchains: public, private, and consortium. (11) Public blockchains are publicly accessible and are generally secure due to their large userbases. Cryptocurrencies, for example, use public blockchains. Private blockchains are only accessible to a select group of users and, while faster than public blockchains due to their smaller userbases, are more susceptible to attack for the same reason (since a smaller userbase means it is easier to gain a majority and thus take control of the network). Consortium blockchains fall between these two extremes.
3. Who can create a blockchain? Anyone with the appropriate skills can create a blockchain of their own for whatever purpose they want. Blockchain technology is a relatively advanced skill, requiring considerable knowledge in programming as well as a base of users in order to make the blockchain work. Many developers choose to use public blockchains such as Ethereum to build applications due to their large userbases, wealth of documentation, and large public profiles. However, due to the bottlenecks and other issues with public blockchains, many developers opt to develop their own blockchains in order to have their needs met. For example, while Ethereum is a powerful blockchain, its relatively slow speed of 15 transactions per second means that anyone looking to develop a program that relies on speed will not be able to use it effectively. Most custom blockchains are built precisely to serve the needs of a particular service or community, and are typically made either from scratch (which takes longer but allows for total control and flexibility) or forked from an existing blockchain (which is faster and cheaper but allows for less control over the final product).
4. What is forking? In software development, a fork is when an existing program or project is split into two entirely separate programs. In the context of blockchains, a fork is when a blockchain splits into two separate blockchains that are no longer connected despite their common origin. Forks can be accidental—such as when two updates are not compatible and end up forcing the creation of a new ledger—or they can be implemented by design. Intentional forks are separated into soft and hard forks. A soft fork is when blocks that would have been regarded as valid become invalid and is backwards compatible due to old nodes continuing to recognize new blocks, only requiring a majority of miners to switch to the new protocol. A hard fork is a fork that makes previously valid blocks invalid or vice versa and requires all systems on the network to update to the new protocol; old users will be rejected by the network, meaning hard forks are not backwards compatible. Hard forks can result in two separate blockchains continuing to exist in parallel or it can result in one blockchain dying off due to obsolescence. The most famous example of a cryptocurrency hard fork was the Ethereum fork of 2016, which occurred due to the theft of three million Ether in the DAO hack. (12) The fork resulted in the creation of Ethereum Classic, maintained by developers who believe that Ethereum abandoned its original mission by forking the blockchain. More recently, in 2017, Bitcoin was hard forked into Bitcoin and Bitcoin Cash, the latter of which features a larger block size allowing for faster transactions, a common feature request among some Bitcoin users as the currency became more popular. (13)
5. What is mining? Many cryptocurrencies, most notably Bitcoin, rely on miners in order to function. Cryptocurrency mining is when a computer connected to the blockchain validates new transactions and records them on the ledger. (14) This is done through solving difficult math problems via a hash algorithm. When a problem is solved, a transaction is confirmed on the blockchain. In exchange for solving these problems, which require processing power, miners receive a monetary reward for every problem they solve, which is taken from the transaction itself as a “mining fee.” Mining is often a good means for those who own computers to make money, though mining popular cryptocurrencies such as Bitcoin requires considerable amounts of processing power and electricity that is beyond the budget of many users. Not all blockchain-based systems use mining—Ripple, for example, is a prominent cryptocurrency that does not use miners—but a great many do as a means of speeding up the rate of transactions on their systems.
6. What is encryption and how does it work? Encryption is a means of obscuring data or information so that it cannot be decoded—decrypted—by anyone who does not know how. Blockchains use encryption to prevent transactions from being tampered with by external actors. Only the nodes involved in the transaction are able to decrypt it, making blockchains a secure means to engage in business.
7. What is a ledger? If you’re familiar with auditing and accounting, a ledger is a record of financial transactions at a given business or other institution. Ledgers have been used for thousands of years to keep accurate financial records. In the context of the blockchain, it is at heart a distributed ledger: a ledger that is kept accurate through constant communication and confirmation from all nodes connected to the network. The blockchain itself is a ledger of transactions represented in computer code, its decentralized nature preventing any one individual or group from engaging in fraud. Given the nature of blockchain technology, blockchains can expand up to an infinite size as they accumulate transactions.
