Author Rosalia Mazza
Blockchain is a digital ledger, managed by distributed networks, made up of blocks of transactions linked to each other and secured thanks to cryptography.
Since the launch of Bitcoin in 2009, blockchain technology became popular thanks to its flexibility and the possibility to benefit from a secure environment for financial transactions.
Users and developers realized that blockchain – also called DLT (Distributed Ledger Technology) – could have infinite use cases: even if Bitcoin has a limited scope, countless blockchain based projects were created, and particularly Ethereum has given way to a number of opportunities in the decentralized space: NFTs, dApps, tokens, everything became possible thanks to a highly flexible infrastructure based on blockchain.
Cryptocurrencies are the most common assets associated with blockchains, but DLT is not limited to financial transactions.
How is all this possible? To start explaining how blockchain works, have a look at our blockchain diagram below: it might seem overwhelming, but we’ll cover every single point.
Table of Contents
Main Elements of a Blockchain
Blockchain is actually a chain of blocks, but these blocks are made up of many elements that make them unique and secure. Moreover, it would be impossible to separate DLT and people: blockchains can be distributed because they’re managed by a network of participants that can communicate without knowing each other. Despite this, they can work according to preset rules that make it possible to reach a common goal without the need for trust.
By explaining the single elements of a blockchain and blocks, it will be easier for you to understand the whole blockchain process.
Ledger
The ledger is the blockchain itself. It actually works as a digital ledger able to keep record of all the transactions that occur on a specific blockchain.
Not all blockchains are equal, and even if they are commonly considered decentralized databases, it’s not always the case.
We can distinguish among different types of ledgers:
Public: everyone can access – without modifying – the data stored by the ledger,
Private: there’s a central management that can approve new users,
Decentralized: there is no central authority. The network is owned by its participants. This is a property that only public blockchains can have.
In any case, blockchains are distributed, meaning that the ledger is spread across different points of communication – or nodes.
Hash
The hash is the ID of the block. The hash is simply an algorithm that permits converting the data contained in transactions into a string of numbers and letters that can be read by the blockchain .
The hash of a block has at least five characteristics:
It’s “one way”: from specific data you can get a specific hash, but not the other way around,
It’s deterministic – this means that if you use the same data, you get the same hash,
It must allow fast computation,
It must be collision resistant. This is a pivotal point to understand why blockchains are secure. This property makes it hard to find two inputs that can give the same output – that is, different data can’t give the same hash.
It has the “avalanche effect” property. This means that any small change in previous blocks or transactions result in an important and evident change in the hash. This is another fundamental property for the security of the blockchain: we say that this technology is tamper-evident because actually any interference is evident to the participants of the network.
Previous hash
With the exception of the genesis block, every block has a previous hash that is equal to the hash of the previous block. The previous hash is what allows linking blocks to each other.
Merkle Root
If the hash is the ID of the block, the Merkle root is the ID of IDs. It is the string made up of the elements of each transaction contained into the block. It confirms all the information and adds data to the Merkle tree, which is able to connect all the hashes found in blockchain – making it tamper-evident.
Fee
As first introduced by Adam Back, the inventor of Hashcash, fees were initially a useful tool to avoid spam transactions. Then, with the creation of Bitcoin, they became useful to reward miners – the network participants that add new blocks in proof-of-work blockchains. This is still their function and, when allowed, fees are the method used to make faster transactions – in fact, when directly communicating with the blockchain, users can, in most cases, decide to pay higher fees to get their transactions validated faster.
Fees The amount of fees you have to pay to complete your transactions depend on several factors, and they might work differently according to the network you choose. Usually, you can customize your fees when directly communicating with the blockchain through your wallet. Consider that in most cases, your transactions are first put in a sort of queue, and the higher the fee you’re willing to pay, the higher your position in the queue. Your wallet usually tells you what is the average fee the network is charging, but you can customize it if you want. |
Nodes
Nodes can be considered as the different points of communication that manage and check the correct functioning of the blockchain. There are different types of nodes according to their functions:
Full nodes usually need to download a constantly updated copy of the ledger, since they’re able to verify transactions and create new ones.
