How Blockchain Works: A Guide to Blockchain Technology
Blockchain technologies are challenging to understand. They’re complex, and it almost feels like they’re a part of their own world. If you’re reading this article because you’re confused about blockchain and you just don’t get it, you’ve come to the right place.
You aren’t the only one with this issue, as there are only 300 million crypto users worldwide at the time of writing. That’s ¾ of the U.S. population. Crypto is a worldwide phenomenon, and although this number is promising, it’s nowhere near the level of adoption of physical currency like paper bills.
So how do blockchains work? What are some of the most popular blockchains? Are blockchain and cryptocurrencies the same?
These are common questions that shouldn’t go unanswered. I’ve been in your shoes, and I know how it feels being overwhelmed by NFT bros and crypto junkies on Twitter.
Today we’ll be diving into the world of blockchain technologies. So strap in as I try my best to break down all the important details of blockchain and smart contracts.
- How Blockchain Works
- Current Applications of Blockchain Technology
- Blockchain Technology and its Consensus Mechanisms
- The Future of Blockchain Technology
How Blockchain Works
One of the most daunting questions to answer: How do blockchains work? A straightforward question, yet it’s difficult to answer. Why?
Well, for one, it’s a new technology that’s breaking the current infrastructure of the business world. Blockchain technology is replacing the fundamental systems that allow corporations to thrive.
It’s also converting the way we think. We’re reliant on trust-based models, and with blockchain technology, trust isn’t top-of-mind.
Capisce? Now, let’s get a solid grasp of how blockchain works.
What is Blockchain Technology?
Take a look at Deloitte’s explanation of blockchain technology:
“You (a “node“) have a file of transactions on your computer (a “ledger”). Two government accountants (let’s call them “miners”) have the same file on theirs (so it’s “distributed”). As you make a transaction, your computer sends an e-mail to each accountant to inform them.
Each accountant rushes to be the first to check whether you can afford it (and be paid their salary “Bitcoins”). The first to check and validate hits “REPLY ALL”, attaching their logic for verifying the transaction (“proof of work”). If the other accountant agrees, everyone updates their file…
This concept is enabled by “Blockchain technology.”
In short—blockchain technology changes the method of verifying transactions. Let’s say you purchase a car from a dealership that uses the old method of recording transactions in a physical book.
Once you’ve put in your credit card information, the dealership charges you for your purchase. Then, an accountant at the dealership checks the information of the transaction and jots it down in the company ledger (a book that keeps a record of all the dealership’s financial interactions with customers, suppliers, etc.).
The information the accountant inputs includes the time of the transaction, the parties involved, what was exchanged in the transaction, and other pieces of information relevant to this exchange.
Company ledgers are a requirement for several reasons; However, there’s one that stands apart from the crowd: They’re needed for the company’s financial statements. If a company doesn’t use a ledger, they won’t have any clue how much money they’re making and how much debt they’re accumulating.
Blockchain technology does the same job as an accountant at a car dealership, automatically.
Instead of recording and verifying transactions on a single server (comparable to the physical accounting book), it’s now spread across hundreds, if not thousands of servers (called a “distributed ledger“). And instead of relying on an accountant to record and verify the transaction, you’re relying on anonymous parties that get rewarded for doing the job of an accountant.
It feels odd saying you’re putting your trust in people you’ve never met. But the beauty of blockchain technology is that you don’t need to trust these parties. Why?
Because the parties (called “miners“) use their computers to verify transactions by solving complex mathematical equations. The miners who first reach the finish line are the ones who verify the transaction while reaping the rewards of their hard work.
Once a transaction is verified, it is added to the distributed ledger (the blockchain), and it’ll never disappear. Miners get rewarded with crypto for their troubles.
The basic principles of blockchain technology are that it’s distributed—meaning no single party controls the data, transparent, irreversible, and most importantly, verifiable. Anyone can go in and view a transaction on the blockchain. You just have to know where to search.
Why is Blockchain Technology Needed?
