Blockchain is a particular type or subset of so-called distributed ledger technology (“DLT”). DLT is a way of recording and sharing data across multiple data stores (also known as ledgers), which each have the exact same data records and are collectively maintained and controlled by a distributed network of computer servers, which are called nodes. Blockchain is a mechanism that employs an encryption method known as cryptography and uses (a set of) specific mathematical algorithms to create and verify a continuously growing data structure – to which data can only be added and from which existing data cannot be removed – that takes the form of a chain of “transaction blocks”, which functions as a distributed ledger. In practice, blockchain is a technology with many “faces”. It can exhibit different features and covers a wide array of systems that range from being fully open and permissionless, to permissioned:
On an open, permissionless blockchain, a person can join or leave the network at will, without having to be (pre-) approved by any (central) entity. All that is needed to join the network and add transactions to the ledger is a computer on which the relevant software has been installed. There is no central owner of the network and software, and identical copies of the ledger are distributed to all the nodes in the network. The vast majority of cryptocurrencies currently in circulation is based on permissionless blockchains (e.g. Bitcoin, Bitcoin Cash, Litecoin, …).
On a permissioned blockchain, transaction validators (i.e. nodes) have to be pre-selected by a network administrator (who sets the rules for the ledger) to be able to join the network. This allows, amongst others, to easily verify the identity of the network participants. However, at the same time it also requires network participants to put trust in a central coordinating entity to select reliable network nodes. In general, permissioned blockchains can be further divided into two subcategories. On the one hand, there are open or public permissioned blockchains, which can be accessed and viewed by anyone, but where only authorised network participants can generate transactions and/or update the state of the ledger. On the other hand, there are closed or “enterprise” permissioned blockchains, where access is restricted and where only the network administrator can generate transactions and update the state of the ledger. What is important to note is that just like on an open permissionless blockchain, transactions on an open permissioned blockchain can be validated and executed without the intermediation of a trusted third-party. Some cryptocurrencies, like Ripple and NEO utilise public permissioned blockchains.
How Blockchain Works
The blockchain is a distributed database
In simple terms, the blockchain can be thought of as a distributed database. Additions to this database are initiated by one of the members (i.e. the network nodes), who creates a new “block” of data, which can contain all sorts of information. This new block is then broadcasted to every party in the network in an encrypted form (utilising cryptography) so that the transaction details are not made public. Those in the network (i.e. the other network nodes) collectively determine the block’s validity in accordance with a pre-defined algorithmic validation method, commonly referred to as a “consensus mechanism”. Once validated, the new “block” is added to the blockchain, which essentially results in an update of the transaction ledger that is distributed across the network.
In principle, this mechanism can be used for any kind of value transaction and can be applied to any asset that can be represented in a digital form.
Transaction “blocks” are signed with a digital signature using a private key
Every user on a blockchain network has a set of two keys. A private key, which is used to create a digital signature for a transaction, and a public key, which is known to everyone on the network. A public key has two uses:
1) it serves as an address on the blockchain network; and
2) it is used to verify a digital signature / validate the identity of the sender.
On the Bitcoin blockchain, this translates into the following example.
Suppose that Anna wants to send 100 Bitcoins to Jeff, then first of all she will have to digitally sign this transaction using her private key (which is only known to her). She will have to address the transaction to Jeff’s public key, which is Jeff’s address on the Bitcoin network. Next, the transaction, which will be collated into a “transaction block”, will have to be verified by the nodes within the Bitcoin network. Here, Anna’s public key will be used to verify her signature. If Anna’s signature is valid, the network will process the transaction, add the block to the chain and transfer 100 Bitcoins from Anna to Jeff.
A user’s public and private keys are kept in a digital wallet or e-wallet. Such wallet can be stored or saved online (online storage is often referred to as “hot storage”) and/or offline (offline storage is commonly referred to as “cold storage”).
Bye-bye middleman?
One of the key advantages of blockchain technology is that it allows to simplify the execution of a wide array of transactions that would normally require the intermediation of a third party (e.g. a custodian, a bank, a securities settlement system, broker-dealers, a trade repository, …). In essence, blockchain is all about decentralizing trust and enabling decentralized authentication of transactions. Simply put, it allows to cut out the “middleman”. In many cases this will likely lead to efficiency gains. However, it is important to underscore that it may also expose interacting parties to certain risks that were previously managed by these intermediaries. For instance, the Bank for International Settlements (“BIS”) recently warned in a report of 2017 titled Distributed ledger technology in payment, clearing and settlement, that the adoption of blockchain technology could introduce new liquidity risks. More in general it seems that when an intermediary functions as a buffer against important risks, such as systemic risk, he cannot simply be replaced by blockchain technology.
The blockchain consensus mechanisms
In principle, any node within a blockchain network can propose the addition of new information to the blockchain. In order to validate whether this addition of information (for example a transaction record) is legitimate, the nodes have to reach some form of agreement. Here a “consensus mechanism” comes into play. In short, a consensus mechanism is a predefined specific (cryptographic) validation method that ensures a correct sequencing of transactions on the blockchain. In the case of cryptocurrencies, such sequencing is required to address the issue of “double-spending” (i.e. the issue that one and the same payment instrument or asset can be transferred more than once if transfers are not registered and controlled centrally).
Proof of Work (PoW)
In a PoW system, network participants have to solve so-called “cryptographic puzzles” to be allowed to add new “blocks” to the blockchain. This puzzle-solving process is commonly referred to as “mining”. In simple terms, these cryptographic puzzles are made up out of all information previously recorded on the blockchain and a new set of transactions to be added to the next “block”. Because the input of each puzzle becomes larger over time (resulting in a more complex calculation), the PoW mechanism requires a vast amount of computing resources, which consume a significant amount of electricity.
If a network participant (i.e. a node) solves a cryptographic puzzle, it proves that he has completed the work, and is rewarded with digital form of value (or in the case of a cryptocurrency, with a newly mined coin). This reward serves as an incentive to uphold the network. The cryptocurrency Bitcoin is based on a PoW consensus mechanism. Other examples include Litecoin, Bitcoin Cash, Monero, etc.
Proof of Stake (PoS)
In a PoS system, a transaction validator (i.e. a network node) must prove ownership of a certain asset (or in the case of cryptocurrencies, a certain amount of coins) in order to participate in the validation of transactions. This act of validating transactions is called “forging” instead of “mining”. For example, in the case of cryptocurrencies, a transaction validator will have to prove his “stake” (i.e. his share) of all coins in existence to be allowed to validate a transaction. Depending on how many coins he holds, he will have a higher chance of being the one to validate the next block (i.e. this all has to do with the fact that he has greater seniority within the network earning him a more trusted position). The transaction validator is paid a transaction fee for his validation services by the transacting parties.
Cryptocurrencies such as Neo and Ada (Cardano) utilize a PoS consensus mechanism
