What is a Blockchain and How Does It Work?

Key Takeaways

• Blockchain technology is an approach to data management that explores flexible data storage and utilization means that preserve the authenticity of data and resists internal and external modification attempts.
• The blockchain is a uni-directional chain of data stored in batches known as blocks. The blocks are identified using unique hash codes that reference other blocks in the chain in such a way that a single hash code can only be changed if every other hash code in the chain is changed.
• The hash codes are generated and attached to the chains through a consensus between participants of the network.
• The blockchain is guarded by a network of computers running algorithms that validate data stored in blocks before hashing them into the blockchain.
• The blockchain can be applied to any concept or sector where immutable data is generated constantly and there is a need to manage this data easily.
• The most popular use of blockchains is for keeping data of cryptographic token transactions.

When Satoshi Nakamoto published the Bitcoin whitepaper, he shared his mission to develop a “purely peer-to-peer version of electronic cash that would allow online payment to be sent directly from one party to another without going through a financial institution”

This version of electronic cash will be built on a peer-to-peer network that timestamps transactions by hashing them into an ongoing chain of hash-based Proof-of-Work, forming a record that cannot be changed without redoing the Proof-of-Work.

Satoshi’s abstract provided the most basic definition of a blockchain and the relationship it shares with cryptocurrency which in this case is the ‘electronic cash’ while the blockchain is the network.

So what exactly is a blockchain and how does it work?

What is a Blockchain?

Modern blockchains are structured to create a similar relationship between the network and other entities that isn’t limited to electronic currencies. But the network itself has retained its basic mode of operation.

A consensus algorithm, hashing system, and an ongoing chain are the basic components of a blockchain. These components work in synergy to develop a tamper-proof but flexible data management system. The system is flexible in the sense that it can be modified to store just about any data and also make these data readily accessible, but very hard or impossible to modify once stored.

As the name suggests, the blockchain is literally a chain of blocks. A ‘block’ is a collection of data. It is a digital record of transactions or activities across the network. These transactions could involve the electronic currencies or any participants of the network. Each block is identified with a unique code, which are known as Hash Codes. Each new block extends the hash of the preceding block in such a way that they are connected and form a continuous chain.

The hash is given to the blocks through the consensus algorithm.

What Is A Consensus Algorithm?

A consensus algorithm is a system through which participants in a blockchain network confirm the validity of data contained in a block. This ensures that the network doesn’t store erroneous or malicious data. Consensus algorithms are designed with proof systems to check the legitimacy of the participants and also evidence that they have validated the information in the block.

This process is packaged in the consensus algorithm and simplified for participants in such a way that anyone, regardless of their understanding of complex computing, can participate in the network by running a blockchain node and validating a block.

Most blockchains reward participants for this role. However, it is important to note that this is not compulsory. The two most popular consensus algorithms are the Proof-of-Work and Proof-of-Stake consensus algorithms.

Proof-of-Work algorithm is one of the earliest consensus algorithms, used notably by the bitcoin blockchain and formerly by Ethereum blockchain. Newer blockchains are showing a preference for Proof of Stake. Other consensus algorithms have emerged. Some of these include Proof-of-History used by Solana blockchain and Proof-of-Authority used by VeChain.

Consensus algorithms play a major role in tamper-proofing the blockchain network. For an attacker to modify the data on the network, they will need to rework the proofs for all the blocks in the network. To stand a chance of doing this successfully, the attacker must possess at least 51% of the computing powers in the network for Proof-of-Work blockchains or 51% of the assets staked on the network for Proof-of-Stake blockchains. This is known as a 51% attack.

What Is The Purpose Of A Blockchain?

The purpose of a blockchain is simple; a system to store data in such a way that data cannot be modified and at the same time be flexible. The blockchain was developed for easy storage of data, easy access to data, and rigid end-to-end resistance to modification attempts.

Like cloud computing, the blockchain is basically a way to store and use data. In contrast to cloud storage, however, the blockchain network is owned by every member of the network.

Instead of a single control point, the blockchain network is dispersed across every participating device. Everyone owns a piece of the blockchain, but no one controls it.

What You Can Do On The Blockchain

Before spending the end of your first 24 hours in the crypto space, you’ve certainly used the blockchain in at least two ways. Either you created a cryptocurrency wallet or you’ve sent a cryptocurrency to a friend or from an exchange to your wallet. The higher chance is that you did both.

