Day 3 of 100 | Crypto Basics | 5 min read
What is Blockchain Technology?
Learn how blockchain creates an unchangeable record of transactions. This revolutionary technology powers cryptocurrencies and much more.
### Understanding the Technology That Makes Cryptocurrency Possible
Blockchain technology is the foundation upon which nearly all cryptocurrencies are built. If you want to truly understand how cryptocurrency works and make informed decisions about investing in it, you need to understand blockchain. This lesson will demystify this revolutionary technology and explain why it represents such a significant breakthrough in computer science and finance.
Think of blockchain as a special type of database, but one that works completely differently from the databases you might be familiar with. When you save a file to your computer or make a post on social media, that information is stored on a server somewhere, controlled by a company or organization. Blockchain changes this fundamental model by distributing the data across thousands of computers around the world, with no single entity in control.
### What Is a Blockchain at Its Core
A blockchain is, at its simplest, a chain of blocks. Each block is a container of data, typically a list of transactions. These blocks are linked together in chronological order, with each new block containing a reference to the block that came before it. This creates an unbroken chain stretching back to the very first block, known as the genesis block.
What makes this structure so powerful is how the blocks are linked together. Each block contains a cryptographic hash of the previous block. A hash is like a digital fingerprint, a unique string of characters generated by running the block's data through a mathematical function. Even the tiniest change to the data would produce a completely different hash.
[EXAMPLE] Imagine you have a block containing ten transactions. You run those transactions through a hash function and get a specific fingerprint, let us say abc123. If someone tried to change even a single digit in one of those transactions, the fingerprint would change completely, perhaps to xyz789. This makes tampering immediately detectable.
Because each block contains the hash of the previous block, changing any block in the chain would change its hash, which would break the link to the next block. You would then need to change that block too, which would change its hash, breaking the link to the next block, and so on. This chain reaction makes it virtually impossible to alter historical data without detection.
### The Key Components of a Blockchain
To fully understand how blockchain works, you need to understand its major components and how they work together.
Blocks are the fundamental units of a blockchain. Each block typically contains several pieces of information: the data being stored, usually transactions showing who sent what to whom; a timestamp indicating when the block was created; the block's own hash; and the hash of the previous block in the chain.
[TIP] The data stored in blocks is not limited to financial transactions. While cryptocurrencies use blockchain primarily for recording value transfers, the technology can store any type of data. Some blockchains are used for recording property ownership, tracking supply chains, or managing digital identities.
Nodes are the computers that store copies of the blockchain and participate in validating new transactions. Anyone can run a node, and there are typically thousands of nodes spread across the world for major cryptocurrencies. This distribution is what makes blockchain truly decentralized, because no single party controls the data.
The consensus mechanism is the set of rules that nodes follow to agree on which transactions are valid and in what order they should be added to the blockchain. Different blockchains use different consensus mechanisms, but they all serve the same purpose: ensuring that all nodes agree on the current state of the ledger without requiring a central authority to make that determination.
### How Transactions Become Part of the Blockchain
Understanding the lifecycle of a transaction helps illustrate how all these components work together.
When you initiate a cryptocurrency transaction, such as sending Bitcoin to a friend, your wallet software creates a transaction message containing several pieces of information: your address, which proves you own the coins you are sending; the recipient's address; the amount being sent; and a digital signature created using your private key, which proves you authorized the transaction.
[WARNING] Your private key is the most sensitive piece of information in cryptocurrency. Never share it with anyone. If someone gains access to your private key, they can sign transactions on your behalf and steal all your funds.
This transaction message is broadcast to the network, where it joins a pool of other pending transactions. Nodes that are participating in the consensus process, whether miners or validators depending on the specific blockchain, select transactions from this pool and group them into a candidate block.
These nodes then compete to have their block added to the chain. In proof-of-work systems like Bitcoin, this competition involves solving complex mathematical puzzles. In proof-of-stake systems, validators are selected based on how much cryptocurrency they have committed as collateral. Once a node wins the right to add a block, it broadcasts the new block to the network.
