What is blockchain and how does it work?

March 2, 2021 by Libonomy

Blockchain is one of the hottest new technology trends and is best known through Bitcoin (BTC). Starting life as a form of Internet currency, the first crypto coin is a formidable financial instrument with a market capitalization near US $1 trillion (February 2021).

In this guide, we explore the basic features of cryptography-based assets and databases, and their biggest strengths and weaknesses. We also answer the question "what is blockchain?" by covering its key features and use cases, give you a brief look at some better-known startups, and examine some of the real-world implications and applications of this new technology.

What is Blockchain Technology?

Blockchain technology is a tool combining cryptographic encryption with distributed network communication to ensure safe and secure interaction between two or more participants over a peer-to-peer network. It is called a blockchain because it is made up of data blocks that link to create a chain.

The first block in a new blockchain is known as a genesis block. This and all subsequent blocks are recorded on the blockchain ledger. The data contained in these blocks is immutable and cannot be changed without significant resources.

A block contains transaction data. As transactions are made with a user's private key, a kind of digital signature, the data is recorded in a block. New blocks are added to the chain when the previous block becomes full, while the data in the previous block are used to create a cryptographic hash for the next block.

As each new block is created, a copy of the blockchain is distributed to the entire network of nodes around the world, thus creating a secure, decentralized ledger of all transactions. No data from a previous block in the distributed ledger, a record of every transaction on a blockchain, can be changed without creating immediate disparities.

A Short History of Blockchain

The first mentions of distributed secure communication date back to the '80s, but the first application of distributed ledger technology (DLT), cryptographic keys, and proof of work (PoW) was Bitcoin. Proposed in late 2008 and launched in early 2009, Bitcoin first appeared as an idea in a now-iconic white paper.

Pseudonymously written by Satoshi Nakamoto, the Bitcoin white paper applied blockchain technology to create a peer-to-peer electronic cash system. This system sought to disrupt legacy financial systems by allowing an individual to transact with other people without the need for a third party, in this use case, a bank.

Instead of the high transaction fees charged by banks to move money from one place to another, distributed ledger technology allowed transactions between people with far lower transaction fees.

The first attempts at using blockchain were payments made between anonymous parties around the world using TCP/IP nodes on a P2P network. These payments were made wallet to wallet rather than from bank account to bank account.

Thanks to the success of Satoshi Nakamoto and Bitcoin, other projects soon followed. Some of the most prominent projects using blockchain technology include Ethereum, Litecoin, and Monero. Later, the original Bitcoin blockchain was made to fork. The new blockchains preserved the record of transactions and balances until the block containing the fork. Those versions included Bitcoin Cash, Bitcoin Gold, and later, BSV.

The launch of Ethereum also saw the birth of smart contracts, which add functionality and versatility to the distributed ledger technology that underpins blockchain.

Blockchain evolved two chief models of securing the network - proof of work (PoW) and proof of stake (PoS). The PoW model includes difficult computational work and significant computing power, while PoS requires a large investment in coins that allows the wallet to participate in block production.

Proof of work blockchains, like Bitcoin, require the availability of computing power. Usually, a massive amount of computing power is required to process blocks and solve the cryptographic hashes required to mine them.

Some miners have massive mining farms full of computers that process blocks. It is possible to become a Bitcoin miner with a high-end graphics card, although the chances of successfully mining a block would carry similar chances as winning the lottery.

Due to the massive amount of computational power required, proof of work blockchains, like Bitcoin, can operate slowly. However, SegWit and other side chain technologies seek to address this issue by decreasing the size of the data required for each transaction, thus speeding up processing.

What is the Main Purpose of Blockchain?

The main purpose of a blockchain system is to achieve transactions between participants without the need for a central authority, such as a notary or signatory, to approve the transaction. Instead, the rules of the blockchain ensure neither party can cheat in the exchange of coins. For Bitcoin users, it is practically impossible to double-spend coins.

A proof of work blockchain structure ensures each transaction record is immutable. Simply put, there is too much computing power required to produce new blocks on-chain and include that in the distributed ledger. It would be prohibitively expensive, based on computing power alone, to make any alteration to or reverse a transaction on the Bitcoin blockchain.

A person attempting double-spending would have to harness the computing power of more than 51% of all machines on the blockchain network they wanted to attack. It is entirely possible that the expense of the attack would outweigh the potential reward.

Another feature of blockchain structure is its ability to broadcast every transaction record around the world. The network includes nodes that communicate through TCP/IP and store transactional history as a copy of the blockchain.

