How Blockchain Works (A Beginner’s Guide)
“Our ancestors said, “This is as good as written in stone.” Our grandchildren will say, “It is as good as written on the blockchain.” ― Andreas M. Antonopoulos, The Internet of Money Volume Two
In truth, you don’t need to know all the technical details of Blockchain to be able to use it, in the same way you don’t need to know exactly how the internet works to be able to send an email or book a flight online.
It’s still valuable to empower yourself by learning the basics, so you can have a better understanding of this important new technology.
Here’s the Luno guide to Blockchain for beginners.
The Bitcoin Blockchain
For many years, people tried to create digital currencies. However, they always ran into one big problem.
If something is digital, you can make copies of it. The media industry discovered this to its peril with the rise of pirating. Which is problematic enough for movies or songs, but it’s a total roadblock for currencies.
A currency you can spend many times (the double spending problem) is worse than Monopoly money.
Your local government issues the banknotes in your wallet right now. You can’t make your own — it’s illegal. You rely on a central authority to control the number of banknotes in circulation. When you make a transfer, your bank subtracts money from your account and adds it to the recipient’s.
This system has chugged along for centuries, but it has flaws. When activists known as cypherpunks started trying to make digital currencies, they wanted to end the need for a central authority, without allowing double spending.
They wanted to subtract trust from the equation and still have the total equal security and stability.
Lots of knowledgeable people were kept awake at night by this conundrum. Then in 2007, a person or group going by the pseudonym ‘Satoshi Nakamoto’ devised a solution. In 2008, subscribers to a cryptography mailing list received a white paper entitled ‘Bitcoin: A Peer-to-Peer Electronic Cash System.’ This unassuming PDF, written by someone no one had heard of, contained the answer: Blockchain.
While Nakamoto never used the word ‘Blockchain’ they did describe it for the first time:
‘The network timestamps transactions by hashing them into an ongoing chain of hash-based proof-of-work, forming a record that cannot be changed without redoing the proof-of-work…Each timestamp includes the previous timestamp in its hash, forming a chain, with each additional timestamp reinforcing the ones before it.’
The clue is in the name
“Bitcoin or other digital currency isn’t saved in a file somewhere; it’s represented by transactions recorded in a blockchain.” ― Don Tapscott, Blockchain Revolution
Blockchain is quite literally a ‘chain’ of ‘blocks.’ Let’s look at the two parts.
A ‘node’ is a computer that runs specialist software as part of the Bitcoin Blockchain.
Together, thousands of nodes across the world form a decentralised network. It isn’t owned or controlled by any single person or group, they all share ownership.
The nodes serve multiple purposes. Every ten minutes, a new ‘block’ is released, bringing with it brand new Bitcoin (currently 12.5 BTC per block.) Some of the nodes will try to ‘mine’ the new Bitcoin by performing complicated calculations to find a data sequence matching the block. Whichever node manages to do that first, wins the freshly released Bitcoin.
This is a brilliant system for releasing Bitcoin. Miners use expensive equipment and other resources to become part of the network. They also take on a lot of risk in setting up their operations (take a look at this photo series to get a sense of the scale of a large mining rig). So the Bitcoin which they earn and can then sell is their payment.
That’s not the whole story
Nodes serve another vital purpose. They verify transactions and confirm that cryptocurrency hasn’t been double spent. Once the majority (more than 50%) of nodes reach a consensus that they can authorise the transactions, they’re recorded. This creates a permanent, secure, unbiased record.
Blockchain is like a database, shared between lots of people, and constantly updated
Since the Blockchain is public, you can look back at a record of all the Bitcoin transactions ever made. You might have heard it described as a Distributed Ledger Technology (DLT.) Nakamoto created it to give the world a way to spend money without centralised control or limitations.
Why Blockchain is amazing
“Blockchain solves the problem of manipulation… I think the technology, if we do it right, may go in history books.”- Vitalik Buterin, founder of Ethereum
There are lots of benefits to storing data this way, in addition to it solving the double spending problem. The big one is that no one can modify, censor, or tamper with it. All records on a Blockchain are permanent.
You don’t need to trust a centralised authority and rely on them doing the right thing. Blockchain removes the need for trust. The technology itself prevents any wrongdoing. It’s transparent — for example, the Bitcoin Blockchain is public and anyone can look at it.
As many different computers store a Blockchain, there’s no single point of failure. This makes it secure and resistant to attack, and compared to similar systems, it’s fast. Sending money abroad via a bank requires many organisations and can take days or even weeks. Whereas a cryptocurrency transfer over the Blockchain takes minutes, sometimes seconds. It’s also likely to be cheaper. Blockchain fees tend to be far lower than international bank transfer fees.
As a piece of technology, Blockchain is versatile, and suitable for anything requiring record keeping. It has numerous potential uses.
Uses of Blockchain
“The blockchain keeps everyone honest, and a whole layer of banking bureaucracy is removed, lowering costs.” ― Paul Vigna, The Age of Cryptocurrency
Blockchain was invented for Bitcoin. We don’t know if Satoshi Nakamoto envisioned it serving any other purposes. Judging from the original white paper, they saw it as part of Bitcoin and not something separate.
But it didn’t take long for people to start asking: what if we could use Blockchain for things other than cryptocurrencies? After all, as we’ve seen, Blockchain is essentially a type of database. Could it be used for other areas requiring transparent, trust-free records?
There are many proposed uses, including:
- Bank settlement
- Tracking digital rights
- Online voting
- Insurance contracts
- Identity documents
- Supply chain tracking
The limitations of Blockchain
As a piece of technology underpinning cryptocurrencies, Blockchain works pretty well. There are still creases to iron out, yet we’ve made a lot of progress and it’s important to remember no technology is ever perfect right from the start. However, Blockchain does have its limitations.
First, cost. Many of the proposed uses for Blockchain (e.g. tracking where the ingredients in a drink you buy came from) don’t justify the cost of storing all the data involved. Remember, every single node in the network stores all the data on a Blockchain — permanently. With time, that can get costly and inefficient when it’s applied as a solution for a problem which a simple database (or even a Google Doc) could solve.
Then there’s the question of security and privacy. The Bitcoin Blockchain excels in both areas, but other proposed Blockchains don’t. To be safe from attack, a Blockchain needs to be distributed across numerous nodes, owned by numerous different people. If the network isn’t big enough, a malicious party could take control of it. Bitcoin is too big to be susceptible to this, known as a ‘51% attack.’ But smaller Blockchains can be attacked quite easily — it’s one reason we strongly encourage our customers to be cautious about investing in new altcoins and why we only support Bitcoin and Ethereum for now.
And remember the issue of trust we discussed earlier? Nakamoto invented the Blockchain to bypass the need to trust a centralised authority. Many so-called Blockchain innovators over the last few years have completely missed the point and proposed centralised systems.
At the moment, cryptocurrencies are still the best use of Blockchain.
At Luno, we believe the applications for other areas are minimal and most of the hype around Blockchain is…well, hype. It’s still early days and we hope this guide will help you understand the ongoing debate around Blockchain.
