The soaring popularity of Bitcoin and Ethereum has brought a lot of attention to blockchain in recent years. What is blockchain though? What are its components, and how does it work? What are its flavors? Where can you use it, and what are its limitations? Read on, as we explain these.
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A brief introduction to blockchain
Blockchain is a technology that emerged a little over a decade back, which offers decentralization, distributed ledger, transparency, and security. It offers them at varying degrees in its different flavors.
The most popular applications of blockchain are cryptocurrencies like Bitcoin, Ethereum, Ripple, Litecoin, Dash, etc. Blockchain has other use cases too, e.g., “Decentralized Finance” (DeFi), “Decentralized Exchange” (DEX), etc. Enterprises can use a different flavor of blockchain, which is called “enterprise blockchain”.
The key components of this technology are as follows:
• Peer-to-peer (P2P) network;
• Cryptographic hash functions;
• Blockchain protocol programs;
• Digital signatures that use modern cryptographic algorithms;
• Consensus algorithms for transaction validation.
The three flavors of blockchain technology are as follows:
• Public blockchain networks: Anyone can join them, e.g., Bitcoin, Ethereum;
• Enterprise or “private” blockchain networks: Businesses use them, and they allow only trusted participants;
• Consortium blockchain networks: Multiple businesses use them in a shared manner, and these are often similar to enterprise blockchain networks.
How does public blockchain work?
We explain the working of a public blockchain with the example of Bitcoin (BTC). This cryptocurrency is the most popular application of blockchain, which was launched in January 2009. Satoshi Nakamoto, a pseudonymous individual or group created it.
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The intentions behind creating Bitcoin
The creators of Bitcoin wanted to build a digital currency and payment network that would operate outside the control of governments and central banks. They witnessed the 2008 financial crisis. Their confidence in the banks and governments was low.
They wanted to build a disintermediated network that won’t depend on central administrators like governments or central banks. Towards this, they wanted the following:
Digital currency: This currency will be the result of mathematical calculations, and governments will not back them with another asset.
Resilience: Governments, central banks, or hackers shouldn’t be able to shut the network down.
Transparency: Everyone should be able to see all transactions.
Decentralization: There wouldn’t be a central administrator, and all participants in the network will have equal authority.
Security of the users: Users should be able to transact securely.
Data security and integrity: No one should be able to manipulate the system. E.g., no one should be able to execute a “double-spending”. “Double-spending” refers to the possibility that someone will execute the same transaction twice. Since digital currencies are just records on computers, a malicious player can conceivably manipulate the record. E.g., he/she can change the recipient.
We now examine how Bitcoin achieved these.
Resilience and decentralization: A P2P network
The Bitcoin network is a P2P network. It allows anyone to join, which includes anonymous or pseudonymous participants. This network doesn’t have a central server or a central administrator. All participants in this network have equal authority. Therefore, it’s a decentralized network.
We call the computers on this P2P network “nodes”. All nodes have the entire history of all the Bitcoin transactions. Conceptually, this looks like a distributed ledger. That’s why we call blockchain the “Distributed Ledger Technology” (DLT).
The Bitcoin blockchain network uses a transaction validation process called “mining”. We call the nodes that participate in this process “miners”, and we will talk about them shortly.
Even if a government shuts one computer down, the network remains. Other computers will have all the transaction records. This makes this network resilient.
Transparency: “Blocks”, a “chain”, and the “blockchain”
The Bitcoin network stores multiple transactions in a “block”. A “block” is a data structure. Apart from transaction records, it has the answer to a cryptographic puzzle. It also has a cryptographic hash of the earlier block.
Note that a cryptographic hash has the following characteristics:
• We create it using a cryptographic hashing algorithm.
• The algorithm converts a text into an alphanumeric string.
• One can easily create such a hash by running such algorithms. However, creating the input text from the hash is practically impossible without knowing the cryptographic key to decode it.
• An input text will always result in the same hash.
• Even the slightest change to the input text will result in a completely different hash.
Every block on the Bitcoin network has the cryptographic hash of the earlier block. The only exception to this is the “Genesis” block, i.e., the first block. Conceptually, this looks like a chain. This is why we call this technology “blockchain”.
Every full node on the Bitcoin network stores all of these blocks. This distributed ledger allows every node to view every transaction, which ensures transparency.
Security of the users: Digital signatures
Bitcoin users sign their transactions with digital signatures. These digital signatures contain a private key and a public key. The public key is the publicly available address of the user, and everyone can see that. Users must secure the private key, which is a secret.
