A blockchain is a peer-to-peer network of computers known as nodes that both participate and monitor asset transfers. Every transfer is recorded on each user’s computer (node), generating a platform of trust based on several identical copies of the ledger.
What makes blockchain technology so valuable is that it removes the need for a centralized third party, which improves efficiency, security and reliability for countless industries.
This enables the creation of a public ledger that can be traced and recorded by all participants.
With recent banking scandals and financial crises in mind, blockchain technology provides an extra level of security for small business payments. It may be in the best interest of small businesses to secure their funds with blockchain technology.
Similar to Google Docs allowing users to work on the same project simultaneously, blockchain allows users public access to money transfers that would otherwise be private. As a result, any modifications are monitored by all users, adding further security measures.
Blockchain technology found its origin in cryptocurrencies like Bitcoin. It enabled the exchange of the currency, recording each blockchain money transfer into a publicly-accessible digital ledger.
Notable users of public blockchains are Ethereum, Ripple, and of course Bitcoin.
Table of contents:
- 1 A Brief History of Blockchain
- 2 How Does Blockchain Work?
- 3 Defining digital trust
- 4 How secure is blockchain?
- 5 Blockchain in FinTech
A Brief History of Blockchain
To start, let’s talk about the history of the blockchain. Before it was ever used in cryptocurrency, it had humble beginnings as a concept in computer science — particularly, in the domains of cryptography and data structures.
The very primitive form of the blockchain was the hash tree, also known as a Merkle tree. This data structure was patented by Ralph Merkle in 1979, and functioned by verifying and handling data between computer systems. In a peer-to-peer network of computers, validating data was important to make sure nothing was altered or changed during transfer. It also helped to ensure that false data was not sent. In essence, it is used to maintain and prove the integrity of data being shared.
In 1991, the Merkle tree was used to create a “secured chain of blocks” — a series of data records, each connected to the one before it. The newest record in this chain would contain the history of the entire chain. And thus, the blockchain was created.
In 2008, Satoshi Nakamato conceptualized the distributed blockchain. It would contain a secure history of data exchanges, utilize a peer-to-peer network to time stamp and verify each exchange, and could be managed autonomously without a central authority. This became the backbone of Bitcoin. And thus, the blockchain we know today was born, as well as the world of cryptocurrencies.
A Simple Database, With So Much More
Behind all this, though is a simple database, according to Marc Baskin, CEO and founder of Morristown, N.J.-based Cryptokist. The blockchain, he said, in its simplest form is a database, like Microsoft Excel, but its attributes make it a superior product that eventually nearly all business models can take advantage of.
It is called blockchain because information is stored in blocks. Once information for a single block is finalized and added to the ledger, the ledger turns a page and starts a new block. You can look back through the connections in a chain of blocks in a way similar to viewing a family tree. The public blockchains (such as Bitcoin and Ethereum), Baskin explained, are:
- Distributed (through a Peer-to-Peer network): It’s like an Excel sheet that the whole world can access and add data to, or closer, a Google Sheet that everyone has permission to see and interact with.
- Transparent: Since its on tens of thousands of computers, it’s completely transparent to everybody. When transactions get recorded on it, they cannot be hidden from the public.
- Immutable: Transactions can be added to the blockchain but cannot be removed, edited or deleted. Computers on the blockchain network lock in the transactions on this ‘database’ through a unique and complex cryptographic process.
- Verifiable: These computers also look at the entire database to make sure the transactions haven’t been tampered with and to verify balances.
- Unhackable: Because of the above reasons, it is virtually unhackable. In cases where bitcoin gets stolen from time to time, it is always a flaw in the applications that are built on top of the blockchain, such as wallets, cryptocurrency exchanges, etc., and not the blockchain itself.
The idea of decentralization
By design, the blockchain is a decentralized technology.
Anything that happens on it is a function of the network as a whole. Some important implications stem from this. By creating a new way to verify transactions aspects of traditional commerce could become unnecessary. Stock market trades become almost simultaneous on the blockchain, for instance — or it could make types of record keeping, like a land registry, fully public. And decentralization is already a reality.
A global network of computers uses blockchain technology to jointly manage the database that records Bitcoin transactions. That is, Bitcoin is managed by its network, and not any one central authority. Decentralization means the network operates on a user-to-user (or peer-to-peer) basis. The forms of mass collaboration this makes possible are just beginning to be investigated.
Blockchain and Bitcoin
The goal of blockchain is to allow digital information to be recorded and distributed, but not edited. That concept can be difficult to wrap our heads around without seeing the technology in action, so let’s take a look how the earliest application of blockchain technology actually works.
Blockchain technology was first outlined in 1991 by Stuart Haber and W. Scott Stornetta, two researchers who wanted to implement a system where document timestamps could not be tampered with. But it wasn’t until almost two decades later, with the launch of Bitcoin in January 2009, that blockchain had its first real-world application.