Other nodes verify the block by checking that all the transactions are valid and that the block follows all the rules of the blockchain protocol. If everything checks out, they add the block to their copy of the chain. This verification process happens simultaneously across the entire network, ensuring that no single party can add invalid transactions.
### Why Decentralization Matters
The decentralized nature of blockchain is not just a technical detail; it is the source of most of cryptocurrency's advantages over traditional financial systems.
Because the blockchain is copied across thousands of computers worldwide, there is no single point of failure. If one node goes offline, or even if hundreds of nodes go offline simultaneously, the network continues to function. This stands in stark contrast to traditional systems, where a central server failure can bring everything to a halt.
[KEY] Decentralization also means that no central authority can censor transactions or freeze accounts. As long as you have access to the internet and know your private key, you can use your cryptocurrency. No government, corporation, or other entity can prevent you from accessing your funds.
Transparency is another benefit of decentralization. Anyone can download the blockchain and verify any transaction that has ever occurred. This creates a level of accountability that is impossible in traditional financial systems, where you must trust institutions to maintain accurate records.
However, decentralization comes with trade-offs. Transactions are typically slower than centralized systems because they require agreement from multiple nodes. Storage requirements grow as the blockchain expands. And recovering from mistakes is difficult because there is no customer service department that can reverse erroneous transactions.
### Different Types of Blockchains
Not all blockchains are created equal, and understanding the differences is important for evaluating cryptocurrency projects.
Public blockchains like Bitcoin and Ethereum are completely open. Anyone can join the network, view the full transaction history, and participate in validation. These blockchains are truly permissionless, meaning no one can prevent you from using them.
Private blockchains restrict participation to approved members. They are often used by businesses that want the benefits of blockchain technology, such as immutability and transparency among participants, without exposing data to the public. These are sometimes called permissioned blockchains.
Consortium blockchains fall somewhere in between. They are governed by a group of organizations rather than a single entity, but membership is still restricted. Many enterprise blockchain projects use this model.
[TIP] When evaluating cryptocurrency projects, pay attention to whether they use a public or private blockchain. The decentralization benefits of cryptocurrency generally come from public blockchains. Private blockchains may be useful for businesses but do not offer the same censorship resistance.
Hybrid blockchains combine elements of both public and private systems. They might keep certain data private while making other data publicly verifiable. This can be useful for applications where some privacy is required but transparency is also valued.
### Beyond Cryptocurrency: Other Blockchain Applications
While cryptocurrency is the most well-known application of blockchain technology, the technology has potential uses far beyond digital money.
Supply chain management is one promising application. By recording each step of a product's journey on a blockchain, companies can create transparent and verifiable supply chains. Consumers could scan a code on a product and see exactly where it came from and how it was made.
Digital identity systems could use blockchain to give individuals control over their personal data. Instead of trusting centralized authorities with your information, you could store verified credentials on a blockchain and share only what is necessary for each interaction.
Voting systems could potentially be made more secure and transparent using blockchain technology. Each vote could be recorded as a transaction, creating an immutable record that can be audited by anyone while still protecting voter privacy.
[EXAMPLE] Consider the diamond industry, where provenance is crucial. Diamonds have been used to fund conflicts and are sometimes mined using child labor. By recording a diamond's journey from mine to store on a blockchain, buyers can verify that their purchase is conflict-free. Several companies are already implementing such systems.
The key takeaway is that blockchain is not just about money. It is a new way of organizing and verifying information that could transform many industries. As you continue learning about cryptocurrency, keep in mind that you are learning about a technology with applications far beyond finance.
Knowledge Check
What connects blocks together in a blockchain?
- Physical cables
- Central servers
- Cryptographic hashes (Correct)
- Database links
Explanation: Blocks in a blockchain are connected through cryptographic hashes. Each block contains its own hash and the hash of the previous block, creating an unbreakable chain. If anyone tries to alter a block, its hash changes, breaking the connection.