Beginner's Guide to the Blockchain

Getting involved with cryptocurrency is exciting. There are so many things to learn, so many digital tokens to analyze, and so many investment choices to make that you will spend a lot of time educating yourself. One of the things that you will surely want to learn more about are blockchains and the role they play in the development of Bitcoin, Ethereum, and other digital assets.

Some people get intimidated by the very term. Blockchain is a word that is linked to technology, and that can make those who aren’t really interested in technology shy away from learning more about the concept. The truth is that you don’t need a technology background to understand what a blockchain is and what it does, and achieving that understanding will place cryptocurrencies in a whole new light. The whole idea of digital assets as a medium of exchange will start to make more sense.

Here is a beginner’s guide to the blockchain. It will delve into some history, answe some basic questions, and describe how the technology is being adopted today by major financial institutions and other companies.

What is Blockchain?

A blockchain may be properly defined as a digital ledger in which transactions made in Bitcoin or another cryptocurrency are recorded chronologically and publicly. Did that basic definition immediately shatter some of the notions you might have about crytpocurrency? Probably so. One of the first misconceptions people have about Bitcoin and other digital assets is that they exist in some sketchy, shadowy world where people want to conceal how they spend money. These people reason that nothing good can come out of such anonymity.

The truth isn’t quite so nefarious. Bitcoin and blockchain technology have a more noble origin story. The actual goal of the first blockchain was to store data in way that prevents misuse or appropriation by those with unethical motives. According to a blockchain article in the MIT Technology Review, the platform makes it almost impossible to fake data, and a blockchain can be used for storing data of all kinds. That’s right. It doesn’t just have to record cryptocurrency transactions.

At the heart of the blockchain is a very old dilemma. That dilemma is finding a way to create trust between individuals so that something of value can be peacefully exchanged. For many years now, banks and other financial institutions have been the facilitators of that trust. Unfortunately, faith in banks and the governments that back them has been eroded over time. Many of these institutions have failed. There is also the matter of the digital age in which we now live. There is a need for faster and more secure transactions. These are some of the problems a blockchain proposes to solve. It is possible to use blockchains to automate trust, and the result is a decentralized method of data exchange.

A blockchain allows digital information to be distributed without being copied. The digital ledger that is a blockchain is incorruptible. It can be used to record much more than cryptocurrency transactions. It can be used to record anything of value. At least one couple has even used a blockchain to record a marriage contract, essentially becoming the first people to create a digital record of a marriage certificate. Notarized documents can be recorded, and a blockchain has even been used to assist refugees from a war torn nation. The possibilities are endless.

The History of Blockchains

In October of 2008, a whitepaper was distributed by an individual named Satoshi Nakamoto. The initial announcement of the whitepaper was made to a mailing list comprised of individuals who had an interest in cryptography. The message announcing the paper was simple and straightforward:

“I’ve been working on a new electronic cash system that’s fully peer-to-peer, with no trusted third-party.”

That simple declaration was the genesis of the cryptocurrency called Bitcoin and the blockchain technology that supports it. It has since been suggested that Satoshi Nakamoto was actually a name assumed by a group of programmers and cryptography experts. Some still believe that Nakamoto was one individual. Whoever or whomever created the technology, their identity has remained a matter of speculation.

The whitepaper was nine pages in length and it described a technology that brand new and controversial. Today, the technology is regarded as something which could completely alter the way individuals and institutions perceive financial systems. This has contributed to the general mystique that often generates misconceptions about blockchain technology.

While blockchain technology and Bitcoin exist as separate ideas, one cannot understand the history of blockchains without referencing the cryptocurrency for which the first blockchain was used. Bitcoin, as a form of digital currency, was dependent upon digital trust in order to make it a viable method of exchange. What the blockchain did was make that trust a possibility. It did this by accomplishing two factors. First, it allowed individuals to record transactions in a public place. Second, it did not permit the records of those transactions to be altered. The idea of a blockchain embraces transparency, a decentralized nature, and a method of time-stamping the the addition of data to a digital ledger.

