What is blockchain and how does it work?
**Key Points**
- **Blockchain** is a digital ledger that securely records transaction data on a distributed network of computers.
- Blockchain ensures data integrity through its immutable nature, achieved through cryptography and consensus mechanisms, meaning once information is recorded, it cannot be retroactively altered.
- Blockchain forms the backbone of cryptocurrency networks like Bitcoin and Ethereum and plays a crucial role in promoting transparency, security, and trust across various sectors beyond finance.
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### Introduction
Blockchain technology has transformed various industries, particularly finance, by introducing a decentralized, transparent, and secure way to manage data and transactions. While it started as the foundation for cryptocurrencies like Bitcoin, its range of applications has now expanded to supply chain management, healthcare, voting systems, and much more.
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### What is blockchain?
Blockchain is a special type of database. It is a decentralized digital ledger maintained by a distributed network of computers. Blockchain data is organized in blocks, which are timestamped and secured using cryptography.
This structure ensures that data is transparent, secure, and immutable. Once data is secured in a block and confirmed, it is almost impossible to change. The decentralized structure eliminates the need for a central authority. Blockchain transactions can occur directly between users without intermediaries.
There are different types of blockchains that exhibit various degrees of decentralization. However, generally, blockchain refers to a decentralized digital ledger used to record cryptocurrency transactions.
#### A Brief History of Blockchain
- **1990s**: Computer scientist Stuart Haber and physicist W. Scott Stornetta used cryptographic techniques to link digital documents in a chain of blocks to prevent tampering.
- **2008**: Satoshi Nakamoto created Bitcoin, the first cryptocurrency powered by blockchain technology.
- **Afterward**: There has been a significant increase in the acceptance of blockchain, and cryptocurrencies have become a global trend.
Although blockchain technology is often used to record cryptocurrency transactions, it is also suitable for recording other types of digital data and can be used in various use cases.
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### Key Features and Benefits of Blockchain
1. **Decentralization**: Information is stored on a network of computers (nodes) rather than a central server. Large decentralized networks like Bitcoin are highly resistant to attacks.
2. **Transparency**: Most blockchains are public, meaning all participants have access to the same database. Transactions are visible to all participants.
3. **Immutable**: Once data is added to the blockchain, it cannot be changed without the consensus of the network.
4. **Data Security**: Cryptography and consensus mechanisms provide strong protection against data tampering.
5. **Efficiency**: Blockchain enables faster and cheaper transactions by eliminating the need for intermediaries. Transactions are processed almost instantly.
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### What is decentralization in blockchain?
Decentralization in blockchain refers to the idea that control and decision-making power within the network is distributed among its users rather than being held by a single entity, such as a bank, government, or corporation.
In a decentralized blockchain network, there is no central authority or intermediary controlling the flow of data or transactions. Instead, transaction verification and recording are conducted by computers in a distributed network that work together to maintain the integrity of the network.
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### How does blockchain work?
In its simplest form, blockchain is a digital ledger that securely records transactions between two parties in a tamper-proof manner. The transaction data is recorded by computers (nodes) in a globally distributed network.
When Alice sends some Bitcoin to Bob, the transaction is broadcast across the network. Each node verifies the transaction by validating digital signatures and other transaction data. Once verified, this transaction is included in a block along with other transactions. We can think of each block as a page in a digital ledger.
Blocks are linked together using cryptographic methods, forming the blockchain. The process of confirming transactions and adding them to the blockchain is done through a consensus mechanism, which is a set of rules that guide the network's nodes in agreeing on the state of the blockchain and the validity of transactions.
#### Summary of Blockchain
1. **Transaction Record**:
- When a transaction is initiated (for example, a transfer of cryptocurrency), it is broadcast across a network of nodes. Each node verifies the transaction using predetermined rules.
2. **Block Creation**:
- Verified transactions are grouped into a block. Each block includes:
- Data (e.g., transaction details)
- A timestamp
- A cryptographic hash: A unique identifier created by running the block's data through a hashing algorithm.
- The hash of the previous block: This is what links blocks to one another, forming a chain.
3. **Consensus Mechanism**:
- To add a block to the chain, network participants must agree on its validity. This is achieved through a consensus algorithm, such as Proof of Work (PoW) and Proof of Stake (PoS). In summary:
- **Proof of Work (PoW)**: Used by Bitcoin, PoW utilizes computational power from validators to solve complex problems.