How Does Blockchain Work? - A Guide

The life cycle of a transaction made on a blockchain includes:

  • The end-user requests a transaction;
  • The transaction is sent and waits in the mempool;
  • The transaction is included in a block, which is broadcast between nodes;
  • More nodes confirm the valid transaction, which is reflected in the receiver's wallet.

 

As a reward, the miner that discovered the block receives a fixed reward plus transaction fees - the collected small payments from all people that sent funds on that platform. Other miners then update their nodes with the latest block of transactions across a peer-to-peer network.

A blockchain requires several key players to make it a functional network for transactions, communication, and smart contracts. As a guide, the players include:

  • Miners - solve hashes to produce a block header;
  • Node operators - broadcast and receive the latest transactions;
  • End-users - send out transactions and update their wallets.

 

A key element to block discovery is hashing, which is the testing of possible block headers against a predetermined number. Finding the right hash value is energy-intensive and requires specialized machines for efficient performance. For example, the Bitcoin network relies on miners operating specialized rigs that expand hashing to 150 quintillion operations per second.

Miners run nodes that are connected repositories that hold a copy of the blockchain. The number of nodes ranges from a minimum of seven to more than 10,000 in a large network, such as the Bitcoin network.

Node operators voluntarily support the network or are chosen for the task through voting. In the case of the Bitcoin network, the only requirements are hard drive space, connectivity, and computing power. However, for proof of stake networks, running a node typically requires holding a significant number of coins.

Blockchain does not have a fixed structure and can grow to thousands of nodes worldwide. For Bitcoin and other networks, address activity is a metric used to gauge the health of the network.

How Secure is Blockchain and Can You Trust It?

In its eleven-year history, Bitcoin has not been exploited in a significant way. So far, no coins have been double spent, meaning the cryptographic protection of transactions is highly secure. However, smaller networks have fallen prey to malicious mining, where transactions were rolled back.

The Ethereum network, created by Vitalik Buterin, is highly secure for basic transactions, but the smart contracts created on top of it have faced significant errors and exploits.

A smart contract code adds more function to a blockchain. However, smart contracts are novel codes that often run untested and unaudited. Hackers can find logical loopholes that allow them to create a cryptocurrency, drain funds, or freeze assets.

Blockchain is also prone to user errors - sometimes due to poor user experience. The relatively new distributed ledger technology uses a public key and a private key along with lengthy alphanumeric addresses to send funds. Errors when sending funds usually center around using the wrong address.

Mistaking a smart contract address for a wallet address is a common mistake, especially when sending Ethereum-based tokens. Coins lost in this way are irretrievable. Sending Bitcoin to other blockchain networks, such as Bitcoin Cash, is semi-reversible, though expensive.

Another danger comes from using compromised wallets. Such wallets steal a user's private key and then their coins. Other risks include honey pots, faked sites, phishing addresses, and compromised exchanges that lose funds in hacks or exploits. However, if used correctly, the technology is extremely safe.

Public vs. Private Blockchains

A blockchain is created by individuals or corporations. The basic rules for participation and the rights to use the blockchain make it public or private. Public networks are borderless, and the rules for joining are specified in the code.

Some blockchain networks, like Bitcoin and Ethereum, are permissionless. For example, Bitcoin allows anyone to join the network. Other blockchain networks allow anyone to buy coins and set up a node as long as they hold a significant balance.

The most important feature of a public blockchain is the need to create consensus between distributed, pseudonymous or anonymous, unaudited parties. Private blockchains leverage the advantages of blockchain technology while keeping control of consensus.

A company may want to create an industry-based blockchain where allowing outside participants would be deemed too much risk. For instance, financial institutions may want to connect their branches in a blockchain-like encrypted structure without allowing public access to transaction data.

The mechanism of consensus would be similar, but access to the blockchain would be set to private to build specific business networks. In the case of a private blockchain, it is also possible for a centralized server to become the central authority when establishing the correct version of the distributed ledger containing the complete transaction record.

Some networks start with features similar to a private network and are later handed over to independent parties. Initially, this was the case with the Binance network, where servers monitored consensus and took more node operators onboard.

What are Cryptocurrencies and Crypto Wallets? - Short Overview

A cryptocurrency is a unit of account that can be traded or used to access a blockchain and its attached smart contracts. There are no physical coins, only blockchain records that are reflected in a user's wallet. Wallet usage has grown significantly over the years; a sign of the growing adoption of digital assets.

Cryptocurrency balances are held in wallets - specially created software programs that resemble eBanking or payments apps. Each wallet uses a digital signature to authorize transactions on a blockchain.