It might help to think about the blockchain by considering the relationship between the Internet and email. Email is just one application that is enabled by an Internet connection, but without Internet networks there is no email. The same can be said of the blockchain. Bitcoin and other digital assets are only one application that can be based on a blockchain. As the world is beginning to see, there are many other uses for this powerful technology.

Therein lies one of the great misunderstandings about blockchain technology. It is assumed by many that Bitcoin and a blockchain are one and the same. This misunderstanding is so prevalent that a blockchain is often referred to as the blockchain, as though there is only one. Any number of blockchains can be created for any number of purposes. The Bitcoin blockchain was just the first and most familiar example.

The digital currency Ethereum has its own blockchain. It has become so popular that many new digital tokens use it as a framework because of something known as Smart Contracts. Once the world began to see the potential of blockchains, the technology began to be used for a variety of purposes. It is estimated that some 15% of financial institutions around the world are now using a blockchain for various applications.

In 2015, Ethereum became the second public blockchain project. It was created by someone who did not remain anonymous. Vitalik Buterin felt that the Bitcoin blockchain suffered from some limitations and sought to improve the technology with his own blockchain platform. This is a significant moment in blockchain history because the Ethereum architecture made it possible for a blockchain to record more than financial transactions. The wedding contract that we mentioned earlier was created and recorded on the Ethereum blockchain.

How does Blockchain work

There are a few ways of explaining how a blockchain works, ranging from the simple to the complex. We’ll start by describing the function of a blockchain in simple terms before moving on to a more technical assessment.

The first thing that you need to understand is that all blockchains have three elements in common. These are cryptography, a distributed network that has a shared ledger, and some type of reward that encourages people to help the network maintain security, verify transactions, and maintain the ledger’s records. In a nutshell, these are the three things that a blockchain has in some form or another.

Each of these elements actually exists as its own individual technology. When the three technologies are combined, a blockchain is possible. Now, let’s take a look at each element individually and supply an explanation.

Cryptography in a blockchain is simply the process of encryption. It is taking data and making that data only accessible to those who possess a public and private key. Let’s sat that there are two individuals who wish to make a transaction of digital good over the internet. Those goods can be tokens, information, sensitive communications, or records. Each individual has a public key and a private key. What these keys actually accomplish is one of the most misunderstood aspects of cryptocurrency.

A public key and a private key work together to create a digital signature. This signature is considered proof of ownership, and it also signifies consent. When these two unique keys are used in tandem with one another, they form an almost impenetrable identity reference. Once this information enters a blockchain, a lasting record of the transaction is created. That transaction can be viewed by anyone at any time.

While the public and private keys of an individual can be obtained and used anonymously to a certain extent, no transaction completed on a blockchain is anonymous. Some individuals believe that Bitcoin and other digital tokens are a totally untraceable method of finance. This is not true. The identity of the person participating in the transaction may be obscured, but the transaction itself is not.

A quick word should be added here on the subject of anonymity. If you plan to invest in cryptocurrency or trade it on an exchange, be prepared to verify your identity. It is practically impossible to find an exchange that will let you trade anonymously.

Identity, in and of itself, is not enough to accomplish the work of a blockchain. It is also important to have verification of transactions. Approving and authorizing transactions is an important companion to authentication through encrypted public and private keys. A distributed network is the starting point of verifying transactions on a blockchain.

To effectively use Bitcoin and other cryptocurrencies as means of exchange, we must have some way of validating that a transaction has occurred. In traditional finance, banks provide the validation. Their systems are responsible for recording transactions, and, as you probably know, trying to convince the bank that their system has made an error is very difficult. With a blockchain, a process of mathematical verification is used to essentially capture a single moment in time when a transaction occurred. This verification is very similar to taking a picture of something. You have created a permanent record of a specific event.

A blockchain is a large network of validating parties who all essentially record the same event at the same time. Their consensus, or agreement, is what validates the occurrence of a transaction. The size of the network is what creates reliability. The Bitcoin blockchain is a very large distributed network.

