Blockchains. DeFi. Cryptocurrencies. Consensus algorithms. These are terms that you may have heard of in recent months, and with the recent boom in Decentralized Finance, have piqued investors’ interests. How does this obscure piece of technology work, and how can you benefit from it?
The excitement surrounding cryptocurrencies and associated niches like non-fungible tokens has led to a wave of interest from newcomers over recent months. However, entering the crypto space can be like climbing into a rabbit hole of new terminology and technical jargon.
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This article will break down the most fundamental principles needed to understand blockchain, the technology underpinning most cryptocurrencies. Knowing the basics of blockchain is essential for any beginner, as it helps navigate many of the other concepts you’ll come across in crypto.
Cryptocurrencies are often associated with blockchain, but they were simply one of the first use cases for the technology. In reality, blockchains can be used for a wide variety of use cases.
The core function of a blockchain is to maintain a record of transactions among multiple participants without the need for a central authority.
The term “blockchain” is often used interchangeably with “distributed ledger.” However, a true blockchain has some defining characteristics.
Blockchains are operated by networks of computers (or nodes) that don’t fall under any single point of control. All nodes can decide the state of the blockchain ledger based on the consensus rules.
Because the blockchain is operated by an entire network, it’s never subject to downtime. If one node goes down, the others will keep the network running (as long as there are other nodes). In this way, the blockchain is censorship-resistant, as the decentralized network of nodes will keep running no matter who intervenes or tries to shut it down.
All blockchain transactions are carried out transparently and witnessed by all nodes on the network. Once a transaction is published on the blockchain ledger, anyone can see it. In this way, if you know someone’s public address on the blockchain, you can view their account balances and see their transactions. Therefore, blockchain isn’t private, even if addresses aren’t associated with named individuals or entities.
Blockchains make use of private keys, which are cryptographic signatures verifying that the account holder is authorized to make a transaction. Key encryption means that blockchains are highly secure, and as long as your private keys are private, your funds are as secure as the blockchain network itself.
Once a transaction has been entered into the blockchain ledger, it cannot be deleted, changed, or tampered with without a majority of the nodes on the network agreeing. And, because nodes are incentivized to act in the interests of the network, it’s prohibitively expensive to attempt to corrupt nodes into falsifying records.
In the traditional financial system, we rely on banks as central authorities who maintain ledgers of transactions and accounts by which we all abide. If Alice wants to send Bob some money, she sends it from her bank account to his bank account, and their respective banks update their account balances accordingly.
Alice and Bob must both trust their banks to get it right and not act fraudulently against them for this system to work. However, even despite the faith we place in it, the traditional financial system remains prone to human error, is expensive to manage, and it can take years for any possible flaw in the process to be uncovered.
The first blockchain was Bitcoin, which was launched in 2009 by a pseudonymous creator called Satoshi Nakamoto. We don’t know much about Satoshi, but there are a few clues that they wanted to create a monetary system that would bypass the banks. Blockchain was the chosen mechanism for achieving this goal. It’s effectively a log or ledger of transactions stored on many computers and is continually updated.
Each time the ledger is updated with new transactions, these transactions are grouped into blocks. Then each computer or node on the network must agree that the transactions are valid and can be added to the ledger, known as a consensus model.
Each block of transactions is tied cryptographically to its predecessor, forming a chain. Hence the name blockchain.
The double-spend problem refers to an issue that pervaded digital currencies until Satoshi Nakamoto invented Bitcoin. The challenge is that a digital coin is simply a file like any other. It’s trivial to copy digital files usually, but when this is applied to digital currencies, it creates a problem, as someone could simply “spend” their crypto twice if they copy it.
Blockchain’s consensus model and hashing algorithms are designed to overcome this problem. The network of nodes knows how many bitcoins are in existence, and each bitcoin’s transaction history is held in the blocks that make up the blockchain.
Therefore, when the nodes agree that a particular transaction has taken place, it’s because they can verify the provenance of the coin involved in the transaction based on the blockchain’s history.
Because each block of transactions is tied cryptographically to its predecessor, this history is effectively fixed in place. Changing one transaction at a point in history will have a knock-on impact on all subsequent blocks. Therefore, the number of bitcoins is fixed, and they can’t be copied or spent twice, thanks to the security design of the blockchain network.
In summary, a blockchain is a type of distributed ledger operated by a decentralized network of nodes that all have an identical copy.
Transactions are added in blocks at the agreement of the nodes in the network, based on consensus rules. The net result is a secure, transparent, distributed system capable of handling trillions of dollars of transactions.
The beside figure shows a simple representation of a blockchain. In the diagram, there is a series of time blocks, ordered in a time sequence. We can see that in each block, there are transactions made by various parties. Each block has its own signature, which is derived from the timestamp and other various data. Once a block containing transactions is added to the end of the chain, transaction information is publicly available to all parties.
It is also important to note that while transaction data is made public, the owners of these transactions are anonymized. While everybody will know that a transaction has occurred, only the sender and the recipient will actually know who performed the said transaction.
In conclusion, a blockchain can be thought of as a distributed ledger, in which every person who participates in the blockchain network will have a copy of the same ledger. Everybody who has a copy of the distributed ledger will be able to verify how much other parties have spent, allowing for a transparent, distributed system which does not depend on a single authority.
By now, it's almost impossible not to have heard about cryptocurrency, although you may not be familiar with precisely what it is and how it works. Don't worry, you're not alone.
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