Blockchain technology is being called the most important innovation since the internet. Enthusiasts of the technology say it will disrupt existing industries and have a direct impact on people’s lives within a few decades. This article will explain what blockchain technology is, how it works, and its benefits in a simple an easy-to-understand way. Are you ready to get started?
So, what is the blockchain?
Blockchain is a database or a ledger. But, this simple explanation doesn’t live up to the genius behind how this technology records values and transactions. Until recent times, people had to trust third parties (such as banks, governments, and companies) to store their assets of value and transactions’ information. When you make a purchase with your credit card, you trust that the credit card company and the bank will keep your personal information and transaction details safe, for example. This belief in institutions is not only applied to financial negotiations. A car rental also keeps a central database with your personal details, your address, the cars you rented and when you need to return them. You believe all this information will also be kept private and safe with them. Information was always centralized in these institutions, and each of them had to maintain their own records and systems. Not anymore!
Trust issues and the blockchain
When people are going to carry out a transaction, they are expected to trust the institutions involved. Picture the above-cited relationships without the presence of institutions. Would you accept a piece of paper saying “I owe you $50” from a person you don’t know? Probably not. Also, banks can collapse, governments can freeze withdrawals (especially in developing countries), and car rentals can shut their doors… That’s why the blockchain technology can be so useful. A decentralized database built on the blockchain removes the need for centralized institutions and databases. Everyone can view and validate transactions on the blockchain, therefore creating transparency and trust. Blockchain eliminates the need for an intermediary involved in these transactions.
Difference between blockchain and Bitcoin (or any other cryptocurrency)
A common mistake that is being made is to think that Bitcoin and blockchain are the same thing. Bitcoin is a digital currency and is used to make payments. Bitcoin uses the blockchain technology to record transaction information. While bitcoin is mainly used for financial transactions, the blockchain can be used to transfer and record anything, not just payments. Blockchain-based systems can be used for a wide variety of applications, such as voting; personal identification; insurance; birth, wedding and death certificates; among others.
How the Blockchain works
A good way to get a clear notion of how the blockchain works is with our car rental example. Every time a person rents a car it creates a transaction and the intermediary in these transactions is the car rental itself. The car rental keeps all the information of the cars rented and the people who have rented them in its own database. If a person rented a car that you also wanted to rent, you’ll need to wait they return it in order to rent it. Even if this person lives in your building (you won’t have this information), you’ll have to get it directly from the car rental after it is returned. Now, imagine a decentralized car rental where people can rent your car directly from you and also rent this car to other people without bringing it back to you. At the same time, there would be a public listing of who has rented it and who is the original owner. In this new car rental model, anyone is able to join and get access to the records. Every time a car is rented a new transaction is recorded and all database is updated. This new car rental is operated by all people who join it without the need for an external institution to centralize the records of what happens with the cars. This is actually how the blockchain works.
Why do they call it blockchain?
Returning to the car rental example, a new transaction is created every time a car is rented. There are lots of people renting cars at the same time. New transactions, for several different cars, are grouped together in a block. This new block of information is organized on top of the previous block of transactions. Every time a new block of transactions is created it is linked to the previous block. Since all blocks are linked, it creates a chain of blocks. In our example, it is possible for anyone to track all the cars that have been rented and by whom. It is even possible to go back to the first block (known as the genesis block) to see who owns a specific car.
Making changes to transactions and blocks already added
When a block of information is added to the blockchain it can’t be changed (technically, it is somewhere near impossible): its registration is immutable. Every time a new block is added to the blockchain, we have what is called a ‘confirmation’ Estimation is that after 6 confirmations it is mathematically impossible to change any transactions in that block. That's why some companies wait for 6 confirmations to accept a payment made through blockchain-based currencies.
Approving transactions to be added to the blockchain
For a transaction to be added to the blockchain, the majority of people on the network need to agree that this transaction is valid. This is called distributed consensus. A transaction is only accepted as valid if more than 50% of the people on the network accept it. Let’s say that a guy joins the car rental network (let’s call him John). John rents his car and receives one CarCoin - the currency used in this network (assuming that every car is rented for one CarCoin). Right after that, he tries to rent one car from Julia and subsequently another one from Marcia. This will create 2 transactions. The first one is sent to everyone on the network, is validated (John pays Julia one CarCoin) and the transaction is added to a new block. After the first transaction goes through, the network receives the second one. They check that John’s CarCoin balance is zero, so they agree that this is an invalid transaction and reject it. People who participate in this validation of transactions and add valid blocks of transactions to the blockchain gets a reward for this effort. This is called mining.
For a transaction to be validated and added to a block, the computers on the network must solve a puzzle. This puzzle is known as proof of work. The computer that correctly solves it, adds the transaction to a new block. The reward for solving it first is paid in the currency (also called token) used on that network - the token in our example was the CarCoin. Since they are extracting small amounts out of a block, this activity is known as mining.
Benefits of Blockchain technology
Blockchain technology brings an opportunity to radically disrupt the way we record and make transactions. It will transform industries as we know because of these benefits:
How the blockchains works
Changes made to the blockchain are visible to everyone on the network. Once transactions are entered onto the blockchain they can’t be modified. Transactions are approved (or not) and added in near real-time. This scenario mitigates the occurrence of eventual fraud made by people or enterprises.
Removal of Intermediaries
Blockchain technology removes the need for third parties to intermediate transactions. Instead, it allows transactions to occur directly between people. This is particularly useful in countries where people can’t trust their governments or in companies with manual record keeping for example. Every time the trust in intermediaries is poor or nonexistent, blockchain puts itself as a better alternative.
Centralized databases are more likely to be hacked, suffer data loss and corruption. Blockchains are maintained on a single ledger shared with the whole network, instead of multiple ledgers that are managed individually by distinct institutions. Every computer on the network keeps a copy of the blockchain decreasing the risk of data loss. Also, in order to hack data on the blockchain, it would be necessary to do it at the same time on over 50% of the computers on the network, something near impossible.
Even though blockchain removes intermediaries of transactions, it keeps trust and security between those involved in the transaction, because of its decentralized and transparent characteristics.
Data entered onto the blockchain can’t be changed. This immutability creates a clear track of every transaction. It is even possible to build an easy-to-follow trail back to the first block (the genesis block) if necessary. This solves many of the security issues that occur in conventional systems and improves corruption combat and prevention.
By removing intermediaries, blockchain technology can naturally reduce costs in many industries. Also, blockchain-based distributed ledgers reduce the costs by replacing individual ledgers with a single decentralized one.
Increased speed of transactions
Transactions are registered near real-time on the blockchain. This is possible because of the removal of intermediaries and its decentralized profile (shared distributed ledger). Any type of transaction or value transfer could potentially benefit from the blockchain technology to increase the speed of transactions. The infographic below groups these benefits: With the hype of bitcoins and cryptocurrencies coming back again, the buzz about blockchain technology is also on the rise.
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