If you’ve attempted to dive into this mysterious thing called blockchain, you’d be forgiven for recoiling in horror at the sheer opaqueness of the technical jargon that is often used to frame it. So before we get into what a crytpocurrency is and how blockchain technology might change the world, let’s discuss what blockchain actually is.
In the simplest terms, a blockchain is a digital ledger of transactions, not unlike the ledgers we have been using for hundreds of years to record sales and purchases. The function of this digital ledger is, in fact, pretty much identical to a traditional ledger in that it records debits and credits between people. That is the core concept behind blockchain; the difference is who holds the ledger and who verifies the transactions.
With traditional transactions, a payment from one person to another involves some kind of intermediary to facilitate the transaction. Let’s say Rob wants to transfer £20 to Melanie. He can either give her cash in the form of a £20 note, or he can use some kind of banking app to transfer the money directly to her bank account. In both cases, a bank is the intermediary verifying the transaction: Rob’s funds are verified when he takes the money out of a cash machine, or they are verified by the app when he makes the digital transfer. The bank decides if the transaction should go ahead. The bank also holds the record of all transactions made by Rob, and is solely responsible for updating it whenever Rob pays someone or receives money into his account. In other words, the bank holds and controls the ledger, and everything flows through the bank.
That’s a lot of responsibility, so it’s important that Rob feels he can trust his bank otherwise he would not risk his money with them. He needs to feel confident that the bank will not defraud him, will not lose his money, will not be robbed, and will not disappear overnight. This need for trust has underpinned pretty much every major behaviour and facet of the monolithic finance industry, to the extent that even when it was discovered that banks were being irresponsible with our money during the financial crisis of 2008, the government (another intermediary) chose to bail them out rather than risk destroying the final fragments of trust by letting them collapse.
Blockchains operate differently in one key respect: they are entirely decentralised. There is no central clearing house like a bank, and there is no central ledger held by one entity. Instead, the ledger is distributed across a vast network of computers, called nodes, each of which holds a copy of the entire ledger on their respective hard drives. These nodes are connected to one another via a piece of software called a peer-to-peer (P2P) client, which synchronises data across the network of nodes and makes sure that everybody has the same version of the ledger at any given point in time.
When a new transaction is entered into a blockchain, it is first encrypted using state-of-the-art cryptographic technology. Once encrypted, the transaction is converted to something called a block, which is basically the term used for an encrypted group of new transactions. That block is then sent (or broadcast) into the network of computer nodes, where it is verified by the nodes and, once verified, passed on through the network so that the block can be added to the end of the ledger on everybody’s computer, under the list of all previous blocks. This is called the chain, hence the tech is referred to as a blockchain.
Once approved and recorded into the ledger, the transaction can be completed. This is how cryptocurrencies like Bitcoin work.
What are the advantages of this system over a banking or central clearing system? Why would Rob use Bitcoin instead of normal currency?
The answer is trust. As mentioned before, with the banking system it is critical that Rob trusts his bank to protect his money and handle it properly. To ensure this happens, enormous regulatory systems exist to verify the actions of the banks and ensure they are fit for purpose. Governments then regulate the regulators, creating a sort of tiered system of checks whose sole purpose is to help prevent mistakes and bad behaviour. In other words, organisations like the Financial Services Authority exist precisely because banks can’t be trusted on their own. And banks frequently make mistakes and misbehave, as we have seen too many times. When you have a single source of authority, power tends to get abused or misused. The trust relationship between people and banks is awkward and precarious: we don’t really trust them but we don’t feel there is much alternative.
Blockchain systems, on the other hand, don’t need you to trust them at all. All transactions (or blocks) in a blockchain are verified by the nodes in the network before being added to the ledger, which means there is no single point of failure and no single approval channel. If a hacker wanted to successfully tamper with the ledger on a blockchain, they would have to simultaneously hack millions of computers, which is almost impossible. A hacker would also be pretty much unable to bring a blockchain network down, as, again, they would need to be able to shut down every single computer in a network of computers distributed around the world.
The encryption process itself is also a key factor. Blockchains like the Bitcoin one use deliberately difficult processes for their verification procedure. In the case of Bitcoin, blocks are verified by nodes performing a deliberately processor- and time-intensive series of calculations, often in the form of puzzles or complex mathematical problems, which mean that verification is neither instant nor accessible. Nodes that do commit the resource to verification of blocks are rewarded with a transaction fee and a bounty of newly-minted Bitcoins. This has the function of both incentivising people to become nodes (because processing blocks like this requires pretty powerful computers and a lot of electricity), whilst also handling the process of generating — or minting — units of the currency. This is referred to as mining, because it involves a considerable amount of effort (by a computer, in this case) to produce a new commodity. It also means that transactions are verified by the most independent way possible, more independent than a government-regulated organisation like the FSA.
This decentralised, democratic and highly secure nature of blockchains means that they can function without the need for regulation (they are self-regulating), government or other opaque intermediary. They work because people don’t trust each other, rather than in spite of.
Let the significance of that sink in for a while and the excitement around blockchain starts to make sense.
Where things get really interesting is the applications of blockchain beyond cryptocurrencies like Bitcoin. Given that one of the underlying principles of the blockchain system is the secure, independent verification of a transaction, it’s easy to imagine other ways in which this type of process can be valuable. Unsurprisingly, many such applications are already in use or development. Some of the best ones are:
Blockchain technology is still very much in its infancy and most of the applications are a long way from general use. Even Bitcoin, the most established blockchain platform, is subject to huge volatility indicative of its relative newcomer status. However, the potential for blockchain to solve some of the major problems we face today makes it an extraordinarily exciting and seductive technology to follow. I will certainly be keeping an eye out.