At the end of 2017, the blockchain industry was in full frenzy mode. New blockchain projects were being announced daily and the hype around popular networks like Bitcoin and Ethereum was through the roof. But this irrational exuberance quickly faded, taking the entire industry out of the public eye in a matter of months.
The initial frenzy might be over, but blockchain as a technological revolution is just getting started. Blockchain networks are hard at work providing decentralized services for consumers and businesses around the globe. No, blockchains will not solve every technological problem in the digital age, but they will come to be useful tools and platforms for new waves of innovation. To understand this, you must first fully understand what a blockchain is, how it works, and why the technology matters.
Let’s take a look at some blockchain basics so you can better understand what is blockchain technology and why it is important.
Table of Contents
What is blockchain technology?
A blockchain is a distributed database used to track and store information. A frequent blockchain analogy is that of a ledger. An accountant uses a ledger to keep track of financial transactions. Within the ledger is a running tally of all debits and credits to that account which helps determine the account balance. Each time there is a transaction it’s recorded along with the change in balance on the account.
Now, imagine this ledger was open to a public network, where anyone who wants to view it or request to add a transaction to the ledger is allowed. When a transaction is requested, it can be viewed to ensure it’s in-line with the current ledger balance and is therefore a valid transaction. Because everyone is viewing the same ledger, it’s easy for a majority of people on the network to ensure the transaction checks-out. If it does, it’s posted to the ledger, which is updated immediately for everyone on the network.
This is the basis of how a blockchain operates. A blockchain promises to hold all of the transaction data for a decentralized, open ledger. Transaction information is grouped together in blocks with each block linked to the blocks coming before and after it in a chain, hence the name blockchain.
But blockchain ledgers don’t just hold financial information, they can keep track of any piece of data imaginable.
How did blockchains start?
While the general public viewed Bitcoin founder Satoshi Nakamoto as the blockchain posterboy, the idea of blockchain networks was being formulated years earlier. In fact, a 1991 academic paper by computer scientists Stuart Haber and Scott Stornetta entitled “How to time-stamp a digital document” was one of the first major technological discoveries that would lead to blockchain networks.
Haber and Stornetta found a method of time-stamping digital information so they were immune from tampering. They believed this would help in many instances where there is a need to certify a document’s history. To do so they introduced the idea of creating a chain where documents could be viewed in a time-based fashion. Just one year later, the pair, along with Dave Bayer included merkle trees to the process which introduced more security and efficiency into the process.
Then came the big blockchain breakthrough. A pseudonymous character going by the name of Satoshi Nakamoto published the Bitcoin whitepaper in 2008 which put together the information gleaned from the previous decade-plus about time-stamping, cryptography, and decentralization to create a new financial technology. Nakamoto took the idea of time-stamping and coupled it with a method for verifying information without the need of a trusted third-party. It was Nakamoto’s insights that gave way to the blockchain revolution occurring today.
How does blockchain work?
Think about how an accountant verifies transactions. They go to the source of a transaction, validate its accuracy, and then include the transaction on the ledger. However, anyone can include a transaction on a blockchain. So how can these transactions be validated?
To verify any transaction, a majority of blockchain network participants need to agree on its validity. This is where consensus mechanisms kick in. A consensus mechanism is a layer of public trust used to achieve agreement on data within a blockchain network. When information is added or updated, participants on the blockchain network must come to a consensus as to the accuracy of the new information.
There are a variety of ways to achieve network consensus, but as it currently stands, there are two main consensus mechanisms used by blockchains:
In this consensus mechanism, network participants (known as miners) solve a series of complex mathematical computations to uncover new transactions. Miners must solve a hash function (an encrypted series of letters and numbers that corresponds with transaction information) to confirm transaction information and create a new block on the blockchain. Once a miner correctly solves a hash function, it is transmitted to all nodes on the blockchain network to confirm the accuracy and validity of the information. The reward to miners for uncovering a new block of transactions is newly minted cryptocurrency. This method prevents attackers on the network as it would require a significant amount of computing power, and therefore money, to perform an attack on a PoW blockchain.
