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What Is Blockchain Technology and How Does It Work?

January 31, 2022
9
min

With its decentralized design, blockchain has shown there is a new way to process, manage and record transactions that eliminate features long taken for granted, such as intermediaries.

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Until now, we’ve assumed that a global computer network would need a home base and someone to run it. And the very idea that a network could produce its own money was the stuff of science fiction. But blockchain technology has shown that a vast network can exist simply on the computers that use it, be open to anyone with an internet connection, and create its own currency. 

By supporting cryptocurrencies such as Bitcoin and Ethereum, blockchain networks have provided an efficient and secure new way to distribute assets anywhere in the world. The key benefit: There’s no need for an intermediary like a bank to handle the transaction.

What is blockchain?

In a nutshell, blockchains are peer-to-peer computer networks that process and record transactions on the internet. A blockchain is a decentralized system, meaning it’s not managed by a company or agency or body of any kind. Blockchains circulate native currencies like Bitcoin, and in the case of Ethereum, data files called smart contracts that house assets and information. Investors can trade digital tokens just like stocks, bonds, or index funds.

Unlike bank transfers or stock trades, blockchains don’t require an intermediary or a broker to fulfill transactions or provide financial services. The software is so strong that every token is unique and cannot be duplicated. That’s why blockchains are often referred to as permissionless networks, meaning they function without the need for supervision or a centralized authority to vouch for the credibility of participants.

One of the innovative features of blockchain technology is its immutability. After a transaction is entered on the Bitcoin blockchain, for instance, it cannot be removed or changed. For this reason, blockchains are often described as trustless systems that guarantee assets: Their transactions cannot be duplicated or faked, so there is no need to trust a third party to confirm their authenticity.

Moreover, the Bitcoin blockchain is transparent, and anyone with an internet connection can examine transactions, though participants remain anonymous. Other blockchains have adopted this approach, too. Essentially, blockchains are digital ledgers, or records of all transactions, that live on every computer involved in their maintenance. Crypto supporters call the whole gamut of applications and features comprising blockchains distributed ledger technology, or DLT.

Are there different types of blockchains?

Blockchains come in a few different flavors. The original one that supports Bitcoin is a public blockchain network that is available to anyone who cares to download it. The second-biggest blockchain in terms of value and users is Ethereum, and it, too, is public, although there is a body called the Ethereum Foundation that guides its evolution with research and upgrades.

Then there are private or permissioned blockchains. These arose after Wall Street grew interested in the technology in 2016 but balked at its openness. Mindful of regulatory obligations and client confidentiality, financial institutions modified blockchain technology so it only could be used by members. R3, one of the original consortiums to take this path, now hosts the world’s largest blockchain for capital market participants such as Nasdaq and Amazon’s AWS cloud computing business.

How does blockchain technology work?

The digital ledger introduced in a white paper by the mysterious Satoshi Nakamoto in 2009 is predicated on the idea that a database can be distributed across a network rather than centralized in one location. As its name suggests, blockchain is composed of blocks of data that record every Bitcoin transaction occurring around the world about every 10 minutes.

To incentivize miners to hash, or assemble blocks of data that are added to the chain, those that complete complex mathematical problems first are rewarded with Bitcoin. This process is called proof of work (PoW). As a result, the Bitcoin blockchain is a self-propelled system that runs without any centralized control. It’s inspired hundreds of copycat blockchains with their own digital tokens.

Blockchains vs. traditional databases

That’s a very different setup from traditional databases, which tend to be housed in vast industrial parks teeming with servers and storage computers and operated by governments, corporations, and other organizations with the usual complement of senior managers, coders, and technicians. Conventional databases also utilize tables rather than blocks. Moreover, access is restricted to authorized users and not open to anyone with an internet connection. Nor, for the most part, are they visible to the public.

What is a blockchain used for?

Although the Bitcoin blockchain is the biggest, its purpose is quite rudimentary: to facilitate the minting and circulation of Bitcoin, an alternative form of money that supporters hope will challenge the ubiquity of the US dollar and other fiat currencies.

In contrast, the Ethereum blockchain is designed to facilitate the development and dissemination of applications called smart contracts. These decentralized apps can distribute a ton of data to participants. They are enabled by ether, the digital currency at the heart of Ethereum. Unlike Bitcoin, ETH isn’t intended to be money, per se, but rather a software tool to support the creation of apps and to help link them together, not to replace the US dollar.

