What is Blockchain Technology? And How Does It Work?

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Updated: 23rd Feb 2021
Written by Drew Cheneler
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January 20, 2021
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Blockchain technology is the main infrastructure that powers cryptocurrencies, yet, many investors do not know what it is and how it works.

Notoriously famous for being one of the most difficult concepts to understand, blockchain technology has a bad track record of being impossible to digest by non-technical individuals.

But is it really that hard to figure out blockchain technology? Believe it or not, the core concept is much easier to understand than others lead you to believe.

What is Blockchain Technology?

Blockchain technology is a form of online infrastructure and database used to store and cryptographically record data in a decentralized fashion.

Blockchain networks function much like an online distributed ledger that forever stores data in a way so that it cannot be removed or altered.

Revolutionary Blockchain Technology
Blockchain Is the Future of Financial Transactions

Blockchain networks remove the need for centralized authority and intermediaries. They allow users to participate in a trustless system where one can interact and make decisions without any oversight.

For the first time, the anonymous creator Satoshi Nakamoto introduced the concept in 2008 when he published a paper named ‘Bitcoin: A Peer-to-Peer Electronic Cash System.

Blockchain technology features several fundamental characteristics that make it unique as a data storage and data distribution network.

These characteristics include:

  • Decentralization – Control and authority is distributed to all users equally.
  • Immutability – Data cannot be changed or removed.
  • Pseudo-anonymity – All participants remain anonymous to a certain degree.
  • Distributed – All data of a network is stored on every node/user.
  • Public – Everyone can access the network, no matter their background.

Each individual feature makes blockchain technology a preferable and more efficient alternative to modern data centers.

While most enterprises and tech giants dislike the idea of using a public decentralized blockchain network, there still exists a different solution.

Blockchain networks can be either permissionless or permissioned. Networks like Bitcoin are permissionless (public), and they allow every living individual to join them.

On the other hand, permissioned (private) blockchains decide who has the privilege to access the network and add or view data.

How Does Blockchain Work?

Blockchains can store and transfer any type of value, be it information or money. But to make that possible in a way that is immutable, secure, and decentralized, developers utilize a set of cryptographic concepts.

Specifically, blockchain networks rely on the use of cryptographic hashing, Merkle trees, and timestamping.

There are additionally three main concepts that you must understand: Blocks, miners, and nodes.

Blocks

As the name implies, Blockchain represents a chain of blocks. Each block carries a list of transactions that are digitally signed by the owner and verified by a miner.

Transactions are grouped together into a single block, and their information is connected to the block that follows.

The network ensures that all transactions are ‘set in stone’ and introduced in a linear timeline that makes it impossible to change the Blockchain.

Miners

A miner is a user who is financially compensated for verifying transactions and keeping the blockchain network stable. His job is to confirm all transactions within a block by using computer processing power.

Miners were created to solve double spending, an issue in which a user can spend the same coins twice. A network proves that certain coins were already spent by verifying their history with the help of timestamping.

Blockchain Mining

To timestamp transactions, most blockchain networks use the Proof-of-Work (PoW) consensus mechanism. It essentially enables a miner to verify whether certain coins within a new transaction were previously signed.

PoW timestamping works by searching for a value with the SHA-256 hash function that gives a hash beginning with a number of zero bits. The timestamped transaction can then be verified with a single hash.

The Merkle tree is a famous hash structure in which all child nodes are connected to the previous node. Moreover, every node contains hash proof that shows a real connection to an older node.

Nodes

To perform their actions, miners, use a computer installed with the Blockchain’s software and network. A computer that stores the network’s entire database is called a node. Miners use nodes to verify transactions and even vote on decisions by reaching a consensus.

All new transactions are broadcasted to the nodes, and each one collects new transactions into blocks. If working alone, the node searches for PoW on its own and sends the information back to all the other nodes.

If the transactions are valid and their coins have not been spent previously, they are accepted and form the network’s next block.

Related: How to Buy Bitcoin

How is Blockchain used?

The $3 billion blockchain industry offers products and services for a variety of use cases. Rightfully so, it is projected to become the ultimate solution for almost every problem that we can find.

Famous companies like Microsoft, Starbucks, Walmart, and IBM already experiment with blockchain networks and explore new ideas and concepts.

While the technology has not yet reached a widespread adoption stage, it still has a bright future ahead.

From cross-border payments, supply chains, and healthcare, to real estate, journalism, and taxation blockchains can be simply used anywhere.

However, most use cases for blockchain technology focus on exchanging value via cryptocurrencies.

