Learn more about how blockchains work, the benefits they provide, and how they can be applied to various industries.
Blockchain is one of the most disruptive technologies since the internet was invented, and will have wide-ranging impact on many industries, including finance, supply chain, and many more.
But what exactly is blockchain technology and how does it work?
Blockchain was made famous when it was used to develop the most popular cryptocurrency, Bitcoin, and is a new way of storing, distributing, and sharing data. But it can do so much more.
In this article, we’ll go over how blockchain works, what benefits it provides, different structures of blockchains, and a few of its potential applications.
A Definition, Analogy, and Real World Example
In technical terms, a blockchain is a series of blocks of data which are linked to each other via cryptographic hash functions – mathematical algorithms that verify the authenticity of data and are extremely difficult to reverse.
Each of these blocks contains data (which can be transaction data, identity data, or many other types) that is secured cryptographically, which makes it resistant to modification. The blockchain is managed by a network of interconnected computers called nodes that maintain these data records, alleviating the need for the network to be managed by a single, centralized party.
To better understand how blockchain works, let’s try an analogy.
Imagine a Google Sheet spreadsheet that is shared with thousands of people. All of these people can see the data that the Google Sheet contains and they have influence over the content in the spreadsheet:
- All changes to the data in the Google Sheet’s cells are readily viewed by all.
- Users can work together to agree upon the validity of the data being entered into the spreadsheet.
- When new data gets entered, everyone will have an updated version right before their eyes.
So in this case, the Google Sheet is the blockchain, the data in the spreadsheet cells is like the data in the blocks, and the spreadsheet users are the network nodes.
Now imagine having all of this distributed, transparent functionality without Google being the central party that provides the Google Sheets technology. Pretty powerful and interesting, huh?
Let’s take a look at a real world example, with a simple one being in the form of payments.
Let’s say you want to pay your friend via PayPal for tickets to the Backstreet Boys reunion concert. I know this isn’t happening, but we can dream, right?
Anyway, you open your PayPal app and send her money. For this transaction to be verified and executed, PayPal, the centralized entity, must:
- Confirm your and your friend’s accounts in their databases.
- Make sure that you have enough money in your account (or have a bank account or credit card linked).
- Withdraw money from your account and transfer it to your friend’s account.
- Update their databases to reflect the executed transaction.
Now let’s say you wanted to pay your friend via Bitcoin. You create a request to send Bitcoin (usually through a cryptocurrency wallet like Coinbase or Trezor) to your friend’s wallet address and the process would go something like this:
- The transaction request gets distributed to Bitcoin’s network of nodes.
- The network nodes validate the transaction and update your and your friend’s balances (a lot more goes into this step, but let’s keep it simple for now).
- A new permanent and unchangeable block that reflects this transaction (among others) is added to the Bitcoin blockchain.
- The transaction is complete.
As you can see, this transaction isn’t verified by a single company with centralized databases. Rather, it’s validated by many others who contribute to the Bitcoin blockchain and maintain a distributed ledger that is permanent and unchangeable.
Cryptocurrencies like Bitcoin, Ethereum, and Litecoin are mentioned as interchangeable with blockchain, but that’s only part of the story. Yes, these cryptocurrencies run on a blockchain, but not every blockchain’s main purpose is to be a form of money. We’ll learn more about the potential uses of different blockchains later in this article.
Characteristics and Benefits of Blockchains
The last time I checked, there were over 2400 (!) different blockchain protocols in existence. While many of these have unique traits, there are three core characteristics of blockchains:
- Decentralization: All the data inside the blockchain is not owned by a single centralized entity. Rather, the nodes, which are the people who help manage the network, all download the blockchain data onto their computers, which means that no one party owns the data. Different blockchains have varying levels of decentralization based on their consensus mechanism (which we go over in this section).