Lightweight nodes – also called Partial nodes or SPV (Simplified Payment Verification). They don’t contribute to the security of the blockchain, nor verify or add transactions. They can simply check if a transaction was regularly transmitted to the network – they’re the type of nodes used by most wallets.
Supernodes – they’re full nodes able to communicate with other full nodes, working like redistribution points. They’re publicly visible and usually constantly online, precisely for their function – in fact, they’re often referred to as “listening nodes”.
What if nodes find an invalid transaction? They can simply avoid propagating it and add it to the block – the transaction is rejected.
There are also cases in which more nodes validate or mine blocks almost simultaneously: in this case, if both blocks are valid, one will be added to the chain, while the transactions of the so-called “orphan block” will be put in the queue (mempool) once again.
Timestamp
The timestamp is another specific component of blocks. As the name suggests, it’s simply the exact date and time at which a block was created. Developers don’t have to add it manually: it’s automatically included thanks to functions included into blockchain codes.
Wallets
Wallets are what allow users to connect with blockchains and use digital assets and decentralized applications.
The two main types of wallets are software and hardware wallets:
Software wallets – like Metamask – can be used online and that’s why they’re usually associated with hot storage;
Hardware wallets – they can have a software component to more easily communicate with other wallets and exchanges, but they allow for offline storage – called “cold” storage. The most popular model of hardware wallet is Ledger.
Morevore, we can list mobile wallets, which are specifically studied to be used on or optimized for mobile devices – like MEW (My Ether Wallet).
Wallets are fundamental to all blockchain and cryptocurrency users, because they’re what provide you with your private key – essential to sign every single transaction and prove the ownership of your digital assets. In addition, they allow you to have a public address that can be used as a pseudonym.
Nonce
The nonce (number used once) could be considered as another element of blockchains, but we don’t always find it.
The nonce is a piece of data that can be manipulated to find the right hash of the block – the nonce is the number computed by miners to try to find the right hash of a block and be able to add it to the main blockchain.
Miners can do that because the algorithm used to find the hash sets a different difficulty each time a new block is added: the hash must fall within that range of difficulty to be the right one.
When no proof-of-work is needed, you won’t find the nonce. To give you a practical example, you won’t find any nonce on the Ethereum block explorers if you check blocks added after the merge that led Ethereum to become a proof-of-stake (PoS) blockchain.
Source: Etherscan.
The Blockchain Process
Every blockchain starts with the genesis block, the first block of the chain.
According to the storage set for a block, each block can contain a certain number of transactions. Each transaction is added to a specific block by nodes, according to the consensus mechanism adopted by the network.
Once a block is full, it is time stamped and added to the main blockchain. Since networks want the blockchain to work properly, nodes that contribute to the security of the technology are rewarded – either with a block reward and/or with part of the fees produced by each transaction.
To better understand the process of the blockchain, let’s make an analogy. Transactions can be considered as simple messages. Every message contains data. Since there is not a single point of communication that can manage your messages, to keep the highest levels of privacy and security, your messages need to be verified by several entities. All operators need to verify that the version of the message is the same for everyone, and this mainly for two reasons:
They don’t want you to send over the whole network meaningless messages that would only increase the workload,
They don’t want you to send a message that is meant to be unique many times, or to different people.
It's difficult work, especially when the same network is used by countless people. And here fees come into play: to send your message, you need to pay a fee to reward operators and avoid the temptation to congest the chain.
Once your message is verified, it’s added to a new block of messages. When the block is complete, all the messages it includes are packed, time stamped, and assigned an ID. Now, you have the certainty that your message won’t be deleted, that anyone can verify that you acted correctly, and the network will continue to run.
But how do you know that your message will reach the right person? This is the function of the public address associated with wallets: it works as a sort of telephone number, but it is far more private and encrypted. At the same time, you have your private key to prove that you own the assets you want to send, and it allows you to sign transactions.