Types of wallets include:

  • Hardware wallet (such as Ledger or Trezor);
  • Exchange-based wallet (such as Binance);
  • Browser-based wallet protected by a private key (such as MyEtherWallet);
  • Offline or paper wallet;
  • Mnemonic wallet, where the user remembers their passphrase.

 

Each wallet has a public key and a private key. The public key is used to create a wallet address to which cryptocurrencies can be sent, while the private key is used as a digital signature to authorize transactions. It is the owner's responsibility to protect their private keys from other people or malicious software.

Applications of Blockchain Technology

The blockchain revolution has touched upon applications such as blockchain databases, intellectual property, and copyrights for the creative industry. Making transactions on a blockchain without the need of a third party to authorize them is a principal driver of adoption. However, the secure structure of blockchain technology lends itself easily to multiple other applications:

  • Financial hubs for transactions or investing;
  • Record keeping;
  • Smart contracts for preset behaviors or other computational tasks;
  • Communication;
  • AI data collection;
  • Monetization of content or data.

 

Distributed networks can also be used for secure decentralized file storage by encoding and encrypting data. Government data and other types of record keeping can be cryptographically protected by blockchain technology since a user's private key can be used to sign votes or allow access to the information.

Ownership transfer of intellectual property and other documents can also be performed with an immutable record. Voting and access information is immutably recorded on the blockchain network. Each of these functions operates in the same way as a financial transaction.

Crowdfunding and kickstarting are tools available to many startups. Since access to cryptocurrencies is mostly borderless, many international startups use blockchain to access venture capital.

Blockchain development has also increased access to investment options for people excluded from the traditional financial system. Voting and governance are used to create grassroots organizations that can generate loans or other forms of financial operations.

A blockchain network is fully auditable and can be used for tamper-proof accounting using a blockchain database, hence a push towards decentralized finance (DeFi), which many personal finance reviews take into account.

Some networks go a step beyond the capabilities of the Bitcoin blockchain with very short block time and fast communication. Those networks aim to solve the issues of the Internet of Things (IoT). By tracking unique digital identities for products, blockchain can be used to track the supply chain of physical goods in warehouses or shops. The technology is also fast enough to deal with domestic microtransactions and can be adapted to operate with little to no fees.

Industries Harnessing the Power of Blockchain

The value of blockchain technology is recognized for multiple business models. The music industry, supply chain, notary services, and identity verification services are all business models that are ripe for disruption through the use of blockchain.

  • Financial institutions: Cryptocurrencies that operate on blockchain technology are used as a form of highly volatile, but potentially high return, investment. Distributed ledger technology (DLT) simplifies cross-border remittances and money transfers. Smart contracts offer further opportunities by offering the ability to perform a transaction without an intermediary. The combination of private key cryptography and decentralized access makes financial blockchain technology ideal for storing sensitive financial transaction information. Finance is perhaps the largest industry being disrupted by blockchain technology.

 

  • Government Organizations: Blockchain has been proposed as a governance and voting tool, due to the power of digital signatures that ensure security through unique, immutable voting.

 

  • Healthcare industry: Blockchain can help protect sensitive data while allowing immediate access to records for all network participants with no geographical limitations. Healthcare records management and supply chains of medical equipment are promising use cases for blockchain technology.

 

  • Insurance companies: Keeping secure user data and verifying claims with a digital signature can boost industry performance. There are also specialized crypto-based insurance companies that secure against trading and finance risks.

 

  • Cloud computing: Blockchain technology and its consensus protocols have found a niche in decentralized computing. Projects like MaidSafe and other decentralized file storage systems use the connectivity between distributed nodes to encrypt and save data on multiple hard drives.

 

  • Trading and exchanges: Ethereum, the network created by Vitalik Buterin, became one of the chief platforms to carry financial apps, payment processing mechanisms, and decentralized exchanges. It became the biggest hub for an industry known as decentralized finance (DeFi). This sector used token-based economics to create interest-bearing mechanisms while ensuring liquidity for traders.

 

  • The Internet of Things (IoT) is an industry tech startups have been addressing for a few years now. Projects like IOTA, VeChain, and others aim to track supply chain information using blockchain technology to ensure immutable reporting. The aim of building a blockchain network for the IoT led to innovations on novel data structures, where every wallet can serve as a node on the blockchain.

 

What are the Main Advantages of Blockchain Technology?

A blockchain has several advantages over holding funds or information on centralized servers. The main advantages include:

  • No geographic limitations and full decentralization;
  • Censorship resistance, especially with multiple nodes online;
  • Fast and relatively cheap transactions;
  • Powerful cryptography and potential for confidentiality.

