Blockchain Guide: What Is It? How Does It Work?

Blockchain technology is a revolutionary concept that has changed the world’s view of information. You must have come across the term “blockchain technology” at least once in your lifetime either through casual surfing through social media or some laid-back conversations with friends or colleagues. Though it has been here for more than a decade, many still know little about what blockchain is. 

Cryptocurrency (digital decentralized currencies) uses blockchain technology to facilitate and validate transactions. As more and more financial institutions and retailers are adapting cryptocurrency and hence blockchain technology, you should have a pretty good understanding of blockchain technology, especially if you are or about to become a cryptocurrency investor. 

In this guide, you will learn everything you need to know about blockchain technology in the simplest of terms. So, if you are ready to learn this exciting technology and how it works, strap in and join us. 

What is a Blockchain?

A blockchain is a decentralized public digital ledger that stores information in blocks. Each block contains transaction data, a time stamp, and a cryptographic hash to the previous block, forming a chain of blocks, hence the name blockchain.

Each block is stored on multiple computers in the blockchain network, making it virtually impossible for anyone to tamper with the data of a block. This approach of giving multiple public users to keep track of the transactions takes out a central validation system, making blockchain a decentralized approach. 

 One of the major applications of blockchain is the creation and transaction validation of cryptocurrencies. However, the technology can be utilized in any industry to keep the data secure and immutable (unchanging over time). This security and decentralization eliminates the need for third parties such as auditors, who are prone to human errors. 

Although the concept was outlined in 1991, the first functional blockchain was developed in 2009 by Satoshi Nakamoto (a pseudonym that the developer or the group of developers used). The blockchain Satoshi created served as a public ledger for keeping Bitcoin (the first cryptocurrency) transactions secure and decentralized.

Though the world still does not know who Satoshi Nakamoto is, his inventions have made way for the creation of several cryptocurrencies, decentralized finance (DeFi) applications, non-fungible tokens (NFTs), and smart contracts. 

How Does Blockchain Work?

In a blockchain network, each transaction is recorded and distributed among the machines in the network as a “block” of data. The data stored in a block contains information about the movement of intellectual property such as digital assets or tangible products. The data stored can vary depending on the developer’s needs. For example, it can record transaction amounts, user addresses, time stamps, etc. 

A block can be used for recording one or more transactions. Once all the information on a block is recorded, it goes through an encryption algorithm that generates the block’s header hash (an identification sequence of numbers) and is appended to the shared network. This header hash is stored on the next blockchain. This prevents altering the sequence of blocks. 

Key Elements of Blockchain Technology 

Let’s see what some of the key elements that all blockchains need: 

How a Block Gets Added to the Blockchain?

As we have seen above, a block is created for keeping the records of transactions. Each blockchain works differently. Let’s take the example of the Bitcoin blockchain and see how a block is added to the network:

• Initiating transaction: When the user initiates a transaction using a cryptocurrency wallet, it will be sent to a memory pool and placed in the queue.
• The mining node selects the transaction: The mining nodes in the blockchain network pick multiple transactions from the queue and enter them into a blockchain.
• Solve the cryptographic problem: When the blockchain is filled, the miner node must solve a cryptographic problem to add the block to the blockchain. The solution to the problem is proof that the work was done to verify transactions. This solution (a hexadecimal value) is added to the new block.
• Broadcasting of the block: Once successfully solved the problem, the mining node can broadcast the block to other nodes on the network.
• Verify the proof of work: Other miners on the network verify the proposed solution added to the block.
• Block is added to the blockchain: If 51% or more miners on the network reach a consensus on the solution, the miner can add the block to the blockchain. For adding a blockchain, the miner will receive rewards, and the transaction will be completed

Types of Blockchain 

While the fundamental principles remain the same, blockchains can be categorized into different groups according to the structure of the nodes and the pathways that govern them. Each type of blockchain has its advantages and disadvantages. Here is a list of four different categories of blockchains: 

1. Public Blockchain: This type of blockchain is open to the public, meaning that every member of the network would have an immutable copy of the ledger.
   
2. Private Blockchain: Where the ledger is only open to a select number of nodes in the network. They offer a secure way of storing and sharing data within a company.
   
3. Hybrid Blockchain: As the name suggests, hybrid blockchain integrates the elements of both public and private blockchains in one. In a hybrid system, the transactions are made private, but they can be verified by the public using smart contracts.
   
