How Blockchain Technology Works |

How Blockchain Technology Works

Blockchain technology is a new way to store and record transactions. While it has similarities with a traditional database, its blocks are linked together cryptographically to ensure that they are tamper proof.

The art of Blockchain is located in the general term of “decentralization.” To simplify, in the traditional way, when two parties want to transact with each other, they need a middleman; the bank. The bank verifies the validity of both parties’ details and then executes the transaction, in exchange for a fee. To verify someone’s identity, the bank requires a unique PIN and then requests to be provided with the receiver’s address (e.g. IBAN).

Blockchain explained

For the same purpose, a transaction conducted in the Blockchain requires a sender to input their Private Key (or PIN, to access their funds) and the receiver’s Public Key (where the assets will be delivered). Instead of a central authority, Blockchain uses multiple validators – the miners. As a reward, the miners then receive a fee (significantly lower than a bank’s) for their service.

Every transaction comes in the form of a large code (or block), that is recorded together with every past transaction, on a large, public ledger. Unlike in the banking system, as all the participating validators hold the same copy of this (shared) ledger, the Blockchain offers absolute transparency and cannot be manipulated.

What is mining

Mining is the process of generating new coins, as well as the validation of every transaction (block) in the ledger. In the Bitcoin Blockchain, new coins are derived by utilizing computational power to solve complex algorithmic puzzles; as a Blockchain grows, generating new coins becomes harder. Solo mining has minor chances of success, hence miners join pools, where they share their computational power for mining. Using the Proof-of-Work method to verify that the mathematical solution is correct and has not been tampered, successful miners are then rewarded by a fraction of the newly produced coins.
Other Blockchains, like Ethereum, use the Proof-of-Stake method to produce new coins. In this case, new coins are delivered to the owners of Ethereum, in proportion to the amount and age of the coins they already hold, like dividends.

Where to store crypto coins

Similar to paper money, to securely store those assets and perform transactions, the Blockchain users must use a wallet. Crypto wallets are separated in cold and hot, they have multiple forms (digital, paper, hardware and more,) each one with its pros and cons.

Blockchain tokens

To fuel certain operations, projects in the Blockchain create their own tokens. While tokens do not have any physical existence, they reflect the amount of ownership on the private key of the holder.

Blockchain tokens are divided in:
1. Native or Built-in tokens, used as a miner incentive for validating transactions and to prevent spamming, by applying a fee on each transaction
2. Application tokens can be generated on top of another Blockchain (e.g. in Ethereum via Smart Contracts) and can reflect various values, from purchasing a service in the Blockchain (SingularDTV entertainment platform), to the ability to vote on a prediction market (Gnosis)
3. Asset-backed tokens, reflect the value of an asset which will be redeemed in the future. They are claims on an underlying asset, that you need to claim from a specific issuer

Blockchain VS Bitcoin

While they are two concepts were introduced and tied together, in the future, we could see them as two independent tools. It is yet unknown if Bitcoin will become an established currency in the future or if investors will keep considering it, mostly, as a storage for their money. However, the decentralized nature of the Blockchain and the ability to build applications could mark a new era in the business world. The benefits of Blockchain, are already being applied to multiple industries, such as pharmaceutical and entertainment.

Blockchain’s Issues

While Bitcoin’s advent was revolutionary, the complexity of Blockchain’s structure makes it hard to understand, for non-tech-savvy investors and most are driven by the hype.

  • The Blockchain is not a convenient and scalable transactional tool. With Bitcoin, only seven transactions per second can be processed, that can only be recorded every 10 minutes, while VISA can handle thousands at the same time.
  • Mining with the Proof-of-Work method (like Bitcoin), requires vast amounts of energy to discover new blocks, which will only grow in time, as the difficulty to generate new blocks increases. As solo miners guarantee the security of the network from manipulation, mining profitability should be ensured, as an incentive to keep them mining. Fewer solo miners could make the Blockchain vulnerable to a “51% attack,” by the inflated power of mining pools.
  • Cryptocurrencies’ extreme price volatility limits the transactional usability of the Blockchain, turning them into more like long-term investments.
  • Payments in the Blockchain require attention. Transactions are irreversible once executed, and users are not protected in case of a scam (phishing).
  • The Blockchain’s unregulated environment makes it prone to fraudulent activities, so cryptocurrencies are a subject of money laundering and tax evasion events, therefore several laws and policies are being applied across countries.
  • Total transparency - The Blockchain does not offer anonymity instead, everything is open and everyone can see everything. Financial transparency could be an issue for corporations accepting payments with cryptos.