In each of these, you’ve used the blockchain for different purposes, but in the same way. By creating a wallet, you’ve successfully registered an account on the decentralized ledger. By completing an asset transfer or receiving an asset, you’ve recorded a set of data on the ledger and under your account. This data can be easily accessed and used, but cannot be modified. 

There are other ways to utilize this ability, such as:

Decentralized Applications

Google and Amazon cloud holds the database of most applications we use. Developers use these platforms to store and serve data to the application users. These applications are centralized, not only because the database is controlled by a single entity but also because the developers have first-hand control over what is stored and served.

Data generated by users are controlled by database managers and cloud service providers. Developers are currently resorting to blockchain networks as a more secure way of managing users’ data through an immutable ledger system; users are also craving for applications where their data are ‘untouchable’. 

Applications built on the blockchain are known as decentralized applications and they cut across areas such as:

Gaming

‘GameFi’ projects swept the crypto space by its feet throughout the last quarter of 2021. Decentralized gaming applications are built on the blockchain and serve users’ data from the network. A huge advantage they have over centralized games is that gamers can lay claim to their gaming assets. These assets can be NFTs or in-game tokens.

Decentralized Finance

Blockchain-based applications can handle core financial transactions. These are popularly known as DeFi applications. DeFi is currently a crypto-centric term, but mainstream financial institutions are also exploring ways to utilize the blockchain in running core financial transactions like lending, fundraisers, and fixed deposits.

A similar concept to banking fixed deposits in DeFi is Yield Farming. These two programs are related. Yield farming is popular amongst cryptocurrency communities.

Blockchain projects like AllianceBlock are building a decentralized asset market where companies can issue and trade stocks, distribute dividends and raise funds.

Decentralized Media

Projects like Steemit have developed a proper blogging platform that runs on the blockchain. Users’ posts, accounts, and history are stored on the blockchain. By this, these posts cannot be censored, the blockchain also handles users’ rewards and manages users’ financial records. Thanks to the rising issue of media censorship, mainstream content creators are switching to similar systems.

Digital Signature

The word ‘NFTs’ has been used once in this article. It is a household term in the crypto space and the world outside it. NFTs are a way of creating proof of ownership on the blockchain. Through Non-Fungible token technology, asset owners can create an indelible proof of ownership on the decentralized ledger.

This proof is represented by cryptographic tokens stored on the blockchain that points to the physical or virtual asset(s). Artists and media creators have used this technology extensively and explored the financial applications of their signatures.

Payment Solutions

You’d expect this to come first. The earliest blockchains had this as their principal purpose. The bitcoin blockchain specifically handles payment requests through its electronic cash system represented by the bitcoin coin. Other blockchains like the LiteCoin blockchain have a similar structure.

But blockchain as a payment solution has gone beyond this. 

Visa in 2021 announced its plans to start processing international payments through the Ethereum blockchain. Sovereign nations are trying out Central Bank-backed Digital Currencies (CBDCs). CBDCs are electronic versions of fiat currencies built on the blockchain. China (digital Yuan) and Nigeria (E-Naira) are some of the notable nations that have already implemented this system.

Mainstream payment firms including Mastercard are rapidly embracing blockchain as a payment solution.

Data Management

The applications mentioned above are in fact, high-level data management approaches using the blockchain. In addition to these, the blockchain can be used solely for data storage and access. The immutable technology means that these data stay preserved in their original form. The flexible technology ensures that they can be easily accessed. 

This can be applied in any system where a huge amount of data is generated routinely. Such systems can be seen in the medical sector and sports as well. The blockchain works well in these cases.

Governance

Decentralized Autonomous Organizations (DAOs) are emerging. Many cryptocurrency projects have developed this system of administration.

DAOs are a systemic design, structured to ensure the general and undiluted participation of the members of the organization. In cryptocurrency communities, rights to this participation are tokenized and every token holder is considered a member of the DAO. Through voting portals, members of the DAO can vote on proposals and also submit their improvement suggestions to be voted on by the rest of the holders.

Systems like these simplify community consensus while ensuring that everyone takes part in the political process. Community decisions are recorded on the blockchain as DAO members make a tokenized statement. The decision made is recorded on the blockchain. With DAOs, both the decision-making process and decisions made are transparent to every member of the organization

Benefits of Using Blockchains

Using systems built on the blockchain or developing a blockchain-based solution for yourself or your organization gives you certain edges. These advantages are drawn from true ownership of your data and the responsiveness of your data store. 

Here are some benefits of using blockchain:

Censorship Resistance

“History is written by the victors.” Administrators of centralized media and other authorities in charge of information dissemination have a final say on what goes out to the public. 

