What Is Blockchain? Meaning and How It Works, With Examples

What Is Blockchain? Meaning and How It Works, With Examples
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Blockchain technology has been in the public mind for over 10 years, and its adoption rate has been phenomenal. Currently, over 1 in 5 adult Americans own the blockchain currency Bitcoin. This article will cover the following information to provide a comprehensive overview of how this technology works:

What is a blockchain?

A blockchain is a digital file consisting of a series of blocks whose order is cryptographically verifiable. The data in each block depends on the type of blockchain, but the most simple kind of content is a transaction. A blockchain also needs a policy for how new blocks can be added and by whom.

For private blockchains, this can be anyone with a specific key. However, for public blockchains (such as Bitcoin and Ethereum), anyone can access and attempt to extend the blockchain. Copies of public blockchains are kept on the computers of anyone who’s willing to store them, known as a distributed ledger.

For a distributed ledger to make sense, everyone needs to have the same copy, known as a consensus. To prevent people from adding an unlimited number of blocks (and wasting everyone’s storage and network capacity), public blockchains need to introduce a cost to add new blocks.

History of blockchain

In 2008, a technical description of a blockchain for keeping track of a digital currency was published under Satoshi Nakamoto’s pseudonym. The name given to this currency was Bitcoin (BTC). Satoshi had a short and mysterious online presence, and the real identity of the person or persons behind the pseudonym still hasn’t been revealed. Bitcoin quickly gained traction among cryptography enthusiasts for its exciting properties.

With the success of Bitcoin, early blockchain enthusiasts started thinking of other things that could be put on a blockchain. One of them, Vitalik Buterin, created the Ethereum blockchain, which lets participants post apps to it. The Ethereum blockchain is the home of the distributed apps, or dApps, ecosystem.

As the world of blockchain technology matured, the need to integrate with the rest of the digital environment became more important. The most obvious example is currency exchanges between crypto and fiat currencies. Another important integration is the Oracle system, which attempts to verify real-world events and put them on a blockchain.

Industries and blockchain use cases

The computer revolution made information storage and processing cheap, while the internet made distribution inexpensive. And now, blockchains have started making verification cheap, as well.

Just as with the computer and internet revolutions, applications of blockchain can have far-reaching consequences across diverse businesses, including:

Finance

At its most basic level, the finance industry records, transfers, and invests valuable assets. This includes customer-serving companies, such as banks, wiring companies, and fund managers, but also infrastructural companies like central banks, credit rating agencies, and stock exchanges.

Blockchain technology can provide financial services with less paperwork and reliance on legacy financial institutions while maintaining security and reducing costs. Take, for instance, Aave, a dApp that lives on the Ethereum blockchain. This service allows users to lend cryptocurrency to others and collect interest. The way it works is that users can deposit their tokens to a liquidity pool and get a certain interest back, or they can borrow tokens from that same pool and pay interest on it.

Health care

The modern health care industry is also an information industry. For effective and safe care, it’s vital that patients’ medical history is accessible to the caregivers who access that information and needs to remain confidential.

Blockchains can alleviate the trade-off between accessibility and confidentiality, such as in Estonia, which verifies medical records have not been tampered with using a private blockchain. The Estonian health system logs whenever a physician or patient requests or enters data. These extensive logs are regularly backed up and hashed.

A blockchain of the hashes is kept so that if an attacker wants to alter a single record, they have to alter the entire blockchain (this is practically infeasible). The logs are essentially tamper-proof in a way that’s relatively inexpensive to maintain.

Supply chain

Supply chain systems orchestrate the movement of goods across industries and countries. The constant market pressure to reduce the cost of logistics creates an incentive to make sourcing and distribution of goods as flexible as possible.

This often comes at the expense of making supply chains illegible, though, making it hard to trace the origin of products due to the many intermediaries. Just as in health care, there is a trade-off between the accessibility of information and the integrity of the records.

This situation can be improved by integrating blockchain or distributed ledger technology. An example is the IBM Food Trust. The Food Trust uses blockchain verification to make records that are tamper-proof and yet lightning-fast to search.

