The Internet brought us the email, social media, cloud computing, and IoT. It greatly reduced the costs of exchanging information and allowed new forms of innovative digital ventures. Even if the Internet provided the means for many new developments, it still has one important limitation for doing business: it does not bring an inherent method to establish one’s identity. Thus, in order to exchange value online, we still have to rely on validation provided by third parties like governments or banks.
During the 90’s, the American computer scientist David Chaum developed eCash which was a digital an electronic cash system designed to protect user’s anonymity. Unfortunately, even if big companies like Microsoft were interested in the product, the vast majority of Internet users were not preoccupied with privacy and security.
Yet, ten years later, we witnessed the crash of the financial industry. In the same time, a person or a group of persons under the pseudonym of Satoshi Nakamoto devised a peer to peer cryptocurrency called bitcoin.
Cryptocurrencies, in contrast to money, are not controlled or regulated by countries and they do not require a third party to establish trust.
No matter how disruptive the bitcoin proved to be for the payments industry, the true innovation was in the underlying protocol, called blockchain. In this article we will provide a simple explanation of how does blockchain work and we will highlight the main benefits of the blockchain
For starters, it is important to mention that, even if blockchain was introduced as the underlying technology of bitcoin, the true value of this technology comes from its wide range of applications.
However, since most of the readers are familiar with bitcoin, our explanation explained article will mostly refer to how bitcoin’s blockchain works.
One can think of the blockchain as digital ledger keeping track of user’s balances. For example, bitcoin’s blockchain is a database that stores the flow, via debit and credits, of its currency- bitcoin.
But why is this blockchain technology so special?
Here is the simple answer: blockchain is a distributed, immutable, and cryptographic database which relies on PoW (“Proof of Work”) consensus mechanism.
For sure, the answer was short. But, was it simple? Did it helped you understand how does blockchain work? Not yet.
Let’s move forward with our blockchain explained article, take this definition piece by piece and explain it.
The blockchain is distributed because, unlike centralized databases that impose controls on who is entitled to access information, any computer with an Internet connection can connect to bitcoin’s blockchain.
Because of the fact that anyone can connect and check the record of transactions, the blockchain creates a system of trust where everything is transparent.
Each transaction that is going to be recorded on the bitcoin’s blockchain has to be cryptographically verified to make sure that the person’s trying to send the number of coins actually owns them.
It is important to understand that transactions are not added one at a time, but are grouped in blocks. The blocks are then linked together, hence the term blockchain.
We will explain in detail how this process works in our PoW section of this blockchain explained article. For the moment, you should only understand that, by making use of cryptography, the computers connected to the blockchain are able to collaborate based on mathematical trust
As a result of the fact that blockchain is built on a p2p network of computers that use cryptography to verify transactions, once the information is added, there is no way to be deleted.
Thus, the blockchain is an immutable database. Immutability is one of the key aspects that makes the blockchain technology unique, as almost anything digitally stored can be easily duplicated.
Here comes the truly unique part, that brings together the above-mentioned characteristics and will help you understand how does blockhain work. Proof of work (“PoW”) is the process that allows the computers agree (reach consensus) regarding which group of transactions (block) should be appended to the blockchain.
The computers, usually called miners, compete against each other, by searching the solution of a cryptographic puzzle, to win the right to add a block to the blockchain. Remember that, when a block is added, as the blockchain is immutable, all transactions are confirmed.
Each time a miner adds a block, he is rewarded with an amount of bitcoin. This is the incentive that makes the miners join the network and compete.
In order to find the solution to the cryptographic puzzle, a miner takes into account just four variables: the timestamp, the proposed transactions, the previous block, and a special variable known as a nonce.
Hey, wait a minute! What is a nonce?
The nonce stands for “number used once” and is a randomly chosen number with a unique quality. Once combined with the other three inputs, it should meet certain difficult criteria. The difficulty of the problem is dynamically modified to make sure that miners solve each puzzle every 10 minutes.
As we already mentioned, one of the four variables taken as inputs is the identity of the previous block, which, in turn, contained a reference to the block before that. With this method, all the blocks are linked together, and no information in any previous block could be altered without changing all the later blocks. If such a change would be proposed by a malevolent person, it would be rejected by the majority of nodes.