- **Proof of Stake (PoS)**: Used by modern blockchains like Ethereum, where the selection of validators for block confirmation is based on the amount of cryptocurrency they have staked.
4. **Joining the Chain**:
- After verification, the block is added to the blockchain. Each subsequent block references the previous block, ensuring a tamper-proof structure. In other words, the identifier of the previous block is necessary for validating the new block.
5. **Transparency**:
- Another feature of blockchain is its transparency. Generally, anyone can check the data of a blockchain, including all transaction data and block data, on public websites known as blockchain explorers. For instance, you can view every transaction recorded on the Bitcoin network, including the wallet addresses of the sender and receiver, the amount transferred, and much more. You can also trace all Bitcoin blocks back to the first block, known as the genesis block.
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### Blockchain Cryptography
Cryptography is key to maintaining a secure, transparent, and tamper-resistant record of transactions for blockchain. For example, hashing is an important cryptographic technique used in blockchains. It is a cryptographic process that converts input of any size into a fixed-size string of characters.
The hash functions used in blockchains are generally collision-resistant, meaning the chances of generating the same output from two pieces of data are negligible. Another characteristic is called the avalanche effect, which refers to the phenomenon where a slight change in input data dramatically alters the output.
Let’s clarify this with SHA256, a function used in Bitcoin. As you can see, changing the capitalization of characters dramatically altered the output. Hash functions are also one-way functions because deriving the input data from the hash output is computationally impossible.
| **Input Data** | **SHA256 Output** |
|------------------|------------------------------------------------------------------|
| Binance Academy | 886c5fd21b403a139d24f2ea1554ff5c0df42d5f873a56d04dc480808c155af3 |
| Binance academy | 4733a0602ade574551bf6d977d94e091d571dc2fcfd8e39767d38301d2c459a7 |
| binance academy | a780cd8a625deb767e999c6bec34bc86e883acc3cf8b7971138f5b25682ab181 |
Each block within a blockchain securely includes the hash of the previous block, establishing a strong chain of blocks. Anyone wanting to modify a block would need to change all subsequent blocks, which is not only technically difficult but also expensive.
Another cryptographic technique widely used in blockchain is public key cryptography. Also known as asymmetric cryptography, it helps establish secure and verifiable transactions between users.
It works like this: each participant has a unique pair of keys: a private key, which they keep secret, and a public key, which is shared openly. When a user initiates a transaction, they sign it using their private key, resulting in a digital signature.
Other network participants can still verify the authenticity of the transaction by applying the sender's public key to the digital signature. This approach ensures secure transactions since only the legitimate holder of the private key can authorize the transaction, and anyone can verify the signatures using the public key.
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### What is a consensus mechanism?
A consensus algorithm is a mechanism that allows users or machines to synchronize in a distributed setting. It must ensure that all agents in the system, even if some agents fail, agree on the same truth.
Consensus mechanisms ensure that all nodes in the network have a single copy of the ledger, which records all transactions.
When tens of thousands of nodes hold copies of the blockchain data, certain challenges can quickly arise, such as data consistency and malicious nodes. To ensure the integrity of the blockchain, various consensus mechanisms exist that control how network nodes reach consensus. Let’s take a closer look at the key consensus mechanisms.
#### Types of Consensus Mechanisms
**What is Proof of Work?**
Proof of Work (PoW) is a consensus mechanism used to validate transactions and maintain the integrity of the blockchain in many blockchain networks. It is the original consensus mechanism used by Bitcoin.
In PoW, miners compete to solve a complex mathematical problem to add the next block to the blockchain. In the mining process, the miner who first solves the problem is rewarded with cryptocurrency.
Miners are required to use powerful computers to solve mathematical problems, create new coins, and secure the network. For this reason, the mining process requires a significant amount of resources (computational power and energy).
**What is Proof of Stake?**
Proof of Stake (PoS) is a consensus mechanism designed to address some of the drawbacks of Proof of Work (PoW). In PoS systems, instead of miners competing to solve complex mathematical problems, validators are selected based on the amount of cryptocurrency they have 'staked' in the network.
Staking refers to the amount of cryptocurrency that validators hold as collateral. Typically, in PoS, validators are randomly selected to create new blocks and validate transactions based on the size of their stake. They are rewarded with transaction fees for creating new blocks and are incentivized to act in the best interest of the network. If they act maliciously, they may lose their staked cryptocurrency.