In the section below, we will explore three of the best use cases that blockchain networks offer.

#1. Cryptocurrency

Cryptocurrencies, crypto assets, or digital assets form the foundation of blockchain technology.

Therefore, they represent the main use case for this industry. Due to their inherently decentralized design cryptocurrencies are favored and used by many.

Instead of exclusively passing information from node-to-node blockchains can also transfer value through coins and tokens as well. Millions of users from all parts of the world use cryptocurrencies to exchange value and make payments.

In places where legacy financial infrastructure is limited or non-existent, these currencies represent the future of digital economies.

Without relying on 3rd-party entities or intermediaries, people can do business both outside and inside their native countries.

#2. Smart Contracts

Experts believe that first-generation blockchain networks like Bitcoin do not really offer a trustless environment.

While users do not have to deal with intermediaries, they still must interact with other anonymous individuals and trust them when creating transactions.

Smart contracts completely remove the need for trust by enabling the community to forge self-executable digital contracts.

One can write a smart contract with a friend and have a certain payment paid out once certain conditions are met, and the agreement can be carried out.

Smart contracts were first introduced by the Ethereum smart contract ecosystem. The project’s launch contributed a ton to the industry by taking blockchain networks one step further.

These contracts can be created for every kind of use case imaginable. They can be used to arrange payments upon delivery, to manage renting an apartment, and even to create business contracts.

#3. Banking and Finance

Blockchain networks have another primary use case: the world of banking and finance. By working around the clock, these networks offer a healthy and more efficient alternative to managing your personal finances.

The famous adage of ‘be your own bank’ rings true as individuals can create transactions at any time of the day. Blockchain transactions are theoretically faster and more secure as well.

The recent boom of decentralized finance (DeFi) in 2020 has resulted in the rise of decentralized financial instruments.

Financial activity that could historically only be done with the help of a bank is now available on blockchain protocols as well.

By using blockchain technology, smart contracts, and decentralized applications, institutions can offer loans, decentralized trading, and many other services.

Advantages of Blockchain Technology

As you have seen so far, blockchain technology offers a wide range of advantages. These advantages are made possible by the decentralized design of this technological infrastructure.

To quickly summarize, here is a list of four main advantages:

  • Secure Transactions: All transactions are cryptographically secured. With the help of timestamping, networks make sure that no coins were spent more than once. Since blockchains are encrypted, someone can’t gain access to your funds.
  • Decentralization: Blockchain networks treat all users in the same way. No one has higher privileges. Users can create payments on their own without having to rely on a 3rd-party entity.
  • Private Transactions: All transactions and users are anonymous; no individual has to share his identity. However, the transactions themselves can still be tracked.
  • Transparency: Blockchains are public and open. Everyone has access to networks and can explore transactions. It is possible to see the transaction history of every wallet.

Disadvantages of Blockchain Technology

Nothing is perfect. While blockchain technology is superior compared to legacy networks, there are still some disadvantages that make it slightly unpopular.

  • Fosters Illegal Activity: The fundamental features of blockchain technology make their networks a safe haven for criminals and illegal activity. Blockchain networks have a notorious reputation for being used to launder money, transfer money illegally, and purchase illegal products or services.
  • Regulation: While blockchain technology is regulated in most parts of the world, some of its products are restricted or even banned. In the past, several countries have banned mining and declared cryptocurrencies as securities.
  • Cost of Mining: The cost of mining cryptocurrencies like Bitcoin and Ethereum is incredibly high. Machines used to miner coins can cost several thousands of dollars. Additionally, they incur gigantic electrical bills as most machines are power-hungry.

Bottom Line: Blockchain Technology

Blockchain technology has evolved far from its original promises. It is now used to power a significant portion of the internet economy.

Created to decentralize the world and help people take control over their own finances and digital networks, blockchains have come far.

As a matter of fact, the entire industry is now valued at $3 billion. By 2025, experts suggest that the industry can reach a valuation of up to $39.7 billion.

However, we still have a long way to reach that point. Blockchain technology is a breeding ground for major innovations and revolutionized use cases. However, it must still win a battle and reach widespread adoption.

No one knows how long it will take, but one thing is certain, blockchain networks will disrupt the world like no other technology in the history of mankind.

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Drew Cheneler
Drew Cheneler
Drew is a recognized Credit, Small Business, and Personal Finance Expert. He has been quoted in CNBC, Fox Business News Section, The Huffington Post, Business.com, Moneyunder30, US Chamber of Commerce, and more. He is known for breaking down complex personal finance topics into action-oriented advice, so you can make the most of your hard-earned money.