Blockchains. DeFi. Cryptocurrencies. Consensus algorithms. These are terms that you may have heard of in recent months, and with the recent boom in Decentralized Finance, have piqued investors’ interests. How does this obscure piece of technology work, and how can you benefit from it?
This is the first part of our Digital Assets Decoded series, which aims to give you a fundamental understanding of the cryptocurrency space, and will allow you to capitalize on the interesting developments in this budding industry.
What is a blockchain, and how does it work? Can it even be trusted? These are the questions we will tackle in this article.
While many equate blockchains with cryptocurrencies, blockchains are actually the fundamental technology upon which cryptocurrencies are built on. The core function of a blockchain is record-keeping among multiple participants without the need for a single authority.
In the traditional systems of a financial institution, the institution acts as a central authority which keeps a record of all changes of its clients’ balances and transactions. This means the bank is the central authority responsible for managing and reporting the financial position of its clients. Such a system requires clients to trust the said financial institution, and sometimes, clients will be subject to obscure policies which they may not be aware of. This validation process is prone to human error, expensive to manage, and sometimes will take years for any possible flaw in the process to be uncovered. For example, in 2012, the Bank of Scotland was fined £4.2 million for incorrect records between the years 2004 and 2011.
Blockchains can help provide an efficient means to transfer value across multiple parties, all while being decentralized and more transparent. They employ the following core principles:
· Decentralization — the ability for multiple parties to come to a decision based on a set of rules which are known to all parties
· Transparency — Transactions are made publicly available, and transaction receipts can be sent as proof that a transaction has occurred between two or more parties
· Security — Using cryptography and mathematics, only owners who can mathematically prove that they own the said currency can spend it
· Immutability — Once a record for transactions have been created, it cannot be destroyed or changed
A blockchain is precisely what its name implies — a chained sequence of “blocks” of transactions. This, in effect, provides all transactors in the network an overview of the sequence of events and transactions in the ecosystem. A block is simply a term for a group of approved transactions which are bundled together at a certain point in time. The mechanism which describes what transactions get approved is called a consensus mechanism, which will be discussed in a later article.
These blocks are then arranged in a chained sequence, with the block containing the most recent transactions at the end of the chain. Once a block has been created and added to the chain, it cannot be tampered with, and everybody who connects to the network will be able to see the contents of the transaction. An example of this is shown in the below figure.
The beside figure shows a simple representation of a blockchain. In the diagram, there is a series of time blocks, ordered in a time sequence. We can see that in each block, there are transactions made by various parties. Each block has its own signature, which is derived from the timestamp and other various data. Once a block containing transactions is added to the end of the chain, transaction information is publicly available to all parties.
It is also important to note that while transaction data is made public, the owners of these transactions are anonymized. While everybody will know that a transaction has occurred, only the sender and the recipient will actually know who performed the said transaction.
In conclusion, a blockchain can be thought of as a distributed ledger, in which every person who participates in the blockchain network will have a copy of the same ledger. Everybody who has a copy of the distributed ledger will be able to verify how much other parties have spent, allowing for a transparent, distributed system which does not depend on a single authority.