What is Blockchain Technology? How Does it Work?

Introduction

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Let’s talk about what blockchain technology is. 

Why was Blockchain designed? 

How does Blockchain help in accountability? 

How does Blockchain help in decentralisation?

We translate all concepts about Blockchain Technology into plain English, so even if you have no technical background, you will understand everything. 

By the end of this course, you will know more about Blockchain Technology and how it works than 99% of the population. 

Without wasting any time, let dive into the topic, “What is Blockchain Technology? How Does it Work?“.

What is Blockchain Technology?

Is it “the next big thing”? 

Are you missing out on a once-in-a-lifetime opportunity when some startup wants you to invest in their Blockchain-based venture? 

Well, stick around. In this article, we will answer these questions and more. 

Today’s topic is Blockchain and the exciting world of blockchain technology. 

Hopefully, by the end of this article, you will understand precisely what blockchain technology is and why it is tough to separate Bitcoin. 

Why Blockchain was Designed?

Before we understand how Blockchain technology works, we need to understand what problems it was designed to solve, so let’s take a step back and let me ask you a question…

How do we tell if something is fake or real in today’s world?

For example, a dollar bill, a driver’s license or a vote in the election. How do we determine whether it is valid or not?

The answer?

We keep a record of it.

For example, each dollar bill has a serial number that the bank records.

The DMV records your driver’s license number, and voting records are used to track who voted and who did not so that the same person won’t be able to vote twice.

Whenever you want to verify that a document is legit, you look it up with the relevant authority.

We even have Notaries licensed by the government to act as witnesses to attest and record the validity of pieces of information or identities.

You will notice there is one thing that all of these mechanisms have in common – they are all centralized.

This means there is a central authority, whether a bank, state office, or person, that can issue and validate the information.

With Power, Comes Corruption

These central authorities have a lot of power, and as you know, power may sometimes corrupt.

So, what happens, if one of these authorities wants to change the facts or even maybe change history a little bit?

This may sound far-fetched, but even our world history is just a record kept by historians in a centralized manner.

The phrase “The victors write history” tells us that those in power can sometimes distort facts.

If you don’t think that’s possible, here is a real-life example.

Today, most money is just a record of who owes what to whom.

Due to the subprime crisis in 2008, almost a thousand companies in the US received over 630 billion dollars that never existed before!

Other companies had debts wholly removed!

Well, some would argue this bailout was justified, but you can’t deny that someone decided to change the records of how much money was owed.

Blockchain Helps in Accountability

This is why Bitcoin was born.

It was the first form of money that removed the need for a central authority.

Its records are kept by everyone, not just by central banks.

And when everyone is keeping track and verifying the facts, you can no longer change the ledger of transactions whenever something doesn’t add up or because it is more convenient.

You have to start being accountable.

What is Decentralisation?

Money isn’t the only place where decentralization can play a role.

Do you remember those big Encyclopedia books we used to rely on when it came to research?

Encyclopedia Britannica employed a hundred full-time editors and over 4,000 contributors to publish what we considered the authority on knowledge.

Just imagine the power the editors of these books had in deciding what was worth mentioning, condemning, condoning or ignoring.

Well, the last volume of Encyclopedia Britannica was published in 2010.

Today, information is much more decentralized, with over 130 thousand active editors maintaining different Wikipedia pages.

The risk of any of them “going rogue” unnoticed is much smaller since each edit is public and can be verified by anyone.

Decentralization reduces the risk of corruption, fraud and manipulation.

Blockchain technology is a new and innovative way to implement decentralization.

Blockchain – A Solution for Centralisation?

In a nutshell, Blockchain technology is a solution to the problem of centralization.

It is a system for keeping records by everybody, without any need for a central authority – a decentralized way of maintaining a practically impossible ledger to falsify. 

When so many eyes are watching and verifying everything being done, it is tough to break the rules unnoticed. 

Understanding the Term “Blockchain”

You might be wondering why it is called Blockchain. 

