How does a blockchain work?

What is a blockchain?

Blockchain technology is safe and robust and thus ideal for storing and processing sensitive information. The revolutionary aspect behind blockchain is that processes are not completed by one, but by many computers, simultaneously.

Bitcoin is a typical application. Trust in Bitcoin is secured through a decentralised, immutable ledger that is not run by a single company or government but by an independent community of computers all around the world. 

All computers are in the same network, called a peer-to-peer network. Inside the industry, this model is often called a “distributed trust model”. 

A model of trust

Blockchains offer groundbreaking technology with the potential to change the internet and even the world for many reasons. As we dive deeper into how blockchains work, you will find it increasingly easy to understand exactly why. 

Each node contains a complete image of a blockchain’s network.

Who can be trusted in a digital space, where everything can easily be copied and most users are anonymous? Blockchain can help to solve this pressing question.

A blockchain is not updated and validated by a single individual, but by hundreds, thousands, or even millions of community members in regular timeframes. 

Instead of one central party such as a company, government or bank, the entire blockchain network agrees on a shared “reality”, i.e. complete history of every transaction that has ever taken place within the network. This agreement is called consensus.

Because every single transaction that has ever taken place within the network is recorded and permanently stored, it is not possible to change the ledger’s history or send the same transaction twice (i.e. double spend).

This certainty creates mutual trust. 

In other words, participants of a blockchain network don’t even have to trust each other because no single user can cheat the system as a whole.

Blockchain technology is suitable for transactions between parties that need to be verifiable and permanent, such as contracts, ownership of intellectual property, identification, and, of course, cryptocurrencies like Bitcoin. 

How do blockchains work?

In a blockchain, transactions are stored in blocks, with each newly generated block referring to the block before it with a unique identifying number called a “hash.” These blocks constitute a chain, hence the name “blockchain”. This chain continues on indefinitely. 

In the case of blockchains such as Bitcoin, trust is based on technological features such as the fact that all blocks can be viewed by the public. No transaction is added to a block without first being verified by a miner - a special type of computer in the network. This way the community ensures that no fraudulent transaction is recorded in a blockchain. 

Consequently, a blockchain can even be used by parties who don’t necessarily trust each other to do business because they know their transactions are tamper-proof. 

Blockchain technology is probably the best invention since the internet itself. It allows value exchange without the need for trust or a central authority. Imagine you and I bet $50 on tomorrow’s weather in San Francisco. I bet it will be sunny, you that it will rain. Today we have three options to manage this transaction:

  1. We can trust each other. Rainy or sunny, the loser will give $50 to the winner. If we are friends, this could be a good way of managing it. However, friends or strangers, one can easily not pay the other.

  2. We can turn the bet into a contract. With a contract in place both parties will be more prone to pay. However, should either of the two decide not to pay, the winner will have to pay additional money to cover legal expenses and the court case might take a long time. Especially for a small amount of cash, this doesn’t seem like the optimal way to manage the transaction.

  3. We can involve a neutral third party. Each of us gives $50 to a third party, who will give the total amount to the winner. But hey, she could also run away with all our money. So we end up with one of the first two options: trust or contract.

Neither trust nor contract is an optimal solution: We can’t trust strangers, and enforcing a contract requires time and money. The blockchain technology is interesting because it offers us a third option which is secure, quick, and cheap.

Blockchain allows us to write a few lines of code, a program running on the blockchain, to which both of us send $50. This program will keep the $100 safe and check tomorrow’s weather automatically on several data sources. Sunny or rainy, it will automatically transfer the whole amount to the winner. Each party can check the contract logic, and once it’s running on the blockchain it can’t be changed or stopped. This may be too much effort for a $50 bet, but imagine selling a house or a company.

This article explains how the blockchain works without discussing the technical details in depth, but by digging just enough to give you a general idea of the underlying logic and mechanisms.

Blockchain Benefits and Challenges

Now that you have a general understanding of how the blockchain works, let’s take a quick look at why it’s so interesting.

Using blockchain technology has remarkable benefits:

However, there are a few challenges that need to be addressed:

Overall, the blockchain technology has the potential to revolutionize several industries, from advertising to energy distribution. Its main power lies in its decentralized nature and ability to eliminate the need for trust.

New use cases are arising all the time — like the possibility of creating a fully decentralized platform that runs smart contracts like Ethereum. But it’s important to remember that the technology is still in its infancy. New tools are being developed every day to improve blockchain security while offering a broader range of features, tools, and services.

Mining Bitcoin

In order to send bitcoins, you need to reference an incoming transaction to your own wallet. This applies to every single transaction across the network. So, where do bitcoins come from in the first place?

As a way to balance the deflationary nature of bitcoin due to software errors and wallet password loss, a reward is given to those who solve the mathematical problem of each block. The activity of running the bitcoin blockchain software in order to obtain these bitcoin rewards is called “mining” — and it’s very much like mining gold.

Rewards are the main incentive for private people to operate the nodes, thus providing the necessary computing power to process transactions and stabilize the blockchain network.

Because it takes a long time for a typical computer to solve a block (about one year on average), nodes band together in groups that divide up the number of guesses to solve the next block. Working as a group speeds up the process of guessing the right number and getting the reward, which is then shared among group members. These groups are called mining pools.

Some of these mining pools are very large, and represent more than 20 percent of the total network computing power. This has clear implications for network security, as seen in the double-spend attack example above. Even if one of these pools could potentially gain 50 percent of the network computing power, the further back along the chain a block goes, the more secure the transactions within it become.

However, some of these mining pools with substantial computing power have decided to limit their members in order to safeguard overall network security.

Since the overall network computing power is likely to increase over time due to technological innovation and the increasing number of nodes, the blockchain system recalibrates the mathematical difficulty of solving the next block to target 10 minutes on average for the entire network. This ensures the network’s stability and overall security.

Moreover, every four years the block reward is cut in half, so mining bitcoin (running the network) gets less interesting over time. To encourage nodes to keep operating, small reward fees can be attached to each transaction; these rewards are collected by the node that successfully includes such transactions in a block and solves its mathematical problem. Due to this mechanism, transactions associated with a higher reward are usually processed faster than those associated with a low reward. What this means is that, when sending a transaction, you can decide if you’d like to process it faster (more expensive) or cheaper (takes more time). Transaction fees in the bitcoin network are currently very small compared with what banks charge, and they’re not associated with the transaction amount.

Published on: 1/18/23, 7:09 PM