So why did Satoshi Nakamoto (the anonymous creator of Bitcoin) create this technology?
From Bitcoin’s original whitepaper, we can see that he pinpointed the issues of the systems we use today:
“Commerce on the Internet has come to rely almost exclusively on financial institutions serving as trusted third parties to process electronic payments. While the system works well enough for most transactions, it still suffers from the inherent weaknesses of the trust-based model.”
Let’s go back to the car dealership analogy. The problem with the bookkeeping system is that you need to rely on the company and its accountant to verify the transaction.
Although this may not really apply to you, what if the accountant made an error when writing down your name in the transaction? It happens to the best of us. At the end of the day, we’re all humans anyways.
And if you were to try to repair your car for damages at the dealership, they wouldn’t be able to trace you back to the original transaction. They wouldn’t be able to verify that it was you who bought the vehicle.
To be fair, companies’ ledgers are more sophisticated nowadays, and everything is recorded digitally and automatically. So the chances of this happening are meagre.
The chances of fraud are much higher though. Companies like WorldCom and HealthSouth purposely entered incorrect information into the ledger to boost the revenues written in their financial statements.
These pain points come down to the leading problem blockchain technologies are trying to solve: Central power.
Companies have complete control of what they write down in their books. They can go back and manipulate the data to make it seem like they have lower expenses and higher income.
The verification of transactions is purely in the hands of the business. Unfortunately, too much power is given to those at the tippy-top of the company’s organizational hierarchy.
Are Blockchain and Cryptocurrencies the Same?
It’s no secret blockchain technology and cryptocurrencies go hand-in-hand. Cryptocurrencies wouldn’t exist if it weren’t for the underlying technology powering its networks.
But to answer your question, no. Cryptocurrencies and blockchain technology are not the same.
Cryptocurrencies are, well, digital currency. In the current market environment, you earn your income through your employer, who pays you using your country’s national currency. For the U.S, your employer would pay you in U.S. dollars.
Your paycheck is then directly sent to your bank (a central power). You could opt to receive a physical check to deposit it at the bank yourself for safekeeping. Either way, you receive a cheque that can only be used at a bank.
In our society, we rely on banks to handle our money for storage and other means.
With the advent of cryptocurrencies, you would get paid in crypto by your employer (through Bitcoin, Ethereum, or some other crypto). Then, you wouldn’t need to deposit your money in a bank, as you wouldn’t receive a cheque. Instead, the money would be directly deposited in a “web3 wallet.”
You could think of the web3 wallet as a chequing account. Except, instead of relying on the bank to keep your chequing account open, you can just eliminate this intermediary altogether.
You are in complete control of your money when using a web3 wallet. No other parties can go in and access your account. The bank relies on accessing your cash to fund its operations in the banking world.
In a nutshell, blockchain technology distributes the verification of transactions among thousands of parties, and cryptocurrencies are the medium of exchange. Therefore, blockchain is the underlying technology. Got it?
Current Applications of Blockchain Technology
Blockchain technology doesn’t only apply to crypto—It can be used in every industry known to society.
From crypto, to finance, to even healthcare, blockchain technology can potentially change the systems these industries run on.
Let’s get into the nitty-gritty.
Blockchain and Smart Contracts
Blockchain and smart contracts—decentralization at its finest. No need for third parties to manually review contracts anymore. Now, simple “if/when…then…” statements can execute the actions of the predetermined conditions on a contract once they’ve been met and verified.
Once the transaction has been verified, it’s added to the blockchain network. How cool is that?
Blockchain and smart contracts have opened the doors for hundreds of businesses and industries alike. Not only are smart contracts automated and thus, efficient, but they’re also trustworthy and transparent since there is no third party involved.
Oh, and the cherry on top is that they’re secure and cost-efficient. Nice!
Just take a look at the uses for blockchain and smart contracts.
Blockchain Technology in Real Estate
Real estate is a perfect example of how blockchain and smart contracts could disrupt a multi-faceted industry.