Well, imagine we are maintaining a shared ledger with many pages of records. 

Each page begins with a sort of summary of the page before it. 

If you change a part of the previous page, you will also have to change the summary on the current page. 

So, the pages are linked or chained together. 

In technological terms, pages are called blocks.

And since each block is linked to the previous block’s data, we have a chain of blocks or a Blockchain. 

Satoshi Nakamoto

Many people think that Satoshi Nakamoto, the mysterious inventor of Bitcoin, created Blockchain Technology. 

Technically, he only created the first real-life implementation of it – Bitcoin. 

The word blockchain is never even mentioned in Satoshi’s original whitepaper. 

The closest he comes to saying Blockchain is a “chain of blocks”. 

How Does Blockchain Work?

Now that you know what blockchain technology is, we still have two critical questions to answer –

How does it work?

And is blockchain going to change our future? 

Let’s start with the first question. 

Another way to ask this question would be –

How do I create a system that allows the creation, verification and updating of records by everybody? 

Well, there are four elements a blockchain needs to have a life of its own. 

Requirements of Blockchain

1. Peer-to-Peer Network

The first thing required to support a blockchain is a peer-to-peer network – A network of computers known as equally privileged nodes. 

It is open to anyone and everyone. 

This is basically what we already have today with the internet. 

We need this network so that we will be able to communicate and share remotely. 

The second ingredient is cryptography.

2. What is Cryptography?

Cryptography is the art of secure communication in a hostile environment.

It allows us to verify messages and prove the authenticity of my messages, even when malicious players are around. 

We need cryptography because of the first element.

Remember, we mentioned that anyone could participate in this network – including bad actors.

It is excellent that we can communicate, but we also need to make sure my communication comes through unaltered. 

The third element is a consensus algorithm.

3. Algorithm

You can switch the technical word “algorithm” with the word “rule”. 

This means that we need to agree on rules for adding a new page, also known as a block, to our records. 

There are many types of consensus rules. 

In Bitcoin’s case, we use a consensus algorithm known as “Proof of Work”.

What is Proof of Work?

This algorithm states that, for someone to earn the right to add a new page to our ledger, they need to find a solution to a math problem that requires computational power. 

Computers around the network run calculations to solve math problems and, in doing so, consume a lot of energy. 

In other words, they do a lot of work. 

That is why when one of them finds the number that solves the problem and displays it to the network, they are displaying a “proof of work”. 

Think of it as the node’s way of saying:

“Hey, I spent quite a bit of energy here in solving this problem first, so I’m entitled to write the next page”. 

As I mentioned before, other consensus algorithms don’t require so much energy.

This is just the algorithm type that the Bitcoin blockchain employs. 

There are pros and cons to different algorithms, but to run a decentralized ledger, you will need to choose one; otherwise, reaching a consensus with so many people in the network will be tough. 

Finally, our last element is punishment and reward.

4. Punishment and Reward

This element is actually derived from game theory, and it makes sure that it will be in people’s best interest always to follow the rules. 

So far, we have set up a network that can communicate securely and follows the rules for reaching a consensus. 

Now we will glue these elements together by rewarding people who help us maintain our records and add new pages. 

This reward is a token, or coin, awarded each time a consensus has been reached and a new block is added to our chain. 

On the other hand, bad actors who try to trick or manipulate the system will lose the money they spent on computational power, or their coins can be taken away from them. 

Ultimately, the vital thing to remember is that the punishment and reward system works on psychological behaviour. 

It turns the system’s rules from something you need to follow into something you will want to follow since it will be in your best interest to do so. 

This was just a very high-level explanation of what a blockchain consists of.

If you want to dig a little deeper into this process, check out our other articles on Bitcoin mining, part of our 7 day free crash course on Bitcoin. 

So there you have the four elements for creating blockchain technology – a peer-to-peer network, cryptography, a consensus algorithm and punishment and reward. 

However, a fifth element can’t be synthesized… market adoption. 