4. Consortium Blockchain: A consortium blockchain would have multiple entities to manage the transactions. These entities govern the blockchain using consensus mechanisms.
   
5. Permissionless Blockchain: Users do not need any permission to join the blockchain. This is the case with most public blockchains.
   
6. Permissioned Blockchain: Open blockchains may be deemed acceptable if they follow specific guidelines that restrict the number of users. Public blockchains are occasionally granted permits for improved scalability and centralization, even if private blockchains are always allowed. 

Benefits of Blockchain Technology 

Before understanding the benefits of blockchain technology, let us quickly have a look at what the limitations of traditional record keeping are. For starters, keeping duplicate records and employing third-party validations are a waste of resources, increasing the transaction charges.

Additionally, traditional record-keeping systems lack transparency and are susceptible to cyberattacks. And here comes blockchain technology that has: 

While the above listed are some of the common advantages of various blockchain technologies, the speed of transaction can vary depending on network traffic, size of blocks, speed of the process used to establish consensus, etc. 

Drawbacks of Blockchains 

Although blockchain technology excels in many aspects, there still is a long way to go to say that blockchain technology is the ultimate solution for all of the data transfer problems. Here are some of the most notable drawbacks of blockchain technology: 

Technology Cost 

Blockchain can indeed cut down much manual labor to cut down transaction fees. However, the technology consumes a vast amount of computational resources to work. It is estimated that Bitcoin uses more electric energy for the resources in the network, more than what a sizable country such as Pakistan would consume in a year.

Miners are now adapting to crypto mining farms that use sustainable energy sources such as solar to mitigate energy costs. 

Lower Transaction Speed 

Although blockchain transactions are typically fast, they can only process a set number of transactions at a time, and they are usually not scalable. For instance, it would take about 10 minutes for Bitcoin to add a new block to the blockchain.

The transaction speed of the Bitcoin blockchain is just seven transactions per second (TPS). At the same time, Mastercard is at 5,000 TPS. However, new blockchain technologies are coming out with higher transaction rates. 

Criminal Activities 

Since blockchain transactions offer a level of anonymity to the users, it is utilized for many illegal activities such as money laundering, and selling drugs and other illegal products. Many of the illegal marketplaces operating in the dark web using the Tor Web browser and onion routing utilize cryptocurrencies as a medium of exchange.

People also suspect that cryptocurrencies are being utilized for terrorist activities as well. So, while anonymity is a plus point of cryptocurrencies, it opens doors to several dangers. 

Restrictions 

There are many rules and regulations in place that restrict owning and trading of cryptocurrencies. These restrictions vary according to the jurisdiction the user is in. However, no government authorities seem to introduce policies restricting the development and maintenance of blockchains. 

Storage Inefficiencies 

Imagine how much data would be stored in a centralized financial system like banks. Now envision that one day all the industries will adopt blockchain for better security.

Since blockchain requires all nodes in the network to store identical copies of the transaction data equally, the allocation of storage will become a nightmare. All of the individual nodes may have to set up storage servers like large corporations to make the blockchain work. 

Blockchain vs Cryptocurrency 

Many people often use blockchain and cryptocurrency synonymously. However, in reality, both of these concepts are completely different from each other. Let’s see how.  

Blockchain is a collection of ledgers that can be considered as a database. Whereas cryptocurrencies are virtual or digital assets that use immutable blockchain technology to exist in the virtual world. Blockchain is not owned by any single person.

Whereas, anyone can own cryptocurrency tokens and trade them with others. While blockchain gives more focus to transparency, cryptocurrency offers anonymity.   

Some of the most popular blockchains are: 

Many blockchains have their native cryptocurrencies that usually go by the same name. Some of the popular cryptocurrencies include:

Pros and Cons of Blockchain Technology

Here is a highlight of what blockchain technology can offer and where it fails. Understanding the pros and cons of the current blockchain technology is the best way to brainstorm for the implementation of a better blockchain technology in the future. 

Conclusion 

Blockchain is a revolutionary technology that has many modern-day applications in addition to being the host of cryptocurrencies. In this guide, we have taken a detailed tour through the incredible world of blockchain and learned all the things you need to know, including what it is, how it works, its advantages and disadvantages, and more. After reading through the entire article, you will be better equipped to get into the world of digital assets such as cryptocurrencies and NFTs.