Blockchain Explained in 3 Easy Steps
How Does Blockchain Work?
Many newcomers to the crypto space think of blockchain as complicated to understand. After reading this article you will realise that this is not the case and that blockchain is a very elegant piece of technology.
Blockchain technology is not a new technology. It is a combination of proven technologies combined in an innovative and simple way. We can break it down into three main technologies:
- Cryptographic Keys
- Distributed Network
- Network Servicing Protocol
The result is a system for digital interactions that does not need a trusted third party.
Let’s take a look at each of the technologies in turn and see how they combine giving us what we know as “blockchain technology”. We will also use Bitcoin as our example in this article, when describing the functionality blockchain. After all Bitcoin was the first real use case for blockchain.
Cryptographic Keys
When you interact with the Bitcoin blockchain you must first create a “wallet”. The wallet is basically the gateway into the Bitcoin ecosystem. This is where the cryptographic keys come into play. In order to access your wallet and perform transactions, you need to use the keys to unlock this functionality.
But how can we trust that the person using the wallet actually has the authority to transact with you and how do we know they are authentic?
Defining Trust
Trust is belief in reliability between two or more parties. Imagine if I were to sell you a book for 1 USD over the internet. We now have three options as to how this transaction can be managed:
- We can trust each other already, as we could be friends and know each other well. Therefore, when you pay the 1 USD, you will trust that I will send you the book in return. However, if we are strangers then the level of trust decreases.
- We could write a contract beforehand, stating that in exchange for the 1 USD, a book will be sent to you in return. With a contract both parties are more likely to carry out their side of the bargain, thus creating an environment of trust. However, it is quite difficult to constantly make contracts for all transactions, especially small transactions. We must consider additional costs to cover legal expenses. This would outweigh the profit from the transaction.
- We could have a neutral third party (a middleman) manage the transaction. So I could allow them to send the book when they verify that they have received the 1 USD. However, this means we now have to trust the middle man not to run away with the goods. Again we have to trust them or set up contracts to ensure this doesn’t happen.
Consequently: we can’t trust strangers and enforcing a contract requires time and money. Both trust and contract aren’t optimal solutions.
But now a third option has opened up to us which could mitigate the need for either trust or a contract . This is our blockchain solution. Blockchain can provide us with a trustless environment.
Defining Digital Trust
In the digital world there are 2 main points we need to consider:
- Proving Identity (authentication)
- Providing Permissions (authorisation)
Basically we want to know, “Are you who you say you are?” and “Have you got permission for what you are trying to do?”
Public and Private Keys
This leads us to cryptographic keys. Cryptographic keys consist of a public key and private key.
Private key cryptography provides a powerful ownership tool that fulfils authentication and authorisation requirements.
So how does this happen?
Imagine again, two people wish to transact over the internet. Each of them holds a public and private key. A public key can be thought of like an “email address”, it is available for people to see. People can use this “email address” to send you things. The private key is like the password and should be kept secret only to you. Subsequently, once you combine your email address and password, it gives you full access to your email account.
So in the case of a Bitcoin wallet, when you combine the public key and private key, you can access the blockchains functionality. This is done by the public and private keys creating a digital signature.
The digital signature is unique to the transaction request and your private key. Therefore, it cannot be used for other transactions. The main purpose of this is to create a secure digital identity reference. Identity is based on possession of a combination of public and private cryptographic keys. This provides a strong control of ownership.
Authentication and authorisation can be allowed in the digital world without relying on trust. Trust is expensive.
Distributed Network
Databases today are centralised and total control rests with the owners . This includes managing: access, updates and security. All big companies, governments and banks use centralised databases. This means we have to trust them with the control over the databases.
The distributed network database created by blockchain has fundamentally changed this dynamic. This is perhaps its most famous feature.
With a distributed network, no one person controls the information. Many people can contribute information, and can control how the record of information is amended and updated.
In the case of Bitcoin, the information we want to keep track of is the amount of Bitcoin each person owns. The distributed network in this case will store information as a ledger. This keeps track of all Bitcoin transactions.