To that end, the Ethereum blockchain supports a community of projects that make apps devoted to decentralized finance, or DeFi. They make loans, provide digital wallets, and offer services to let users swap Ether for other tokens. Uniswap and MakerDAO are two of the biggest DeFi players.

The Ethereum blockchain also enables entrepreneurs to assemble decentralized autonomous organizations, or DAOs. These cooperative groups operate on the blockchain instead of a physical place and their members tend to organize around a mission such as making art or investing.

Traditional industries have also embraced blockchain technology. Logistics companies use it to track goods in transit and permit every party involved in supply chains to access and manage the digital ledger in real time from any location. The national governments of Zambia and Georgia have experimented with using the immutability of blockchain technology for land records and to discourage property theft and corruption. Likewise, some political scientists have advocated using blockchain software to manage and record election results to promote online voting and deter ballot fraud. Health-care providers also see private blockchains as a potentially better way to manage databases of medical records.

The technology has also been tapped by auction houses and insurance companies to track and record the provenance of fine art, wine, and other luxury collectibles. Blockchain software has even been tapped to record the unique characteristics of diamonds so they can be traced from the moment they’re mined to their eventual sale.

Potential advantages of blockchain technology

Blockchain technology does some things better than traditional networks.

  1. Accuracy. Decentralized ledger technology can process and record transactions and other network activity with virtually no risk of alteration because the information is shared across many thousands of nodes.
  2. Efficiency. Blockchain software permits parties to participate in transactions without the need for an intermediary.
  3. Transparency. Public blockchain networks are accessible to anyone.
  4. Security. Thanks to their decentralized structure, blockchains are extremely hard to hack because there’s no hub to attack.
  5. Economical. As a permissionless network, a blockchain can move assets anywhere on the internet with minimal fees.

Potential drawbacks to blockchain technology

Blockchain technology’s innovations are offset by several weaknesses.

  1. Energy consumption. Mining Bitcoin has become an industrialized business that requires massive computer farms and sources of electricity, potentially worsening global warming.  
  2. Scalability. While blockchains have removed intermediaries, the process of adding transactions to chains can be slower than traditional methods.
  3. Lost assets. Users who misplace or lose the alphanumeric keys to Bitcoin and other digital tokens can almost never recover their assets.
  4. Crime. Because blockchains are largely unregulated, they can be used to launder illicit wealth and facilitate illegal activity.
  5. No watchdogs, yet. There is little recourse for investors and users who lose assets to fraud or hackers, but regulators such as the U.S. Securities and Exchange Commission are poised to crack down.

Blockchain hype and reality

Blockchain technology has triggered a speculative bubble that touched $3 trillion at one point in 2021. Global financial institutions, entertainment conglomerates, and even the U.S. Federal Reserve are racing to understand and adopt blockchain in one form or another. And it’s changing popular culture by spurring the development of NFTs, digital images that people can buy and sell, and the virtual reality landscape known as the metaverse. Jack Dorsey, the co-founder of Twitter and chief executive officer of payments service Square, is such a big believer that in 2021 he changed the corporate name of the latter company to Block.

Still, it may be premature to rank blockchain alongside digital engineering marvels such as the web browser or search engine, both of which changed the way we use the internet and reshaped the global economy. For all the hype, blockchain technology has yet to become a phenomenon that affects our daily lives. That’s a big reason the market for cryptocurrencies is so speculative, and so volatile. While blockchain has the potential to rewire the digital infrastructure of so many industries, the technology must first demonstrate that it truly is a great improvement on the existing order.

The bottom line

No recent development in computer science has triggered as much excitement and controversy as blockchain technology. With its novel decentralized design, blockchain has shown there is a new way to process, manage, and record transactions that eliminate features long taken for granted, such as intermediaries.

By utilizing digital tokens to make the software tick, the innovation has also introduced an entirely new asset class to the capital markets, triggering a bout of speculation unseen since the heyday of the dot-com boom in the late 1990s.

If blockchain is ever to be adopted on a mass-market basis, it will have to overcome a raft of challenges, including regulatory scrutiny and its own technical limitations. Perhaps the most important hurdle blockchain advocates must clear is convincing consumers and corporations alike that their beloved system is a major improvement on the status quo. Until that occurs, blockchain will be an intriguing and, in places, valuable software tool. But it may not change the world the way its biggest fans envision.

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