What is Blockchain Technology?
The Financial Crisis in ‘09 was devastating. The unemployment rate rose from 5% to 10% in two years. Hundreds of thousands lost their jobs and millions lost their homes. Markets crashed, dumping the Dow Jones Industrial Average below 10,000 points for the first time. Everyone lost hope in the once flawless financial sector.
Satoshi Nakamoto came up with a solution that revolutionized the industry and possibly the way in which society is structured. A new technology rose from a white paper that transcribed the complex protocol behind Bitcoin and the crypto universe: blockchain.
How does a Blockchain Work: A Step-by-Step Guide
Figure 7 - Process that shows how a block is generated when a transaction is requested
A blockchain is a distributed ledger that keeps track of user balances. For newcomers, a blockchain is a chain of blocks that store data. Mainly, the blocks store transactional data between users. The content of each block varies between blockchains. For simplicity, Bitcoin’s blockchain will be used as a reference.
Figure 6 - Adjacent blocks linked by the “blockchain” to have traceability of previous transactions
Bitcoin’s Blockchain Components
Figure 8 - Key components of a block and the information compiled on each of them
Each block contains its hash, data, and the hash of the previous block. The transactions between users is the data composing of the block: the amount sent or received, and the keys of each party. Simple right?
Hash has a unique connotation in the blockchain context. Think of it like a fingerprint. The hash of each block is what identifies each block, and its content. It’s the way to individualize each block. The previous block’s hash is vital because it’s the connector between the chain of old blocks and the new verified block. With today’s computer power, it takes around 10 minutes for miners to decrypt the “golden” hash.
This chain characteristic is what makes blockchain secure. It’s impossible to manipulate the blocks because every subsequent block would be invalidated as the fingerprint of the block's hash, would scramble to avoid further blocks from being manipulated. Furthermore, miners play an exceptional part in securing and maintaining the proper functioning of the blockchain and are rewarded for it (miners receive 6.25 Bitcoin per new block).
Figure 9 - There are two types of consensus mechanisms: PoW and PoS
Proof-of-Work vs. Proof-of-Stake
A decentralized network needs a way to keep running. Without an incentive to validate new transactions blockchain would freeze, new blocks wouldn’t be appended. To keep the protocol running miners compete against each other to create and verify the hash of the upcoming blocks. Rewarded for solving complex mathematical puzzles, miners receive newly minted Bitcoin. The best part is that all Bitcoin holders have access to a node, or a full copy of the blockchain, to verify that everything is in order. As a result, there is constant node supervision.
Mining is getting too expensive and less competitive. Big players have thousands of mines running, making it extremely difficult to compete against them. As a result, a different type of consensus mechanism is being considered. One that doesn’t involve as much energy and is more competitive.
Instead of having to work, or mine, for the reward, crypto holders “lock-up” crypto assets to verify new blocks to join the chain. It’s a matter of putting at risk your capital and reputation. Crypto-assets from a staker can be seized if a staker is trying to tamper with the blockchain.
Stakers are incentivized to play by the rules and accumulate more of the crypto assets. Interest rates work as a reward in PoS. So, as more rewards are collected, the staker’s position will continue to increase. The best part is that depending on how much is at stake, a right to vote is received—the more at stake, the louder the staker’s voice.
Figure 10 - Key benefits of the blockchain compared to other technological infrastructure solutions
For the first time ever, interacting on a decentralized peer-to-peer network is possible. A new democratized community has been created, ruled by, and limited to the will of the users.
A network in which pseudonymously, users are free to transact with one another through a transparent and secure system means blockchain technology. Expensive fees, delays in payment, and pricey conversions have become obsolete. With blockchain technology, one can send and receive money in minutes without paying fees. Once and for all, banks are removed from the equation. Institutional freedom at last. Financial availability and security are almost guaranteed with blockchain. Neverending interactions in servers between miners keep the blockchain running smoothly non-stop.
Cons of Using Blockchain
The anonymity of the system, if abused, can lead to unethical and illegal applications. Satoshi himself asked users not to abuse the liberties granted by his creation. Still, Bitcoin was and is used for illicit transactions.
Bitcoin’s blockchain cannot process transactions as fast as a credit or debit card transaction, so some doubt that it can be used as an efficient means of transactions. Imagine paying one bitcoin for a motorcycle when the price is at $12,000. Patiently, waiting for the transaction to be verified, bitcoin’s price skyrockets and now one bitcoin is worth $13,000. Bitcoin’s high volatility poses a threat to buyers and sellers if transactions are not fast enough. Other crypto have established shorter transaction times as a competitive advantage, be sure to check them out.
Trust is crucial for the functioning of blockchain technology. Cooperation within the network is needed to reach its potential. The thing is, a lot of users don’t know how blockchain technology works. So, its potential cannot be exploited.
Blockchain exists because market participants demand institutional freedom. The need for third party institutions for the functionality of the system has become a thing of the past. Blockchain began as a peer-to-peer marketplace where users can send and receive money freely in a secure and transparent environment and it is evolving to even broader uses.
From storing information to voting implementations, blockchain technology is to continue serving its primary purpose: the store of information with security. No one is capable of stealing or misusing the data stored. It’s a common misconception to limit blockchain’s use to transactional details. As one of the use cases is a digital vault in which personal belongings, identities, relationships, etc., are stored in a secure database, that is if conditions apply, they can be accessed and kept secure at the hand of the owner.
It’s hard to imagine blockchain technology’s potential because it's still early in its development. The only certainty is the elimination of a middleman dictating the rules. Finally, users can decide upon the outcome of their goods. Society is demanding democratized solutions in which the best product, according to its users, will thrive. With blockchain technology, there is always room for more innovation. The imagination of its developers is its only limitation.
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List of References
How Does Bitcoin Work, page 12
Blockchain Technology, page 13
Colored Coins, page 13
Distributed Ledger and Bitcoin’s Blockchain Components, page 14
Consensus Mechanism, page 14
Blockchain’s Benefits, page 16