How Secure Is Blockchain Technology?
Regarding the process described above, it’s evident that the blockchain is an append-only system – you can only move forward.
Thanks to hashes that link the blocks to each other and to the Merkle structure, any attempt of manipulation is evident to the whole network – that’s why blockchain is a tamper evident system, and nodes have plenty of ways to reject spam or invalid transactions, accepting only the valid ones.
This structure guarantees immutability, and all users can be sure that their transactions won’t be lost.
Distribution across several nodes also guarantees that the blockchain will work even if a node fails – this property of blockchains is known as fault tolerance.
Moreover, the consensus mechanisms put in place by the network guarantees that the whole network will work to reach a common goal – and to act fairly, since they’re rewarded for that.
The whole structure of this technology guarantees the security of the blockchain.
Of course, attacks are still possible, but they're extremely difficult and require the majority of the network to behave against the same network.
When you hear about stolen cryptocurrencies, the attacks are not direct to the blockchain, but to a particular exchange, or are possible thanks to bugs found in smart contracts – used in DeFi (decentralized finance).
But as long as the blockchain works correctly, we can assume that it is secure, because of its very infrastructure. Also, DeFi projects always adopt more complex security measures and benefit from external audits to make sure that the code of their smart contracts is correct and free of bugs.
How Many Types of Blockchain Networks Are There?
There are mainly four types of blockchain: public, private, hybrid and consortium blockchains.
Public Blockchains
These blockchains can be accessed by anyone – that’s why they’re permissionless.
Ethereum is an example of public blockchain. It can be used by anyone, and it’s so flexible to allow other project owners to build different infrastructures on top of Ethereum.
Just to mention some of the use cases of Ethereum, this blockchain can be used to build dApps – decentralized applications – like Uniswap (a decentralized crypto exchange), Aave (mainly used as a lending protocol), Gitcoin Grants (a crowdfunding platform), Etherisc (a decentralized insurance platform).
Private Blockchains
Private blockchains are distributed, but not decentralized. There is still a central management of the network that decides who can participate and use the ledger – that’s why they’re also referred to as permissioned blockchains. Private blockchains don’t need cryptocurrencies to work.
Corda is an example of private DLT. Its technology was used to create ClaimShare, a permissioned system to detect insurance frauds.
Hybrid Blockchains
This type of blockchain uses both permissioned and permissionless elements.
An example is Quorum Consensys, which allows the creation of business solutions by benefiting from the advantages of Ethereum and, at the same time, offering tailor-made permissioned solutions.
Quorum was born as a permissioned blockchain created by JP Morgan Chase in 2016 to facilitate B2B financial transactions.
Consortium Blockchains
Consortium blockchains are permissioned, but not controlled by a single entity. Participants are pre-selected, but then they have equal power for what concerns the management of the network.
Hyperledger Besu is an example of a protocol that creates the right consortium environment for institutions that want to use blockchain technology.
In 2019, Hyperledger Besu was used to create LACChain, a consortium blockchain sponsored by the IDB (Inter-American Development Bank) to support projects focused on economic inclusion and sustainability in Latin America.
Is Blockchain Cryptocurrency?
No. Blockchain is the digital, tamper-evident ledger used to store data, cryptocurrencies are digital currencies that exploit blockchain technology.
The two are strictly correlated, but totally different: cryptocurrencies benefit from blockchain because it’s the right fit to store transactions in a secure way, avoiding issues like double-spending.
They’re the fuel of public networks and are often used as a form of currency alternative to the more traditional fiat.
Double spending
Do you remember our analogy to explain the blockchain process? We said that your message should be unique because we’re talking of transactions in reality. The network has to make sure that a person who owns 1 BTC can’t spend it twice.
In the traditional financial system it’s a straightforward process: your bank can easily verify your account balance and deduct money each time you make a transaction.
On the other hand, blockchains are distributed, and they need to follow more or less the same process but by keeping the whole network fast enough to stay secure and as inexpensive as possible.