We know that miners compete to solve cryptographic puzzles. Let’s continue our simple explanation of how blockchain does work by discussing how the puzzles are solved.
Remember that, in order to find the solution, miners have to guess the nonce. The nonce, when passed through a function along with other three inputs, should produce a result that falls within a certain range.
How do the miners find this number? By simply guessing.
Since the use of a hash function makes it impossible to know the output in advance, miners repeatedly come up with different values and apply the hash function until the result starts with a certain number of zeroes (the difficulty).
The miner who finds the correct hash, announces the result to the other participants. As a reward, the miner gets some newly minted coins.
By solving cryptographic puzzles, miners secure the network and provide protection against double-spending.
We have seen that miners work on transactions to solve the puzzles and earn new coins.
But this is not all. Somebody needs to verify that the solution found by a miner is correct. This tasks belong to validation notes, or simply nodes. Their opinion on a certain proposed block is called consensus. If more than 51% of the nodes consider the block legit, it is saved to the blockchain.
In order to do that, nodes download and validate the entire blockchain, since its inception. Hence, the nodes are capable to enforce all the rules on the new blocks that are proposed by the miners.
Another aspect that needs to be clarified in order to fully understand how blockchain works, is the difference between public and private blockchains.
In general, two types of entities can own the hardware that powers a blockchain: public and private. To understand how blockchain works with respect to public and private blockchains, we will use a simple analogy.
Public blockchains, like the Internet, are open to anyone. There is no gatekeeper. Conversely, private blockchains are like intranets. They are walled and usually companies transmit and store private information through them.
Public and private blockchain have many similarities:
Private blockchains appeared several years after bitcoin did, when companies realized the utility of the blockchain but:
To conclude, companies that opted to use private blockchains will enjoy significant money and time savings. Even if private blockchains are not so much different than their older peers, they provide a lot of powerful cases for enterprises.
To many people, the blockchain has more to offer than the bitcoin, the cryptocurrency it was created to support. Without further ado, let’s see the most important benefits that blockchain could bring to businesses in different industries.
In the healthcare sector, professionals already use digitization to manage medical records. Furthermore, hospitals are equipped with smart devices that oversee the patients.
However, only a few devices communicate with one another. By combining blockchain and IoT, new applications could link these devices to enable monitoring and disease management.
Imagine, for example, new smart drugs that could track themselves and present their effectiveness and side effects in medical trials with no risk of modified results.
The blockchain technology is able to offer two main benefits to supply chain management: traceability and cost-effectiveness. The blockchain can track the movement of goods, along with their origin, quantity and any other characteristics. This brings a totally new level of transparency to B2B systems and has the potential to simplify many processes like production, ownership transfer, insurance and so on.
The promise of blockchains here boils down to trust. By using blockchain to count the number of votes in elections, the likelihood of electoral fraud will be greatly diminished.
Business can sometimes be overwhelmed by time-consuming contractual transactions. By using smart contracts on top of the blockchain, an agreement can be automatically defined, signed and enforced. There will be no need for mediators and cumbersome procedures, which will save both time and money
Today, cloud storage is centralized, meaning that users must trust a single provider who controls their data. Conversely, with blockchain, cloud storage could become decentralized. By hashing and storing data in multiple locations, the overall security will be increased. Also, the users like me and you will be able to rent out their excess capacity.
As we have seen, one of the variables a miner takes into account to calculate the hash is the timestamp. Simply put, the trustless decentralized network clearly confirms the existence of (something) at a certain moment in time.
As shown in our simple explanation of how blockchain works, this technology has applications that go far beyond bitcoin or cryptocurrencies. Blockchain will probably disrupt all the industries that currently rely on intermediaries, like banking, finance, healthcare, insurance, legal, and many more.
Even if this will result in complete transformations and job losses, we think that he removal of intermediaries will bring overall positive outcomes.
As a result of blockchain’s adoption, people and businesses will be able to trade more efficiently, significantly boosting innovation. With an ever-growing list of uses, blockchain is deemed have a significant impact on our future.
We are just witnessing the beginning.