The use of modern cryptography links the private key and the public key. This linkage uses tools like integer factorization, which makes it practically impossible to recreate the private key from the public key. Users can securely transact as long as they secure their private key.
Creating the digital money and transaction validation: Bitcoin “mining” and the “Proof of Work” (POW) consensus algorithm
How does the Bitcoin network create a Bitcoin or a fraction of it? How does the transaction validation process work and how it keeps hackers at bay?
The transaction validation process works as follows:
• Users submit transactions by signing them digitally. These transactions could create a Bitcoin or a fraction of it. Note that there can be a maximum of 21 million Bitcoins.
• Transactions might involve transferring existing Bitcoins or fractions of them between users.
• Transactions go into a pool named “mempool”.
• Miners pick up transactions and try to create a new block that will have these transactions.
• Miners operate in a competitive environment since Bitcoin mining involves rewards. Miners get a fraction of a Bitcoin for successfully validating transactions and creating new blocks.
• Creating a new block requires miners to solve a moderately difficult cryptographic puzzle. It doesn’t require skills or intelligence. Miners need to try one number after another at high speed, therefore, the process is computing-intensive. Bitcoin miners use computers with GPU. They run this process for a long time, which results in high energy bills.
• Once a miner solves this puzzle, he/she broadcasts it to the entire Bitcoin network. All miners can see the solution.
• Since everyone can see the proof, the miner in question creates the new block and gets the reward. We call this consensus algorithm “Proof of Work” (POW).
The Bitcoin network has many miners. Hackers need to control a majority of the miners to manipulate. That’s practically impossible due to the large network. The transparency in the network reduces the chances of manipulations.
Hackers need to use massive computing power to overpower the majority of the network. Commercially available computing technologies can’t achieve this today.
Maintaining data integrity
We explain how the Bitcoin network maintains data integrity by showing how it prevents “double-spending”. Double-spending involves modifying an existing transaction.
Hackers will need to modify an existing block for this. If they do that, then the data in the block changes. The next block has the cryptographic hash of this block. Therefore, hackers need to create a new cryptographic hash of the block they changed. The “chain” breaks otherwise, and anyone on the network can see that!
Assume that the hacker creates the cryptographic hash for the modified block. That’s not easy, and this activity will attract attention from the other miners in the network. He/she will need to incorporate the new hash in the next block. That changes the data in the next block. Hackers need to create the new cryptographic hash of this block, and they need to incorporate that in the next block.
They need to continue this process. That’s impractical since all of these require heavy computing power. Such unusual activities will immediately raise alarms too. The transparent and decentralized Bitcoin network will immediately find out the efforts to manipulate the network. This design makes the data immutable.
Ethereum: The next generation of public blockchain networks
We talked about how Bitcoin ensures decentralization, transparency, security, immutability, disintermediation, and a distributed ledger. The only use case of Bitcoin is to transfer this digital currency from one user to another. Ethereum changed that.
A team of computer experts and software developers led by Vitalik Buterin launched Ethereum in July 2015. Gavin Wood, Charles Hoskinson, and Anthony Di lorio were some of the other key personnel.
Ethereum is a public blockchain with many similarities with Bitcoin. It has a native cryptocurrency named Ether (ETH). The transaction validation process involves mining and POW. However, Ethereum allows developers to create blockchain applications.
It offers “Ethereum Virtual Machine” (EVM), a runtime environment to execute blockchain applications running on the Ethereum network. Developers can create “Smart contracts”, and they can develop “Decentralized Apps” (DApps).
This allows them to develop decentralized businesses. Storj, the decentralized cloud storage is a good example. It allows individuals to use the excess storage space on their computers to store data owned by others.
Ethereum “Smart contracts”: An introduction
Ethereum smart contracts are pieces of code. Ethereum blockchain developers use Solidity, a proprietary language to code them. Smart contracts have the following characteristics:
• They are open-source.
• Smart contracts have “If-Else-Then” statements, and they transfer cryptographic assets based on predefined conditions.
• They run automatically upon the fulfillment of the triggering condition.
• They are stored on a decentralized blockchain.
• You can’t modify smart contracts after deploying them.
• The execution results of smart contracts are stored on a decentralized blockchain. You can’t reverse their execution.
Smart contracts can have contractual clauses. They don’t need manual administrative efforts, furthermore, they are transparent and irreversible. These factors make smart contracts efficient.
Ethereum “Decentralized Applications” (DApps): An introduction
Ethereum blockchain developers can use EVMs and smart contracts to create DApps. DApps are similar to web applications, and they have the following characteristics:
• You can code the front-end of a DApp using any technology, however, the back-end must consist of smart contracts.
• DApps are open-source applications.