Different blockchains use different methods to deal with double spending, but every method is based on the coordinated work of nodes.
For example, Bitcoin uses the UTXO (Unspent Transaction Output) model: it’s like if every time you make a transaction with BTC, all the supply is used, and the network gives you back the amount that is left over after the number of coins you wanted to use is spent.
Ethereum uses a process more similar to banks, based on single accounts.
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Is Blockchain Actually Decentralized?
As mentioned, not all blockchains are decentralized. The difference between centralization and decentralization lies in the presence of a central authority that manages the network.
While decentralized blockchains are also public – or at least hybrid, there are also private blockchains where a central authority does exist, and it’s the authority that allows other users to participate in the network.
In decentralized blockchains, every participant has the same rights and can have the same power.
We mentioned dApps, which are a common use case of Ethereum: consider that when you’re using a decentralized application you’re using a product that is owned and maintained by the whole network of participants, in a fully permissionless environment.
Of course, also in these cases there is a team that started the project and created the codes. But since these applications are built with smart contracts, there’s no need for human intervention to make the application work after the launch.
Ways People Use Blockchain Technology
Blockchain technology is mainly used by people for cryptocurrencies.
These digital assets, necessary when it comes to public blockchains, are used for many purposes:
Purchases – even if it’s still not very common to find businesses that offer cryptocurrencies as a payment method.
Trading: as any other financial assets, cryptocurrencies can be used on exchanges to try to make a profit through trading.
Investments: hodling cryptocurrencies, as well as staking them, can be considered as investments on a longer term basis (if compared to daily trading or speculation) to try to earn streams of crypto passive income.
Smart contracts: these contracts, able to autoexecute according to preset rules, can be used to code virtually anything, and cryptocurrencies are needed to fuel the whole structure. Top use cases of smart contracts are NFTs and dApps.
There are also use cases in which digital assets are not the main element and that go beyond the financial sector, especially for what concerns institutions and business owners:
Supply chain: supply chain processes can be made more transparent, both for consumers and for business partners. Walmart Canada uses blockchain to solve the costly issue of disputed invoices between the company and its third-party carriers.
Real estate: in real estate blockchain is not only used for financial transactions – including mortgages, but also to turn an illiquid asset into a liquid one thanks to tokenization. An example of a company that offers this solution is SolidBlock.
Identity verification: IBM uses blockchain also for identity verification, providing other institutions with a database where they can check users’ credentials.
Fraud prevention: blockchain technology can be used to prevent fraud in many sectors, like telecommunications and insurance – an example is Prudential Financial.
Healthcare: blockchain in healthcare is used to cover a number of issues that range from data management to security measures. An example is Medicalchain, which secure health records while providing institutions with a single hub to check data.
Environment: DLT can be used for environmental friendly and sustainable solutions. An example is Powerledger, the Australian company that allows tracking and trading renewable energy.
These are just some of the use cases of blockchain: DLT is flexible enough to be used in cases that range from cybersecurity, to Web3, to the metaverse.
How Does Blockchain Compare to Banking?
Since blockchain is mainly used for financial transactions, it’s very common to compare this relatively new technology and the traditional financial system mainly controlled by banks.
The main differences between the two could be listed as follows:
Blockchains allow for the creation of more secure accounts, since their underlying technology doesn’t need to rely on third parties and has no single point of failure.
Distribution is also the reason why blockchains can work 24/7 – without needing to be bound to service hours followed by banks.
Privacy is an advantage of blockchains when compared to the traditional banking system. People can use pseudonyms or even stay anonymous when they make transactions on the blockchain.
KYC (Know Your Customer) policies are another huge difference between the two systems. To create a financial account with a bank you need to provide all your sensitive data to your bank. When it comes to blockchain-based financial platforms, you don’t need to share your data to create an account, but a clarification is needed: you are free to join decentralized platforms only by connecting your decentralized wallet. But when you use centralized platforms, more similar to traditional banking institutions, you still need to provide your data – since they need to be compliant with KYC policies.
