What is blockchain and how does it work
Blockchain is a type of what is called a distributed ledger technology. Simply, blockchain is a new method of recording and verifying transactions among different users in a network. Whereas previously transactions would be recorded and verified by a central authority which has a central ledger, blockchain transactions are verified by all participants in the network (so the ledger is distributed) thus invalidating the need for a central body that verifies and clears transactions. That has massive implications for how to potentially organise and clear the markets of the future. Furthermore, there are other applications for blockchain technology outside of using it as a means of exchange that may alter how we approach data in the new economy.
To understand how blockchain changes transactions, let’s first examine how transactions are generally handled under a traditional system with a central body. When two individuals agree to a transaction (say, buying a piece of land), they first agree to the terms of exchange. For example, they might exchange the land deed for a sum of money. To exchange the sum of money, the payer will inform their bank to transfer a sum of money from their account to the payee’s account (which for simplicity’s sake we’ll assume is at the same bank). The bank will record the transaction, verify its veracity by making sure that it was, in fact, the payer who had made the request to transfer money, and once those checks are complete, will conduct the transaction. Such verification may take a long period of time. Additionally, it relies on the security of the verifying body. If they were to have their security compromised or were maliciously inclined, the record of the transaction may be altered or deleted entirely. And to top it all off, in the case of a security breach, the personal information of the associated parties may be compromised.
Blockchain attempts to address these issues through disintermediation. Instead of a central body that verifies and records transactions, the verification and record process is performed by all participants in a network, or nodes. All nodes have a record of every transaction that has occurred in the network and continuously record all transactions that occur to compare against other parts of the network. This ensures consensus among nodes (that is, network participants) and continuity and security of the blockchain as well as network integrity and trust. Here is how bitcoin, the most widely well-known blockchain network, executes transactions:
- An individual (‘A’) agrees to a transaction with ‘B’, where A transfers coin to B.
- ‘A’ broadcasts a message to network announcing the transaction (“A’s account decreases by 5, B’s account increases by 5”). This record of the transaction is simply called a record.
- Multiple records are combined into blocks. Each transaction is timestamped to ensure chronological order. When the size of a block of transactions reaches 1 megabyte, a new block begins. Each transaction is hashed (a process of encryption which will be briefly explained below). Hashing ensures that the transaction is not altered as any alteration in the record will change the “hash” entirely.
- To begin a new block, the old block is hashed, timestamped, and information about it is included in the new block. This ensures that if a block or transaction is altered, that change will be detected because, as mentioned above, any change, however small, in the encrypted information will change the hash entirely.
- To be included in the chain, the node broadcasting a block has to solve a complex math problem that involves guessing random numbers that when combined with block information give some defined result. The node that solves the problem wins the right to place the next block on the chain and broadcast that to the network. The new block is sent out to the network and appended to the chain. The timestamps ensure the chronological order of transactions.
- There may sometimes be natural discrepancies among chains due to near-simultaneous solutions. In that case, the nodes continue to work on appending new blocks. The node that finds the next solution and appends a new block will propagate that solution to the rest of the network. Nodes with the same chain will continue as normal. Nodes with a competing chain will adopt the competing chain as it now is longer. This ensures seamless continuity in the case of discrepancies.
Let’s take an aside to explain hashing—hashing is a word that means encryption that results in a string of text and numbers. Usually, as in the case of bitcoin and many other blockchain networks, a user has two keys: public and private. The public key is known to everyone, while the private key is known only to its owner. One can use their public key to encrypt a message to an individual, which produces a unique hash. That individual can then use their private key to decrypt the message and read the hash. A message that is encrypted using a person’s public key can only be decrypted with their private key and vice versa. In the example above, a record is encrypted using A’s private key. If one wished to verify that it was really A that ordered the transaction, they can use A’s public key to decrypt the record which proves that it could have only been A that agreed to this record. Furthermore, any change in the message that is coded, however minute, will result in an entirely different hash. This ensures that any changes after the fact will be detected and eliminates the mistrust in the recording of transactions. The hashing process is further used to include a trace of the old blocks in new blocks. If a person attempts to make changes in old blocks, the hashes of every single block that follows it in the chain will also be altered. This further ensures that no changes are made to the record as the rest of the network will then detect such changes.
The following example of bitcoin shows the potential advantages of blockchain technology:
Disintermediation: Transactions can be executed and verified without relying on a 3rd party. This eliminates the need for trust during the process of exchange. Paradoxically, this can make exchange even easier as well when talking about smart contracts. Furthermore, any node in the network can confirm the veracity of any transaction as they wish.
Data cannot be altered or deleted: Due to hashing encryption, any change in any part of the blockchain will propagate forward and can be traced directly to its source. Security breaches are now much less of a concern.