Gaming

Today, gaming is a massive industry that rivals traditional entertainment industries, such as television and film. As a long-term business, massively multiplayer online (MMO) games are much more viable than single-player games, thanks to the network effects. The more players are currently playing an MMO, the higher the value is to a new player, thanks to the greater availability of fellow teammates and opponents.

However, MMO games come with the fundamental problem of widespread cheating and fraud. This puts owners of these games in the uncomfortable and costly position of playing judge between players, a process that is often faulty. A common source of fraud is trading between players. By establishing a blockchain-based smart contract, players can make promises, such as “pay you back later,” enforceable, preventing a common type of scam.

For example, on the blockchain-enabled XAYA platform, trading between players can be done with a safe peer-to-peer protocol. The protocol even allows for trading items between different games. Basically, players just drop items into a trade proposal box and cryptographically sign the swap when they’re happy with the exchange. The exchange is then stored securely in the platform’s digital ledger.

Real estate

The real estate market trades commercial and private structures and land but is known to be illiquid due to regulatory hurdles for ownership and the fact that assets change hands so rarely. The traditional way to securitize real estate is through real estate investment trusts (REITs). With blockchain technology, however, there’s a new option: tokenization of real estate.

Tokenizing real estate and trading it on a digital market can enable unprecedented levels of automation and diversification of portfolios. In fact, tokenization has been successfully carried out on a resort in Aspen.

For tokenization to be meaningful, interaction with regulatory bodies is necessary (blockchains alone can’t guarantee ownership of a physical asset). Once the tokenization of a property is cleared by the regulator, the tokenization service provider acts as an intermediary, selling tokens on a blockchain. When the asset produces some return, such as rents, token holders are entitled to a share of the operational margins.

Benefits of using blockchain technology

Blockchains provide several benefits compared to other network techniques. Here are some benefits related to public blockchains (i.e., open for participation without an invite), such as Ethereum and Bitcoin.

Decentralized

Decentralization means no single central authority controls the blockchain. Anyone can start mining, perform and validate transactions, or deploy services without the permission of any authority. This reduces regulatory risk.

The most obvious effect of this is that Bitcoin is still standing, despite attempts by U.S. federal prosecutors to shut it down since as early as 2012. In China, cryptocurrencies have been officially banned since 2019, but the country still accounts for about 46% of Bitcoin’s energy use.

Security

As shown in the original Bitcoin paper, there are solid mathematical reasons for trusting the integrity of a blockchain with sufficient participation. The economic incentive for attacking the Bitcoin blockchain is huge, and there’s no judicial body that will prosecute attackers. And yet, theft is practically non-existent.

Theft used to be fairly prevalent in the Bitcoin world, but it was almost exclusively a matter of attacking the layers between Bitcoin and fiat currency rather than attacking the blockchain itself. Since the security of these layers has improved, theft has almost entirely disappeared.

Immutability

Immutability means that once a block is on the blockchain, it can’t be altered. Putting something on a blockchain is a little like sending it into space. Immutability is a key property of any blockchain that stores a digital currency, such as Bitcoin. If the blockchain was vulnerable to manipulation, there could be no trust in the future value of the currency. An example is the Estonian health care records, where keeping an immutable record is the main purpose of the entire system.

Transparency

Transparency means that everyone has access to the full contents of the blockchain. With Bitcoin, for instance, this means being able to see the balance of every account.

As another example, the Ethereum blockchain hosts apps. Some of these apps take payments. Why should you trust you’ll get the service you paid for when anyone can post apps to Ethereum, and there’s no vetting, such as on Apple’s App Store? One reason for trust is that the entire source code of the app is available right on the blockchain for anyone to see. So, the potential customer may check for themselves that the app works as intended.

Fast

The confirmation time of a transaction depends on the blockchain design. For example, with Bitcoin, the median confirmation time is about seven minutes. Using a blockchain optimized for speed, such as Solana, the confirmation time is near-instant, on the same scale as, for instance, Visa.

Bitcoin may seem unwieldy by comparison, but when compared to traditional ways of securely transferring large amounts of transactions, it’s decidedly faster and cheaper. An important detail here is that most blockchains (including Bitcoin) allow users to include a voluntarily higher-than-minimal transaction fee, which is given to node operators as an incentive to include the transaction in the next block. Thanks to this, users can always pay the market price to expedite a time-critical transaction.