5. Market Adoption

We can have a group of five people sharing a ledger with a consensus algorithm, but it doesn’t make it decentralized since not enough people are a part of the system. 

Moreover, if there’s no adoption, there’s no value to our coin, and the fourth element of punishment and reward isn’t very effective. Only once you achieve critical mass in the number of users does a blockchain become truly decentralized and immutable.

And at that point, the coin of that blockchain usually begins to appreciate. 

It is hard to say what triggers mass-scale market adoption. 

Things started using the dark web in Bitcoin’s case, where people used Bitcoin to pay for drugs and other illegal stuff. 

But since then, more people have begun to research Bitcoin and blockchain and have seen the benefits they offer, either in practice or as an investment. 

So there you have it, the five elements of a truly open, public, decentralized blockchain. 

Decentralised Blockchains

Until today, only a handful of blockchains with over 1,000 truly independent participants can be considered decentralized – Bitcoin, Ethereum, Cardano and Monero, to name a few. 

You are right if you think it sounds like a lot of hard work to put a blockchain in motion.

But this is where Ethereum comes in. 

Ethereum is a “Do It Yourself” blockchain, with all five elements already in motion. 

All you need to do is build the right solution on top of it. 

But that’s a different whiteboard episode, you can check it out later. 

Now let’s move on to another term you may have heard – a private or closed blockchain. 

Private or Closed Blockchain

This term refers to companies that screen and limit the players who can participate in their blockchain. 

It is a bit like how the internet, which is open to everybody and anybody, is different from an intranet – an internal network of company computers. 

While we assume some companies will find value in running private blockchains to improve their internal processes, it is far from anything exciting as it has nothing to do with decentralization. 

Let’s compare open or public blockchains to closed, private ones to emphasise this a bit more. 

Open or Public Blockchain vs Closed or Private Blockchain

A public blockchain is open to everybody, and it is transnational and borderless.

It is censorship-resistant, and it doesn’t require any 3rd party.

It is also neutral – there is no such thing as a “good”, “bad”, “illegal” or “legal” transaction; there is only a “valid” or “invalid” one.

On the other hand, a private blockchain is limited to authorized participants only, and a handful of entities govern it.

In the words of Andreas Antonopoulos, in most cases of private blockchains, you don’t need a blockchain; you can share a spreadsheet between the participants.

The idea of blockchain was to decentralize a process through the general public, which is precisely the opposite of what a private blockchain does.

On the other hand, the features of a public blockchain create enormous benefits.

There is no single point of failure.

The records are immutable, also known as tamper-proof.

And finally, it is censorship-resistant, so you can’t remove a record or stop it from getting published – as long as it follows the consensus rules.

Before we end today’s lesson, we still have one central question to answer.

Is Blockchain Technology the Next “Big Thing”?

We assume you may have heard of different startups using blockchain technology to solve some problems.

In most cases, when we hear of such a company, we ask two questions:

First, are they using a public or private blockchain? 

Since if they’re not using a public blockchain, there is nothing very disruptive here.

Second, do they even need a blockchain? 

If you remember, we discussed the dangers of centralization at the beginning of this lesson.

But these dangers are only meaningful if there is a lot at stake.

For example, the queue to the pharmacy is managed in a centralized manner, but we don’t care since there is not a lot at stake, and it is more efficient that way.

Blockchain technology is very good at decentralizing, but it is also inefficient, slow and energy-consuming.

For example, on average, Bitcoin’s network takes 10 minutes to confirm a transaction.

Not the ideal waiting time for buying a cup of coffee at 7-11.

The only reason to choose Blockchain technology as your solution is if your problem is centralization.

If you don’t need to decentralize something, you probably don’t need to use blockchain technology and are better off with some centralized solution.

It will probably work better.

History of Blockchain

Although blockchain is a new technology, it already boasts a rich and exciting history. The following is a brief timeline of some of blockchain development’s most important and notable events.

2008

• Satoshi Nakamoto, a pseudonym for a person or group, publishes “Bitcoin: A Peer-to-Peer Electronic Cash System.”

