The Blockchain and how it works

By September 11, 2017Technology

The Internet has changed the world and has disrupted many old technologies, making them redundant. Many homes used to have a copy of an encyclopaedia, now they don’t. Now there is Wikipedia, which has essentially made many centralised published paper or digital (DVD) encyclopaedias redundant. Immediately those centralised volumes are published, they start to fossilise. As more or better information becomes available, it cannot be included in the published volumes and the latter become outdated.

Wikipedia is centralised in that it is represented by a master copy, but that master copy is able to be updated by anybody who has permission and the ability to update any entry. The server containing the master copy is able to be accessed by those clients in a client-server based system. Any client is able to update or change the master copy, and those clients and their permissions, as well as the master copy, are maintained by a central administrative authority1. Whenever a user accesses a Wikipedia page, they get access to the latest version of the master copy. This latest version, in some cases, may have been updated only minutes before the user accesses the page. As a consequence, the information is rarely, if ever, seriously out-of-date. This system works extremely well.

The Blockchain has a fundamentally different digital backbone. Every ‘node’ (i.e. every computer) on the network has a ‘master copy’, or ledger, each updated independently. It is therefore a system that does not need a trusted third party (i.e. a central authority). The security of the system is implicit in its structure.

Digital trust

In the digital world, determining trust often boils down to proving identity (authentication) and proving permissions (authorisation). To put it simply: ‘Are you who you say you are?’ and ‘Are you allowed to do what you want to do?’1

Authentication, in blockchain technology, is provided by private key cryptography. Possession of that private key is ownership, and spares the owner from having to share personal information for an exchange, which would leave that information open to being hacked1.

Authentication is not enough. Authorisation is determined by all the nodes agreeing that the transaction being attempted is a legitimate one (e.g. whether the person making the transaction has enough digital cash in their account). Authorising transactions is a result of the entire network applying the rules upon which it was designed (the blockchain’s protocol). This distributed network of nodes dramatically reduces the risk of corruption or failure.1

Because of its authentication and authorisation systems and the security implicit in its widely distributed ledger, it requires no bank, no financial institution. You therefore do not need a middleman of any kind in which to place your trust2.

Structure of the Blockchain

There are three different systems that combine to create a blockchain. They are:

  1. Private key cryptography
  2. Distributed network with a shared ledger
  3. Incentive to service the network’s transactions, record-keeping and security3

Each person who wishes to make transactions over the internet has a private key and a public key, the combination of which creates a secure digital identity (authentication). This identity provides control of ownership3.

If person A wishes to undertake a transaction, make an announcement that they are transferring some digital currency to person B, they take their private key and attach it to the public key of person B. A block, containing the digital signature, timestamp and relevant transactional information is then broadcast to all nodes in the network3. Every single node on the network processes every block, coming to its own conclusion and then voting on those conclusions to make certain that the majority agree with those conclusions. Once there is a consensus, the distributed ledger (the chain of blocks) is updated and all nodes maintain their own identical copy of the ledger4.

One aspect remains, and that is ‘how do you attract enough computing power to service the network and make it secure?’ This is accomplished by way of a reward system; i.e. ‘mining’. Mining is an approach to avoiding the ‘tragedy of the commons’3. The ‘tragedy of the commons’ refers to the overuse of a public resource by one or more individuals that harms the public resource to the extent that it is diminished, affecting all users5.

Mining

In ‘mining’, the person provides their computer power to service the network, and there is a reward for one of those computers. The reward comes in the form of a specified amount of bitcoin or ether. When a block is created, miners take the information in the block, and apply a mathematical formula to it, turning it into something else. That something else is a far shorter, apparently random sequence of letters and numbers known as a ‘hash’. This ‘hash’ is temporarily stored along with the relevant block, at the end of the blockchain6.

