What Is Blockchain Technology?
Updated January 24, 2022.
A blockchain is a highly secure, reliable, and decentralized network that allows people to record transaction activity, store data, and exchange value in a distributed ledger that is not controlled by any central authority, but instead maintained by computers all around the world.
Blockchain is the foundational technology that underpins the value proposition of the entire cryptocurrency/Web3 ecosystem. It’s the engine that secures Bitcoin and establishes the foundation for why smart contracts have value.
The fundamental value proposition of blockchains is the ability to exchange value in a trust-minimized, permissionless way that doesn’t require the intermediation of any third party. The most basic case possible to showcase this is payments or the transfer of funds from one party to another.
For example, let’s assume that Bob would like to send Alice a payment. Using legacy systems, Bob would send his payment to a third party—a bank or financial institution—that would take full custody of his funds and transfer those funds to Alice. In the case of blockchains, Bob sends money directly to Alice’s account without a centralized intermediary, but with full assurances that funds are transferred between accounts. The transaction takes place in a decentralized manner, without any intermediaries involved, enforced by deterministic processes secured by cryptography, encryption, math, and physics.
In this educational post, we explore what a blockchain is, how blockchains work, what benefits they can provide that aren’t present in centralized systems, and how they’re being used to reshape the role of trust in society.
Who Invented Blockchain Technology?
While protocols similar to blockchain were conceptualized as early as the 1980s and were implemented in the 1990s for verification of document timestamps, the invention of the first decentralized blockchain is widely attributed to the pseudonymous person (or group of people) known as Satoshi Nakamoto, who published the Bitcoin whitepaper in 2008.
Blockchain technology serves as the backbone of the Bitcoin network, which was launched in 2009 when its implementation was released as open-source software. Interestingly, the word blockchain is never mentioned in the Bitcoin whitepaper — the term has been popularized by later proponents of the technology.
How Does a Blockchain Work?
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 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 a 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, making it nigh impossible to make malicious changes to the ledger or state of the network. For a transaction to be valid, the digital signature must be correct and the public key must have sufficient funds to cover the transaction.
Once a block is confirmed, it is appended to an ever-growing distributed ledger. The ledger is a continual chain of blocks linked using cryptography, and is thus termed a “blockchain”. Nodes are rewarded for their services with transaction fees and/or newly minted cryptocurrency (referred to as a block reward).
There are many different ways to design a blockchain, with each design having 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 (Solana), 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 others between security, decentralization, and scalability — commonly known as the Scalability Trilemma. Other important design features include privacy, transaction finality, and more.
Benefits of Blockchain
Blockchains offer several value propositions not available in centralized systems.
- 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 tamper-proof 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.
Blockchain Use Cases and Applications
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, and more. The Web3 ecosystem powered by blockchains and hybrid smart contracts offers the same multi-use application for exchanging value, which can be applied in many unique ways to create utility for end-users through a wide range of use cases, ultimately creating a positive impact for society.
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.
Blockchains such as Ethereum show how a public permissionless blockchain can be used as a highly secure and reliable distributed 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 state “if x event happens, then execute y action.” The blockchain processes these predefined instructions by producing outputs (transferring value) based on inputs (data). This capability has enabled an entirely new financial ecosystem of permissionless, transparent financial services known as decentralized finance (DeFi).
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 (NFT) 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.
Blockchains can act as a middleware to ensure two or more enterprise databases have matching records without putting their sensitive internal data on a public blockchain. Since a public blockchain is always online, easily auditable, resistant to manipulation, and permissionless to access, enterprises can use it to 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 a zero-knowledge proof (ZKP) 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.
Ledger of Record
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 “Ledger of Record” that can improve the tracking of financial contracts, storing of medical records, tracking of identities, and much more.
Blockchains can be designed to provide a specific utility. For example, to provide distributed video streaming using a decentralized network of nodes, host a tamper-proof 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.
Blockchains can serve as a way to track and verify ownership of assets via NFTs that represent ownership of in-game digital items and collectibles. Players can tap into a global liquidity pool and trade in-game assets at decentralized marketplaces while maintaining full custody over them, enabling fully community-owned blockchain games. With the potential of interoperable blockchain games and the metaverse, players might be able to trade in-game assets between different games in the future.
As an immutable distributed database, blockchain can improve supply chain processes by enhancing traceability and improving coordination between different participants, enabling faster and more cost-efficient delivery of products. Since each participant has their own copy of the blockchain, each party can identify errors, review the status of transactions, and hold counterparties responsible for their actions. No participant can overwrite historical data as doing so would require having to rewrite all subsequent blocks on all shared copies of the blockchain.
The combination of blockchains, smart contracts, and oracles has shown the potential to solve the problem of transparency in the traditional insurance industry, streamline the insurance process for all participants, and make insurance available to regions that otherwise would be isolated from the global insurance industry. Smart contracts offer automated execution of insurance policies based on if/then parameters that can replace the traditional claims process in a way that is highly transparent and reliable.
Blockchain Is Here to Stay
In the past decade, blockchain technology has transitioned from a pioneering promise to a valuable utility that brings meaningful benefits to its many users around the world. While the blockchain industry is still far from realizing its full potential, the exponential growth in the adoption of blockchain-based smart contracts is setting the stage for the technology to redefine many traditional industries and create entirely new ones through the power of trust-minimized applications and deterministic agreements powered by cryptographic truth.