Network nodes stake their own cryptocurrency to the network to verify transactions. New blocks are created by nodes based on a random selection that usually incorporates a combination of how many tokens are staked and for how long. If there is an attempt to falsify transactions, the staked cryptocurrency is lost forever, creating an economic incentive for transactions to be verified correctly.
Lifecycle of a blockchain transaction
Each blockchain transaction goes through the same process of validation and security before its fate is sealed on the blockchain forever.
Here is the lifecycle of a blockchain transaction:
- A transaction request is sent from a user to the blockchain
- The request is transmitted to all participants on the blockchain network
- Each network participant validates that the transaction is valid
- The valid transaction is stored within a block
- When the block is full, it is verified through the consensus mechanism to be completely accurate and locked
- After consensus is reached, the block is added to the blockchain where it is stored forever
Making changes to a blockchain
Because a blockchain is nothing more than a protocol, it is constantly being updated and improved. Yet, blockchains don’t operate in a traditional corporate structure with leaders making executive decisions. So, if blockchains are truly decentralized, who decides whether to adapt new protocol changes, and how are these changes enforced?
A new change to a blockchain can be proposed by anyone on the network. But, a majority of the network participants have to agree to such a change in order for it to take effect. If there are disagreements in regards to a proposed change, a fork in the blockchain will be activated. There are two types of forks that can occur.
A hard fork occurs when one group of network nodes continues to use old rules to validate transactions, while another group of nodes uses an updated set of rules. Because these two groups can no longer communicate with one another the blockchain splits into two separate chains, one using the old set of rules and the other using the new rules. These two blockchains are identical up until the point of the hard fork and then go their separate ways. Users holding cryptocurrency before the hard fork retain their tokens held before the fork and are awarded tokens of the new blockchain created as a result of the fork (e.g. Bitcoin holders kept their Bitcoin and received Bitcoin Cash tokens after the network’s hard fork)
Both Bitcoin and Ethereum have both experienced hard forks as a result of differences of opinions on certain actions within the community. The most infamous Bitcoin hard fork occurred when there was an argument on whether or not to increase the block size on the Bitcoin blockchain. One group of nodes (Bitcoin Cash) switched to a new set of rules that increased the block size while another group (Bitcoin) continued using the original set of rules.
While some forks occur because of protocol disagreements, others are generated by people looking to clone an existing blockchain protocol and make changes to the structure. In fact, Bitcoin has seen over 44 forks of its blockchain in an attempt to use the backbone of its codebase but improve upon the protocol in various ways.
A soft fork occurs when there is a change to the blockchain protocol, which makes previously valid transactions invalid. Therefore, a soft fork is backwards compatible, and all nodes will still be able to communicate with one another on the same chain. This generally occurs when new blockchain rules are implemented that don’t contradict or clash with the previous set of rules. Soft forks are much less contentious than hard forks since they don’t create a separate blockchain.
Think about the last time you tried to buy a house. Even after you negotiate on price and come to terms on an agreement, it takes significant time and energy to seal the deal. There is a mountain of paperwork to complete, and coordination needed between an inspector, mortgage lender, escrow service, realtors, the list goes on. All-in-all, the process is daunting.
Now, imagine if you could forgo this entire headache with the use of pre-programmed code that helps you through the homebuying process in a more seamless manner. This code could not only move the process along more quickly, it could act as an escrow service to handle all financial transactions. This is the idea behind smart contracts.
In the past, if you wanted to carry out any sort of contract, a trusted third-party was needed to verify the contract and that its contents were carried out fairly. With smart contracts, verified computer code replaces any intermediary or third-party, and verifies the contract automatically. By removing unnecessary pieces of the process and automating contracts themselves, smart contracts reduce fraud, mitigate arbitration and other costs, and speed the process for all types of transactions.
The idea for smart contracts has been around for decades, but it is only through the use of decentralized blockchain networks that this tool is becoming a reality. Blockchains get rid of any need for a middleman in executing a contract, eliminating unnecessary costs and saving time.
