In my last article in this series, I provided a baseline for what Crypto is and how it’s more than just digital currencies. I outlined how Crypto is the next evolution of the Internet. The aim is to decentralize today’s power structures, removing friction from our current systems, and empower participants. The key invention that has the potential to enable these aims is called Blockchain and that’s the focus of today’s article.
As a reminder, this series is not an endorsement or recommendation to buy, sell or hold digital currencies. The intent is to provide you with an understanding of the concepts and principles underpinning this transformational technology.
What is a Blockchain?
While the word may sound complicated, a blockchain is nothing more than a digital ledger of transactions. As a comparison, consider your printed bank statement. It too is a ledger. One that details your financial transactions. Both types of ledgers list transactions in chronological order, but that is where the similarities end.
The “block” in blockchain comes from how data is stored on the digital ledger. Multiple transactions are grouped and stored in a block that gets linked sequentially to the previous block. Each block is time-stamped and tagged to the preceding block when it is recorded onto the ledger. This information is subsequently hardcoded into the next block which creates an immutable chain of record. Once recorded, the block cannot be manipulated. The data is irreversible.
Blockchains are stored in a decentralized fashion. Instead of being stored in one location, on one computer, or in one copy of the ledger, copies of the blockchain ledger are stored across thousands of computers. Anyone can store a copy of the ledger on their personal computer.
Continuing our example of your bank statement, the bank has one ledger that records transactions. Their ledger is proprietary to them, and only they can see it. Therefore, they are the only one that can change the ledger, and they are the only one that can say if the data stored on it is true. In contrast, everyone who has a copy of the blockchain ledger stored on their computer can see the transactions contained on the ledger.
This decentralized approach offers a couple of advantages. First, the blockchain provides transparency to everyone involved. As blocks are added to the chain each copy of the ledger is updated in real-time. Everyone can see every block ever created. Second, the distributed nature of the blockchain means that no single user has control. All of the users collectively have control of the ledger. Finally, the integrity of the blockchain is maintained using consensus. If one user attempts to modify an existing block, all of the other users will identify it as incorrect and discard it.
Can blockchain be trusted?
In real life, the systems that impact our daily activities are based in large part on trust. We trust that our bank is going to record our financial transactions correctly. We trust the systems that have access to our personal information are not going to misuse it. We trust our institutions to obey our laws and treat everyone fairly. Can blockchain replicate this trust?
The beauty of blockchain technology is that it can. Using a decentralized ledger that provides transparency and relies upon consensus offers the ability to create systems with immutable features and security. Let’s assume a user on the blockchain wanted to change the rules or modify a block. That would require a 51% consensus of the users. As the user base grows, it will take more and more effort to reach a consensus. Without this consensus, the proposed change would fail. The rules would not change. The integrity of the data remains intact.
Now that we’ve covered what a blockchain is, let’s turn our attention to two other important aspects: how do you know who the users are and how are blocks created.
Using cryptography for digital identity
In the real world, there are many ways we can verify the identity of an individual. We can use fingerprints, facial features, signatures, and our knowledge of the person we are interacting with to confirm our interactions are legitimate. But how do you do that in a digital world?
Let’s use the example of opening a checking account for reference. When you open a checking account, you have to sign a signature card. This is the bank’s way of recording the authenticity of your signature. In the event there is ever a question about a check being written by someone other than you, the bank can reference the signature card to prove (or disprove) it was you that wrote it. When you engage with someone to buy a good or service, the check you write is the record between you and them and your signature proves it’s you. Together, the check and signature substantiate the authenticity of the transaction.
In the digital world, we could use an image of our signature, but that would be easy to copy and paste. We need a way to verify the authenticity of the digital signature. Fortunately, this is a problem that has been solved using cryptography – the art of writing or solving codes. Each user on the blockchain has a unique identifier that contains both a public and a private key. The private key unlocks the public one. Only the user has access to the private key. When a transaction takes place, the public key is recorded along with the other details. The veracity of the transaction can be confirmed by comparing it to the private key held by the legitimate user. As long as the user keeps their private key a secret, no one can impersonate them.
The use of public/private secret keys opens up tremendous opportunities for facilitating interactions among people and institutions. Imagine a voting system that used this authentication technique to ensure the integrity of an election. Each citizen could be given a token that represents their public key. When they cast their vote by giving the token to their candidate of choice, they sign it using their private key. The candidate with the most tokens is declared the winner. And the integrity is maintained because each token can only have one public/private key.
You may have been asked before to sign documents electronically. This is becoming common when you buy a house or finance a mortgage. You’ll be emailed a form and asked to create a digital signature. Once you sign the electronic form with the digital signature, the form becomes encrypted and can no longer be modified. This is a relatively simple application of using cryptography to substantiate the digital identity of someone.
How blocks are created
Now that we’ve talked about the merits of a blockchain and the cryptography that fosters digital identities, let’s turn our focus to how blocks are created. The act of creating a block is often referred to as mining. While there aren’t any prospectors tucked away in a computer somewhere physically mining for gold, the process of creating a block does require resources and that’s where the term comes from.
Each block contains three types of information: the transaction data between the parties, the hash of the block, and the hash of the previous block.
The transaction data is the information describing the transaction between two parties on the system. Imagine you and I are users on the system and I give you ten dollars. The transaction data would consist of my public key, your public key, and instructions to debit my wallet and credit yours.
A hash is a unique identifier for the block. It is similar to a fingerprint. The hash contains the block identifier, all of the information contained within the block, and the hash of the previous block.
The inclusion of the previous block’s hash is the chain between blocks. This process of including the previous hash makes it nearly impossible to modify existing blocks on the ledger.
The creation of a hash requires solving a very complex mathematical problem and can take up to ten minutes in some cases. Expending the resources necessary – in terms of computer hardware and energy – to solve the math problem is the “mining” aspect of creating a block. Once solved, a math proof of the work involved in solving the problem is included in the hash of the block.
Now that the block has been created, it needs to be added to the ledger. Since the blockchain ledger is distributed among all its users, every user will receive a copy of the new block. Users will verify the authenticity of the block by using the proof of work to solve the math problem. If everything checks out, they will add the block to the blockchain. This is where consensus comes into play. Provided more than 50% of users agree, the block is added to the ledger and the process moves onto the next block. If a malicious block is presented, the majority of users will dismiss it.
Ok, we’re 1,500 words into this article so let’s bring it to a close. Blockchain is the underlying technology that supports the digital architecture being developed to disrupt existing systems. Using cryptography, complex mathematical problems, and consensus among users, the data stored on the blockchain ledger is nearly impossible to change. These characteristics offer a high degree of trust among users that the transactions recorded on the chain are legitimate. As the number of users and transactions on the blockchain grows, it becomes more secure.
The possibilities for disrupting current systems using blockchain technologies are limitless. The simple ones to imagine involve our financial systems and that is where a lot of development is underway. Future articles in this series will provide examples of some of the applications currently in use or under development.
Until next time…
Disclosure: The topics discussed in this article are for general financial education and are not intended to provide specific investment advice or recommendations. Opinions, estimates, forecasts, and statements of financial market trends are based on current market conditions and are subject to change without notice. The information has been obtained from sources considered reliable but is not guaranteed. Sources include Andreessen Horowitz, Investopedia and Simply Explained.