**Other popular consensus mechanisms**
Proof of Work and Proof of Stake are the most common consensus algorithms, but there are many other types. Some are hybrids that combine elements of both systems, while others are entirely different approaches.
For example, Delegated Proof of Stake (DPoS) is similar to PoS, but instead of all validators being eligible to create new blocks, token holders elect representatives from a small set who create blocks on their behalf.
On the other hand, in Proof of Authority (PoA), validators are identified through their reputation or identity rather than by the amount of cryptocurrency they hold. Validators are selected based on their trustworthiness, and they can be removed from the network if they act maliciously.
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### What are the different types of blockchain networks?
1. **Public Blockchain**:
- A decentralized network that is open to anyone who wants to participate. This network is typically open source, transparent, and permissionless, meaning anyone can access and use it. Bitcoin and Ethereum are examples of public blockchains.
2. **Private Blockchain**:
- As the name suggests, a private blockchain is not open to the public. Private blockchains are typically run by a single entity, such as a company, and are used for internal purposes and use cases.
- Private blockchains are permissioned environments with rules that determine who can view and write to the chain. They are not decentralized systems due to a clear hierarchy of control. However, they can be distributed as many nodes may keep a copy of the chain on their machines.
3. **Consortium Blockchain**:
- Consortium blockchains are a hybrid of public and private blockchains. In a consortium blockchain, multiple organizations come together to create a shared blockchain network that is jointly managed and operated. This network can be open or closed, depending on the needs of the consortium members.
- Instead of an open system where anyone can validate blocks or a closed system where only a single entity nominates block producers, in a consortium chain, a few equally powerful parties act as validators.
- The system's rules are flexible: the visibility of the chain can be limited to validators, made visible to authorized individuals, or visible to everyone. If validators can reach consensus, changes can be implemented easily. As far as the functioning of the blockchain is concerned, if a certain threshold of honesty is maintained by these parties, the system will not face issues.
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### What is blockchain used for?
Although blockchain technology is still in its early stages, there are many potential use cases across various industries. Some common current applications of blockchain technology include:
1. **Cryptocurrencies**:
- Blockchain technology was designed to support the creation of cryptocurrencies, using the blockchain as a secure and decentralized ledger to record transactions.
- Traditional cross-border transactions involve intermediaries and higher fees, but blockchain enables faster, cheaper, and more transparent international transfers. In addition to its property as a store of value, many use Bitcoin and other cryptocurrencies for global remittances.
2. **Smart Contracts**:
- Smart contracts are self-executing agreements that can be programmed to automatically execute when specific conditions are met. Blockchain technology enables the creation and execution of smart contracts in a secure and decentralized manner.
- Some of the most popular applications of smart contracts include decentralized applications (DApps) and organizations (DAOs), which make up a significant portion of decentralized finance (DeFi) platforms. DeFi platforms leverage blockchain to provide financial services such as lending, borrowing, and trading without traditional institutions. This democratizes access to financial tools.
3. **Tokenization**:
- Real-world assets (RWAs) such as real estate, stocks, or art can be converted into digital tokens on the blockchain. This enhances liquidity and broadens access to investment opportunities.
4. **Digital Identity**:
- Blockchain can be used to create secure and tamper-proof digital identities that can be used for verifying personal information and other sensitive data. As our personal information and assets move online, this can become increasingly important.
5. **Voting**:
- By providing a decentralized, tamper-proof ledger of all votes cast, blockchain technology can be used to create a secure and transparent voting system that eliminates the possibility of voter fraud and ensures the integrity of the voting process.
6. **Supply Chain Management**:
- Blockchain technology can be used to create a ledger of all transactions within a supply chain. Each transaction (or group of transactions) can be recorded on the blockchain as a block, creating an immutable and transparent record of the entire supply chain process.
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### Concluding Thoughts
Blockchain technology offers a secure and transparent way to record transactions and store data. It is a technology that is revolutionizing various industries by bringing a new level of trust and security to the digital world.
Whether enabling peer-to-peer transactions, creating new forms of digital assets, or facilitating decentralized applications, blockchain technology opens up a world of possibilities. As this technology evolves and is widely adopted, we can expect the emergence of more innovative and transformative use cases in the coming years.
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### Further Reading
- **What is cryptocurrency and how does it work?**
- **What is a stablecoin?**
- **What is cryptocurrency mining and how does it work?**
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