The ledger file is not stored in a central database like a bank. Instead it is distributed across a network of private computers. Each of these computers is called a “node” and has a copy of the ledger. Anyone can run a node and nodes spread transactions around the network.
For a centralised database, the “master copy” is edited and then all users can see the new version.
Whereas for a distributed network, every node in the network is updating the record independently and forming consensus as to what it should look like. There is no master copy.
It is this difference that makes blockchain technology so useful by eliminating the need for a trusted third party to maintain a database truthfully.
Network Serving Protocol
When a transaction is broadcast to the distributed network, how does this transaction get processed with all the nodes in consensus? This is where mining comes in.
With Bitcoin, the goal of the protocol is to eliminate the possibility that the same Bitcoin is used in separate transactions at the same time (double spend). It needs to make sure, that all nodes in the network are in consensus, with regards to ledger updates. It does this by using a person’s self interest to help service the distributed network.
Some nodes in the network can become mining nodes (miners). Anyone can become a miner providing they download the software and have the right computing equipment. The job of the miner is to group outstanding transactions into blocks and add them to the blockchain.
In order for a block to be added to the blockchain, each block must contain an answer to a complex mathematical problem. Consequently, the miners have to solve this complex mathematical puzzle before the block can be added. This is part of the Bitcoin protocol and is called “Proof of Work” (PoW).
The miners can only find this number by guessing at random. This basically means that miners use their computing power to vote in agreement about new blocks or reject invalid blocks.
The first miner to solve the problem announces its victory to the rest of the network. All the other miners immediately stop work on that block and start trying to figure out the solution for the next block. As a reward for its work, the victorious miner gets some new Bitcoin.
Mining is very energy intensive and requires specialist computer equipment. Nevertheless, people decide to invest in mining in order to obtain the Bitcoin rewards. This is a clever solution using self interest, to service the distributed network.
Currently the mining reward for Bitcoin is 12.5 Bitcoins. Additionally, the Bitcoin protocol stipulates that there will only ever be 21 million Bitcoins mined into existence.
The type, amount and verification can be different for each blockchain. It is a matter of the blockchain’s protocol for what is and is not a valid transaction. The process of verification, rules and incentives can also be tailored for each blockchain. But they all have one objective in mind: reaching decentralised consensus.
Bringing it all Together
So let’s bring all the different parts of the jigsaw together and see how the whole process works.
The process begins with Peter taking his private key and making an announcement. He wants to send 10 Bitcoins so Simon. He will then broadcast this message to the network.
The message will tell the network that the amount of Bitcoins in his account should go down by 10 Bitcoins, and the amount in Simon’s account should go up by 10 Bitcoins. Peter broadcasts this by creating a digital signature through combining his private key with Simon’s public key.
Nodes in the network will receive the message and verify authentication and authorisation. They will then apply the requested transactions. This is done by the process of mining. The miners bundle the transaction request into a block and strat solving the mathematical problem to validate the block.
Once this has been validated, a block containing a digital signature, timestamp and ledger is then broadcast to all nodes in the network. The new block is added to the blockchain.
All ledgers across the distributed network are then updated with the new information. They now all have a record that Peter is down 10 Bitcoins and Simon has gained 10 Bitcoins. And of course the miner will receive his hard earned reward of 12.5 Bitcoins.
It’s as easy as that.
Conclusion
Blockchain technology is a very elegant solution to the problem of trust. It allows for an immutable public ledger to be updated without the need for a middleman. This in turn will enable P2P transactions between anyone of any socioeconomic background. This is a very powerful technological development which will have a big impact on how our economies work. Already we can see many use cases for this technology:
- Digital identity
- Digital assets
- Audit trails
- Smart contracts
- Remittances
- Distributed storage
This is just to name but a few use cases already out there. However, the first use case for blockchain was of course Bitcoin. Bitcoin is revolutionising the world. It has proven itself to be history’s first permanent, decentralised, global, trustless ledger of records.