Reduced costs

The fact that anyone can set up a mining or node operation has another great benefit: market prices. The low barrier to entry means that when prices are higher, operators are incentivized to validate more transactions. Banks charge extra for expedience and extra volume by cloaking it as a high-end service. These services suffer from asymmetric information and, therefore, hidden costs. On the blockchain, an organization that wants to transfer a large amount quickly always pays the market price for this.

Components of a blockchain

A blockchain protocol includes several components needed to guarantee the decentralized system will have the desired properties. A good protocol should be robust to attacks and yet be open enough that it’s easy to participate in the operation. On top of this, the protocol should also guarantee whatever special properties the specific blockchain aims to have.

Blocks

The block is essentially the smallest component of any blockchain. Its purpose is to contain data, such as a transaction, log entry, or code, and be verifiable as a successor to its predecessor in the chain.

In the case of Bitcoin, for example, the block header contains a cryptographic hash of the previous block header, a time stamp, and a nonce. The body of the block contains transaction data, on average, about 2,800 transactions per block.

Miners

Miners provide safety for proof-of-work blockchains. For the network to accept a new block, the block header must be appended with a so-called nonce. A valid nonce makes the hash of the block begin with a predefined number of zeroes. Due to the properties of secure hashing algorithms (such as SHA-265), there’s no automatic way to find a nonce. The only way is to try a lot of random nonces and see if one of them is valid. This is what a mining computer does. Nowadays, this activity is subject to enterprise-level competition, with incumbents like Stronghold Digital Mining and Genesis Digital Assets.

Node operators

Node operators keep a copy of the distributed ledger. They’re responsible for carrying out the blockchain protocol according to specifications, including receiving, validating, and recording transactions. Currently, there are over 13,000 Bitcoin nodes and 2,500 Ethereum nodes.

Private blockchains

All that has been said in this article applies to public blockchains. In some situations, the problems that come with public blockchains are not worth it. This might be the case when the issuer wants to maintain top-down control of the blockchain network or when there’s simply not very much expected value from inviting others to develop solutions on it. Private blockchains instead rely on invite-only participation. There are some advantages and drawbacks to this.

The advantages of private blockchains include:

  • All participants are implicitly assumed to be trustworthy, so there’s no need for expensive consensus mechanisms.
  • The higher trust can make high-volume transactions cheaper.
  • The benefit of immutability still remains.
  • The benefit of transparency and traceability remains for trusted parties.

The drawbacks of private blockchains include:

  • A private blockchain isn’t fundamentally decentralized since a central authority controls who is allowed to write to and read from it.
  • Since market participants may be blocked from entering, the guarantees on market prices for the services have looser guarantees.
  • A private blockchain may still be compromised if one of the trusted nodes is compromised.

Examples of private blockchains include Ripple, a finance platform, and Quorum, an Ethereum-like solution for housing dApps in-house.

How a blockchain works using Bitcoin

The Bitcoin protocol defines a multi-step process for how transactions are recorded to the distributed ledger. The protocol is designed this way so that no central structure is required whatsoever, and it’s robust enough to withstand any single part failing or going offline for a while.

The steps are as follows:

1. An asset is purchased or sold on the blockchain

A Bitcoin transaction is created and signed by the user who’s sending Bitcoin to another user. The transaction contains information about the sender, recipient, and volume. The transaction is signed using the sender’s private key. This transaction is then broadcast to node operators in a peer-to-peer network. The broadcasting can be done on a best-effort basis, and it’s not necessary that all node operators receive every transaction.

2. The network confirms the event/transaction

Node operators receive incoming transactions. For each transaction, they have to verify that:

  • The transaction has really been signed using the purported sender’s private key. This can be done using the sender’s public key.
  • The sender has enough balance to make the transaction.

If the transaction doesn’t fulfill these criteria, the node operator will reject it. If a certain node decides to confirm the transaction despite it being invalid, other nodes can choose not to include a block that this node has created. The network maintains integrity as long as a majority of the computing power belongs to nodes who abide by the rules.

