Digital coins or Cryptocurrencies such as Bitcoin are based on a technology called blockchain. Each cryptocurrency may be different but they all use blockchains to record transactions. So, what is a blockchain? How do they work? What problems do they solve? And how can they be used? Like the name indicates, a blockchain is a chain of blocks that contain information. You can think of a blockchain as a distributed ledger that is open to anyone. Once data gets recorded inside a blockchain, it becomes very difficult to change. Think of a blockchain like a database that stores information. However, unlike a traditional database where all the information is centralized, a blockchain distributes this information across the network. In other words, a Blockchain is decentralized so the same information gets stored across many nodes (i.e. computers) within the network. Each blockchain on every node are exact duplicates of each other.
What’s even more interesting is that you can apply blockchain technology to much more than just digital currencies. The creation of blockchain technology piqued a lot of interest and soon others realized that this technology can be used for other things like storing medical records, creating a digital notary or even collecting taxes.
As you can see, blockchains are constantly evolving. For example, one recent developments is the creation of smart contracts. These contracts are simple programs that are stored on the blockchain and can be used to automatically exchange coins based on certain conditions.
Read below to get a more detailed explanation of blockchain technology. You’ll realize that blockchain has the potential to be applied to anything that requires trust and security. In fact, it may revolutionize how normal, everyday transactions are recorded.
How Blockchains Work
Blockchain technology was originally described in 1991 by a group of researchers. They initially intended to use blockchains to timestamp digital documents to make it impossible to backdate or to tamper with them. This technology went mostly unused until it was adapted by Satoshi Nakamoto in 2009 to create the Bitcoin digital cryptocurrency.
So how does this work? Let’s take a closer look at a block. Each block in a blockchain consists of the following elements:
- The hash (i.e. fingerprint) of the current block and
- The hash from the previous block.
The data that is stored inside the block depends on the type of blockchain. The bitcoin blockchain, for example, stores the details of a transaction. This information includes:
- The sender of the bitcoin,
- Who the Bitcoins are intended for (the receiver) and
- The amount of coins.
The Hash of the Current Block and the Previous Block
Each block has a hash, which is similar to a fingerprint. A hash identifies a block and all of its contents and it’s always unique – just like a fingerprint.
Once a block is created, its hash gets calculated. Changing something inside the block will cause the hash to change. So, hashes are very useful when you want to detect changes to blocks. If the fingerprint of a block changes, it’s no longer the same block.
The third element inside each block is the hash of the previous block.
This effectively creates a chain of blocks and it’s this technique that makes a blockchain so secure.
How Blockchains Are Used to Prevent Tampering
So how are blockchains used to secure transactions? This is done by combining the following elements:
- Hash technology,
- A concept called Proof-of-Work and
- Distributing countless copies of each block across a network
Let’s look at an example to see how this is done. Imagine you have a chain of three blocks.
Current Hash 1Z8F
Previous Hash: 0000
Current Hash: 6BQ1
Previous Hash: 1Z8F
Current Hash: 3H4Q
Previous Hash: 6BQ1
As you can see, each block has its own hash and the hash of the previous block. Block 3 points to block 2 and block 2 points to block 1. The first block is called the Genesis block because it cannot point to any previous blocks.
Let’s say that you tamper with the second block. This causes the hash of the block to change (for example, hash 6BQ1 now becomes H62Y). This in turn will make block 3 and all following blocks invalid because they no longer store a valid hash of the previous block. So, changing a single block will make all the following blocks invalid.
Proof of Work
Using hashes is not enough to prevent tampering, however. Computers these days are very fast and can calculate hundreds of thousands of hashes per second. You can effectively make your blockchain valid again by tampering with a block while recalculating all the hashes of other blocks as well.
To mitigate this, blockchains use something called Proof-of-Work, which is a mechanism that slows down the creation of new blocks. In bitcoin’s case, it takes about 10 minutes to calculate the required proof of work and add a new block to the chain. This mechanism makes it very difficult to tamper with the blocks because if you tamper with one block you will need to recalculate the proof of work for all the following blocks.
Therefore, the security of a blockchain comes from its creative use of hashing and the proof-of-work mechanism. But there is one more way that blockchains secure themselves and that is by being distributed.
Instead of using a central entity to manage the chain, blockchains use a peer-to-peer (P2P) network and everyone is allowed to join. When someone joins this network, they add what is called a “Node” to the network and they get a full copy of the blockchain. A node is a powerful computer that runs the software necessary to keep blockchains running by participating in the relay of information. Anyone can run a node as long as they download the software required to run the blockchain and are willing to offer the storage space and energy required by the blockchain.
Since each node has an exact copy of every block on the network and they’re running the required software to enable the blockchain to work, a node is therefore used to verify that everything transaction is valid.
