What Is Blockchain?
A Step-by-Step Primer on How Distributed Ledger Technology Works
Over the last decade, blockchain has become integrated into the daily vernacular. For a good reason — thanks to Bitcoin, blockchain technology has been implemented across numerous industries.
Having proven itself with Bitcoin, blockchain is likely to become the key technology behind many central bank digital currencies (CBDCs). The question then is, what is so innovative about blockchain technology?
What Problems Does Blockchain Solve?
At a basic level, blockchain is nothing more than a type of database. Every time one accesses an online account, such as Twitter, Google, or Facebook, one links up to a database. As the word implies, every database is a set of information, which is organized in a logical order.
Databases make it easier to manage and update sets of information. What sets blockchain apart as a database technology?
- Blockchain is a distributed database. Computers in a network — nodes — run identical copies. Therefore, if one copy on a node is compromised in any way, the blockchain network’s redundancy ensures it will continue to run.
- Nodes sync to update the database. If some nodes give an erroneous record that doesn’t match up with the rest of the nodes (51%), the record is dismissed.
- Blockchain forms the database in a chronological order. Because each data block is time-stamped, it creates a chain. This has the effect of creating immutability. If a particular data block were tampered with, a new chain would branch out, effectively creating a false database that is dismissed by the network.
- Added data blocks are individually encrypted through the hashing method. Simply put, hashing transforms one value into a string of characters of fixed length. Using the same formula that produces the hash, any data of arbitrary size is then transformed into a fixed-size data set. Therefore, hashing is not only useful to validate data, but to store it in such a way that doesn’t reveal the original input.
Given these key features, blockchain is a decentralized, distributed, immutable, and secure database, also commonly called DLT — distributed ledger technology. Depending on how such a ledger is deployed, we have different blockchains that serve different purposes.
How Is a Blockchain Network Secured?
The best starting point would be to consider how cloud computing works. Specifically, one of the most popular workspace environments is Google Doc/Sheet. When such a document is created, the originator gives sharing rights to users.
In turn, they can modify the document, with each change visible to all who were given sharing rights. Therefore, working on Google Doc/Sheet is accessing and modifying a distributed data chain. In Bitcoin’s blockchain, which generates the most popular cryptocurrency that once reached a $1T market cap, the originator is Satoshi Nakamoto as the pseudonymous creator.
Instead of giving sharing rights to individual users, Satoshi Nakamoto, Bitcoin’s creator, made the network public and open-source. Using the Script programming language, Bitcoin is nothing more than a smart contract that records whether the BTC token is spent or bought.
What prevents someone from tweaking the smart contract so that spent tokens can be reclaimed? This problem is known as double-spending, and all blockchain features fall in place to resolve it. If we revisit the above analogy, a Google Doc user could simply manipulate the data sets. The data chain would then be updated to all other users, presenting false data as true. Needless to say, it would be impossible to create a viable cryptocurrency with such a loose system.
Blockchain deals with this monumental problem in a revolutionary manner:
- Each data block in the chain consists of the three elements: transaction data itself, a 32-bit nonce number that is randomly generated when the block is created, and the aforementioned hash.
- When a data block is time-stamped, it is signed by the generated nonce number, tied, and transformed into a cryptographic hash.
- The network participants holding blockchain copies create these block, in a process called mining. Because each block is nonce-stamped with hash, in addition to referencing the previous block in the chain, mining becomes a complex task.
The Power of Mining
Mining was intentionally designed to create a barrier to tampering. Specifically, miners employ a specialized software that resolves mathematical problems, so they can find a nonce that generates a hash that is accepted as the next block in the chain.
Nonce itself is a 32-bit randomly generated number, while the encrypting hash is a 256-bit function. This translates to an enormous 4B potential nonce-hash combos to be mined before the right block is found. Once such nonce is found, it is added to the chain as a verified block upon reaching the consensus from the majority of nodes.
For all this work, the miner receives a reward in the form of the network’s native cryptocurrency. In the case of Bitcoin, this would be BTC. Such a reward system represents the cornerstone of decentralization because network participants are inherently incentivized to…participate.
In short, the computational power needed to accomplish this mining process creates such a barrier that it is virtually impossible to manipulate blockchain networks. After all, this is why Bitcoin makes headlines on its power usage, usually compared to a country. According to Digiconomist, the Bitcoin network presently uses 204 TWh as annualized consumption, which is comparable to a country the size of Thailand.
However, such energy expenditure only applies to Proof-of-Work (PoW) blockchains in which work translates to electricity usage needed to resolve cryptographic math, represented as the miner’s hashpower contributing to the network’s total hash rate (TH/s).
In contrast, Proof-of-Stake (PoS) blockchains use economic staking of native tokens to accomplish the same goal. For this reason, miners are called validators in PoS networks.
For instance, once Ethereum transitions from PoW to PoS, its energy usage is poised to go down by 99.95%, according to the Ethereum Foundation.
