What is a blockchain?
Blockchain technology is at the heart of cryptocurrencies like Bitcoin. Here’s how blockchain works to build a secure digital ledger of crypto transactions.
8 min read
The following statements do not constitute investment advice or any other advice on financial services, financial instruments, financial products, or digital assets. They are intended to provide general information. The following statements do not constitute an offer to conclude a contract for the purchase or sale of financial instruments and financial products or an invitation to submit such an offer and to buy or sell any particular digital asset. Cryptocurrencies are subject to high fluctuations in value. A decline in value or a complete loss are possible at any time. The loss of access to data and passwords can also lead to a complete loss.
A blockchain is a database that’s structured as a chain of blocks, each of which holds a set of information. That’s a neat and simple definition, but it doesn’t help if you don’t know what a database is. So, to really know what a blockchain is, it’s helpful to start with an understanding of how databases work.
A database is a place where information is stored electronically. Users can search and filter this information to find the particular bit they’re looking for. Databases are used everywhere in the real world—including banks, which use them to store information about accounts and transactions.
But not all databases work in the same way. In some databases, the information can be changed or edited by a central authority, or by anyone with permission to do so. Part of what makes a blockchain database different is that the information in each block cannot be changed or edited after it’s added to the chain. So, when new information is added, a new block is created rather than an old one being edited.
Blockchains essentially function as digital ledgers, and they have a number of different uses. In this article, we’ll focus on the blockchain technology that underpins popular cryptocurrencies such as Bitcoin and Ethereum, adding a layer of security and transparency that’s essential to how cryptocurrencies work.
What is blockchain technology?
The blockchain technology that drives many popular cryptocurrencies is sometimes referred to as Distributed Ledger Technology, or DLT. But a blockchain is just one type of distributed ledger, and it works in specific ways that don’t necessarily apply to other types of decentralized databases.
If you wanted to boil the essence of blockchain technology down into a single word, that word might be “security.” That’s because blockchain tech offers a way of recording information that makes it nearly impossible to edit or alter that information.
Let’s take a look at how it all works.
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How does blockchain work?
The information in a blockchain is recorded in blocks. Each of these blocks holds a certain group of data. When a new group is added, it forms a new block that’s chained onto the previous block (hence the name “blockchain”).
This chain structure is a crucial part of what makes a blockchain different from other types of databases. To understand how the chain itself works, it’s important to understand three key elements included in every block on a blockchain. Each block contains:
- Its own hash code. A hash code is essentially an alphanumeric representation of data. A block’s hash is unique to that block, and it changes if any of its underlying data changes in any way.
- The hash code of the block before it in the chain. This hash serves as a reference that keeps the blocks in a linear, chronological order. If each block refers to the unique hash of the block ahead of it, the chain stays intact. And remember—if the information in the block changes, the hash changes, too.
- A time stamp. This time stamp tells when the block was created, so it also helps to keep the chain in chronological order.
These three elements work together to ensure that the blocks in a blockchain are immutable—in other words, they can’t be changed. If someone attempted to change one block, that block’s hash and time stamp would change. The next block in the chain would no longer include the hash of the block preceding it, and it would quickly become apparent that the blockchain had been altered.
Is blockchain technology secure?
A blockchain’s use of hashes and timestamps makes it extremely difficult to alter the data in a block once it’s added to the chain. So in a sense, blockchain can be considered very secure. But while blockchain technology has this impressive security feature built in by design, it still has some potential trust issues.
For example—if only a few participants are allowed to create blocks in the ledger, those participants may be able to input incorrect information or corrupt the system in some way. The blockchain functions only because those individuals who have access to it are trustworthy.
Early cryptocurrency developers, beginning with Bitcoin’s Satoshi Nakamoto, recognized this and developed the concept of a decentralized blockchain to eliminate the need for a trusted third party to validate transactions.
What is a decentralized blockchain?
A decentralized blockchain adds a peer-to-peer network on top of the existing security features inherent in a blockchain database. The members in this network don’t have to trust or even know each other, but each member gets a copy of the same blockchain ledger. There’s no “master” copy stored in a centralized location, but rather a huge amount of copies that are continually validating the accuracy of the blockchain.
This decentralization eliminates the need to trust one central authority, and it also protects the blockchain from hack attempts. If a hacker tries to alter or edit the blockchain in any way, they would only be altering their own copy. This newly altered copy would not match the copies stored on the network’s other computers, so it would be easy to suss out the error.