2009

• The first successful Bitcoin (BTC) transaction occurs between computer scientist Hal Finney and the mysterious Satoshi Nakamoto.

2010

• Florida-based programmer Laszlo Hanycez completes the first-ever purchase using Bitcoin — two Papa John’s pizzas. Hanycez transferred 10,000 BTCs, worth about $60 at the time. Today it’s worth $80 million.
• The market cap of Bitcoin officially exceeds $1 million.

2011

• 1 BTC = $1USD, giving the cryptocurrency parity with the US dollar.
• Electronic Frontier Foundation, Wikileaks and other organizations start accepting Bitcoin as donations.

2012

• Blockchain and cryptocurrency are mentioned in popular television shows like The Good Wife, injecting blockchain into pop culture.
• Early Bitcoin developer Vitalik Buterin launched Bitcoin Magazine.

2013

• BTC’s market cap surpassed $1 billion.
• Bitcoin reached $100/BTC for the first time.
• Buterin publishes an “Ethereum Project” paper suggesting that blockchain has other possibilities besides Bitcoin (e.g., smart contracts).

2014

• Gaming companies Zynga, The D Las Vegas Hotel, and Overstock.com accept Bitcoin as payment.
• Buterin’s Ethereum Project is crowdfunded via an Initial Coin Offering (ICO), raising over $18 million in BTC and opening up new avenues for blockchain.
• R3, a group of over 200 blockchain firms, is formed to discover new ways blockchain can be implemented in technology.
• PayPal announces Bitcoin integration.

2015

• The number of merchants accepting BTC exceeds 100,000.
• NASDAQ and San Francisco blockchain company Chain team up to test the technology for trading shares in private companies.

2016

• Tech giant IBM announces a blockchain strategy for cloud-based business solutions.
• The government of Japan recognizes the legitimacy of blockchain and cryptocurrencies.

2017

• Bitcoin reaches $1,000/BTC for the first time.
• The cryptocurrency market cap reaches $150 billion.
• JP Morgan CEO Jamie Dimon believes in blockchain as a future technology, giving the ledger system a vote of confidence from Wall Street.
• Bitcoin reaches its all-time high at $19,783.21/BTC.
• Dubai announces its government will be blockchain-powered by 2020.

2018

• Facebook commits to starting a blockchain group and hints at the possibility of creating its cryptocurrency.
• IBM develops a blockchain-based banking platform with large banks like Citi and Barclays signing on.

2019

• China’s President Ji Xinping publicly embraces blockchain as China’s central bank announces it is working on its cryptocurrency.
• Twitter & Square CEO Jack Dorsey announces that Square will be hiring blockchain engineers to work on the company’s future crypto plans.
• The New York Stock Exchange (NYSE) announces the creation of Bakkt – a digital wallet company that includes crypto trading.

2020

• Bitcoin almost reaches $30,000 by the end of 2020
• PayPal announces it will allow users to buy, sell and hold cryptocurrencies.
• The Bahamas becomes the world’s first country to launch its central bank digital currency, fittingly known as the “Sand Dollar.”
• Blockchain has become a key player in the fight against COVID-19, mainly for securely storing medical research data and patient information.

Conclusion

To sum it up, Blockchain technology is truly disruptive, but at the moment, only a handful of use cases require it.

So the real question is this: is our world ready for more complex blockchain implementation at the current moment than what Bitcoin already offers?

In the early 2000s, there were many Amazons, Googles and Facebooks that never caught on, for the changes they presented… And today, many of these blockchain startups face the same fate.

Hopefully, by now, you understand what Blockchain technology is – an open, censorship-resistant method for managing records by everybody, making them practically impossible to falsify.

It is a solution to the problems centralization presents.

I also hope that whenever you hear the term “blockchain technology” in the future, you will know to take it with a grain of salt and ask the right questions.

You may still have some questions.

If so, leave them in the comment section below.

 

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