You can look at a blockchain like a database that stores information. However, unlike a traditional database where all the information is centralized, a blockchain distributes this information across the network. In a traditional database, if you want to retrieve some information you will need to connect to a central repository. This creates an inherent weakness since all the information is centralized. As you can imagine, because everything is stored in a central repository it becomes important to put a lot of security to protect that central database and to make sure that the information stored there is kept safe. One can imagine what would happen if this central database gets corrupted or is no longer valid? In the best cases may have a backup you can use but if someone corrupts the database, the information stored there will no longer be reliable.
Blockchain on the other hand is decentralized so the same information is stored across every node within the network. Each blockchain on every node are exact duplicates of each other. This way there can be thousands of duplicates of the blockchains all around the world. So, if one of them becomes corrupt the damage to the system is minimal because thousands of other nodes have the correct information stored on them. All of the nodes that store the correct information on their blockchains will reject the one with corrupt information.
Therefore, based on everything explained above, the properties of blockchains include the following:
- Transactions are near real time,
- No intermediaries are necessary to validate transactions,
- All transactions are recorded in a distributed ledger,
- All transactions are irreversible,
- The transactions are extremely resistant to censorship.
Let’s see what happens when someone creates a new block. That block is sent to everyone on the network. Each node then verifies the block to make sure that it hasn’t been tampered with. And if everything checks out, each node adds this block to their own blockchain. All the nodes in this network create what’s called “consensus.” In other words, they agree about what blocks are valid and which aren’t. Blocks that are tampered with will be rejected by other nodes in the network. So, to successfully tamper with a blockchain, you will need to tamper will all the blocks on the chain, redo the proof of work for each block and take control of more than 50 percent of the peer-to-peer network. Only then will your tampered block become accepted by everyone else. This is almost impossible to do.
How Blockchain Transaction Differ from Traditional Transactions
In the current financial system, if you buy a product using a credit card, you’ll need to go through several intermediaries. For example, you’ll need to ask your credit card company to pay the seller. In order for the seller to be able to accept your credit card, they will need to use a merchant account that enabled credit card processing. What’s more, before the money gets deposited into the seller’s bank account, several more intermediaries will need to get involved in order to make the transaction work. All of these intermediaries take a transaction fee because they each own a part of the transaction process. In this model, you and the seller need to pay these intermediaries for the services they render in order to make this transaction possible.
On the other hand, if you had paid cash for the purchase, none of these intermediaries would have been required. That’s because in order to settle the transaction all you would have needed to do is pay cash in return for the goods.
Paying for transactions using cryptocurrencies such as Bitcoin is almost like paying cash because the blockchain technology almost eliminates the need for any intermediaries. That’s what the blockchain is for. It verifies each transaction and enabled the system to work efficiently without any middlemen.
In other words, in the cryptocurrency world we store transactions inside the blockchains. Let’s say I want to give Bob three Bitcoins. The way this is done in the bitcoin world is through this process:
- Step 1: Agree on a transaction
- Step 2: Create a transaction message
- Step 3: Sign the transaction message
When I give Bob the three Bitcoins the transaction is recorded inside the block. This block then gets added to the blockchain and every node in the network gets an exact copy of this block.
Let’s say a couple of minutes later Bob decides that he wants to spend his bitcoins. He decides that he wants to give one Bitcoin to Alice. This new transaction gets recorded inside a new block. This new block gets spread across the network just like all the preceding blocks. But before other nodes on the network validate this new block they will verify that Bob actually had a bitcoin to give to Alice. Therefore, they will examine the previous blocks in the network and see that Bob actually received 3 bitcoins so it’s ok for him to spend 1 bitcoin. Since everything checks out, all the nodes will immediately accept this transaction on the network.
In fact, everything that is written in a blockchain is transparent and you can actually see it live.
So, what does this mean? It means that in the new blockchain system you no longer need any intermediaries. In the old system each intermediary had to store a piece of the transaction. In the blockchain system, everything gets stored across the blocks in real time making it simple to easily check everything in real time.
Blockchains have the potential to revolutionize how we record many types of transactions. Because blockchains are distributed ledgers, you can use blockchain technology to validate anything that requires trust and security – whether that is the exchange of digital currency or the management of medical records or housing permits
Blockchain technology is constantly changing and becoming more advanced. The development of smart contracts has made the application of blockchains much more useful. We haven’t even scratched the surface of where this technology can take us. The potential of blockchain technology is yet to be discovered.
Business Consulting Services: If you’re a small business owner looking to start or improve an online business then let me show you how to benefit from my experience. I have helped several online resellers grow their businesses by developing an online strategy to sell on Amazon, eBay or any other marketplace. Call me at 310-574-2541 or email me at Pez@Pezlogic.com for a complimentary business review.