Types of Blockchains
The primary divergence point for blockchains is whether they are permissionless or permissioned, which shouldn’t be confused with private vs. public. This difference is closely related to the number of nodes verifying the blockchain network. They have fewer nodes because there is a permission barrier prohibiting access to permissioned blockchains. Consequently, such blockchains are highly centralized. On the upside, they are generally faster because fewer nodes verify data blocks. With that said, permissioned blockchains can also be public.
One such public/permissioned hybrid blockchain is Ripple. In Ripple (XRP), network participants (nodes) are given permission to maintain the network by Ripple, Coil, and the XRP Ledger Foundation. Together, they create Unique Node Lists (UNLs), based on nodes’ trustworthiness level. The latter mainly revolves around the node’s past performance and provable identity.
Presently, the Ripple blockchain network is running on 35 trusted nodes. For comparison, the two top cryptocurrencies, Bitcoin (BTC) and Ethereum (ETH) run on significantly more decentralized networks, at 15,539 and 6,089 nodes, respectively.
Altogether, based on the primary permissioned/permissionless criteria, blockchains can be public, private, hybrid, and federated (consortium-controlled).
Can Any Data Be Recorded on a Blockchain?
Bitcoin (BTC) popularized blockchain technology with its use as a peer-to-peer (P2P) digital money. Because Bitcoin was designed to have a limited supply of 21M coins, it is not susceptible to inflationary forces. Likewise, because it is run on such a decentralized network, no central bank will ever be able to tamper with its money supply like the Federal Reserve does with the dollar.
However, any data can benefit from blockchain’s immutability, security, and decentralization. The dollar itself can be tokenized in the form of stablecoins. These types of cryptocurrencies remove volatility from the equation while providing global payment networks comparable to the likes of Visa, but even faster and cheaper.
The most prominent blockchain payment networks emphasizing stablecoins are Terra and Tron. There are a variety of ways in which stablecoins maintain their peg to the dollar. Some collateralize them with cash reserves in a 1:1 ratio, such as USD Coin (USDC). Terra’s UST stablecoin uses an algorithmic collateralization system, in which the native LUNA cryptocurrency is burned (removed from circulation) to buy UST when the peg goes over the 1:1 ratio.
Vice-versa, UST tokens are burned to buy LUNA when the peg goes under the 1:1 dollar peg. Whether regular or algorithmic, stablecoins represent frictionless 24/7 payment systems. Central bank digital currencies (CBDCs) are trying to catch up, but central banks will completely control them, removing financial privacy in the process.
Outside of payment systems, blockchain networks can be used to verify the provenance of assets. For example, an artwork can be tokenized with a smart contract as an NFT — non-fungible token. The same applies to audio, e-books, video, and even real estate deeds. Case in point, CityDAO is using blockchain to tokenize real-world land plots in Wyoming to manage the land development and ownership.
Likewise, blockchain networks can establish provenance in the supply chain. For instance, Walmart is using Hyperledger Fabric, a permissioned blockchain, to establish the traceability of consumer products. Therefore, if some food item turns foul, it can be traced back to its source, along with all the handlers on the way.
The biggest blockchain usage comes from its embedded smart contracts. These are executed agreements that trigger when conditions are met, stored on a blockchain. Although all blockchain networks employ smart contracts, it took Ethereum to make it easy to deploy them as dApps — decentralized applications.
When dApps are combined with blockchain’s immutability/security, an entire financial infrastructure can be recreated in a decentralized manner:
- Markets without market makers – Uniswap, Sushiswap, Balancer
- Banking without banks – Anchor, Aave, Compound, Curve
- Auction houses without auctioneers – OpenSea, Rarible, SuperRare
Presently, there are over $200B worth of crypto assets locked across smart contract platforms. They provide services from decentralized exchanges (DEXes) and lending to NFT marketplaces and insurance, such as Nexus Mutual.
In the end, even voting itself can be tokenized. Perhaps, this would be the most robust way to secure elections. If a person’s identity is tied to their wallet address, already verified through KYC/AML rules, it would then be a simple matter for them to cast votes that can’t be tampered with.
Of course, this would be best done on public and highly decentralized networks such as Ethereum. Voting records can then be anonymized, transparent, immutable, traceable, and auditable. Effectively, just as Bitcoin proved it solved the double-spending problem, the same can be done with double-voting. After all, they are both accounting units.
Should Blockchain Replace All Databases?
In conclusion, what is a blockchain good for? Should organizations use it as a default data management solution? To answer that, we have to keep in mind that blockchain’s key feature is data redundancy stemming from decentralization. Once we understand that, we can measure the balancing act between long-term record storage and its cost-effectiveness.
As for blockchain’s smart contracts, if the gatekeeper/mediator in the traditional setup is either inefficient or too expensive, it is time to replace it with a smart contract platform. For instance, TUI Group tourism company implemented blockchain smart contracts to directly link customers with hotel service providers, effectively replacing the booking system.
Lastly, if it is important for the record to contain all historical data, there is no better way than to create a time-stamped and redundant data chain, the blockchain.