Blockchain is the foundational technology that underpins the value proposition of the entire cryptocurrency ecosystem. It’s the engine that secures Bitcoin and the reason Ethereum smart contracts have value. As part of the first installment in an Education series about blockchain technology, this article aims to provide insight into what is a blockchain, why it provides value, and how it’s being used to reshape the way trust is managed in society.

What is a Blockchain and How Does it Work

A blockchain is highly secure, reliable, and decentralized network that allows people to store data, exchange value, and record transaction activity in a shared ledger that is not controlled by any central authority, but instead maintained by computers all around the world.

A ledger is a book or computer file that keeps track of economic activity. Ledgers can track individual account balances and/or the ongoing movement of money within entire economies. Today, most ledgers are handled by centralized entities such as a bank, which maintain and store ledgers on their own servers and in opaque databases.

A blockchain is a digital ledger that is stored and maintained by a decentralized network of computers. Each computer (node) in the network runs the same software and maintains, stores, and validates a copy of the ledger. Public blockchains use their own native asset known as cryptocurrency to financially incentivize nodes to communicate with one another and reach an agreement (consensus) on the validity of the ledger.

Users propose additions to the ledger by submitting transactions that transfer value from one account to another. User accounts are known as public keys (also called public address) and each public key has an associated private key. The public key is akin to an email address and the private key is similar to a password that the public key owner must enter (called a digital signature) to transfer funds stored on their address.

Pending transactions are grouped together into “blocks”, where they are processed and validated by each node in the network. Having each node check each transaction ensures that changes to the ledger are redundantly validated. For a transaction to be valid, the public key must have sufficient funds to cover the transaction and the digital signature must be correct.

Once a block is confirmed, it is appended to the ledger. The ledger is a continual chain of blocks, and thus termed a “blockchain”. Nodes are rewarded for their services with transaction fees and/or newly minted cryptocurrency (referred to as a block reward).

Centralized bank transactions vs. decentralized blockchain transactions
The difference in how the user's funds are handled when making a payment through a blockchain vs. the banking system

There are many different ways to design a blockchain, which each have advantages and disadvantages.

  • Network Access & Participation - Blockchains can vary in terms of how open or limited the network is to use and participate in. The three main types of blockchains: public (completely open), private (completely closed), and permissioned (open access, limited participation).
  • Consensus Mechanism - Blockchains can reach consensus about transactions through different means. Some of the most popular consensus mechanisms are Proof of Work (Bitcoin), Proof of Stake (Tezos), and Proof of Authority (most private blockchains).
  • Design Features - Blockchains currently cannot satisfy all desired qualities. Instead, blockchains make tradeoffs to optimize certain feature sets over overs. Important design features include security, scalability, decentralization, privacy, transaction finality, and more.

Why are Blockchains Valuable

Blockchains offer several value propositions not available on centralized ledgers.

  • Security - In a sufficiently decentralized blockchain, there is a very high probability that only valid transactions will be confirmed despite the efforts of malicious actors.
  • Immutability - Once a block is redundantly confirmed, it becomes a part of the unchangeable ledger that gets increasingly more difficult to alter over time.
  • Reliability - Blockchains have globally distributed networks with 24/7 uptime. They are always online and are not restricted geographically or politically.
  • Peer-to-Peer - Blockchains cut out intermediaries that siphon off value from transactions. Parties transact directly with each other without incurring any counterparty risk—the probability that the other participant in the contract will not fulfill their obligations.

Overall, blockchains create infrastructure that two or more parties can use to conduct highly secure, reliable, and tamperproof economic exchange. The counterparty risk is shifted from reliance on probabilistic trusted third parties to reliance on deterministic open-source software that executes exactly as instructed. Companies become more efficient by avoiding reconciliations, removing unnecessary intermediaries, and reducing counterparty risk.

How Blockchains Produce Value

The Internet is a way of sharing digital information that can be applied in a multitude of ways, such as email, messaging, telecommunication, social media, etc. Blockchains offer the same multi-use application for exchanging value, which can be applied in many unique ways to produce value for end users.

Monetary System

Bitcoin demonstrates how a public permissionless blockchain can be used as a self-contained financial ecosystem with its own monetary policy. Bitcoin has a native currency BTC with built-in distribution mechanics and financial incentives to keep the network operational without a central coordinator. Bitcoin has a censorship-resistant hard cap on the money supply; there will never be more than 21 million BTC. These deflationary monetary properties lead some to argue that BTC is a stronger store of value than inflationary fiat currencies.

Smart Contracts

Ethereum shows how a public permissionless blockchain can be used as a highly secure and reliable world computer for processing conditional agreements known as smart contracts. Instead of tracking the movement of a single currency, users send instructions to the blockchain that states “if x event happens, then execute y action.” The blockchain processes these predefined instructions (smart contracts) by producing outputs (transferring value) based on inputs (data). Ethereum can process millions of separate smart contracts in parallel.

Asset Tokenization

Several projects are using the blockchain as a global public registry for assets. Through a smart contract, developers can create a unique non-fungible token that represents ownership of a real-world asset such as a building, car, rare trading card, or more. Blockchains provide authenticity to asset ownership, transparent tracking of an asset’s life cycle, and global liquidity to previously illiquid assets.

Middleware

Baseline Protocol is a way of using the blockchain (focused on the Ethereum mainnet) as a middleware to ensure two or more enterprise databases have matching records without putting their sensitive internal data on the blockchain. Since the Ethereum mainnet is always online, easily auditable, resistant to manipulation, and permissionless to access, enterprises can use it inform one another on actions taken by either side by storing them as data on the blockchain. The data is stored using a privacy technique known as zero knowledge proofs where only parties in the agreement have the context to understand its meaning. The proof serves as a common frame of reference for the state of the business process; e.g. the current terms of a volume discount agreement between a seller and buyer.

Golden Records

Blockchains can serve as immutable environments for storing historical records. Having a highly trusted set of records reduces friction within fragmented markets which often contain many disparate databases. Blockchains offer a “Golden Record” that can improve the tracking of financial contracts, storing of medical records, tracking of identities, and much more

Utility

Blockchains can be designed to provide a specific utility. For example, using a decentralized network of nodes to provide distributed video streaming, host a tamperproof online game, or immutably store files. Similar to torrent systems, blockchains provide a way to harness the power of a decentralized network to produce a shared public utility.

Further Reading

Learn more by checking out the next article in the Education series about Smart Contracts. Follow us on Twitter to get notified of upcoming article releases and join our Telegram for the latest news on Chainlink.