8. What is double spending? Double spending is when one digital token (unit of currency) on a cryptocurrency network is spent twice or more. Imagine if you had a dollar and were able to spend it multiple times and you have an idea of what double spending is. It is obviously impossible to spend physical currency more than once without counterfeiting it (which is illegal), but since digital currencies consist of replicable computer files, it is possible to spend the same tokens repeatedly without an anti-fraud system built in. (15) Double spending, if allowed to spiral out of control, leads to hyperinflation and losses for organizations and businesses who are victims of it. The blockchain is designed to prevent double spending through distributed verification of all transactions. By requiring all nodes on a blockchain to process and verify the transaction, the network ensures the integrity of all transactions that occur without needing a central authority.
9. What is the difference between the Bitcoin blockchain and the Ethereum blockchain? While all based on the same fundamental technology, there are often steep differences between different types of blockchains. Bitcoin and Ethereum are the two most popular and well-known cryptocurrencies and their blockchains are incredibly divergent. The most important differences between them is their algorithm, transaction time, and scalability. Bitcoin uses the SHA-256 algorithm, while Ethereum uses the proprietary Ethash algorithm. This is more relevant to miners as it means that Bitcoin and Ethereum require different types of hardware to mine. Bitcoin also takes an average of ten minutes to conduct transactions, while Ethereum takes 12 to 14 seconds. Ethereum is also scalable while Bitcoin currently is not.
10. What types of records are found in a blockchain database? All blockchains contain both transactional records and block records. While both can be readily accessed, it is also possible to integrate one with the other.
11. What kinds of records can be stored on a blockchain? Any type of record can be stored on a blockchain; there is no limit. This flexibility has resulted in many industries using blockchains for record-keeping.
12. What is a Merkle tree and what does it have to do with the blockchain? Also known as a hash tree, a Merkle tree is a common data structure in cryptography. In a Merkle tree, certain nodes are identified as “leaf nodes,” which are designated with the hash of a block. (16) Non-leaf nodes are responsible for storing the child nodes’ cryptographic hashes. This type of data structure streamlines the processing and verification of transactions on a blockchain, because it eliminates the need for transferring entire blocks between nodes in order to verify them. Initial experiments in the early 90’s theorized about the use of Merkle trees to speed data processing, but it wasn’t until the blockchain was formally invented in 2008 that the Merkle tree was utilized for this purpose.
The blockchain is the key technology that powers cryptocurrencies such as Bitcoin and distinguishes them from attempts to create digital currencies in the past.
The versatility and security of the blockchain makes it the first technology of its type to allow digital currencies to compete with traditional fiat ones. Even better, given the blockchain’s distributed nature, no one single authority can dominate a blockchain, freeing cryptocurrencies such as Bitcoin from political and financial manipulation.
Beyond these advantages, the nature of the blockchain makes it a revolutionary technology. In eliminating the need for middleman businesses, the blockchain makes it possible to connect consumers and merchants like never before. Financial services such as PayPal and merchant services such as Uber and Airbnb could be turned upside down by the blockchain’s ability to allow customers and sellers to engage in transactions that are automatically verified and guaranteed by a decentralized network that is nearly impossible to hack.
In short, the blockchain is a technology that has the ability to change the world. It is part of what has given Bitcoin and other cryptocurrencies their resilience in a market where exchanges go bust and prices constantly fluctuate. Free of human error due to its distributed nature, developers and businesses are finding new uses for the blockchain every day, from real estate transactions to secure digital communication.
While becoming an expert on the blockchain isn’t necessary if you want to get involved in crypto, understanding its basics will allow you to make better investment decisions. Not all blockchains are created equal, and knowing about how the blockchain functions will make it possible for you to spend your money wisely. Ultimately, the blockchain is a technology that will come to dominate our lives due to its versatility and usefulness, so it behooves you to understand how it functions.
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