The power of Decentralized Autonomous Organizations (DAOs)
With smart contracts in place, an entire world opens up for blockchain networks to run new types of organizations that are completely autonomous. A decentralized autonomous organization, or DAO, represents the next evolution of organizations that are operated completely by computer code that can easily be verified. The organization itself is controlled by its members and, through the use of smart contracts, can execute any task imaginable. In theory, DAOs evade government control to become global, living organizations.
- Decentralized: Does not need any single entity to operate and is owned and operated by a network of participants
- Autonomous: Runs on its own via a pre-programmed set of rules, without the need for human intervention
- Organization: A pool of participants all working together toward the same stated goal
DAOs use cryptocurrencies as internal property, which comes in handy to reward activities and give users voting rights when it comes time to make decisions about the DAO itself. DAOs operate using blockchain networks so as to provide a secure digital ledger to track all transactions conducted by the organization, enable voting, pay employees, and conduct any other function an organization might need.
In theory, Bitcoin was the first ever DAO, as it is organized around a set of protocols, is owned by no centralized entity, and carries out a stated goal (creating a global currency). As smart contracts have evolved, so too have the use cases for DAOs, which now include:
- MakerDAO – Cryptocurrency lending platform
- Aragon – Gives users the power to create their own DAOs
- Moloch DAO – Awards grants for building new projects on the Ethereum network
- PieDAO – Asset allocation and investing in virtual currencies
The decentralization of blockchain networks holds the key to their importance. By eliminating trusted third-parties blockchains not only increase efficiency in global transactions, but eliminate security and censorship risks.
Trusted third-parties are unsafe
The use of third-parties in financial transactions has been found time and again to be not just inefficient, but unsafe. Applications are hacked and user data is stolen regularly, third-party companies sell user data against their will, and large corporations acting as intermediaries are not always truthful in their business dealings.
By eliminating third parties in all types of transactions, blockchains create systems in which there is no trust needed to ensure security and transparency in the network. All transactions are made public and verifiable (to some degree depending on the network), and verification is completed not by one centralized entity, but by an entire network of validators.
Even though the world has become smaller through globalization, it still remains time-intensive and expensive to send funds across borders. Making cross-border payments can cost an average of 7% in fees alone and take significantly more time to complete than domestic payments. Blockchains are specifically designed as geographically non-discriminatory financial technology. They know no bounds and therefore transactions across borders occur more smoothly at a reduced cost.
Creating global currencies
As we live in a more global world there has become an increasing need to create global currencies. By unifying currency across borders, blockchains allow anyone to transact in a common currency, regardless of their locality. In this way, blockchain networks allow for users anywhere in the world to transact using common, global currencies that are much more transparent than their fiat counterparts.
Where do cryptocurrencies fit in?
Since blockchains rely on a network of stakeholders to verify transactions, these participants need proper economic incentivization to ensure they act in the best interest of the network. Without this incentivization they might falsify transactions for their own benefit. To combat fraud, blockchains use a combination of economic game theory and cryptocurrencies.
What is cryptocurrency anyway? A cryptocurrency is a financial asset backed by the blockchain.Why not simply use fiat currencies instead of crypto? Cryptocurrencies are necessary because centralized fiat currency is subject to the whims of their controlling entities. For instance, if Bitcoin validation was incentivized using the US dollar, eventually, the US Federal Government could alter the economics of the dollar to hurt Bitcoin. Or, government entities could restrict the use of fiat currencies in blockchain networks.
This makes fiat not a viable form of currency for a decentralized network and has led to the creation of crypto to act as the economic incentive and medium of exchange with which network validators are rewarded for successfully verifying transactions.
What is blockchain used for?
Bitcoin has made blockchains popular, but this technological innovation is much more than about sending and receiving money within the financial services industry. As previously mentioned, these networks can store any type of information, which creates many more blockchain uses than initially imagined. Maybe you’ve wondered what is Ethereum, or if it’s used for the same purposes as Bitcoin?
Let’s take a look at a few blockchain applications and the benefits they provide:
|Intended Industry||Blockchain Application||Benefits||Blockchain Protocols|
|Supply Chain Management||
Is blockchain safe?