For one, smart contracts could revolutionize purchase and sale agreements for properties. For example, take a look at PropertyClub, a real estate platform using blockchain and smart contracts to conduct transactions in their marketplace.
PropertyClub’s mission is to remove entry barriers for property renting while reducing costs and enhancing the user experience from beginning to end.
Say goodbye to brokerages who’ve been dwindling the quality and total supply of property listings. With PropertyClub, you get direct access to landlords and property managers without going through a broker.
Another area that has already seen improvements is the transfer of property titles. Property registries often require a middle-man to carry out the transaction between the buyer and seller. With blockchain and smart contracts, a property sale can be set up to execute on its own without the need for an intermediary.
The list goes on and on. Blockchain technology is being used to facilitate the business of rental property owners, real estate investors, firms, startups, and agents.
If you just Google “real estate and blockchain,” you’ll see what I mean.
Blockchain Technology in Finance
Next up: Finance—or as the crypto world likes to call it, “DeFi.”
Decentralized finance is taking over the world of traditional finance, one step at a time. Blockchain technology is opening the floor for traders, investors, and holders who don’t want to deal with the unlevel playing field found in traditional exchanges.
It is well-known institutions have the upper hand when trading stocks. Their robust systems, access to unfair tools, and constant bailouts (like we saw in 2008) are just the tip of the iceberg. DeFi is trying to give power back to the people.
So what are some of DeFi’s use cases?
Decentralized exchanges (DEXs) are the most popular form of DeFi. You could think of it as the New York Stock Exchange (NYSE), but without brokers executing trades. Just connect your web3 wallet to the DEX, and you can trade all kinds of currencies, from U.S. dollars to Bitcoin, Ethereum, and altcoins.
Yield farming is another use case of DeFi. Instead of just trading or holding your cryptocurrencies through a DEX, you can lend your funds to others through smart contracts.
But, wait… why would I want to do this?
Well, it’s pretty much the same concept as putting your money in a savings account. First, you lend your money to the bank who can use the liquidity to run their operations. Then, for your troubles, you receive interest.
The thing is, with banks, your interest rates are extremely low. In fact, you’re losing money to inflation. This is not ideal, especially when you have decentralized options that could net you interest returns in the three-digit range.
That’s right, you could be earning over 100% APR! Although, I will say the higher the APR, the riskier the asset.
DeFi will continue to push the boundaries of blockchain and smart contracts. It’s a matter of building a scalable network that doesn’t cost you an arm and a leg in transaction fees. I’m looking at you, Ethereum.
What are the Most Popular Blockchains?
Even if you’re new to blockchain technologies, you’ve probably already heard about the most popular blockchains before reading this article. They’ve taken the world by storm, and with the COVID-19 outbreak, we’ve experienced a sharp increase in the adoption of cryptocurrencies.
Bitcoin is by far the most popular blockchain. I’ve already explained how it works, so there is no need to go over it again.
Ethereum is up next. Ethereum is known for its network of apps, cryptocurrencies, and platforms. It is the king of blockchain and smart contracts, and it’s almost impossible to dethrone the Ethereum network from its top position.
Although the concept of smart contracts was introduced a while back by a computer scientist and cryptographer, the idea hadn’t been manifested into reality until the birth of Ethereum in 2015.
Ethereum basically merged blockchain and smart contracts into one. Through its coding language Solidity, smart contracts can be easily programmed within the network. You just have to learn how to code in Solidity!
Within the network, smart contracts have their own web3 wallet address, like if it were an individual’s digital account. They retain a balance, and users can interact with the smart contract by sending or receiving ETH.
Bitcoin and Ethereum are by far the most popular blockchains, but it doesn’t end there. The Binance Smart Chain network, Solana, Cardano, and XRP are up there in terms of network participants and market cap.
Blockchain Technology and its Consensus Mechanisms
If you’re read up until this point, I hope you have a solid grasp of blockchain technology and its use cases. I hope you also understand the concept behind smart contracts and its applications to business.