 

A blockchain network can have a transparent history of balances and transactions. Using blockchain technology means all transactions are immutable and no third party can cook the books. The technology is also highly secure due to the unbreakable cryptography used. As mentioned earlier, for Bitcoin, the SHA-256 mining algorithm makes it astronomically difficult and expensive to crack the code.

Some types of blockchain technology function to veil transactions and send funds privately. Coins like Monero, ZCash, and others veil the relevant data, making the two parties untraceable.

Does Blockchain Have Any Limitations or Disadvantages?

Blockchain comes with a preset bandwidth, meaning speed a basic limitation. The Bitcoin blockchain has a preset time of 10 minutes for each block, and a limited number of transactions are allowed per block. Computing those transactions is energy-intensive, with additional time needed for transaction verification across nodes. Thus, Bitcoin is a reliable, but rather slow coin.

Other limitations and disadvantages include:

  • Difficult scalability with slow transaction rate;
  • 51% attacks where a single miner produces most of the blocks and can roll back transactions;
  • Money laundering and terrorism financing;
  • Malicious wallets and hacking;
  • Energy-intensive mining;
  • Growing storage requirements to keep the entire network record of Bitcoin or other assets.

 

The 51% attack is considered one of the worst flaws in PoW blockchains. If transactions can be altered, a blockchain loses its credibility as an immutable ledger. Projects like Libonomy solve that problem by replacing mining with reward distribution. This stake-based process allows for 6,000 transactions per second, also solving the problem of latency and backlogs.

One of the biggest threats to PoW blockchain credibility is the so-called 51% attack. This type of exploit means a single malicious actor can control more than 51% of the hashing power of the blockchain network.

Blockchain technology that uses PoS is immune to a 51% attack, although a malicious actor can still try to switch consensus and double-spend coins. Most modern networks have managed to avoid double-spending so far.

Illegal activities remain one of the biggest worries for blockchain users. Blockchain-based assets are not audited and authorities only investigate dubious transactions under special circumstances. As of 2021, most exchanges comply with financial regulations, employing know your customer (KYC) and other verification methods to test real-world identities. Still, concerns remain that cryptocurrency is a security risk and an accessible tool for money laundering.

While blockchain technology is neutral, users can conceal asset flows from the traditional financial system. Banks will often refuse to cooperate with cryptocurrency exchanges.

Immutability is one of the most significant features of blockchain, although it is also one of its biggest flaws. Human error makes it possible to lose significant funds, immutably, through a combination of technical mistakes or deliberate attempts at fraud. Even when following best practices such as double-checking addresses and keeping wallet keys safe, it is still possible to make mistakes and see funds locked or sent mistakenly and lost forever with or without human intervention.

What is the Impact of Blockchain Technology on Society?

One of the signs of the impact of blockchain technology and its adoption is that it has been scrutinized by auditors and regulators. Even Bitcoin is finding favorable acceptance with businesses and investment funds. Blockchain is now seen as a significant innovation - a way to reach new investors and disrupt industries.

Blockchain technology and Bitcoin became wildly popular in 2017 when market prices for most cryptocurrencies reached all-time highs. CoinDesk, and other blockchain news outlets, carried headlines about the massive market cap increases. Rising digital asset prices raised the popularity of cryptocurrencies for trading and speculation. Bitcoin mining also turned into a competition to generate new coins.

Bitcoin existed for years as peer-to-peer (P2P) electronic cash. The asset was initially viewed as a cheap commodity for Internet trades, in-game purchases, or as a novelty item. In theory, blockchain technology and Bitcoin helped connect communities excluded by the banking system or limited by high rates for international remittance.

The application of blockchain technology can enable:

  • Borderless transactions;
  • Sound money as a hedge against inflation;
  • Censorship-proof transactions;
  • Secure encryption for individuals or businesses;
  • Certification and proof of ownership;
  • Virtual item trading, certification, and ownership.

 

Hundreds of blockchain companies have emerged over the course of the past decade, aiming to create networks that transcend current borders and limitations. Blockchain was immediately adopted by the gaming industry, with as many as 44% of gamers using blockchain technology to purchase or protect items.

Wider blockchain adoption is slower. Regulators are skeptical about banking blockchain ETFs (exchange-traded funds), and some forms of cryptocurrency investments are banned for US- and Canada-based users. While a blockchain system is not easily censored and user data remains protected, price speculation and trading are a matter of individual risk and hinge on local regulations.

Bitcoin has been adopted in cases of hyperinflation, becoming the de facto national currency in states such as Venezuela, Iran, and Turkey. Cryptocurrency ownership cannot be censored by governments and is a hedge against the inflation of fiat currencies.