All of this makes blockchains sound great in theory, but what about their security? How are blockchains any more secure than their centralized counterparts? For starters, centralized networks pose a locality threat. Imagine there is a large file with sensitive data stored on a centralized server. All a hacker has to do is break into one server and retrieve the sensitive data. Alternatively, a decentralized blockchain network would require the hacker to break into a majority of the distributed network in order to access the desired information. Blockchain data cannot be breached via a singular attack, and instead, it would take a well-coordinated, large attack on a majority of network nodes to be successful.
This same philosophy also applies to attempts to bring down an entire network, either maliciously or in error. Blockchain consensus mechanisms help fight against a distributed denial of service (DDoS) attack which can bring down an entire network in an instant.
Meanwhile, human error has also resulted in internet outages. A mistake by one Amazon employee led to a huge outage of Amazon Web Services (AWS) in 2017, bringing down much of the internet along with it. Amazon admitted that one of its employees accidentally brought down more servers than they had intended, initiating a cascade of issues for the technology giant. Because network nodes on a blockchain are independent entities and distributed across the network, there is no way for one node to take down the rest of the network, mitigating this risk.
Think this is just talk? Go ahead and ask the Bitcoin blockchain, which has been operational for 99.98% of the time since its inception, with the previous two outages coming in March, 2013 and August, 2010.
Potential blockchain drawbacks
While blockchains may be touted by cypherpunks and cryptocurrency advocates as the cure to all technological problems, they don’t come without their own host of issues.
The decentralization of blockchain networks is relative. Some networks are more decentralized than others, which only allow select network validators to verify transactions. This centralization provides no significant benefit to storing data on a traditional database. Even blockchain networks which view themselves as fully decentralized often aren’t, and almost always rely on some sort of intermediary or third-party centralized services (such as cryptocurrency exchanges for liquidity) to ensure the network’s success.
There has yet to be a blockchain that has scaled enough to handle mass amounts of transactions. In fact, when blockchains became more popular toward the end of 2017, transaction costs increased on major blockchain networks, while the time it took to validate a transaction slowed substantially. Scalability is being addressed in many ways, from second-layer solutions (i.e. Bitcoin’s Lightning Network), to upgrades and improvements of current blockchains (i.e. Ethereum 2.0), but these solutions have yet to fully solve the blockchain scaling problem.
One of the first red flags raised by blockchain detractors was the anonymity of blockchain networks. This feature, according to some, allows for money laundering and other types of fraud within the financial system much more easily than through traditional channels. Criminals can hide the origin of funds through these networks and payments for illegal goods and services can be made using cryptocurrencies that are extremely difficult to trace back to their users. However, it is a misnomer to call cryptocurrencies anonymous. Instead, these blockchain-based assets are really pseudonymous, and in this way are similar to cash. They provide users with privacy, but not so much that the transactions can’t ultimately be traced if needed.
Because proof-of-work (PoW) blockchains require energy-intensive computations to maintain the network, they eat up a lot of energy. Bitcoin is not yet a global currency, but it already consumes more energy than many nations. Several cities and countries have even gone as far as to ban the mining of cryptocurrency in hopes of curbing this high energy usage.
In many ways, the blockchain feature of data immutability is actually a drawback as well. The law of data immutability states that a piece of data cannot be altered or changed once it has been created. The most well-known case where blockchain immutability created tension was in The DAO hack, where in 2016 about $50 million in ether was stolen from a decentralized autonomous organization (DAO) on the Ethereum network. This created uncertainty within the Ethereum community as many wanted to fork the blockchain to fix the theft and revert the stolen ether back to their original owners, while others believed that a major feature of blockchain networks is that no transaction can be changed at any time, ever. This eventually led to the network creating a hard fork, resulting in two distinct networks, Ethereum and Ethereum Classic, which continue on to this day.
But immutability isn’t just an issue in theft, it can also be a problem when it comes to data mistakes. Imagine you are attempting to send cryptocurrency to a family member but by accident input the incorrect wallet address of the recipient. Once you hit send, the transaction will be processed and there is no way for you to undo your mistake. This is especially a problem for new and inexperienced blockchain users who don’t feel comfortable executing transactions.
