What is blockchain technology and how does it work?

Blockchain technology provides an innovative way to securely record, store and transfer data. Blockchain is the technology that makes cryptocurrency possible. Blockchain technology first emerged as the underlying technology of Bitcoin. Today, there are numerous blockchain networks, with different functionalities created for different use cases. It's a system of storing and sharing information that can be verified by everyone who has access to the network. Blockchain technology was first developed for Bitcoin, but now there are many different kinds of blockchain networks in use all over the world.

Many people see blockchain as being revolutionary because it solves some problems with how we interact on the internet today - like ensuring privacy or providing transparency across transactions.

What is blockchain technology?

Blockchain technology is defined as a decentralised, distributed & immutable ledger, shared across networks to track assets and record transactions. Blockchain is used most commonly as a way to digitally record financial transactions. It’s a relatively new technology, but it’s become increasingly popular thanks to some unique advantages.

Blockchain is built on what’s known as a distributed network. This simply means there is no single point of authority – like a bank or government – that controls it. Instead, the trust in the system comes from its transparency.   

Anyone within an individual blockchain network can view and verify transactions, creating a level of accountability that is difficult for anyone with bad intentions to get around (at least without anyone else noticing).  

Blockchain example: Let’s say John owes $30 to Tim, but he only had $10 at the time. John writes a note confirming that he’s going to pay another $20 at a later date and gives the note to Tim as a record of the amount owed. Now, the only thing stopping that note from being manipulated is good faith on behalf of John and trusting Tim. But if Tim chose to try and change the amount he was owed – let’s say from the original $20 to $120 – John would have no way to prove it. 

But what would happen if John had made copies of the original note? In that case, there’s increased visibility over the transaction, so it’s easy to see if one party had attempted to manipulate the original document. This transparency and fraud prevention is effectively what blockchain allows, only on a more sophisticated and much larger scale.

In a blockchain, each individual transaction is time-stamped and stored in what’s known as a ‘block’. These blocks are digitally chained together in chronological order, forming the blockchain. Each block can be identified by a hash code – which is similar in nature to an ID card – and there’s no limit to the number of new blocks that can be recorded. So does that mean all transactions are eligible to be recorded on a blockchain? Well, no. For that, we need to understand the role of miners, whose job it is to validate transactions. But let’s hold off on that for now and dive into the history of blockchain first. 

History of blockchain

The first work on blockchain technology came nearly 18 years before the introduction of Bitcoin when, in 1991, research scientists Stuart Haber and W Scott Stornetta brought the concept into existence. With their understanding of how easily digital media was being modified, they proposed blockchain as a solution by digitally time-stamping documents. Within a year, they incorporated something called ‘Merkle Tree’ into the blockchain, which added to its security and efficiency. Merkle Tree is a data structure, used in computer science, that makes it possible to record many transactions in a single block, making it faster and easier to verify.

Then came the pivotal moment: the introduction of Bitcoin. In 2008, an online document titled ‘Bitcoin: A Peer-to-Peer Electronic Cash System’ was published under the pseudonym of Satoshi Nakamoto, proposing how digital transactions could take place between two parties, with no centralised authority. The following year, the original white paper on Bitcoin was released and it comprehensively detailed how the Bitcoin blockchain structure worked. Today, it serves as a digital ledger for all Bitcoin transactions across the globe.

Bitcoin got the world talking and ignited the imagination of developers around the world. One such spark led a Canadian developer, Vitalik Buterin, to propose a platform for decentralised value transfers and decentralised software applications. In 2014, along with seven other co-founders, Ethereum was launched on the back of a crowdfunding initiative.

Ethereum brought the concept of ‘smart contracts’ into the blockchain space. These are programs that self-execute once the terms set and agreed upon by both parties are met. This space quickly became a developer’s haven as it provided a platform for them to develop decentralised apps (dApps) and other smart contract-based applications.

How does blockchain work?