In the case of a network like Bitcoin’s, at least 51% of the computers in the network would have to validate the hacker’s erroneous version of the blockchain in order for it to be considered legitimate. Given the cost and computing power required to influence that many computers in a decentralized network, it’s virtually impossible to successfully introduce an error into the blockchain.
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How is blockchain used?
Blockchain technology has a lot of potential uses in fields ranging from banking to supply-chain logistics. But the reason you’ve probably heard of blockchain is its use in the growing field of cryptocurrency.
Blockchain has made possible the rise in cryptocurrencies such as Bitcoin, which uses blockchain technology in order to transparently record monetary transactions. Blockchain and Bitcoin have become almost synonymous in popular culture, but many other cryptocurrencies also run on decentralized blockchain networks. One belief commonly held among those in the crypto community is that, without a trusted third-party required to verify transactions, a decentralized blockchain allows for a more democratic and inherently trustworthy approach to currency.
Advantages and disadvantages of blockchain
Blockchain technology is becoming increasingly prominent in a number of fields that require data storage. It has some very clear advantages over other types of databases—some of which we outlined above.
Here’s a quick breakdown of those advantages with a focus on cryptocurrency blockchains, as well as some disadvantages to consider.
Advantages of blockchain technology
Greater security. The data on a decentralized blockchain are stored in copies across a peer-to-peer network, rather than in a centralized location. As new blocks are added to the blockchain, the computers within the network must validate the blocks’ legitimacy. This, coupled with the inherent security built into blockchain technology, allows for greater security than many other types of databases.
Increased accuracy. Human involvement—and thus human error—in verifying transactions is minimal in a cryptocurrency blockchain. Instead, the network of computers works to validate and approve any new information entered. This generally leads to fewer errors and greater accuracy than some other methods of storing data.
More efficient payments. When a bank processes payments, the transactions are typically managed and processed through a central authority. It’s common for banks to operate only during limited working hours. Therefore, a payment made before the weekend might not be processed until Monday. A blockchain doesn’t necessarily have these restrictions. In most cases you can make a transaction from your wallet or exchange 24 hours a day, 7 days a week.
Verified transactions. Any information entered onto a blockchain will be verified by the computers in the network. Once approved, it will be added as the next block in the chain. This process ensures that any new transaction information added to the agreed-upon version of the blockchain is legitimate and accurate.
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Disadvantages of blockchain technology
Criminal activity. A blockchain such as Bitcoin’s is designed to protect user confidentiality, which makes it difficult to hack. But this same feature means that criminals may attempt to use blockchain technology to transact currency illegally. Banks generally have strict processes to verify their customers’ identities, but this isn’t always the case with cryptocurrency.
Cost and speed. Depending on the exact system used to verify transactions, a blockchain may suck up huge amounts of computational power. Bitcoin’s “proof of work” system, for example, comes at a significant cost in energy and thus a significant cost to the environment. The amount of time it takes to process a transaction may also become a disadvantage in certain blockchains. It may take minutes to add a new transaction or block to the chain, but with an increased number of users, speed can become an issue.
Does Bitcoin need blockchain?
Yes. Blockchains underpin many popular cryptocurrencies, including Bitcoin. Bitcoin was in fact the first example of a decentralized blockchain network in action, so it’s safe to say it would not exist without this technology.
How is blockchain technology used in banking?
Banks are still developing how they use blockchain technology. Blockchain was initially viewed as a technology that would upset the banking world, and the realities of a global pandemic have accelerated its use in banking. Blockchain could help banks make business much simpler and more streamlined, removing manual and paper-based processes. Projects are being run to explore how to reduce costs within banking operations, carry out cross-border currency transactions, and even integrate blockchain wallets.
Who is currently using blockchain technology?
Blockchain technology is relatively new, but it has generated a lot of interest with different businesses. Industries actively working with blockchain technology include healthcare, travel, energy, insurance, and even governments. For healthcare companies, for example, blockchain can help to securely store protected patient data within the healthcare system. It’s a trend that many are anticipating will grow, as businesses continue to commission blockchain projects and explore how to use this technology.
How do I invest in blockchain?
You can invest in companies developing blockchain technology. Various projects are already underway to look at how to use this technology within different businesses. You can invest in specific blockchain stocks if you see the potential growth opportunity for those companies as blockchain becomes more popular. The second option is to invest in cryptocurrency, though crypto investments can be extremely volatile and are by no means a safe way to store your money. When investing in crypto, it’s important to remember that your investments can go down as well as up in value—sometimes drastically, and sometimes in the span of just a few hours.
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