As Bitcoin is heading from one all-time high to another, there is a lot of talk around cryptocurrencies and even about blockchains, the technology behind cryptocurrencies. That said, only a few investors know what’s the technology behind cryptocurrencies and how it works.
A blockchain is a decentralized, digital ledger technology (DLT) that records transactions across a network of computers in a secure and transparent manner. The name blockchain is derived from the structure of the technology, since data is stored in blocks that are linked together in a chronological chain. To ensure data integrity and security, blockchains use cryptographic techniques.
Unlike traditional systems that rely on a central authority (such as a bank), blockchains operate on a peer-to-peer network where every participant (node) has a copy of the ledger. The decentralized nature of blockchains mean that there is no single point of control or failure within the network and the data on the blockchain cannot be easily changed once recorded. In addition, blockchains offer—in contrary to public opinion—a high transparency, as all data and transactions are visible to anybody who downloads the blockchain.
Each block contains a list of the respective transactions, a unique identifier called a “hash,” and the hash of the previous block which is creating the chain. As a result, the data is nearly impossible to alter after a block is added to the chain because changing one block requires altering all subsequent blocks and the network would reject inconsistent copies of the blockchain.
When someone initiates a transaction, it is broadcast to the network for validation. Then the validators confirm the transaction’s legitimacy based on the network’s consensus rules. Generally, there are two consensus mechanisms (algorithms) used to ensure agreement among nodes. The first is the so-called Proof of Work (PoW), where participants solve complex puzzles to validate transactions. This method is, for example, used on the Bitcoin blockchain. The second method is the so-called Proof of Stake (PoS), where participants stake cryptocurrency to earn validation rights. This method is, for example, used on the Ethereum 2.0 blockchain. As the underlying process is somewhat complex, a detailed explanation would be the topic of another article. Once a transaction is validated, it is added to a block.
Even as blockchains are mainly in focus since they are the backbone of cryptocurrencies, there are much more applications of blockchains. The first application that comes to mind are smart contracts which are self-executing contracts with predefined rules. Blockchains are also used in supply chain management as they enable the tracking of goods in real time, or within the healthcare sector as blockchains enable secure sharing of patient records. Another use case would be the use of blockchains for public or other votes, as the use of a blockchain would ensure tamper-proof elections and fast results after the vote is closed.
This article is for information purposes only and does not constitute any investment advice.
The views expressed are the views of the author, not necessarily those of LSEG Lipper or LSEG.