- Transparency: The nodes that have downloaded the blockchain onto their computers can see all the data that is stored on said blockchain. Every single bit of data can be traced right back to its very origins. For example, in the Bitcoin blockchain, every single bitcoin (or fraction of a bitcoin) can be traced back to see who owned the currency in the past and what transactions those coins were involved in.
- Immutability: The data stored on the blockchain is secured via cryptographic hash functions and thus cannot be tampered with. This ensures that the blockchain provides top-level security of its data, and the data cannot be edited once it has made it onto the blockchain.
These three properties – decentralization, transparency, and immutability – help provide the following key benefits:
- Trustlessness: You no longer have to trust a central party to execute a transaction. The decentralized nature of blockchains allow peer-to-peer transactions – whether they are a transfer of money or exchange of data – to be carried out without a single party sitting in the middle. And blockchain’s transparency lets everyone see that these transactions were executed.
- Enhanced traceability: Transactions on the blockchain are tracked in chronological order and can’t be changed or reversed due to the cryptographic hashing. All of the network’s nodes have access to every transaction, which makes it very easy to trace what transactions took place, when, and by whom.
- Censorship resistance: If a central party manages a network’s data, it has the ability to censor how you use their app. For instance, PayPal has a history of not allowing pornography workers to use its payment system. That has led to the rise of SpankChain, a decentralized platform that helps these workers get paid with no censorship.
- Reduced cost: Goods are costlier than they need to be because middlemen add fees and charges. With blockchain, these intermediaries are kept to a minimum because of the trustlessness of the network, thus reducing costs.
- Increased speed and efficiency: Blockchain is increasingly replacing slow, paper-based processes, as well as processes that require alignment of multiple separate databases. By aggregating data on a single distributed ledger, transactions can be executed and shared more efficiently, leading to faster operations in many cases.
- Improved security: The combination of distributed data and cryptographic hashing makes blockchains more difficult to hack than centralized databases. Hackers no longer have a single database to attack. Rather, they will have to find a way to overcome the security provided by thousands of computers across the world who are monitoring the network.
Categories of Blockchains
Blockchains fall into three general categories – public, private, and consortium blockchains. Each have their pros and cons and are best applied to different situations.
Let’s first review public blockchains, which are also called “permissionless” blockchains.
Public blockchains are open to the public, and anyone can access and participate in these networks without anyone’s permission – hence, permissionless. These are the blockchains that you are most familiar with – Bitcoin, Ethereum, Litecoin, and many other cryptocurrencies.
The advantages of public blockchains are that it’s simple to join their network. Any willing participant can join, read, write, and make legitimate changes to the network, provided that the rules of the network are followed. As a result, public blockchains are decentralized in the purest sense of the word – there is no one central body controlling the data on the blockchain. Also, once data gets written to a public blockchain, it cannot be changed.
But they do have certain drawbacks which makes them impractical for some use cases, namely by enterprises:
- Many public blockchains suffer from scalability issues. Bitcoin can only manage somewhere between 3-7 transactions per second, and it takes 10 minutes to mine a block. Ethereum fares a little better with 25 transactions per second and a 15-second block time. This is simply not good enough for big enterprises who need to deal with millions of transactions per day with near zero latency.
- Consensus mechanisms are extremely important for public blockchains. However, as in the case of proof-of-work (PoW) chains like Bitcoin, consensus can be an extremely time-consuming and expensive process, which doesn’t fit well with enterprises.
- Finally, public blockchains are transparent. This is a huge problem for enterprises who need to store and transact across terabytes of confidential data. In this case, public blockchains simply can’t work.
Thus, many enterprises choose to use private blockchains.
Public blockchains are open to anyone who wants to participate. Private or permissioned blockchains, on the other hand, are controlled by a central authority and only allow a select few to take part in the network.
Entities who want to participate in a private blockchain must gain permission to do so from the centralized body. Once the entity has joined the ecosystem, they can play a role in the consensus of the network.