Governments and blockchain
The ethos of blockchain is to be uncensensored by any centralized entity. This decentralization — which extends outside of corporate entities and into governments as well — is one of the primary reasons blockchains are useful. Yet, even though blockchain networks attempt to subvert governments, there are still many ways governments can benefit from these solutions.
Blockchains can improve government oversight
Some governments are embracing blockchain technology and exploring how it can be a useful tool in improving inefficient government and regulatory processes. Here are the ways in which some countries are looking toward blockchain solutions:
- United States – FDA tracking of prescription drugs via blockchain
- Estonia – Blockchain to power digital identities for citizens
- Canada – Blockchain-based government contracts
- Denmark – Perform internal elections
- Georgia – Blockchain-based land registry
- United Kingdom – Track meat distribution
The relationships between Blockchain and government
Government entities seek to control all aspects of their local financial system, from currency distribution to taxes and everything in between. However, blockchain networks do everything they can to circumvent this control and maintain their independence, putting these two at odds with one another.
There is no consensus among governments about how blockchain networks and cryptocurrencies should be handled, and for that reason, it appears that every country is taking matters into its own hands in regards to the legality of cryptocurrencies. Some government regimes have made it clear they do not approve of cryptocurrencies at all, going so far as to ban the digital assets altogether. Other countries are embracing the technology and hoping to create a clear line of communication between these networks and government entities.
What the experts are saying
Both those within the blockchain industry and those who fully grasp the underlying technology are already onboard with how this phenomenon is changing the world. Let’s hear what those in the financial and technology world have to say about blockchain:
- “Whereas most technologies tend to automate workers on the periphery, doing menial tasks, blockchains automate away the center. Instead of putting the taxi driver out of a job, blockchain puts Uber out of a job and lets the taxi drivers work with the customer directly.” – Vitalik Buterin, co-founder of Ethereum, January, 2019
- “Blockchain is the future of apps but getting access to the technology has been just way too difficult. Now that Blockchain is part of The Salesforce Platform, it’s as easy as adding Einstein AI, Mobile, or Voice to your enterprise apps.” – Marc Benioff, CEO of Salesforce, June, 2019
- “If we were building a financial system from scratch today, we’d do it on a digital platform. Digital can lower the cost of a range of transactions by as much as 90%, providing nearly universal access to innovative financial products and services.” – Bill Gates, founder of Microsoft, December, 2018
- “We’ve always been supportive of blockchain. We’ve always believed it’s a good technology.” – Umar Farooq, JPMorgan head of digital treasury services, February, 2019
- “The old question, ‘Is it in the database?’ will be replaced by ‘Is it on the blockchain?’” – William Mougayar, author of The Business Blockchain, May, 2016
The future of blockchain
The invention of the Internet brought an opportunity to digitize many processes that had previously been done via pen and paper. Over several decades, the Internet became a ubiquitous technology, without which the world could not function. Simple tasks today such as sending an email or making an online payment were unthinkable just a few decades ago.
Much like the early days of the Internet, no one knows what the impact of blockchain will be five, ten, or twenty years from now. As the advantages of this technological advancement become more and more obvious, blockchains will establish themselves as necessary pieces of technology for a more secure and efficient future. It may be that there is a time where blockchains become as ubiquitous as the Internet or cell phones, or, it may be that this technology will only prove useful in a select few instances. These early days of blockchain are a testing ground for what lies ahead.
This information is for educational purposes only and should not be taken as investment advice, personal recommendation, or an offer of, or solicitation to, buy or sell any financial instruments. This material has been prepared without regard to any particular investment objectives or financial situation and has not been prepared in accordance with the legal and regulatory requirements to promote independent research. Any references to past performance of a financial instrument, index or a packaged investment product are not, and should not be taken as a reliable indicator of future results. eToro makes no representation and assumes no liability as to the accuracy or completeness of the content of this guide. Make sure you understand the risks involved in trading before committing any capital. Never risk more than you are prepared to lose.