So, to sum up the process thus far let’s assume that two individuals are going to complete a Bitcoin transaction. Person A uses their private key to initiate a transfer of Bitcoin to Person B’s public key. At that moment, interactions begin to occur. The two keys are linked, a time-stamp is created, a description might be added, and a cryptographic hash is created to preserve a record of these interactions. All of the information is then added to a “block”, and the block is broadcast or distributed to the network of validating parties, or nodes.

Finally, to verify these transactions the blocks of hashed information must be verified. This is the solving of the mathematical equation mentioned earlier. The third and final piece of technology exists to reward those who solve the equation. Most often the reward is in digital tokens. Therefore, those who help to preserve the integrity of the Bitcoin blockchain by verifying transactions are given Bitcoin as a reward. The amount of the reward can vary based on many factors.

The process above is generally referred to as a Proof of Work system. Some blockchains being developed today are transitioning to something known as a Proof of Stake system which functions a little differently than the standard blockchain.

Proof of Work vs. Proof of Stake

Those who help to maintain a blockchain by verifying transactions and solving the blockchain’s mathematical equations are often able to earn a reward for their efforts. This is called mining. Mining cryptocurrency today is a complex operation that requires expensive equipment. It can also consume loads of electricity. These factors put mining beyond the reach of the average cryptocurrency hobbyist, although it is possible to participate in mining collectives where individuals purchase contracts from the collective and share the rewards that are earned.

The Proof of Work system was the initial method of managing a blockchain. It has been a part of the Bitcoin platform since the very beginning. Let us first define Proof of Work in very simple terms: Proof of Work may be defined as a requirement to solve complex computer problems that are mathematical in nature. This is what is referred to when you hear someone speak of mining. Those who solve these equations are called miners. The first miner to resolve an equation is given a reward. Miners are essentially in competition with one another to be the first to solve these equations.

Proof of Work has another goal, however, that reaches beyond rewarding those who solve cryptographic problems on the blockchain. That goal is to help deter cyber attacks. The Proof of Work system is actually much older than Bitcoin. It can be traced to 1993. But, the most important feature of the Proof of Work protocol as it applies to a blockchain is that it enables a trust-free system of exchange, the very hallmark of cryptocurrrency. Proof of Work makes it possible for distribution to occur without the need of third-party involvement.

Remember, we initially mentioned that cryptocurrency and blockchain technology provides the ability to engage in exchange without the need for a third-party such as a bank or credit card processor. The third-party in a traditional fiat exchange system is the one who maintains the ledger. You want to send $500 to a friend from your account. Someone has to track that distribution and record it so that your account reflects a debit of $500 and your friend’s account shows a deposit. Third-parties perform this service.

A blockchain is a ledger. When transactions are made involving Bitcoin or other cryptocurrencies, these transactions are packaged together in what is called a block. Miners then verify that these transactions are legitimate by solving a complex equation. Once verified, the transactions become a part of the public blockchain where they are maintained forever.

The launch of the Ethereum platform introduced something known as a Proof of Stake. This protocol functions differently than a Proof of Work. Proof of Stake achieves the same goal of verifying transactions on a blockchain, but it goes about the process in a different way. Peercoin was actually the first cryptocurrency to use the protocol, but it has gained popularity due to Ethereum.

In this system, the individual or group who verifies a block does not perform work. They are chosen in a rather arbitrary fashion according to the stake they have in the digital asset. In this system, no new coins are being created as a result of the verification process. A fixed number of tokens was established at the beginning and this number does not change.

So, how are individuals rewarded in this type of system? They are given transaction fees from the transactions they process. The method of choosing those who hold a stake and are able to verify can vary from token to token.

Conclusion

You now have a very basic idea of what a blockchain is, how it works, and how it rewards those who help to maintain it. This explanation, however, has not sufficed to fully explore the complexities of blockchain technology and what it has to offer the world.

We are only just learning about the full possibilities of this technology. Hopefully, the information you have received here will inspire you to do additional research about how businesses are using blockchains for a wide variety of applications.

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