How Blockchain Technology Works
The leading venture capitalist Marc Andreessen described blockchain as the most important invention since the internet itself. If internet changed the way we transfer information, blockchain is changing the way we transfer value. So, let’s learn about how it works.
While talking about blockchain technology, people sometimes mean different things and it can be very confusing. Sometimes they are talking about the Bitcoin's Blockchain, sometimes about crypto-currencies in general, and sometimes they are talking about distributed systems. At a very high level, blockchain is generally referred to a decentralized ledger of all transactions across a peer-to-peer network. Blockchain technology is not the same as Bitcoin. Instead blockchain is the technology underlying Bitcoin and other crypto currencies. Using this technology, participants such as buyers and sellers can interact and transfer value directly to each other over the internet without the need for a third-party intermediary. Let’s see how it works.
The blockchain technology facilitates peer-to-peer transactions without any intermediary such as a bank or a governing body. The blockchain technology makes it possible to remove all middlemen when transacting between two parties. As I mentioned earlier, Bitcoin is an application that makes use of the blockchain technology to send money around and enable transactions between two parties. In fact, it is the first application of blockchain technology applied to money.
At its core, the blockchain is essentially a database of all transactions happening in the network. The database is public and therefore not owned by any one party. It is distributed, that is, it is not stored on any one computer owned by somebody. Instead it is stored on many computers across the world. The database is constantly synchronized to keep the transactions up-to-date, and is secured by the art of cryptography making it hacker proof. These four features make this an exceptional technology.
Blockchain works as a network of computers, all of which must approve a transaction that has taken place before it is recorded, in a “chain” of computer code. In case of bitcoin, cryptography is used to keep transactions secure and costs are shared among those in the network. After the transaction is validated, the details of the transfer are recorded on a public ledger that anyone on the network can see.
In the existing financial system, a central ledger maintained by the institution acts as the custodian of the information. But on a blockchain the information is transparently held in a shared database and no one party acts as a middleman. This increases the trust among parties, as there is no possibility of abusing the system by anyone.
Let’s understand the blockchain technology in a bit more detail by looking at the example of how a transaction happens using Bitcoin. Anybody can download a simple piece of software and install it on their computer to use Bitcoin. Because it is a decentralized, peer-to-peer system, you do not need to register an account with any particular company or hand over any of your personal details. Once you have a wallet you can create addresses which effectively become your identity within the network.
Let’s say Party A wants to send money to Party B in the form of bitcoins. This is a transaction which will eventually change the bitcoin balances for both Party A and Party B. The transaction is collected in a block. A block records some or all of the most recent Bitcoin transactions that have not yet entered any prior blocks. The new block is then broadcasted to all the parties or so called nodes in the network. The parties in the network approve that the transaction is valid through a process called mining. With Bitcoin, miners use special software to solve math problems linked to blocks which is the basis for approving the transactions. The minors are issued a certain number of bitcoins in exchange of doing this work. Once the transactions are approved, the new block is added to the block chain, which is the ledger of all the past transactions. Once the block is added, the ledger balances are updated to reflect the new balances for all parties. The process goes on and a new block is formed every 10 minutes with a new set of transactions.
Financial institutions such as banks and brokerage firms have long held the role of trusted intermediary third parties that validate the authenticity and accuracy of a transaction. However, blockchain simply eliminate the need for third parties. Initially banks looked at the technology as a threat, however, they have now started embracing it. The world's biggest banks are looking for opportunities in this area by doing research on innovative ways blockchain can be used in banking and finance related applications. For example, blockchain technology significantly increase the speed of execution of securities settlement. It can also help reduce the capital, that banks have to hold, against each trade. Infact, in 2015, Nasdaq formally debuted its blockchain product, Nasdaq Linq, which be the first major global stock exchange to publicly trial blockchain technology.