Breaking down blockchain technology

If you have a nodding acquaintance with investing or finance, chances are you've heard of blockchain, the technology that powers cryptocurrencies. It's become somewhat of a buzzword, with blockchain projects popping up all over the place, from small unknown startups to huge companies like Facebook and Bank of America. (Bank of America has filed nearly 50 patents for blockchain-related projects.)

So what exactly is a blockchain? Here's a short overview, and a bit of history to go along with it.

Blockchain was developed by a person — or group of people — known as Satoshi Nakamoto. The true identity of Nakamoto remains an open question, as the name is a pseudonym. A member of a group called the cypherpunks, Nakamoto set out to develop a technology that would decentralize financial transactions and information. This was largely in response to the global economic crisis of 2008. Since centralized finance (Wall Street, banks) was responsible for the financial meltdown, Nakamoto set out to create an alternative paradigm of storing value that didn't rely on central authority or trust in institutions.

By decentralizing finance, Nakamoto hoped to take power out of established institutions like banks and governments and put it back into the hands of the people. To do this, he created the blockchain.

Blockchain is a distributed digital ledger of transactions that are permanent and unalterable — it's virtually impossible to tamper with blockchain data once it's been recorded on the ledger. These transactions can include the exchange of cryptocurrency, such as Bitcoin, or other items of value like health records and instant messages. This is done on a peer-to-peer network of computers, which are also called nodes, that is distributed globally.

The technology removes the need for intermediaries, or middlemen, from transactions. In the case of a financial transaction, this middleman would normally be a bank or a platform like PayPal (or its subsidiary Venmo). In the case of health records, the middleman might be a hospital or medical provider. With intermediaries, transactions are potentially slower and always more costly, often requiring high fees. (If you've ever had to transfer medical records from one provider to another, you know what a headache such a task can be — it can take days and multiple phone calls!) But on the blockchain, transactions can happen much more efficiently and at a far lower cost.

Without third parties managing transactions or storing data, blockchain is a trustless system, meaning all information is known for a fact, at all times. You no longer have to place your trust in established entities like banks.

Multiple blockchain networks exist — there isn't just one. Bitcoin was the first blockchain to appear, and other cryptocurrencies run off the Bitcoin blockchain. Other blockchains include Ethereum, and there are many other blockchains in development.

An actual block on the blockchain is just a digital file that records transactions. Multiple transactions are stored in one block, so you can think of each block as a page in a financial ledger — a long list of transactions can be recorded on a page, but eventually the page will fill up, and you'll need a new page. In the case of blockchain transactions, when it runs out of room a new block — or digital file — will be created. Though the transactions are viewable to anyone on the blockchain network, they are encrypted, so no one knows the identity of those making the transactions.

Each block on the chain has its own identity, which is called a hash, and each block contains the hash of the previous block, sort of like how each brick in a wall is supported by those before it. The hash is like a fingerprint, and it's just a long combination of numbers and letters. If someone tries to tamper with a block, this will change its hash, which then will change the hash of all succeeding blocks in the chain. Because this happens, it sets off an immediate alarm among every single node in the blockchain, which, in the case of the Bitcoin blockchain, is around 11,000. They'll reject this change as invalid, and the network will self-heal.

When a transaction is made on the blockchain, such as a bitcoin payment, the entire network of nodes has to validate it. Once verified, the transaction will be added to a block along with other transactions. This validation is known as a consensus, and this built-in system of checks-and-balances is a critical component of blockchain technology and what makes it so secure.

When one node completes a transaction, it sends it to a neighboring node that sends it to other nodes until every node on the chain has stored the transaction. Each node should have a record of all the blocks on the chain and their transactions in the same order.

Part of blockchain's security is that it's built on powerful cryptography. In order to create a hash for a new block, the computer has to solve a complex algorithm, and it's very difficult to get the right answer on the first go. The computer must calculate the algorithm over and over and over — hundreds, if not thousands, of times — to get a correct hash. This requires a lot of time and a tremendous amount of energy, which is costly both financially and environmentally. In fact, energy consumption is one of the chief concerns mounting about blockchain technology, but there are blockchain developers and projects out there trying to change this.

People who operate nodes that solve these algorithms are called miners on a Proof-of-Work (PoW) blockchain network, which is what powers Bitcoin and Ethereum. All the miners on the network compete to create one block, and the first miner to successfully create a hash — and therefore a new block — is rewarded in cryptocurrency. The problem with this is that thousands of nodes are consuming energy to create a block.

So miners are competing against each other to create hashes for blocks in the blockchain network. This particular consensus protocol is called Proof-of-Work. With PoW consensus, there is a limited amount of cryptocurrency, and this is why the price of cryptocurrency should, theoretically, increase over time. For example, only 21 million bitcoins exist, and roughly four million have yet to enter circulation. The number of bitcoins in circulation will increase as mining continues but will not exceed 21 million. Because of this limitation on volume, the value of Bitcoin should continue to rise, which is why people have purchased them as investments.

But PoW is not the only system for creating new blocks.

A more energy-efficient way to create blocks on the chain is something called Proof-of-Stake (PoS). Here, miners are pre-chosen to solve the algorithm to create a new hash in a specified amount of time based on the amount of coins they own, so just one node will do the calculations as opposed to thousands to create a new block. On a PoS network, the nodes and people who operate them are called forgers. Forgers are not rewarded in cryptocurrency for solving the hash — instead they receive transaction fees. Not dissimilar to a middleman fee, but contained within the blockchain.

PoS is becoming an increasingly popular model for new blockchain development.

Blockchain technology is touted for its security — this is one of its essential benefits. This is why developers are creating systems for digital voting on the blockchain and why financial transactions can take place on the network. Since there's no centralized hub for data storage, it can't be easily hacked, and because nodes must achieve a consensus, it can't be easily tampered with.

This doesn't mean there aren't some risks as far as security goes. A few potential risks are Sybil Attacks and Denial-of-Service attacks, but there are ways to mitigate these, so they rarely occur.

It's important to note that though there have been well-publicized Bitcoin hacks that have taken place since its inception, these had nothing to do with flaws in blockchain technology. The hacks, including the infamous Mt. Gox hack in 2014, occurred in centralized exchanges where thousands of people stored their coins online. This is not the safest way to store cryptocurrency — it’s best to store it in a personal wallet, be it a software wallet, hardware wallet, or paper wallet.

There are multiple applications for blockchain outside of cryptocurrency, which can include secure online voting, peer-to-peer banking, smart contracts, energy grids, media distribution, along with others we have yet to conceive. Given this, blockchain is widely considered a foundational technology, not a disruptive technology. Like electricity or the internet, it may have the potential to upend multiple industries and entities given it can change how we exchange and store valuable information.  

Some blockchain evangelists claim the technology is a panacea for all the world's ills, that it will save the planet and dismantle power structures and oligarchies altogether. This may or may not be true. Still, pushing toward decentralization, no matter the context, will inevitably lead to some restructuring of power. Given blockchain is still nascent, the wide ranging effects of this decentralization will only be evidenced over time.

This educational article is provided by Republic to help its users understand this area of the market, it should not be construed as investment advice as it is impersonal, disinterested and was produced by Republic for Republic’s users, without remuneration received or expected.