Fees are usually lower when using blockchains, and in any case you’re free to choose the network you find more convenient according to your needs. In fact, also in the crypto space there are differences in terms of fees: to give you a practical example, you usually spend more to make a transaction on Ethereum than on Solana.
The Biggest Reasons for Blockchain Technology Growth
Blockchain technology can have virtually infinite use cases. The reasons behind its success are its flexibility, immutability, security, and – in cases of public blockchains – full control over financial assets, no need for trust, and pseudonymity (full anonymity in some cases).
Started as an alternative peer-to-peer economic system after the 2008 financial crisis, DLT was improved thanks to the contribution of different developers and blockchain-based projects and reached, in less than 15 years, a market size estimated at almost $5 billion in 2021.
When Was Blockchain First Used
Bitcoin was the first project to create a new, alternative financial system based on blockchain that was fully structured, in order to be used by anyone, without geographical boundaries and without the need for trust in third parties and institutions.
Bitcoin was launched in 2009, but from Bitcoin’s whitepaper it’s evident that Satoshi Nakamoto inherited the legacy of its predecessors.
The first source we can mention is How to Time-Stamp a Digital Document, published by Stuart Haber and W. Scott Stornetta in 1991. In this paper, the two researchers introduce a method to make documents immutable thanks to a network of “clients” that could time stamp documents using a method that would make it impossible to modify the date, and that would make the whole document tamper-evident.
In 1993, a group of cryptographers known as Cypherpunks published a manifesto in which they assessed the need for privacy in a world where the number of digital transactions was increasing, threatening people’s sensitive data. Their ideas are fundamental, because it seems very possible that Satoshi Nakamoto was a part of this group – their email list was the first place where Bitcoin's whitepaper was shared.
1993 is an important year also because the NIST (the US National Institute of Standards and Technology) and the NSA (the US National Security Agency) developed the SHA (Security Hash Algorithm). Its improved version – the SHA256, developed in 2001 – was then used by Bitcoin. This algorithm can transform any data into a string of 256 bits – 64 characters, like the hashes of the blocks. It’s used also to derive the public addresses of wallets.
But the closest predecessors of Nakamoto are Wei Dai and Adam Back.
In 1997, Adam Back developed Hashcash, an algorithm used to avoid spam emails through proof-of-work. In 1998, Wei Dai developed B-Money, an anonymous and distributed system for electronic financial transactions. It wasn’t officially launched, but Bitcoin inherited many characteristics from B-Money.
Advantages of Blockchains
Immutability: blockchains are made up of blocks that are time stamped and linked to each other thanks to cryptography. Moreover, thanks to the Merkle tree structure, the blockchain is structured as a whole and each attempt to modify it would be evident.
Privacy: most blockchains, even when public, don’t reveal sensitive data.
No single point of failure: working on several nodes, even when one point of communication fails or goes offline, the whole blockchain can keep working.
Inclusivity: this advantage is evident in case of public and decentralized blockchains. Anyone can benefit from blockchain technology when both these conditions apply.
Disadvantages of Blockchains
Hacking attacks: despite its high level of security, it’s still possible to hack a blockchain. This is true especially when the blockchain is not sufficiently distributed across a high number of nodes.
Conflict: when a blockchain is decentralized and any participant can work to make the network work properly, it’s easier for conflictual situations to arise – Ethereum is the main example of a situation in which not the whole network agrees on the same decision.
The Future of Blockchain Technology
Blockchain technology, despite its many use cases and structural advantages, is still in its early stage and most use cases could be still untapped.
In the meantime, everyday developers and institutions may further contribute to create new solutions based on this distributed technology.
We can already see some of these innovative experiments across many sectors: governments are studying projects to integrate the more traditional fiat with the new digital economy – CBDCs (Central Bank Digital Currencies) are a good examples, healthcare develops new tools to share data while protecting people’s privacy, entire businesses can be built on top of decentralized exchanges.