Primarily, there are three parts to recording a blockchain transaction:

1. Hash encryption

When a transaction is initiated on a blockchain, it creates a new block which contains three important pieces of information:

Note: Nonce is the only component of a block that a miner can change. All other data is predetermined.

Now, the network itself establishes the digital identity, or signature, for the transaction.

2. Mining

Mining is the way transactions are authenticated and recorded on the blockchain ledger. To validate a signature, miners need to generate the ‘hash’ output. The hash is like a human fingerprint in that it is unique, therefore it’s difficult to compute. To find the right hash value, miners need to solve complex mathematical puzzles and find the exact nonce number that generates an accepted hash. And given there’s no template to solve these puzzles, miners must use trial-and-error.

After finding the right nonce value, they add the block to the chain. Once this has been done, the miner gets a financial reward – for example, native coins (i.e. Bitcoin) and/or transaction fees of that block.

3. Validation and nodes

After mining, the block needs to be communicated to all the nodes in the network, which validates it. In other words, miners have to confirm the transaction is complete by telling everyone about it. Nodes play a crucial role in validating a new block, and any electronic device that can hold and distribute copies of the blockchain ledger is considered a node. The use of a consensus algorithm – an agreed set of criteria that legitimises a block – achieves the validation.

After validation, the newest ledger has to be made accessible to everyone in the blockchain’s infrastructure. Nodes allow this while also contributing to the upkeep of the decentralised nature of the technology.

So, after the block has been mined and added to the blockchain, all the nodes in the network exchange the latest version of the digital ledger. By doing this, the nodes have maintained the consistency of the ledger throughout the network, making it impossible for any party to alter the ledger without triggering all the validators in the network about it. Without nodes or miners, the hallmark principle of blockchain – decentralisation – is not possible. With nodes being a critical piece of the infrastructure, it’s worth understanding them in more detail.

How does blockchain mining work?

Mining is an essential part of maintaining and building a proof of work blockchain. People also view it as an avenue for earning crypto tokens as a reward for successful mining. So, let’s dig into how blockchain mining works. First off, mining is like forgetting the key combination of a number lock. Traders start with something like 0-0-0 and try different combinations to try and crack the code. Here, they’re using mental energy to find the right code. If they fail, they can also use physical energy to smash the lock into bits and pieces. 

However, mining doesn’t work like that. The network encrypts the block into a cryptographic puzzle where validation is possible only after finding the right hash value. So, how do traders find the hash? This is where mining is more than just solving mathematical problems. As there is no set template for finding the right hash, miners need to adopt a trial-and-error method to discover the exact hash. 

To accomplish this, miners combine the nonce value with the previous block’s header. Here, the header contains information and is not changeable. However, miners can change the nonce value. Changing the nonce value quickly to generate the right hash is known as hashing. Confused? Put it this way: to keep changing the nonce number and crack the code, miners need a huge amount of computational power, which requires a huge amount of electricity. This is a key reason why small-scale mining is no longer feasible. To understand how complex it is to confirm a correct hash value, here’s an example of what one looks like: 682c18061d0e703c6c6ede973d41ff3e82ccc63a3362e9652889f9efd39e27ae

Once the miner eventually generates the right hash value, they transmit the block to all the nodes (participants) within the network. They verify and confirm the block, then add it to the chain of blocks. 

Types of blockchain consensus algorithms

Blockchain consensus algorithms are essentially a process where everyone on a network agrees on the real-time state of the blockchain – and it’s really important. Achieving consensus is necessary to maintain trust, security and reliability in a decentralised setting.

Different blockchains follow different consensus algorithms, and these are the most popular:

Other notable algorithms include:

Blockchain technology with its inherent qualities of safety, security, and enhanced accessibility make it a tool potent enough to disrupt industries. From transacting currencies without extra permission to documenting land titles, the potential applications for blockchain are enormous. Here are some major industries where blockchain is currently being used at scale.

How to invest in blockchain?

The blockchain industry is maturing quickly, with more users and institutions adopting the technology and a growing number of services, products and applications being built on blockchain technology. As it becomes more mainstream, investing in blockchain will become more enticing. The diversity of blockchain has given rise to multiple avenues to invest in and leverage the potential of this disruptive industry.