Blockchain technology also opened a new venue for developer talent and startups. Decentralized gaming, gambling, trades, and the token economy expanded. Blockchain transactions became one method of avoiding the high prices of international remittances.

Blockchain means almost anyone can create an open network and generate assets to build venture capital, connect users, and increase trading liquidity. So far, the market capitalization of blockchain assets is still a small fraction of the entirety of the legacy financial system.

Is Blockchain the Future of the Internet?

The current Internet infrastructure relies on significant data storage resources to support cloud computing platforms. Most connections use standard routing which can be monitored, constricted, or outright banned for certain regions. Only 50 million people, or 0.71% of the world's population, use blockchain as of 2021, pointing to almost limitless growth potential.

Blockchain startups support the idea of Web 3.0, a new set of interactions going beyond the world wide web. The idea of decentralized technologies means some of the blockchain and node infrastructure can put up the foundations of Web 3.0 solutions.

There are multiple relationships possible, even with consumer computers. Lightning Network is one instance of a decentralized value transfer channel, partially based on the blockchain. For now, some networks use leading cloud storage services such as AWS. However, some networks attempt to build their own data storage solution with node-based connectivity and decentralized hard drive usage.

Networks like Nano or Iota allow fast connectivity for consumer electronics, without the heavy price of electricity-intensive ASIC.

There is no doubt blockchain is here to stay, and it can coexist with the current Internet infrastructure. However, to increase security and independence, blockchain structures may become the future of peer-to-peer connectivity.

Conclusion

Blockchain started with a simple idea and basic implementation. The development of blockchain projects coincided with a decade of rapid technological advancement, leading to growing investments in blockchain solutions. Blockchain adoption expanded when most products became available for mobile clients. Initially, a tool for gamers and a niche payment channel, Bitcoin and other cryptocurrencies became an avenue for venture capital.

The market prices of cryptocurrencies have been turbulent, seeing many markets peak and crash within days. Despite this, the appeal of blockchain technology has grown, with additional applications built on top of existing protocols.

Over a little more than a decade, the number of users has grown along with the addition of new coins. So far, Bitcoin and blockchain usage is mostly unrestricted by the governments of most countries. Limitations are local and mostly apply to the transparency of trading. Most blockchains are unregulated, though security authorities keep an eye on assets that could be used for fraud.

Despite this, the innovation continues to adapt and grow with new types of governance and safer contract codes. Blockchain continues to disrupt multiple intermediary models and industries.

FAQ

  • Can a blockchain be hacked?

Hypothetically, every blockchain is open to attack. The encoded rules that make those attacks prohibitively expensive protects blockchains. An attacker would either need more than 51% of mining power or hold a significant balance of staking coins to overrule the consensus and rewrite the ledger. Side technologies related to blockchain, such as smart contracts, are open to various forms of hacking. Human interaction is often the case, especially in exploits to steal funds from exchanges. Wallets themselves are well protected by cryptography, but error or carelessness can expose your private key.

  • Is blockchain software?

Blockchain networks are created through code that stipulates the basic rules such as block time, block size, and the difficulty of mining a block. So, blockchain is a software solution to the real-world problem of connecting distributed parties in a way that ensures consensus. There are also multiple additional pieces of software, including trading platforms, wallets, distributed games, and oracles that send and receive information from blockchains. Most blockchain software is open source, often created with community contributions.

  • Can blockchain technology help businesses?

Blockchain technology has found multiple applications since the creation of the first coins. There is no strict necessity for using blockchain, but it can help many aspects of a business. Depending on the legal system, a business can gain easier access to venture capital by raising cryptocurrency funds.

Blockchain technology is relatively easy to create and integrate. It is possible to include third parties to mine and secure the blockchain or keep the blockchain ledger centralized. Blockchain has multiple potential use cases, and industry experts see its potential to disrupt many legacy industries including real estate, the food industry, health care providers, and displacing intermediaries.

  • Is blockchain all hype?

Regardless of positive headlines on CoinDesk or headlines designed to promote FUD or FOMO in other less reputable publications, the technology blockchain uses is a legitimate tool that solves multiple business problems.

Since the inception of Bitcoin, the price of blockchain-based digital assets has created multiple instances of market hype. For example, Long Island Iced Tea, an OTC-traded company, added blockchain to its name and boosted its stock price. Blockchain itself may have been overly promoted - hyped.

Despite the speculative elements of cryptocurrencies and the associated economy blockchain has created, blockchain remains a solid approach to problems like digital identity, verification, file keeping, and the integration of distant actors. Blockchain algorithms allow for trading functionality, value transfer, and building the Internet of Money.

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