3. The event/transaction is added to as a block

The node operators bundle transactions into blocks (for Bitcoin, about 2,800 transactions per block). The node operators can choose to exclude or include specific transactions in the current block based on how many transactions are made at the moment.

In fact, nodes are perfectly free to exclude a certain transaction just because they feel like it; however, they’re incentivized to include transactions since they get a small fee for it. The size of this fee can be computed from the transaction data, and senders can increase it to get faster service.

4. The block is added to the chain of events

When a miner finds a nonce that is valid for a specific block, the validated block gets broadcasted to the rest of the network. Nodes accept the new block by adding it to their local copies of the blockchain. Miners implicitly accept the new block by trying to find a nonce to another block that points to the recently added one as its parent block.

Popular blockchains

There are uncountably many ways to define a blockchain, and we never know what variants will appear in the future. Right now, however, there are a few specific blockchains that stand out as foundational due to their earliness, innovative ideas, or market value. They include:

Bitcoin

Bitcoin was the first public blockchain and is also the biggest in terms of value. It’s mainly used as a distributed ledger to keep track of its currency, also called Bitcoin. As of October 2021, the market cap of Bitcoin was about $900 billion.

Ethereum

Ethereum is a blockchain where the blocks can contain code that gets executed by the nodes in the network. The code can be executed when it’s first posted to Ethereum, and it can also be executed by later calls to it that are posted to the blockchain.

These pieces of code are called distributed apps (dApps). For instance, the dApps can handle complex transactions that depend on several users giving clearance or even users voting.

One popular DApp protocol is Uniswap, which is a token exchange app that lets users offer their own tokens for sale against, for instance, ETH (the Ethereum native token) or BTC. Another example is Polymarket, where users can bet on future events and automatically get paid when the event is resolved. As of October 2021, the market cap of Ethereum is about $380 billion.

Solana

In public blockchains, there is a trade-off between the time it takes to reach consensus and how easy it is to send fake transactions, e.g., by double-spending. Solana improves the preconditions for this trade-off by taking time synchronization seriously. As a consequence, Solana can process transactions much faster than both Bitcoin and Ethereum.

There are ways to build on top of, for example, Ethereum and Bitcoin to execute transactions faster — these are called L2 protocols. Solana doesn’t need to rely on L2 protocols but can handle fast transactions natively; it’s an L1 solution. The market cap of Solana is over $46 billion.

Chainlink

The blockchain is a waterproof way of handling information stored on a distributed ledger. The problem is that most information isn’t stored on a distributed ledger. Take the exchange rate between USD and EUR, for instance.

By creating a market for data sources called Oracles, startup Chainlink posits a solution to this problem. The Chainlink protocol incentivizes Oracles to provide accurate data by rewarding fast and accurate data and requiring Oracles to stake some tokens that can be confiscated if they provide false data. The market cap for Chainlink is about $12 billion.

Dogecoin

Dogecoin is a digital currency that was created as a satire of blockchains or a meme. The author claims he made it in “like 2 hours.” Dogecoin currently has a market cap of about $30 billion.

How could a memecoin succeed? Here’s a hypothesis: When a new coin is launched, skeptics will try to pick holes in the coin’s business model. Most coins don’t survive this. But what if the coin in question doesn’t take its own business model seriously, and the value proposition is that people should buy it because wouldn’t that be a funny joke?

Dogecoin is an example of the creativity and potential latent in the crypto space because it shows us that the market can find a solution to the problems that face it, even when the solution is completely ridiculous.

Keep an eye on blockchain technology

The basic idea of blockchain is still very new, and new applications and variants are being vigorously explored. However, some remain skeptical amid the hype. In this early stage, the models are still being developed, and some of the early attempts seem harmless or less-than-serious.

But the fact that around 46 million Americans own a share of Bitcoin is a sign that there’s already widespread trust in the technology. And there’s a good reason for this. Bitcoin and Ethereum have withstood constant attacks without a legal system to back them up, only relying on their technology. With trust established, it seems more likely that blockchain technology will deliver on its promise to disrupt and improve a wide range of industries. And thanks to a sound technological foundation, we can be certain this disruption will make these industries more transparent, valuable, and secure.

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