• DApps must use a cryptographic token.
• No one user can hold the majority of the cryptographic tokens for a DApp.
• You can change a DApp only after its user community reaches a consensus about the change.
• DApps must store data on a decentralized blockchain, and they must use established cryptographic standards for that.
Note: Many entrepreneurs and developers create DApps on the Ethereum blockchain network. Many blockchain-cryptocurrency projects used ICOs (Initial Coin Offerings) to raise funds for their projects, and many of them used the Ethereum platform for this. NEO, EOS, and other smart contract platforms emerged subsequently. However, Ethereum continues to be popular for blockchain application development.
Pros and cons of public blockchain networks
Public blockchain networks like Bitcoin and Ethereum offer the following advantages:
• They offer a disintermediated way to conduct financial transactions using digital currencies. Users don’t need to explicitly trust 3rd parties like banks since transactions are mathematically validated.
• These networks uphold transparency, immutability, decentralization, and security. Governments can’t shut them down furthermore, hackers can’t manipulate them.
• Ethereum and similar smart contract platforms allow developers to create DApps. This encourages decentralized business models.
These blockchain networks have a few disadvantages, which are as follows:
• Governments and central banks won’t allow cryptocurrencies like Bitcoin or Ether to overshadow their respective national currencies. Uncertainties remain over the future of these cryptocurrencies.
• The Bitcoin mining process involves the POW consensus algorithm, which requires plenty of electricity. Bitcoin mining requires very high levels of electricity, which could cause adverse environmental impacts.
• Bitcoin, Ethereum, and similar public blockchains offer a low transaction throughput, which impacts their large-scale adoption.
• These blockchain networks don’t scale well.
• Many national governments have apprehensions about the anonymity these blockchain networks allow. Criminals sometimes take advantage of this anonymity, and they finance illegal transactions on the “dark web” using these cryptocurrencies.
Enterprise blockchains: An introduction
Various factors make public blockchain networks unsuitable for businesses:
• Public blockchain networks like Bitcoin and Ethereum allow anyone to join them. Even anonymous or pseudonymous participants can join these networks. Businesses can’t allow anyone to join their networks, therefore, public blockchain isn’t suitable for enterprises.
• Any participant can see any transaction on the Bitcoin network. Businesses can’t operate this way. They have confidential information, and they need to implement access control.
• Bitcoin and Ethereum don’t scale well, and they have low transaction throughput. However, Businesses need applications with high scalability and performance.
• Furthermore, blockchain is new. It takes a good deal of expertise to create and maintain blockchain applications. Businesses need to reduce such complexities to establish effective development and maintenance processes. Public blockchain networks don’t allow such controls to businesses.
These gave rise to enterprise blockchain networks. They have the following characteristics:
• They are “permissioned” networks, i.e., only trusted parties can join them.
• Enterprise blockchain networks implement access control to protect sensitive data.
• Enterprise blockchain networks use consensus algorithms that allow performance and scalability.
• Open-source frameworks and tools make it easy to develop and maintain such blockchain networks.
Examples of enterprise blockchain frameworks
Creating enterprise blockchain involves a ground-up project since you can’t build them on existing public blockchain networks. That’s hard work. Architects and developers needed help, and enterprise blockchain frameworks provide that help.
Popular enterprise blockchain frameworks:
This is an open-source project from the Hyperledger Consortium. Hyperledger Consortium is an industry group to create and support open-source tools and frameworks to create enterprise blockchain networks. Companies like IBM, Fujitsu, NEC, American Express, etc. participate in this.
Hyperledger Fabric offers the following advantages:
• A framework to create permissioned blockchain networks;
• Modular architecture;
• Data security;
• Access control;
• Useful development tools like SDKs (software development kits).
R3 Corda is an enterprise blockchain platform from R3. Particularly useful for highly-regulated industries like financial services, R3 Corda offers the following advantages:
• User-friendly development tools;
• Access control.
The global blockchain market
Blockchain promises much. Naturally, the market for this promising technology is growing. We aren’t quite talking about the cryptocurrency market here, which has its dynamics. We focus on blockchain technology here.
A Markets and Markets report states that the global blockchain market will grow from $3 billion in 2020 to $39.7 billion in 2025. That’s a phenomenal CAGR of 67.3% during the 2020-2025 period.
Conclusion – What is blockchain?
Blockchain is a new technology, however, it has attracted plenty of attention. Much of the attention is focused on cryptocurrencies. However, blockchain technology has much more to offer than just digital currencies. We talked about the components of this technology and how it works. We reviewed various flavors or blockchains, furthermore, we analyzed its pros and cons.
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