Now that we’re more knowledgeable, let’s look at the future of blockchain technology.
When I first explained to you the blockchain supporting the Bitcoin ecosystem, I didn’t mention that it’s an outdated verification system. The Bitcoin network is old—13 years old, to be exact. The consensus mechanism that fuels the verification of transactions is slow, inefficient, and not entirely decentralized.
Woah. Let’s backtrack. I’m getting a bit ahead of myself here—what’s a consensus mechanism?
A consensus mechanism (also called a consensus protocol) allows parties to agree on which transactions should be added to the blockchain.
Proof-of-work (PoW) is the first consensus mechanism to reach mainstream adoption. Bitcoin and Ethereum 1.0 use PoW for their underpinned blockchain technologies. As I explained in the first blockchain example, miners are the parties trying to solve the network’s complicated mathematical equations. When they solve the equation, they’ll agree on which transaction to add to the network.
The main problem with PoW is that its energy inefficient. Since mining is competitive, as thousands of miners compete to receive partial cryptocurrencies for their efforts, dedicated miners will upgrade their equipment to beat their rivals.
The more computer power, the higher chance of guessing the answer to the equation.
Although you can mine using standard, run-of-the-mill gaming GPUs, specialized GPUs are more efficient for mining. The problem with this is that the more computer power you have, the more energy you expend.
Bitcoin mining consumes 70 Terawatt Hours per year or the equivalent of the electricity used by small countries like Austria and Belgium.
Climate change is knocking on our door, and she says PoW isn’t the way to move forward.
Proof-of-stake (PoS) is the natural evolution of PoW, and it’s what Ethereum will eventually run on with its integration of the Beacon Chain.
PoS eliminates the energy inefficiency of PoW. Validators replace miners, and the staking mechanism replaces hardware.
Picture this—You want to earn a higher passive income, and your savings account isn’t cutting it out. Your bank offers you a term deposit, where you make 0.5% off of your investment. So you lock up your money with the bank, who benefits from your secured funds for the next three months.
In this situation, the bank is the network, and you are the validator. By locking up your funds, you are essentially undergoing the staking mechanism. The only difference is that the cryptocurrencies staked are used to validate transactions based on a raffle system.
The more coins you have staked, the higher your chance of being selected as the validator for the transaction.
Other Consensus Mechanisms
Proof-of-stake is the status quo. But as more and more technologies enter the space, they find ways to optimize the consensus mechanism.
For example, Solana uses a combination of Proof-of-stake and Proof-of-history to decrease cost and latency.
The Future of Blockchain Technology
As time goes on, it’s no doubt blockchain technologies will continue to improve. As blockchain incorporates itself within the business models of the web3 landscape, businesses will gear themselves towards a true blockchain-led transformation.
We’re already starting to see this with the development of DAOs. The entire organizational hierarchy is being flattened because of its underlying technology. So It isn’t a question of if this will happen, as we’re already seeing progress—it’s a question of when we’ll see blockchain and smart contracts become the foundation of the business world.
The thing about blockchain technology is that it isn’t exactly a disruptive technology—it’s more of a foundational technology. What’s the difference?
Disruptive technologies replace vital operational aspects of an entire industry. Disruptive technologies are innovative at heart and far superior to the current technologies of market leaders.
On the other hand, foundational technologies are the catalysts of progress in various industries. It’s not necessarily industry-specific. In fact, foundational technologies have the power to create new industries.
And with foundational technologies comes a time of societal change. We change the way we interact with our world according to present-day foundations. For example, with the evolution of web2, it was more common to message each other through social media instead of calling a friend to hang out.
With smartphones, we can access the World Wide Web from our pockets. No need to go back home on your computer to load up Reddit–you can do this directly with a smartphone.
Blockchain technologies are removing the need for the trust-based model that our corporate world is built upon. As a result, the hierarchy is being flattened, and hopefully, we’ll experience less of a gap between social classes.