However, in an ideal scenario, information should be free of censorship in most situations, but this is currently not obtainable with centralized media solutions but is easily achievable with the blockchain.

Data stored on the blockchain is not only immutable but also everlasting. Media facilities built on the blockchain are resistant to censorship attempts to modify its content. 

Data Security

The importance of censorship-resistant data storage technology extends beyond the longevity of personal and institutional data; it also ensures the security of data. In blockchain-based payment solutions, account owners are assured of the safety of their electronic currencies as long as they retain ownership of their accounts. Other assets or data running on the blockchain share this benefit as well.

Easy Access

The blockchain is a flexible ledger with a simplified data storage, sorting, and presentation procedure. Data can be easily generated and stored on the blockchain. Obtaining stored data is even easier. Users can easily obtain desired data by using hashcodes or any other specific identifiers. 

A majority of present-day blockchains are public. Systems like this allow anyone to create an account or store information. Information stored can be easily sorted at will, regardless of when the information was entered into the ledger. Explorers such as Etherscan and BscScan offer users an easy way to track transactions and inspect wallets on Ethereum and BNB respectively.

Cost and Time Saving

Decentralized finance applications and other solutions built on the blockchain are relatively ‘cheap’. Compared to traditional solutions with custodial administrational systems, blockchain-based solutions are permissionless and this feature only could save users a great deal of time, and cost. The time spent on going through rigorous procedures and stages is trimmed and the cost of these procedures is also saved.

Universality

Peers on a blockchain network can easily exchange data between themselves. Regardless of the location and legal stipulations, data, including valuable virtual assets can be transacted between members of a blockchain network. This is a major benefit of using blockchain-based payment solutions.

Disadvantages of Blockchains

We could go on with enumerating the benefits of using the blockchain, but it is equally important to reflect on some of the detriments of using blockchain-based solutions. Here are some disadvantages of using applications built on the blockchain.

Rigid Data Management Structure

Immutable data is essential for data security and censorship resistance, but some occasions require that certain data be edited. Blockchains are uni-directional and thus this is not (easily) possible. This results in a dilemma, where blockchain users will have to choose between data security and the ability to easily modify the data they store. The latter cannot be obtained while using a blockchain.

The fact that a central authority cannot modify data stored on the blockchain also makes for a general misuse scenario. Users of blockchain-based media can put out toxic or false messages. This message will go on to circulate as no single point of control is able to put them away or edit them.

Scalability and Memory Capacity

Blockchain technology is a high-capacity computing procedure. It requires certain high-end computing resources for users’ devices and this might also include the device memory, especially when the user is running a blockchain node. Blockchain applications could grow to several hundred megabytes or gigabytes. Depending on the device, this could consume resources meant for other applications. Many blockchains aren’t scalable. They are unable to handle increasing usage pressure without making huge adjustments.

Privacy

When using a public blockchain, users’ data can be easily accessed. Even though they can’t be modified, anyone can easily view them. Data accessed in this manner can include users’ electronic cash transactions. It is therefore not easy to achieve transaction privacy while using (public) blockchain systems like this.

Can The Blockchain Be Hacked?

Billions of dollars worth of electronic assets have been lost in cryptocurrency hacks. Incidents like these raise questions about the hack-proof technology the blockchain was thought to offer. Post-mortem reports on these cases reveal the actual causes and it has never been a direct breach on the blockchain network.

The blockchain despite being a ‘closed end’ system can be manipulated without itself being affected. Scammers can steer their way into personal accounts on a decentralized ledger and interact with individual records without breaking the whole network. Breaking the whole network is in fact, not (currently) possible.

Most mishaps that occur in blockchain-based applications are either due to;

·        Phishing or other social engineering techniques used to gain personal account passwords.

·        Exploitation of smart contract vulnerabilities

·        Common scams

In any of these cases, the blockchain remains intact and only the victim(s) accounts are affected. Modifying a whole proof-of-work blockchain network will need extremely high computing power, one more powerful than the 50% of the computing powers in the network put together. Devices with this ability are yet to exist. 

A similar requirement applies to Proof-of-Stake blockchains. It is worth mentioning that this doesn’t still guarantee a successful modification of a blockchain network.

What are the Different Types of Blockchains?

Many outlets have attempted to classify blockchains according to several subjects, popular classifications are based on Purpose of use, Accessibility, and Phase of development. A more convenient and widely acknowledged classification is according to accessibility, but other taxonomies are also worthy of note.

According to the Purpose of use; blockchains are either Multi-purpose or Single-use.

