Blockchain is the latest technology buzzword sweeping through the internet and its advocators claim it will revolutionize the way every industry does business, from farming to banking and even healthcare. Blockchain fever hit the mainstream media in late 2017 when the price of Bitcoin, a digital currency based on blockchain technology, went through the roof and made its tech-savvy early adopters overnight billionaires. But in order to understand why and how blockchain technology is causing such a huge stir in the financial world and beyond, we first need to understand what it is and how it works.
Distributed Ledger Technology
Perhaps the simplest way to describe blockchain technology is as a reliable, open and shared record of transactions across a peer-to-peer maintained network which allows everyone involved to know, and agree upon, who owns what. This record is also known as a “distributed ledger”. Its reliability comes from the fact that every “node”, which refers to each terminal participating in the network, has a complete identical copy of the ledger and every terminal must all agree on a newer version for each and every change made to the ledger.
Each update can be thought of as an addition of a “block” containing a record of all of the transactions that took place on the network after the previous block was verified. Once all of the transactions on a new block have been verified by the network it joins the ledger or “chain” with all the blocks that came before it – hence the name, blockchain.
Trust and Transactions
The blockchain is designed to minimize the need for a centralized monitoring system. Instead of relying on the accuracy of a central ledger controlled by one party, which all parties of a transaction must trust to be honest, everyone on the network must agree on a transaction before it is added to the blockchain.
For example, I want to send US$20 to my friend John, who lives in another country from mine. Traditionally, I first have to send the money through a trusted intermediary, such as a bank. The bank will then record the receipt of my money on its centralized private ledger along with my request to send to John. The bank will then identify John's account and credit it with the US$20, update and balance its ledger accordingly. This will usually take several days and the bank will charge me considerable fees. I will also have to trust that the bank will credit John with the money, as I have no way of checking the bank's private ledger in order to verify the transaction if John told me that he didn't receive the money,.
On the other hand with blockchain, there is no need to trust one central ledger, or in fact any single party in the system, in order to trust that the system will function. What's more, transactions on the blockchain take place in seconds instead of days, and more often than not incurs substantially lower fees.
Mining the Blockchain
Blockchain technology uses mathematics, economics, as well as game theory, to incentivize all parties involved in the ecosystem to reach a consensus on which is the correct ledger.
The Bitcoin blockchain protocol has a consensus algorithm called “Proof of Work” where for a given transaction to be settled between two users, the algorithm requires that a set of nodes (called “miners”) compete to validate transactions through solving complex algorithmic problems. Each time a miner validates a block of transactions and broadcasts it to the network – where it is examined, agreed upon as correct and added to the blockchain – the miner receives an amount of newly generated Bitcoin as their reward.
As each block is verified, it is designated a “hash” – a unique string of numbers and letters cryptographically generated from the data it contains – that identifies its place in the system. The hash from the previous block also becomes part of the data used to generate a new blocks' hash. The hash is uniquely generated from the data contained within a block, so if you were to change the data in a given block, even a tiny bit, you would be unable to generate the same hash. Once you have the hash for a particular block, it is easy to verify the accuracy of the data. However, you cannot work backwards from the hash to figure out the original data.
So Bitcoin miners help to keep the blockchain ledger accurate by using their computing power to compete against each other to solve complex problems and the first to solve the problem receives a reward. These rewards include earning the transaction fees paid by users who want to carry out a transaction as well as earning new Bitcoins for successfully solving the algorithmic problem. These economic incentives drive miners to constantly monitor the network so that they can gather a new set of transactions to fit into a new “block”. They then use their computing resources to solve the complex algorithm and create a new hash in order to “prove” that they did the work.
The first miner that solves the problem adds new block, with its hash, to the blockchain and then broadcasts it to the network. The rest of the network then examines and verifies the new blockchain, and once it's agreed upon by consensus, all will synchronize to the same new version. As miners are competing to run computations, there are times when several blocks get solved at the same time, creating a “fork” which splits the single chain into multiple chains. When this happens, the longest of these chains becomes the network’s “canonical” chain, i.e. the one which the majority of miners trusted and continued to work on.
So as each new block is added to the system, it becomes increasingly difficult to go back and alter a block. An attacker would have to overwrite the chain with new blocks that it had generated faster than anybody else on the network. This is a practical impossibility, making the data inside these blocks effectively immutable and enabling users to continue to trust the system.
The Future of Blockchain
Even though the first blockchain technology application was originally utilised for verifying Bitcoin transactions, the potential of the technology can be applied to countless fields and industries way beyond Bitcoin and cryptocurrencies. Blockchain ledgers can be applied to record land titles, loans, copyright ownership, identities, logistics manifests and many more. So while the technology is still in its infancy stage, it is easy to see why there is so much excitement surrounding its future and potential development.
In summary, you can view this well-explained video from Centre for International Governance Innovation.