While the hash is generated from the relevant block, and the hash from the block before it in the chain, as well as other data, it is impossible to generate the data from the ‘hash’. It acts like a modern version of a wax seal, validating everything that precedes it. Tampering with it in any way also changes the ‘hash’ of any and all subsequent blocks in the chain. That is how miners ‘seal off’ a block in the chain. Every time someone successfully creates a ‘hash’ they get a reward of a certain amount of bitcoin or ether6.

To be rewarded, the ‘hash’ has to look a particular way; it must have a series of zeroes at the start. There’s no way of telling what the hash will look like before you produce it. Miners cannot meddle with the transaction data in a block, but to change the hash they must change other data used to create the hash. They do this using another random piece of data called a ‘nonce’. If the hash doesn’t fit the required format, the nonce is changed and the hash regenerated. This can be repeated many times until the required hash format is generated. Once that is done, the ‘winning’ computer gains the reward. As soon as the correct hash is found, the other miners all move onto the next block6.

Bitcoin

Bitcoin is a form of digital currency or cryptocurrency, created and held electronically. Nobody controls it, prints it or mints it. Bitcoin are produced by people running computers all around the world, using software that solves mathematical problems7 (generating a hash; see above). Bitcoin essentially acts as money and is restricted to financial transactions.

Bitcoin can be used to buy things electronically, however, as you can see from the discussion above, it is decentralised, so that no single institution controls the Bitcoin network. Transaction fees are minuscule and you can send Bitcoin anywhere and it will arrive minutes later, as soon as the transaction is processed by the network, not 3 or 5 working days later, as is common in the banking system7.

Ethereum

While Bitcoin is solely for financial transactions and could disrupt systems like Paypal and online banking, Ethereum has the goal of using blockchain technology to replace third parties – those that store data, transfer mortgages, administer contracts or more complex financial instruments8.

As an example, if you want to rent a car from a service that uses Ethereum, you will generate a smart contract. This smart contract will stipulate that if you send the required amount of funds, the rental company will send you the digital key to unlock the car. Everybody on the network will see the transaction and if the digital key is not sent, then your funds are refunded, if that is written into the contract9.

Every time a smart contract or anything else is executed on Ethereum, it uses a distinct amount of processing power and since it is run by the nodes in the network, it is important to keep superfluous activity to a minimum. So, every executed contract on Ethereum is given a cost in ‘gas’9. This operates essentially as a transaction fee, but it is small, and it goes to the miners to secure the blockchain10.

One of the advantages of smart contracts is that there is no need for ‘middlemen’ like lawyers or notaries. This means that you can carry out transactions and contracts without waiting times inherent in filing paperwork, and without paying significant fees to those middlemen.

Applications

System of Record

Digital identity

As noted above, the cryptographic keys can provide a digital identity. Because it is not based on accounts or permissions associated with accounts and because ownership of private keys is ownership of the digital asset, this is a new, secure way to manage identity that avoids exposing users to sharing too much personal information vulnerable to being hacked11.

Tokenisation

For the purposes of authenticating a unique physical item, that item is paired with a corresponding digital token, thereby binding the physical and digital worlds. These digital tokens can be used for supply chain management, intellectual property management, counterfeiting detection and fraud detection11.

Auditing

Currently banks and other businesses using the client-server infrastructure have to secure account information they hold on users against hackers. This costs banks and other businesses billions of dollars per annum and is not hacker-proof. The hacking of such data can expose customers’ intimate financial details. Blockchain technology offers a means to automatically create a record of who has accessed information or records, and to set controls on permissions required to see information11.

Platform

Smart contracting

Blockchains are where digital relationships are being formed and secured. A consortium of the largest banks and several insurance companies, is in the process of building a platform to establish new digital relationships between such businesses themselves. This version of smart contracts (see above) uses information and documents stored in Blockchains to support complex legal agreements.

Ethereum takes the platform idea further. This is about applying business logic on a Blockchain, so that transactions of any complexity can be coded, then authorised by the network running the code. Ethereum’s primary purpose is to be a platform for smart contract code, comprising programs controlling Blockchain assets, executed by a Blockchain protocol, and running on the Ethereum network.