These private blockchains have been specifically designed for enterprise needs and offer benefits such as:
- High Performance – Because the number of nodes are limited in private blockchains, consensus can be reached very quickly. Thus transactions can be executed faster and the system can be scaled more easily.
- Compliance – Enterprises may have to adhere to various compliance requirements, and having control over the network helps them achieve this.
- Data Privacy – All the nodes in the private blockchain network are carefully vetted members of the community. No random person can enter the network and become a participant; thus privacy is increased.
The Linux Foundation’s Hyperledger Fabric is an example of a permissioned blockchain framework (it can also be used to create consortium blockchains, which we go over below). It has been designed from the ground up to cater to enterprise requirements and has been implemented by large organizations for various purposes.
One of these companies is Walmart. The world’s largest retailer is working with IBM to use blockchain to track the source of their vegetables throughout the supply chain.
Each entity who handles vegetables that get delivered to Walmart can be a node who adds their data to the network. This will allow Walmart to quickly and easily identify who handled what food, when, and where. Walmart is leveraging IBM’s Food Trust product, which is built with Hyperledger Fabric.
A consortium blockchain is a hybrid blockchain which can be described as “kind of decentralized.” Yes, that’s a technical term.
Instead of allowing anybody to participate in the blockchain (like in public blockchains), or having one entity primarily control the network (like in private blockchains), a small number of entities are selected to manage the network and have equal influence in doing so.
Consortium blockchains follow a permission system called shared permissioned ledgers. This is a closed ecosystem between multiple entities who share the same blockchain. The right to read the blockchain may be public, but the ability to form consensus and edit the network data is restricted only to the participants.
Vitalik Buterin, the co-founder of Ethereum, defines a consortium blockchain as such:
“In general, so far there has been little emphasis on the distinction between consortium blockchains and fully private blockchains, although it is important: the former provides a hybrid between the ‘low-trust’ provided by public blockchains and the ‘single highly-trusted entity’ model of private blockchains, whereas the latter can be more accurately described as a traditional centralized system with a degree of cryptographic auditability attached.”
Facebook’s Libra can be considered a consortium blockchain, where Libra’s partners such as Visa, Uber, PayPal, and others will help manage the network.
Decentralization brings a myriad of benefits. But with the lack of a central authority, who makes the decisions, and how do all the nodes come to an agreement?
Enter consensus mechanisms.
Per Wikipedia, “Consensus decision-making is a group decision-making process in which group members develop, and agree to support a decision in the best interest of the whole.”
In simpler terms, consensus is a dynamic way of reaching agreement in a group. And consensus mechanisms are at the core of how blockchain nodes reach agreements of which transactions are approved.
We can write all day about the different types of consensus mechanisms that blockchains use and all of their technical details. And maybe one day, we will. But for now, we’ll review the two most popular consensus mechanisms – Proof of Work and Proof of Stake – on a high level.
Proof of Work
The Proof of Work (PoW) algorithm was created before the advent of cryptocurrencies but was made famous and applied by Satoshi Nakamoto – the unknown founder of Bitcoin – to provide consensus for its ecosystem.
In Bitcoin’s PoW mechanism, miners need to solve a difficult computational problem to validate the transactions in a block and add it to the blockchain. To do so, they must dedicate a large amount of their computing power and if they are successful, they will receive monetary rewards in the form of bitcoins.
The difficulty of this work, called the hashrate, is adjusted so that a block can be generated only once every 10 minutes. There is a low probability of successfully generating a block, so it’s difficult to predict which miner will be successful and reap the rewards.
Each mined block contains the hash of the preceding block, and all blocks are connected, forming the blockchain. Changing the data in a block requires the regeneration of all preceding blocks, which is extremely resource-intensive and nearly impossible. This difficulty protects the immutability of the data on the blockchain.
The main advantage of PoW is its security. Miners need to spend a real-world resource (their computing power) to mine these blocks, which can get really expensive. It is not in the best interest of the miners to go against the system since they can incur huge losses.
