How Does the Blockchain Work? Pt. 2
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The top five things that you need to know.
The talk about Blockchain technology seems ubiquitous. But what exactly is a blockchain? More specifically, what are the blockchain essentials that you should really know?
Let’s dive in to find out more about it, and separate the hype from the reality.
1. What is a Blockchain?
A blockchain is a tamper-proof distributed public ledger that manages transactions.
Think of it like a magical Google spreadsheet in the cloud, or more specifically on a network.
Put simply, a blockchain is basically an incorruptible distributed ledger of data, which can be used to store informational assets ranging from managing cryptographic contracts to transferring value.
The most recognized application on a blockchain is Bitcoin. This allows the transfer of value from one person to another with no central intermediary, and without allowing a person or party to spend their Bitcoin twice – the double spend rule.
What does this mean?
It means that “value” can have a change of title and ownership from one person or party to another, without the need of a trusted third party to validate and govern the trade.
How is that, you might ask?
Well, the governance is in the protocol.
Besidse being a ledger for “data of value,” or cryptocurrencies, blockchain technology is finding broader usage in peer-to-peer lending, (smart) contract management, healthcare data, stock transfers, and even elections.
Like any emerging and disruptive technology, no one can predict the future of Blockchain technology. But one thing’s for sure — it isn’t (just) for purchasing black market goods and services!
As a matter of fact, blockchain technology is finding its way into big firms such as IBM, Microsoft, and major banks.
Interest in the technology is driven by fear of disruption – the fact that it excludes trusted third parties (banks and clearinghouses) during the transfer of value, which in turn results in fast, private and less expensive financial transactions.
Blockchain can facilitate the peer-to-peer transfer of anything that’s of value.
This may include assets, properties, and contracts. The most crucial and far-reaching blockchain application is applied in Bitcoin, with transfer of value, and Ethereum, with its enhancement of smart contracts.
Let’s jump in and learn the historical background of these blockchain essentials.
The Bitcoin currency, as many have come to know it, has been with us since 2008 when Satoshi Nakamoto — a person, or group of people — published a whitepaper about peer-to-peer electronic currency.
The major innovation that Bitcoin unveiled was direct and secure transfer of money or "value" directly to any party on the network.
The Bitcoin currency network is decentralized — there's no central authority — and the underlying blockchain technology is used to store information which is verified by a network of "miners" who validate all transactions on the network.
How should I think of this?
Bitcoin is simply a virtual currency system which resembles the real world cash system.
Since it's launch in 2008, through the boom and bust of the hype cycle, Bitcoin has continued to grow at an exponential rate, and the fringe curiosity that consumed a group of highly capable tech nerds has ushered in some new upgrades that have brought blockchain closer to the mainstream.
3. Ethereum — Blockchain 2.0
Ethereum is a blockchain system based on the concepts of Bitcoin.
It is considered a second generation blockchain technology that was designed to let any person, with a basic level of computer skills, to develop and deploy their own decentralized applications on the blockchain.
Just like Bitcoin, Ethereum is decentralized — no one regulates or owns it — and it has it's own cryptocurrency or "fuel" called "Ether" which acts in the same way bitcoin does. However, Ethereum has a few innovations worth noting. The first being a second application on its blockchain infrastructure called a "smart contract", it's own virtual machine which powers the memory and applications on the network called the "Ethereum Virtual Machine", and its own programming language called "Solidity".
Ethereum is kinda like Bitcoin on steroids, but made to be more accessible.
It was developed by Vitalik Buterin, a 19 year old Russian Canadian in 2013 as a next generation blockchain technology, with capabilities to be able to program and perform arbitrary and complex computations.
Rather than just providing users with a set of predefined operations — like Bitcoin transactions — Ethereum lets users develop their own operations with the complexity they wish.
4. Smart Contracts
What is a "smart" contract?
Well, they actually aren’t that “smart.”
Think of them like self executing dumb software robots that live and do business on a decentralized network.
Smart contracts are autonomous computer systems, written in code, that manage executions between individuals on the blockchain.
The code resides at specified addresses on the Ethereum blockchain. These contracts are powered by our friend, the Ethereum Virtual Machine (EVM), and by Ether. It's the little engine that could, that keeps all the smart contracts running on time and coordinates them with the rest of the network.
In order to create an added layer of customization and security, Ethereum created some high-level languages that are used to create smart contracts for the EVM. These are Solidity, Serpent, and LLL.
These are the major innovation that Ethereum has brought to blockchains, and it allows for many amazing types of autonomous program.