Automated governance

This is still experimental, and research is continuing11. However, there is consideration regarding using the Blockchain for voting. The basic concept is that on a particular issue, voters can express their wishes directly or delegate their vote to someone they think is better placed to decide on their behalf, or they can vote as part of a political party or other organisation. The Blockchain, because it is basically tamper-proof makes fixing elections impossible12.

For markets

Another way to think of cryptocurrency is as a digital bearer bond. This means establishing a digitally unique identity for keys to control code that can express particular ownership rights (e.g. it can be owned or can own other things). This means that ownership of code can come to represent a stock, a physical item, or any other asset. Rules for transacting these instruments can be coded in the Blockchain protocol11.

Clearing and settlement

In equities trading, a trade is often not settled for about three days. There are non-Blockchain ways of getting this number down, but this compromises security. With Blockchain technology, the trade is the settlement. It is effectively instantaneous11.

Regulatory compliance

Regulatory compliance could enable regulatory compliance in code form. Government legal systems could be translated into digital code. In the case of banks, this could mean improving the efficiency of anti laundering compliance, by automating it11.

The future

The Blockchain is a way of validating any kind of item of value, be it money, titles, deeds, music, art scientific discoveries, intellectual property or even votes. While it is a difficult and expensive business to set up your own Blockchain, because it requires significant infrastructure and development capabilities, large tech companies such as Microsoft, Amazon and IBM are developing ‘Blockchain-as-a-service’ to the cloud environment, making it more easily accessible. As more companies discover the power of Blockchain, there will be even greater demand13.

Just as the internet was the first digital medium for information, so Blockchain will be the main digital medium for value. It is expected that two-thirds of banks will implement Blockchain solutions to their business models in the next few years13. This they are doing to streamline processes to improve efficiency and decrease costs14. It is also expected that the Blockchain will be adopted by central banks and that cryptographically secured currencies will become widely used in government and business15.

The Blockchain can eliminate the middleman, be it banker, accountant, solicitor, art dealer, real estate agent, insurance assessor, music publishers, and anyone else who makes a living as an intermediary13.

There have been concerns that the cloud is not secure, fast or large enough to handle the influx of information created by the Internet of Things (where everyday objects will have computing power built in; fridges, toasters, televisions, air-conditioners etc.). The Blockchain, because it harnesses the computing power of an enormous network, and because of its secure nature will overcome these problems13.

The Blockchain will enhance transparency in government. It is completely public. It prevents history from being rewritten by allowing information to be extended but never amended. It could also make elections cheap and instantaneous15.

Sources

  1. https://www.coindesk.com/information/what-is-blockchain-technology/
  2. http://www.afr.com/technology/web/ecommerce/heres-a-blockchain-explanation-your-parents-could-understand-20170627-gx00oq
  3. https://www.coindesk.com/information/how-does-blockchain-technology-work/
  4. https://www.coindesk.com/information/what-is-a-distributed-ledger/
  5. http://www.investopedia.com/terms/t/tragedy-of-the-commons.asp
  6. https://www.coindesk.com/information/how-bitcoin-mining-works/
  7. https://www.coindesk.com/information/what-is-bitcoin/
  8. https://www.coindesk.com/information/what-is-ethereum/
  9. https://www.digitaltrends.com/cool-tech/what-is-ethereum-blockchain-cryptocurrency/
  10. https://coinsutra.com/ethereum-gas-limit-gas-price-fees/
  11. https://www.coindesk.com/information/applications-use-cases-blockchains/
  12. https://www.newscientist.com/article/mg23531424-500-bitcoin-tech-to-put-political-power-in-the-hands-of-voters/
  13. https://www.forbes.com/sites/danielnewman/2017/04/13/blockchain-101-how-this-next-big-service-will-change-the-future/#4db6af14bd3c
  14. http://www.businessinsider.com/blockchain-in-banking-2017-3/?r=AU&IR=T
  15. https://www.shapingtomorrow.com/home/alert/665529-Future-of–Blockchain

 

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