The Bitcoin protocol is built on blockchain. In a research paper introducing the digital currency, Bitcoin’s pseudonymous creator Satoshi Nakamoto referred to it as “a new electronic cash system that’s fully peer-to-peer, with no trusted third party.”
How Does Blockchain Work?
Picture a spreadsheet that is duplicated thousands of times across a network of computers. Then imagine that this network is designed to regularly update this spreadsheet and you have a basic understanding of the blockchain.
Information held on a blockchain exists as a shared — and continually reconciled — database. This is a way of using the network that has obvious benefits. The blockchain database isn’t stored in any single location, meaning the records it keeps are truly public and easily verifiable. No centralized version of this information exists for a hacker to corrupt. Hosted by millions of computers simultaneously, its data is accessible to anyone on the internet.
To go in deeper with the Google spreadsheet analogy, I would like you to read this piece from a blockchain specialist.
When a block stores new data it is added to the blockchain. Blockchain, as its name suggests, consists of multiple blocks strung together. In order for a block to be added to the blockchain, however, four things must happen:
A transaction must occur. Let’s continue with the example of your impulsive Amazon purchase. After hastily clicking through multiple checkout prompts, you go against your better judgment and make a purchase.
That transaction must be verified. After making that purchase, your transaction must be verified. With other public records of information, like the Securities Exchange Commission, Wikipedia, or your local library, there’s someone in charge of vetting new data entries. With blockchain, however, that job is left up to a network of computers. These networks often consist of thousands (or in the case of Bitcoin, about 5 million) computers spread across the globe. When you make your purchase from Amazon, that network of computers rushes to check that your transaction happened in the way you said it did. That is, they confirm the details of the purchase, including the transaction’s time, dollar amount, and participants. (More on how this happens in a second.)
That transaction must be stored in a block. After your transaction has been verified as accurate, it gets the green light. The transaction’s dollar amount, your digital signature, and Amazon’s digital signature are all stored in a block. There, the transaction will likely join hundreds, or thousands, of others like it.
That block must be given a hash. Not unlike an angel earning its wings, once all of a block’s transactions have been verified, it must be given a unique, identifying code called a hash. The block is also given the hash of the most recent block added to the blockchain. Once hashed, the block can be added to the blockchain.
When that new block is added to the blockchain, it becomes publicly available for anyone to view — even you. If you take a look at Bitcoin’s blockchain, you will see that you have access to transaction data, along with information about when (“Time”), where (“Height”), and by who (“Relayed By”) the block was added to the blockchain.
Blockchain Validation: Public and Private Keys
As you saw above, a blockchain is a decentralized store of data, and the most common type of data stored is transactions.
If I send Gavin one BTC, I’m telling every node that’s what I’m doing, and they all record the transaction if it’s allowed. By checking the ledgers, nodes may refuse the transaction if I don’t have enough Bitcoin to send, or if I’m not the account holder.
Each transaction must pass validation, and that’s where blockchain technology becomes a bit more complicated. Every blockchain “wallet” (think of this like a blockchain bank account) has a public key and a private key.
The public key isn’t sensitive, but the private key is. Only the true account holder should have access to the private key (and if anyone gets hold of it, your account could be taken over). If you want to keep your coins super safe, then you should look into our suggestions for the best cryptocurrency cold wallets.
When sending Gavin the one BTC mentioned above, my wallet presents the public key along with a digital signature. This digital signature is unique and is only generated with the private key. By using the signature and public key, other nodes can verify that this is a legitimate transaction, all without ever revealing the private key.
This is a simplified example—the cryptography behind the public/private key system is much more complex. Public and private keys aren’t numbers like bank accounts. Rather, they use Secure Hash Algorithm 256 (SHA-256) and RACE Integrity Primitives Evaluation Message Digest 160 (RIPEMD-160).
Never heard of these algorithms? No worries. You don’t need to understand them in-depth to use cryptocurrencies. Just know that these algorithms run the internet as we know it, encrypting web pages through SSL and TLS and more. In the future, other encryption algorithms may be used for blockchains.
Just know that all this encryption and verification comes at a cost. Every node needs a lot of computing power to verify all the transactions that ever happen and update its ledger accordingly.
This is where mining comes into play: users can earn small transaction fees as payment for verification.
By running the ledger this way, miners running nodes get paid, and every transaction gets verified. It’s an elegant system.
But it’s not all perfect.
During periods of high transaction demand, the fees can go up. If there aren’t enough nodes to go around, users can actually pay more to get their transactions processed sooner than others, and miners end up favoring the higher-paying transactions. Those who pay lower fees will still get processed, but at a much slower rate—unless the fee is too low, in which case nobody will bother verifying the transaction.
