Blockchain—More Than a Buzzword?
Over the last few years, blockchain evolved into one of the hottest buzzwords in tech; one that’s being used for nearly everything. It is best known for being the technical foundation of the cryptocurrency Bitcoin. However, there is a lot of misconception about it. So, let’s clear the air before we dive into how blockchain works and explore different use cases.
Blockchain Is Bitcoin – Isn’t It?
Many people equate blockchain and Bitcoin, which is quite understandable. After all, Bitcoin is by far the best-known application of blockchain technology today. In fact, I first learned about blockchain myself when I started to dig into cryptocurrencies (digital currencies backed by cryptography) several years ago. However, blockchain and Bitcoin are not the same thing. While Bitcoin is an electronic payment network, blockchain is the underlying technology that powers it.
While Bitcoin is an electronic payment network, blockchain is the underlying technology that powers it.
Once I had understood what blockchain is and how it works, I quickly realized that this technology has almost limitless application possibilities and could easily become the technology of the future. Already today, we see promising blockchain-based projects such as Walmart’s and IMB’s joint attempt to digitally track the movement of pork in China on a blockchain-based supply chain tool (Fortune.com, 2016). Figure 1 can give you a rough idea of what blockchain could be used for in different industries.
What Makes Blockchain Special
So, what is it that makes blockchain so special? And why do I think that it paves the way for the future? Well, the blockchain technology is based on cryptography-driven consensus building using peer-to-peer computing nodes and a decentralized database allowing for transactions over a secure and trusted layer.
Sounds complex? It isn’t. Let’s break it down to easy real-life examples.
Probably the easiest way to understand how blockchain technology works is to understand how Bitcoin works. In the rest of this article I am therefore going to explore the usefulness of Bitcoin and other cryptocurrencies over traditional payment processes and explain the advantages of blockchain in this scenario.
Traditional Payment Processes
With the current state of financial transactions, a third party—most often a bank—has to be trusted to verify if a transaction is valid and successful. Now, let’s assume that Party A (the sender) wants to transfer money to Party B (the benificiary) and see what the transaction process looks like.
How it works
Within the SWIFT (Society for Worldwide Interbank Financial Telecommunication) network the sender’s bank directly transfers the money to the beneficiary’s bank as seen in figure 2, step 2a. In this scenario, at least two intermediate entities—the banks—are involved.
If the transaction has to be executed outside the SWIFT network, the number of intermediate entities quickly rises to up to six. As seen in step 2b, the sender’s bank has to transfer the money to another domestic bank. This bank needs a correspondence relationship with a bank in the same payment system as the beneficiary’s bank, which acts as the man-in-the-middle. Furhermore, all banks have to report their transactions to regulators periodically.
Downsides of Traditional Transaction Systems
This process is expensive, slow, and error-prone due to the fact that all involved entities operate their own—mostly closed—centralized systems. Each system operates with its own ledger to store account and transaction data. As a result, different information is stored for a single transaction with no single source of truth being available. Therefore, when reviewing a transaction, it is critical that a trusted third party stores all information about the transaction in its own ledger.
This trusted third party is the only entity with full information about the transaction, leading to a potential single point of failure.
The Technologically Superior Alternative: Bitcoin
An alternative to this traditional process is the sharing of ledgers (distributed ledger) between different entities (countries, banks, companies, citizens, etc.) using a decentralized system. Each entity (node) has the same rights within this network and owns its own copy of the ledger. This solves the single point of failure problem and keeps the network up and running even if a node (entity) malfunctions. The system is fully redundant. A distributed ledger can therefore be described as a network of replicated databases, synchronized via the internet and visible to anyone within the network.
The Double-Spending Problem
The concept of distributed ledgers is not new and was discussed long before Bitcoin and blockchain appeared on stage. However, the financial industry was not able to solve the so-called double-spending problem. The double-spending problem describes a potential flaw leading to a single digital token to be spent more than once. This is possible because the digital file required for a digital token can be duplicated or falsified. Not only would that lead to a decreased user trust in the currency, it would also lead to inflation due to the creation of new amounts of fraudulent currency that did not previously exist.
Although first described in relation to financial transactions, the double-spending problem is not restricted to the financial sector. It affects all digital information units. Without solving this problem, the concept of a distributed ledger is of no or little value.
In 2008, the technical concept „Bitcoin: A Peer-to-Peer Electronic Cash System“ was published under the alias „Satoshi Nakamoto“. This concept first described the blockchain technology and provided the solution to the double-spending problem.
In 2009, Bitcoin went online and brought the concept of the blockchain from theory to practice.
How it works
Back to our example where Party A (sender) wants to transfer money to Party B (beneficiary). With Bitcoin, both parties need access to so-called „wallets“, which allow them to access the Bitcoin blockchain in a similar way like a web browser allows you to access the internet. In other words, what Google Chrome, Firefox, or Internet Explorer are to the Internet, a wallet is to blockchain: a point of access.
If Party A requests to take money from its own wallet and transfer it to the wallet of Party B, an order is created, which joins a so called „block“ together with other orders. The block contains the transaction data of all orders, a time stamp, and a cryptographic hash of the previously created block. This cryptographic hash links the block to other blocks—creating a chain of blocks—which cannot be modified separately. Hence the name blockchain.
Each order added to the blockchain is analysed by various nodes (entities in the blockchain), which inspect the distributed ledger and verify that Party A has the right amount of Bitcoins available it wants to spend. If the verification is successful, specialist nodes—so-called „miners“—group Party A’s order with other, similar orders and create a new block which is then added to the blockchain.
Finally, Party B receives the Bitcoins in its wallet and the transaction is complete; all without having involved an intermediate entity in the transaction process. This is made possible by the blockchain technology and its distributed ledgers as described above.
With this article I hope to have provided a basic understanding of blockchain technology and how it powers the cryptocurrency Bitcoin. By solving the old double-spending problem and making it almost impossible to manipulate data stored in a blockchain, this technology opens up almost limitless application possibilities—at least in theory.
In the next parts of this series I am going to take a deeper dive into how blockchain technology works and explain the different kinds of blockchains that exist, including both the advantages and limitations they come with. I am also going to show you real-world use cases for blockchain technology. So, stay tuned and feel free to post your thoughts and questions in the comment section below.