Cryptocurrencies

By far the most popular application of blockchain tech is cryptocurrency. To date, over 10,000 cryptocurrencies are being traded publicly and each of them has its own use, ranging from buying digital art to funding movies. With more industries and sectors adopting blockchain technology, an increase in demand for digital currencies is likely.

Since most cryptocurrencies are dependent on a blockchain, they are a straightforward avenue to invest in. Given the speed to market and the well-known volatility of these currencies, potential investors should do plenty of research and due diligence. Reading the white paper or official documents of the associated project is a good way to begin understanding its credibility. If traders are interested in purchasing cryptocurrencies, they should first learn about the crypto spot market.

Cryptocurrency CFD Trading

Short for “Contract For Difference”, a CFD is a contract between a trader and a broker, where traders speculate on the change in a coin’s price. In cryptocurrency CFD trading, the level of investment is often low when compared with directly investing in coins. This is due to traders only having to invest a percentage of the whole value of the trade to gain full exposure to it. So, if their prediction is correct, they gain profits for 100% of the trade value. However, if their prediction fails, they have to bear the entire loss.

Example:  Traders are trading bitcoin CFDs with a trade value of $10,000. If they think Bitcoin will rise in value they would place a buy order (go long), if they think it will fall then they would place a sell order (go short). 

Traders only have to pay a small deposit from their initial $10,000 upfront – let’s say $100. Despite that, traders will still enjoy the profit based on the entire $10,000 – if their prediction is correct. But if their prediction is incorrect, they will have to pay the losses accrued on the total of $10,000.

Learn more about the difference between trading cryptocurrency on the spot market and cryptocurrency CFDs.

How is blockchain secure?

Many people tout blockchain as the future of industry and data storage, so its security is of paramount importance. Here are some critical factors required to maintain the integrity of the blockchain:

What is a blockchain wallet?

A blockchain wallet is a digital wallet that allows users to transact on a blockchain, manage transactions and track the value of digital currencies. It works in a similar way to a bank account, with each wallet having a unique cryptographic address (similar to an account number) which is used to send, receive, and exchange cryptocurrencies.

Blockchain wallets are secured by a private key (a 256-bit number). Knowing this number will allow direct access to any funds held in the wallet, so it should not be shared. Make sure don’t forget it because, thanks to the decentralised nature of blockchain, there’s no ‘forgot my password’ service – if traders forget their private key, they’ll be locked out of their digital wallet forever!

There are two major types of blockchain wallets:

A combination of hot and cold wallets can be a great way to secure coins while still being able to conduct transactions.  

Advantages of blockchain

Explore the five key advantages of blockchain below:

Disadvantages of blockchain

We've explored the advantages now let us cover the disadvantages of blockchain:

What is cryptocurrency?

Cryptocurrencies, also known as coins or tokens, are encrypted digital currencies. Since no government regulates them, cryptocurrency is the basis of a decentralised financial system. Most of these coins use blockchain technology to record their transactions. With a smartphone and internet access, anyone can buy, sell, and exchange cryptocurrencies with no input from a bank. This peer-to-peer transaction method is a core advantage of cryptocurrencies as they are time-efficient and more secure than traditional banking systems.

There are over 10,000 coins available to trade in the crypto market, with each of them having a variety of uses. Bitcoin and Ethereum are two of the most famous cryptocurrencies in the current market. As Bitcoin continues solidifying its place as a credible store of value, Ethereum is fueling the use of smart contracts in the space.

The general view of cryptocurrency as a speculative asset is reducing as coins are becoming more widely used as a store of value. While cryptocurrencies are known to be volatile, as awareness and understanding of the market grow, the market is likely to become more stable.

A final word

Blockchain and cryptocurrencies like Bitcoin are here to stay. The sooner traders learn about how these technologies work the quicker traders will be able to adopt them as they become increasingly integrated into our lives.

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