Aside from transaction fees, miners can also get paid in shiny new Bitcoins. By paying miners a fraction of a BTC on top of the transaction fee, new Bitcoins are drip-fed into the market. These unmined Bitcoins get more difficult to mine as time goes on, until one day there won’t be any unmined coins left, and miners will only get paid in transaction fees.
Defining digital trust
Trust is a risk judgement between different parties, and in the digital world, determining trust often boils down to proving identity (authentication) and proving permissions (authorization).
Put more simply, we want to know, ‘Are you who you say you are?’ and ‘Should you be able to do what you are trying to do?’
In the case of blockchain technology, private key cryptography provides a powerful ownership tool that fulfills authentication requirements. Possession of a private key is ownership. It also spares a person from having to share more personal information than they would need to for an exchange, leaving them exposed to hackers.
Authentication is not enough. Authorization – having enough money, broadcasting the correct transaction type, etc – needs a distributed, peer-to-peer network as a starting point. A distributed network reduces the risk of centralized corruption or failure.
This distributed network must also be committed to the transaction network’s recordkeeping and security. Authorizing transactions is a result of the entire network applying the rules upon which it was designed (the blockchain’s protocol).
Authentication and authorization supplied in this way allow for interactions in the digital world without relying on (expensive) trust. Today, entrepreneurs in industries around the world have woken up to the implications of this development – unimagined, new and powerful digital relationshionships are possible. Blockchain technology is often described as the backbone for a transaction layer for the Internet, the foundation of the Internet of Value.
In fact, the idea that cryptographic keys and shared ledgers can incentivize users to secure and formalize digital relationships has imaginations running wild. Everyone from governments to IT firms to banks is seeking to build this transaction layer.
Authentication and authorization, vital to digital transactions, are established as a result of the configuration of blockchain technology.
The idea can be applied to any need for a trustworthy system of record.
How secure is blockchain?
While no system is “unhackable,” blockchain’s simple topology is the most secure today, according to Alex Tapscott, the CEO and founder of Northwest Passage Ventures, a venture capital firm that invests in blockchain technology companies.
“In order to move anything of value over any kind of blockchain, the network [of nodes] must first agree that that transaction is valid, which means no single entity can go in and say one way or the other whether or not a transaction happened,” Tapscott said. “To hack it, you wouldn’t just have to hack one system like in a bank…, you’d have to hack every single computer on that network, which is fighting against you doing that.”
The computing resources of most blockchains are tremendous, Tapscott said, because it’s not just one computer but many. For example, the Bitcoin blockchain harnesses anywhere between 10 and 100 times as much computing power compared to all of Google’s serving farms put together.
Public vs. Private Blockchains
There are a variety of blockchain permutations, and they fall mainly into one of two categories - public or private. Public blockchains allow anyone to see or send transactions as long as they’re part of the consensus process. There are also consortium blockchains, where only a pre-selected number of nodes are authorized to use the ledger. For example, a group of banks and their clearinghouse might use blockchain as part of the trade-clearing, where each node is associated with a step in the verification process.
Private blockchains, in contrast, restrict the ability to write to a distributed ledger to one organization, such as a group of employees within a corporation, or between a set number of organizations, such as a number of banks that agree to a network partnership.
Along the way, blockchain - because of its self-policing security - eliminates huge amounts of record keeping, which can get very confusing when multiple parties are involved in a transaction, according to Saurabh Gupta, vice president of strategy at IT services company Genpact.
Blockchain in FinTech
But it’s financial services technology where blockchain is currently shining brightly.
At a high level, blockchain removes third parties from the transaction equation; in other words, a financial transaction on a blockchain needs no bank or government backer, and that means no fees.
Because blockchain entries can be seen in real time, the technology also has the potential to reduce time for clearance and settlement, which can take up to five days.
Accenture recently released a report claiming blockchain technology could reduce infrastructure costs for eight of the world’s 10 largest investment banks by an average of 30%, “translating to $8 billion to $12 billion in annual cost savings for those banks.”
In the case of cross-border payments, processing is often complex and includes multiple layers of communication among payment participants to verify transactions - an operation known as payment and settlement.
Payments, clearance and settlement in the financial services industry - including stock markets - is rife with inefficiencies because each organization in the process maintains its own data and must communicate with the others through electronic messaging about where it is in the process. As a result, settlements typically take two days. Those delays in settlements force banks to set aside money that could otherwise be invested.
Because it can instantly share data with each organization involved in a blockchain database or ledger, the technology reduces or eliminates the need for reconciliation, confirmation and trade break analysis. That helps yield a more efficient and effective clearance and settlement process, according to Accenture.
Smart Contracts with Blockchain
Blockchain smart contracts can be used to automate asset transfers without the need for manual input, while providing an extra level of security to protect transfers. Since these contracts incorporate blockchain technology, they are decentralized, enabling equal authority for both parties.
Overall, smart contracts limit possible errors in communication and workflow through their automation and accuracy, greatly reducing the possibility of corruption and mishandling by eliminating the middleman.
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