Consensus of all ledger participants on what to be recorded on the block: No single user can exercise power over what is to be recorded in the block without the agreement of all other network participants. Trust in a central authority is no longer required.
These advantages certainly make blockchain an exciting technology to examine and potentially pursue. Disadvantages naturally exist, and they might dissuade any potential adopters of the technology. Disadvantages include:
Size of and unwieldiness of the ledger: One natural disadvantage is the necessity of having a full record of all transactions for users. Since all users have to have a record of transactions, and since a user may not use the network until the data download and verification process is complete, there is a constraint on usage. In bitcoin’s case, the ledger is now 100GB in size and in Ethereum’s case, it has grown to over 200GB in size in its first 30 months. This is woefully inefficient as network participants need to download and process this data to participate and as network size grows, the verification process will become exponentially more resource-consuming. This brings us to the next point.
Energy Inefficiency: As it is, blockchain is extremely energy inefficient. Bitcoin mining is estimated to have consumed 30 terawatt-hours of electricity in 2017 (Alex Hern – The Guardian, 2017). This is enough energy to power the Republic of Ireland for a year. If bitcoin were to replace traditional banking and payment methods, its usage will surely skyrocket and its energy usage mushroom. Considering concerns about global warming and the source of the electricity used to mine bitcoin, this may have very severe repercussions on the fight to protect our planet.
Performance: Performance is another concern. Almost all current blockchain technology can only process a few transactions every second. For example, in the case of bitcoin the network can execute 7 transactions per second, with a transaction taking 60 minutes to be confirmed (O’Keefe, 2018). Contrast this with a payment network like Visa which can reportedly process 24,000 transactions a second due to its centralized nature all while serving a much larger user base. As it stands, blockchain technology does not scale well to a large number of users.
This is not to say that future blockchain iterations cannot become faster. One cryptocurrency/payment network, Ripple, can process 1500 transactions per second. But given that those cryptocurrencies serve much smaller userbases, there are some definite challenges to creating a system that would be able to handle the requirements of modern-day life.
What are Proof-of-Work and Proof-of-Stake models
Initial blockchain applications used a proof-of-work concept. In it, any users that contribute to the verification and maintenance process of the network will receive credit for this work. Naturally, this incentivises many nodes to participate in this process, contributing to the energy inefficiency problem. Proof-of-Stake models attempt to solve this problem of duplication and redundancy. Instead of any node being able to participate, one that wants to do so has to commit some of its proof-of-work credit into the network. The larger the node’s “stake”, the bigger of a say that a node gets in the verification and maintenance process. This is supposedly done to decrease the potential for excessive control of the network by its largest users. Ethereum, the second most widely used cryptocurrency, is notably moving from a pure proof-of-work to a hybrid proof-of-work/proof-of-stake model.
What are possible applications of the technology
Blockchain is often derided as a solution searching for a problem. That is often true. However, there are several areas where there may be genuine applications for the technology that improves on current technology.
Supply chain management is one area where interesting applications of blockchain may provide value to firms. Since records of transactions cannot be altered, they can be used to detect where a shipment has been and where it went. This may have large implications on problems such as enforcing product rules or tariffs as well as determining if a product was improperly stored (Dale, 2019).
Healthcare is another possible application of blockchain. Healthcare providers may store encrypted patient information on the blockchain. They would then only be able to access it if the patient provides their private key to allow access to the information (Daley, 2018). The technology may also be used in much the same way as it could within supply chains. It may be used to ensure that medication is labelled correctly and that it is handled and stored safely. It may also be used to reduce errors while administering healthcare or medication.
Finally, smart contracts are an interesting way to further ensure that exchange is eased. Instead of participants having to rely on trust that the other party will fulfil their end of an agreement, smart contracts execute only when the conditions that the two parties have agreed on have been fulfilled. Thus, no actions on behalf of either party to complete the contract are required. Furthermore, since the contracts are executed automatically, it is not possible for a contract to execute unless both parties have fulfilled their obligations. If a service has not been completed, a smart contract will not process payment until it is completed.
What is the future direction of the technology
Given the excitement around the technology, there are still many possible applications that blockchain may yet be applied to. However, it is important for the technology that its proponents do not try to oversell its capabilities as that might lead to its dismissal. Reed’s law states that the usefulness of networks increases exponentially as their size grows (Wikipedia, 2019). Thus, even if older solutions may be less efficient, their size gives them a huge advantage and any missteps on the part of the challengers will be very damaging to their long-term viability. Cryptocurrencies like bitcoin and ethereum may purport to solve problems within the financial system, but their ineffectiveness so far beyond speculative assets has soured potential participants on their use. The use of blockchain technology in areas such as smart contracts is a promising way in which this technology may lead to better systems for our day-to-day lives.
Source from: MERatings