The Blockchain: How It Works

The Blockchain is a distributed database, an ever-growing list of ordered entries, which are called blocks. Each block contains a timestamp and a link to the previous block.

The Blockchain principle was developed by a mysterious person going by the name of Satoshi Nakamoto, whose identity remains unknown to this day. Because of the mystery, some suspect that this name disguises a group of infotech specialists, possibly even secret service. The first project leveraging the principles of the Blockchain was created a year later — as the cryptocurrency (or digital money) called Bitcoin, which uses the blockchain as a public log of all transactions ever performed with it.

Blockchain Principles

The blockchain uses a distributed database, or ledger, based on specific mathematical equations called cryptographic hash functions, or a hashing algorithm.

The classical example of a decentralised database is the monetary system devised on the island of Yap in Micronesia. The islanders used limestone discs close to two metres in diameter and weighing about 200 kg each. These peculiar “coins’ were stored at visible locations accessible to anyone on the island, and everybody knew exactly who owned them because every transaction was announced publicly — every inhabitant of Yap would be informed about them. Importantly, the islanders continued to consider “coins” that were not physically accessible (e.g. those that drowned in the ocean during transport from the quarry on a neighbouring island) to be in circulation as well. And since everyone knew who owned which “coin” and could remember previous transactions with specific coins, there was no way to appropriate someone else’s money.

This principle of keeping each participant of the system informed about everyone’s property is used in the blockchain. However, because today’s virtual environment is not the island of Yap, which was inhabited by just a few hundred people who knew each other, the transactions are guaranteed by cryptographic hash functions. These are special equations that compute unique codes that have the length of a predetermined number of characters (usually around 30), based on any text entered into a given equation, or function. These functions can hash any amount of information, whether it is just a single character or an enormous block of data. Cryptographic hash functions are one-way only: they can only assign unique codes. If the same string of text is entered, the resulting code, or hash, will always remain the same; if so much as a single character is different, the unique code will be completely different.

Thanks to this feature, cryptographic hash functions serve several purposes in the blockchain: anonymity (personal data can also be encrypted, although you can always prove their identity if necessary — by entering information that only you know); universality, verifying that the participants of a transaction use the same database; and the creation of new blocks.

Blocks and Blockchain 2.0

Blocks, or new entries in the blockchain, are generated in the classical system on a regular basis using multiple transactions at once — this is performed by so-called miners, who use their available computing power to complete the task. In this case, mining is a fully decentralised process; the process is also used to issue (create) new cryptocurrency units. Miners are compensated for creating new blocks in new units of digital currency — and this is where the algorithms of different blockchains may vary. The blockchain treats a transaction as final once a new block is added to the chain containing information about the transaction. Overall, this method makes blockchains particularly secure against modification of entries: modifying a single older block will require changes to every block that has been generated since.

At the same time, decentralised mining and issue of new digital money is not necessary. New blocks may be generated in a centralised manner (with distributed databases or hybrid ones, which are only partly distributed), while coin issue can be tied to a specific carrier of value, the subject of a transaction, someone’s right of ownership etc. This means that the possibilities of a blockchain reach far beyond digital coins — today, we are witnessing a transition to so-called Blockchain 2.0, where the blockchain is used for a variety of other transactions, including verification of ownership. It applies in particular to transactions with real estate, stocks, certain goods etc. There is potential (we could call this Blockchain 3.0) to incorporate transactions beyond trading, such as organising a wide variety of activities, or operating various sorts of managerial or administrative mechanisms.

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