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Blockchain Basics

What is the
Blockchain and
How Does it Work?

Blockchain technology is becoming increasingly relevant to our modern society, from smart contracts to decentralised organisations. In this series, we’ll investigate the basics of the blockchain – from where it all began to where it’s heading. Along the way, you’ll begin to get a grasp on just what this technology is capable of and how it may be relevant to your professional or personal life.

 

How did the Blockchain Begin?

The concept of a blockchain was created by Satoshi Nakamoto – a near-mythical character whose true identity still remains safely obscured to this day. His vision was a purely peer-to-peer version of electronic cash, which he aptly named Bitcoin. Its stated goals – as per the white-paper and subsequent material from Satoshi – can be summarized as follows:

  • To allow trustless online payments without a financial institution;
  • To allow public verification of all transactions;
  • To create an open ledger;
  • To allow changes to the underlying architecture via consensus;
  • To prevent double spending; and
  • To harness the full power of encryption to increase privacy.

 

The Bitcoin Whitepaper

The 8 page PDF that started it all.

Why Was the Blockchain Needed?

A primary motivator for Bitcoin was a lack of transparency within the financial system. Currency is centrally controlled by private ‘Reserve’ banks, and funds distilled to the populace through traditional financial institutions. It was no accident that the release of Bitcoin followed so soon after the financial crisis of 2008.

Satoshi Nakamoto believed that the monetary system should return to how things were done in centuries past, where a supply-limited decentralized currency (gold) was the primary unit of exchange. Accordingly, he designed an open system, governed by maths and limited in supply – the blockchain.

In this first post we’ll look at the basic principles of the blockchain, including how and why it works. In the second, we’ll look specifically at the first blockchain – Bitcoin – in more detail to understand how this has worked in practice.

 

An Open Ledger

Ledgers have existed for as long as people have engaged in trade and commerce. Writing the details of a transaction down – monetary or otherwise – has been the first line of defence against any form of wrongdoing or fraud, and allowed parties to keep track of their transactions.

In ancient and medieval times, this may have been a piece of parchment or a ‘tally-stick’.

Medieval Tally Sticks

An ancient tally stick. The wooden slate was broken manually in two, with each party keeping one half. – By Winchester City Council Museums – CC BY-SA 2.0

In modern times, ledgers are used everywhere. Databases, bank accounts and even sports statistics are all ledgers in one way or another. Problems arise in the private nature of the stored data. Vast amounts of wealth are simply records in databases, of which no details are open to the public. A certain level of misuse and fraud on multiple levels in unavoidable, and simply accepted as a reality of the system.

A blockchain like Bitcoin is instead an open, public ledger, with the goal of allowing two willing parties to transact without any third party intermediary. All transactions are publicly viewable and recorded by any computer able to host a copy of the ledger. The more computers, or nodes, that host that copy, the harder it is for any potential hostile actor to try and ‘game the system’.

 

Transactions

So what are these transactions? Unlike our fiat currencies, a ‘coin’ within the a blockchain system is actually really just a chain of digital signatures. An owner owning one coin (or part thereof) sends it to another by signing the entitlement to that part over on the public ledger.

The beauty of the blockchain system is that, because of the open ledger and the mathematical rules, the person receiving the coin can verify that the person sending the coin is the owner. This is due to the magic of encryption.

It is well outside the scope of this article to delve into the complexities of cryptography. Indeed, the field has developed over decades and involves many complicated ideas. However, it is important to understand the basics, not just to understand bitcoin, but to begin to get an idea why cryptography allows sharing ledgers publicly to be more secure than hosting a ledger on a private server.

Bitcoin utilizes asymmetrical (public key) cryptography. This is a cryptographic system that uses pairs of keys: public keys and private keys. The public keys are known to the network, and the private keys are only known to the owner of the public key (as long as they keep it confidential!)

By using this method, it allows people to create digital signatures which combine their private key and a short message. Anyone who can see the public key can, using the algorithm that governs all public/private key pairs, validate that the signature is correct. Changing even a single letter in the private key will mean the system will recognise it as invalid.

This is where cryptocurrencies get their name from. An example of a public and private key pair is as follows:

Public Key (Username) : 1AaNg5UKd4NqVPZLN1CaAM8L3a5BRAa2G3

Private Key (Password) : L2RAZS1sFgaCRn3NdzfhYb1zTtnB9LDv97z4BvNtqkgijpnXSR91

Think of the Public Key as your username, and the Private Key as your password. To send something from a public key, you need to input your private key into a wallet, a program that interacts on your behalf with the blockchain. It takes care of the validation so you don’t need to.

Your transaction is then sent as a message to a trusted node. This is usually the nearest computer with a long history of validating transactions. This node checks the transaction against the public key and the mathematical rules of the network. If the public and private keys match, it is declared valid and becomes a verified transaction. The node then sends this to all other nodes for their verification and sharing.

A distributed network

Nodes act as the distributed computers which log and validate transactions.

A Chain of Blocks

This is where we come to the blockchain itself. This transaction, along with a large number of others, get bundled up into one ‘block’ and added to the ledger by a miner. There are various methods of mining which we’ll cover later – what’s important is that it’s added to the record on the ledger. Once there, it is there permanently.

The final act of the network before moving onto the next block is to generate a hash of all of the data in the block. This essentially takes every piece of data in that block, runs it through a mathematical algorithm, and generates a long string of letters and numbers based off that data. If even one byte was to change in the data, the hash would look completely different. The network then adds that hash to the ‘header’ of the next block – linking them together and creating an increasing chain of hashes. Voila – a blockchain.

 

A Resilient Network

With the increasing number of blocks and hashes, all publicly viewable by ‘block explorers’, the ledger becomes harder to attack, fool or replace. When many computers host this record and keep in sync with each other, it becomes near impossible.

In the early days, Satoshi Nakomoto was unsure as to whether the system – which was experimental – could really resist attacks or fraud. As time has progressed, it’s become apparent that the blockchain model offers a very resilient method to create, disseminate and secure a public ledger. It’s been this proof of concept, and the innovation that’s grown from it, that’s fuelled the excitement now surrounding the blockchain and cryptocurrency space.

In our next instalment, we’ll look at Bitcoin specifically and discuss mining, transaction times, decentralised governance (consensus) and the various proposals to improve upon its model.


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