The main disadvantages are as follows:
- PoW mining uses a lot of energy and can be detrimental to the environment.
- Wealthy companies can buy large amounts of mining equipment and increase their hashrate within the system. If they gain 51% of the hashrate, then they will be able to control the network and render it useless. But again, this is extremely difficult to pull off.
Proof of Stake
The Proof of Stake (PoS) consensus mechanism shares the same purpose as PoW – to validate transactions and achieve system consensus.
However, instead of miners dedicating computing power to create new blocks, validators are deterministically chosen as block creators based on their stake. Their stake is typically how many coins they are willing to lock up within the system in order to create the next block.
For instance, if Mike stakes 20 coins and Vicky stakes 200, Vicky has a 10x better chance to be the next block validator. And she will get a reward proportional to the number of coins she staked.
The biggest advantage that PoS has over PoW is energy efficiency. Because PoS doesn’t require a large amount of energy to create blocks, it is much more environmentally friendly.
There are debates about which consensus mechanism is more secure.
With PoW, you need a significant amount of computing power to overtake 51% of the network, which is very difficult and expensive. And PoW has proven to be resilient for a longer amount of time.
With PoS, you’ll need over 51% of the amount of coins on the network (which is also very difficult to achieve), but if you were to attack the system this way, others in the network will leave, and your coins will be rendered valueless. While this system seems to be effective, it is not as proven as PoW.
There are a few other consensus mechanisms, such as Delegated Proof of Stake (DPoS), Proof of Capacity (PoC), Proof of Elapsed Time (PoET), and others, each with their cool acronyms. We’ll go over those in future posts.
Applications of Blockchain
There are many scenarios where the decentralized, transparent, and immutable nature of blockchains can be beneficially applied. Let’s go over a few of these potential use cases.
As mentioned earlier with the PayPal/Bitcoin example, blockchains are often used for peer-to-peer payments. Bitcoin, Litecoin, Dash, and many other cryptocurrencies are being used by people to pay each other and purchase goods and services from merchants. And there are many companies such as BitPay, Crypto.com, and others that provide the infrastructure for retailers to accept cryptocurrencies as payment.
Supply Chain Management
Just as in the Walmart example, blockchains are being used to create more transparent supply chain networks. The origin and movement of goods can be tracked with speed and transparency never available before.
If food contamination occurs, retailers can use the data on the blockchain to quickly identify the source of the tainted food.
Everledger is doing the same for diamonds, Ernst and Young built a blockchain platform called TATTOO to track the source of wines, and many other blockchain networks are being created to better track the supply chain of goods around the world.
The process of getting a loan is miserable. You have to fill out tons of paperwork, generate all kinds of identification to prove you are you, and depend on some human loan officer to determine whether you are worthy of borrowing money. This process takes weeks, if not months.
Companies like MakerDAO and Compound Finance are building blockchain-based lending solutions that take the manual parts of the process and replace them with computer code. Loans can now be executed much more quickly and with little to no human intervention.
The elections process requires a lot of trust. As a voter, you have to trust that your ballot was properly delivered and not edited, and all ballots were accurately read and counted.
Blockchain-based voting systems can help prevent elections fraud by making votes transparent and immutable. West Virginia was the first US state to test voting on the blockchain and ran a successful trial in November 2018 with startup Voatz (PDF download).
On an organizational level, Aragon One builds tools to help decentralized companies vote on policies and procedures. These tools are used by Aragon One itself to determine its own future direction.
Those are just a few possible applications of blockchain. There are many, many more use cases where blockchain technology can make processes more efficient and effective.
There’s a lot going on with blockchain. The complex technology is constantly evolving, and we’re just scratching the surface on how it can be used.
It’s clear that blockchain will have a profound impact on how the world runs and will provide many benefits to industries across the globe.
We hope this blog post has shed some light on how the technology works and the benefits it can bring.
We would love to hear your thoughts about this article or blockchain in general. Thanks for reading!