Single-Use Blockchains

Single-use blockchains are designed to focus on a single application. Older blockchains were mainly designed to handle electronic currency transactions. Institutions outside the crypto space are also exploring ways to use blockchain technology to optimize their services, and they usually resort to developing single-purpose blockchains that solve a particular problem for them.

Multi-Purpose Blockchains

Majority of contemporary blockchains are multi-purpose. Each one serves a number of uses. Blockchain networks like the Ethereum network can process electronic cash transactions and also power decentralized applications that cut across many mainstream sectors. Multipurpose blockchains are also able to run governance operations. They basically develop several ways to leverage the data management system of blockchain technology.

When it comes to matters of accessibility, blockchains are either private, public, or a modified hybrid.

Public blockchains

Public blockchains are open to everyone. Anyone, regardless of demographics and knowledge level can create an account on the ledger and create storable data on the blockchain. In addition, anyone can create a node on the blockchain and participate in the blockchain consensus.

Private Blockchains

Private blockchains are closed networks. While the basics remain the same with any other blockchain, there are limits to who can be an active part of the network. They are ‘gated’ and only open to selected parties. Private blockchains are more popular among custodial institutions. Access is only limited to confirmed members of the organization.

Hybrid Blockchains

Blockchains that operate a mixed permission system are known as hybrid blockchains. They feature a partly ‘gated’ and partly open system. Designated individuals control the gated parts. Participation is only open to selected persons and data generated from these parts are rarely public. The open parts are permissionless and free of central regulation.

Federated blockchains

Federated blockchains are owned by institutions and are specially developed to suit the needs of that particular institution. They are also known as consortium blockchains and can be private, public, or a mixture of both. Their structure and mode of operation are totally determined by the organization.

Another convenient way to classify blockchains is according to the phase of blockchain evolution. But blockchains are in constant evolution and this method of classification would require constant revisions. 

However, given the current stage of blockchain development, blockchains can be classified into;

First-Generation Blockchains

First-generation blockchains are mainly focused on creating an efficient Peer-to-peer medium of transaction. The network upholds a cryptographic token that can be transacted amongst peers. Records of electronic cash transactions are kept on the distributed public ledger. The Proof-of-Work algorithm prevents modification of transaction records and double-spending. The Bitcoin blockchain is a first-generation blockchain.

Second-Generation Blockchains

Second-generation blockchains extend the technology and attempt to exploit it in several interesting ways. A huge figure in this phase is the Ethereum blockchain. Ethereum blockchain featured a state machine capable of reading a series of codes and translating them into machine languages than can be understood by the blockchain. The state machine is known as Ethereum Virtual Machine (EVM) and the codes are known as smart contracts. Smart contracts automate transactions and owner-authorized permissions.

Third-Generation Blockchains

Second-generation blockchains were attractive and welcomed tons of users who generated tons of data while using the numerous features of the blockchain. This became a popular problem as these blockchains aren’t well adapted to handle the high frequency of use. This ushered in the next stage of blockchain evolution. Third-generation blockchains are ‘super-optimized’ and focused on scalability and user experience. 

They are notably faster than the first and second-generation blockchains and more scalable. An example of third-generation blockchains includes the Solana, Polkadot, and Aptos.

Fourth-Generation Blockchains.

Fourth-generation blockchains are only speculative currently. Modifications of third-generation blockchains or a new blockchain could fall into this category. Fourth-generation blockchains are expected to be even more economic, scalable and faster than third-generation blockchains. A huge improvement expected in fourth-generation blockchains is interoperability. 

Fourth-generation blockchains will attempt to develop an effective means of communicating with each other and blockchains from other generations. Several third-generation blockchains are already working on this.

Final thoughts

It is hard to finish a discussion about blockchain and blockchain technology without mentioning the word ‘revolutionary’. This best describes how the blockchain manages data and how this technology has been used to date. Projects working on blockchain-based utilities are rapidly designing efficient alternatives to applications running on centralized systems. Even though these projects are in their baby stage, they have shown huge potential.

The decentralized web and decentralized payment solutions are futuristic. Even if they don’t play the role we currently envision in the future, they are very likely to be a bigger part of our everyday systems. The common blockchain user is fascinated by the ability to perform certain activities without taking permission from central authorities and also by the total control they have over the data they generate.

But blockchain technology is still ‘untapped’, currently. This is considering the tremendous progress made in this aspect. Like cloud computing and the internet put together in one piece, the blockchain is designed to penetrate every system. It holds data security as a huge advantage over these two.