how blockchain works

How Blockchain Technology Works — A Complete Guide

The crypto revolution is set to change the whole finance scene, thanks to blockchain technology. We know blockchain forms the basis of cryptocurrency, but only a few people understand how the technology actually works. In this article, we’ll try to explain the concept as simply as possible, and you can consider this guide Finvesting’s Blockchain for noobs.

The Three Components of Blockchain Technology

Blockchain is essentially a combination of three computing innovations:

  1. Cryptographic keys

  2. Distributed network

  3. Consensus protocol

These three components work together to ensure the proper functioning of the blockchain. Next, we’ll take a quick look at each component.

Cryptographic Keys

There are two types of cryptographic keys, namely Public and Private keys. Every individual actively involved in the blockchain space holds these two keys. To uphold security in blockchain, this identity system was put in place. Using an individual’s public key, it is possible to encode a message so just only the individual with the private key can decipher and understand it.

A private key acts like a digital signature. Anyone with the accompanying public key can confirm that the message was made by the private key holder. This private key is the most important part of a crypto wallet. This is evidenced in the popular saying “Not your keys, not your coins” which implies that you can’t claim to own the crypto if the private key is with someone else.

To confirm this, we need a verification system in place and a distributed network plays this role, just like a notary.

Distributed Network

The blockchain is usually referred to as a public ledger and the reason is because of how blockchain works. It essentially “distributes” a full copy of the blockchain among every participant in the network, and it is verified by the different nodes to reach a consensus.

Usually, to verify a transaction, a minimum number of participants in the network need to agree to it. The size of the network determines how safe the system is. This is what makes Bitcoin unique, that is, it has one of the largest distributed networks in 2021. Thanks to a large community of nodes, the whole network is able to maintain its decentralized, transparent, trustless and censorship-resistant capabilities.

Consensus Protocol

To understand how blockchain works, we need to understand its consensus protocol.

Consensus protocols are methods employed by blockchain networks to reach an agreement on the authenticity of transactions. Various consensus protocols exist but the most popular ones are the Proof of Stake (PoS) and Proof of Work (PoW) algorithms.

Proof of work is an energy-intensive algorithm used for verifying transactions through a process known as ‘mining’. In the context of blockchains, mining is when validators on a network attempt to solve complex computational problems using powerful computers with high processing power. The first miner to solve the problem is rewarded with cryptocurrency, and the transaction is verified.

On the other hand, PoS involves holding an amount of cryptocurrency in a staking wallet to qualify as a validator. Instead of mining, validating nodes are selected based on how much they staked and for how long. Selected nodes will then be able to participate in consensus and verify transactions.

With a consensus protocol, blockchain cleverly tackles immutability and decentralization issues when processing and verifying cryptocurrency transactions.

Blockchain — Two Words

When you break down the term “blockchain”, you get “block” and “chain”. Going by this analogy, we can safely say a blockchain is a chain of blocks. What, then, is a block?

Much like how a cell is the basic unit of life, a block is the basic unit of a blockchain. A block is a container of data that houses three kinds of information:

  1. A digital signature (cryptographic keys),
  2. timestamp (creates a timeline of the transactions), and
  3. a unique transaction hash (can be compared to a fingerprint).

When a transaction takes place, a block is created, it is distributed to the whole network which then verifies its validity, and only when a specific number of nodes agree to it, a consensus is reached. The new block is then appended to the previous one, creating a linear chain in reverse chronological order. The transaction is irreversible because it contains the hash of the previously mined block.

In a chain, each block contains cryptographic hash information and the previous block’s hash, which serves as a reference maintaining the integrity of the chain. As such, if a single block is modified, the preceding blocks are rendered invalid.

When talking about Bitcoin, to modify a block in its blockchain, an attacker would need to seize control of the majority of nodes on the network. This scenario is popularly known as a 51% attack. Established blockchains like Bitcoin and Ethereum are resistant to this kind of attack since the more the nodes on a blockchain network, the bigger the hash rate. Bitcoin’s overall hash rate is over a hundred exa hashes per second, making it almost impossible to hack the Bitcoin network and modify the information stored in verified blocks.

Only when the block is added to the chain is the transaction completed. The mechanism is both transparent and secure at the same time. One thing to notice here is that every blockchain is a distributed database where each node keeps a full copy of the ledger on their computer.

Difference between Blockchain and Banks

There are differences between the banking system and blockchain, both have their advantages and disadvantages. But because of how blockchain works, it has an edge over the banking system.

  • Banks are only operational for a certain period in a day but the blockchain is always online any time, any day.
  • The level of privacy and security of a bank account depends on the bank’s security practices, whereas the blockchain becomes more secure as the network grows and becomes more distributed.
  • Banks may charge huge transaction fees and the transactions take several days to process sometimes. Even in 2021, when the world is more connected than ever, global transactions are difficult to carry out. Blockchain makes this super quick, and transactions take place in an instant.
  • Banks and financial institutions in general hold lots of personally identifiable information about an account holder. Blockchain offers anonymity and you decide who can access your information and what they can use it for.

FAQs

What are some drawbacks of blockchain?

Blockchain is a relatively new technology, so understanding how it works could be tricky at times, but we haven’t yet reached a stage where it can be adopted globally, and several changes need to be implemented to make it truly useful. It’s just liked the internet in its early stages, when people couldn’t predict how it would evolve. At Finvesting, we‘re firm believers in the potential of blockchain technology to transform the finance industry (and others), if implemented right.

What are the different use cases of blockchain, other than cryptocurrency?

Blockchain technology has numerous use cases spread across virtually every industry known to man. It has been used to implement smart contracts that play a major role in the decentralised finance (DeFi) sector. Blockchain technology is also used to facilitate cross-border payments and remittances, improve traceability and achieve more efficiency in overall business processes. Several other applications are also being discovered as the technology evolves.