Next, let's explore the consensus mechanisms in blockchain.
5. Consensus Mechanisms
When you interact with multiple parties, you need some sort of consensus mechanism to ensure everyone has got the right records. – Dan O'Prey, co-founder of Hyperledger
Both Bitcoin and Ethereum use a decentralized system to confirm the transactions without relying on a trusted third party.
Therefore, consensus, or coming to a uniform agreement, helps a network of autonomous programs and computers come to an agreed state of the blockchain without conflict.
As a matter of fact, this consensus is the backbone of the blockchain and any other decentralized and distributed technology.
The proof of work, proof of stake and closed consensus are the most common mechanisms used in blockchain technologies.
A. Proof of Work
The most common consensus mechanism that's used for blockchain technology is what's called "proof of work". It is the system used in Bitcoin.
When a transaction is initiated, the information is stored in a candidate block, which is filled with the transaction's information. A cryptographic beacon is sent out to the mining network that the candidate block has been created, and the miners get to work on solving a cryptographic puzzle that has a prize for whomever solves it, in the form of newly minted coins/currency.
Miners have what some would think of as supercomputers that are much more powerful than the average person's MacBook Pro. These machines have a "hashrate" or computing power that gives them an advantage when competing to solve consensus problems for reward.
I know what all you climate control advocates are saying: Doesn't that demand a lot of electricity and processing power?
The short answer is yes, the cost of mining is based primarily, on hardware, electricity costs, and to some degree temperature.
The problem with the Proof of Work consensus is that it requires the miner to use their supercomputer to try out millions of computations per second, in competition with other supercomputers around the world, to determine if the blockchain can be updated or not.
B. Proof of Stake
The main objective of this mechanism is to allow stakeholders, the people with the most invested, or owned, in the Blockchain ecosystem to have the strongest incentives to lead in the provision of consensus solutions for a blockchain transaction.
In simple terms:
Proof of Stake consensus allows miners that have more "money", cryptocurrency, or "skin in the game" to have a greater opportunity to mine blocks and make decisions for the network.
The process starts with the miner consuming his/her cryptocurrency — commonly referred to as the kernel — which provides privileges for updating the blockchain, which is similar to Proof of Work.
However, the hashing computation in Proof of Stake is done using a limited search space, where stakeholders with the greatest stakes have the ability to mine a commensurate allocation of the network, and are effectively stewards of the Blockchain system.
Think of it like : the more a miner has, the more they can get, and the more they can decide.
The one benefit of this controversial crypto-economic system is that by allowing stakeholders with incentives to take charge of consensus, the mechanism reduces the computing power required for consensus.
This should make the climate control kids happy, but…
The main problem of this mechanism is that it disadvantages other miners in the network since only the "richest" stakeholders are permitted to have control of consensus in the blockchain.
C. Closed Consensus
In a Closed consensus mechanism, certain nodes are required to put up a security deposit in order to participate in updating the blockchain.
This consensus mechanism doesn't require mining, and is growing in popularity in some banking and insurance segments.
The management of the consensus is done using security deposits which incentivize the validators. The "arbitrators" — conflict management nodes — are the enforcers on the blockchain, and they adjudicate when something is not right or if a miner is not acting fairly.
The main objective of using an arbitrator's protocol is to enforce consensus among the autonomous nodes in the blockchain.
If a validator authenticates a transaction which the arbitrators have considered illegitimate, then the validator loses their security deposit, and they also forfeit their privileges of providing consensus in the blockchain network in the future.
Now that you understand the basic essentials of blockchain technology, you should be able to answer very easily:
- What is a blockchain?
- How does bitcoin work?
- What are the major innovations that the Ethereum blockchain brought to the technology?
- What is a smart contract?
- What are the different types of consensus mechanism that power a blockchain?
Hopefully this inspires further exploration and your own personal discovery, and exploration of how you might be able to join in the conversation and experiment.
If you want more information, and you missed the first post in this series, check out this easy to understand post here: How Does the Blockchain Work?
Or, if you are ready to move forward, you can read the rest of the series:
- How does the Blockchain Work? Part 3 – what is consensus and why does it matter?
- How does the Blockchain Work? Part 4 – what’s the difference between private, public, and consortium blockchain?
The main take away that you should get from these articles is that understanding the blockchain is not that hard, and when you do, you have the ability to affect your team, startup, and industry in ways that you might not thought possible in the past.
I’m always interested in meeting blockchain founders, academic researchers, and technologists who are working on challenging projects, so please feel free to contact me on LinkedIn, or by email at firstname.lastname@example.org.