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What is blockchain technology?


1a – What is a blockchain?

The blockchain is the technology that makes cryptocurrency possible. This is the first thing anyone needs to know in order to understand what Bitcoin is.

In layman’s terms, a blockchain is a publicly accessible accounting book (ledger) that records all transactions made with a single currency. Blockchain technology can actually record transactions of any form of digital information, but its most important use to date has been enabling the movement of cryptocurrency between different people.

A good way to understand how a blockchain functions is to compare it to a regular accounting book. A traditional accounting book is usually maintained and updated by a singular person or entity such as a bank. It’s the bank that acts as a central authority by keeping track of how much money people have in their accounts and any transfers they make or receive. In this way a regular accounting book is ‘centralised’, with the bank acting as the middleman for all transactions.

A blockchain, on the other hand, is ‘decentralised’. This means that transactions are recorded on its ledger without a central authority verifying them. It might sound a little complicated, but the following analogy should help you get to grips with how it works:

Think of a 5-a-side football game that you’re playing with your friends, where there isn’t a referee (central authority) present. As players, you can keep track of the score as the game goes on, and the game only continues if everyone agrees on the score shown on the scoreboard (ledger). If one person from the ten thinks that the score is different, for instance they insist that their team is winning 3-1 when the others know the score is actually 2-1, the majority’s opinion takes priority. The same democratic process takes place with each new goal scored, and the score is then adjusted to reflect which team scored the goal.

The blockchain is the football game, the score is the transaction history, and agreeing whether a goal has been scored and who scored it is the verification of a transaction. All taking place without a central authority (referee) updating the ledger (scoreboard).

Now you’ve got the basic premise, let’s look at how an actual blockchain works. Don’t worry if everything hasn’t clicked into place yet, going through the following sections will help you build a better picture of what Bitcoin is.

1b – What is a ‘block’ within the blockchain?

Blocks are groups of transactions stored on a blockchain.

Imagine keeping a record of your personal finances in a new, empty accounting book. As soon as you start to record your transactions in the book, the pages within it start to get filled, and new pages will continually be added as the old ones are full. If you picked out a transaction from any individual page and changed it, the accounting book becomes useless after that point, as the balance shown on the following pages would be incorrect.

A ‘block’ within a blockchain is just like an individual page of an accounting book: it is a record of different transactions. When new transactions on the blockchain are verified, they are grouped together in a single block. New blocks are then added on top of those that have been created before, updating the ledger and creating a chain of connected blocks: a blockchain.

In the same way that you cannot change one of the transactions on a previous page in your personal accounts book without invalidating all the subsequent pages, you cannot alter a block once it has been added to the blockchain.

1c – Why you should care

In a sentence, blockchain technology is important because it removes middlemen.

You no longer need a centralised authority (such as a bank) to have control over regular transactions, giving power back to regular people. At present, if you were to go to your local high street shop to buy a pair of shoes with your debit card, the transaction would look a little like this:

You > Your bank > The shop’s bank > The shop.

This is because banks control your money for you. They have to verify that you have enough funds to complete a payment before they can transfer your funds to someone else; that ‘someone else’ will be the shop owner’s bank, which will then add the money to his/her account for them. Sounds like an over complicated way to buy shoes, no?

Blockchain technology removes the need for an intermediary such as a bank to oversee and record transactions. Here’s how a blockchain transaction works:

You > The shop.

During this process, no centralised banks are needed as this verification process is carried out by the users of the blockchain themselves – just like how the score was maintained in the football game in section 1a. Once this transaction has occurred, it will be added to a block, which will later be added to the blockchain.

1d – What problem does blockchain technology solve?

Blockchain technology provides a solution to what is commonly known as the ‘double-spending problem’.

Put simply, a blockchain stops people from being able to spend the same money twice, while removing the need for a central authority to oversee and verify transactions.

Take the example of cash. The double spending problem doesn’t exist when spending cash because the exchange is physical: if you give a £10 pound note to someone, you no longer have that note and cannot therefore give it to another person. However, if you spend £10 pounds digitally, it is more complicated to verify that you no longer have it in your possession and stop you spending it again.

With digital currencies, a system needs to be in place to stop people spending the same money more than once. Banks have patched over this problem through centralised control: taking charge of verifying every transaction that takes place between people’s accounts. By controlling everyone’s transactions, the bank decides how much money each person has in their account and ensures that nobody can transfer the same £10 to two different people.

But there’s a catch. This also means that banks have complete control over your money. If a bank is compromised by a malicious third party, or decides to act in a fraudulent manner, its account holders could lose their money because ultimately their accounts are owned and controlled by the bank.

Blockchain technology solves the double spending problem without the need for a bank. Each transaction on a blockchain is verified by its users, and then added to the public ledger of the blockchain (as explained in section 1b). Once you transfer £10 to someone else, the transfer is recorded on the blockchain, proving that you no longer have that £10 and cannot spend it again.

The crucial part of this is the decentralisation of the process: you no longer have to place your trust in a central body to handle financial transactions. When banks are controlling everyone’s money, all the data is hidden away to be seen and managed by a select group of people. These people have a great deal of power, if they are corrupt or incompetent, then everyone with money in the bank is at risk. The blockchain is public and transparent, granting equal power to all of its users and taking it away from shady financial institutions.

Solving the double spending problem with blockchain technology is what made cryptocurrency a viable alternative to ‘regular’ currencies.

1e – So, what is a cryptocurrency?

A cryptocurrency is a digital currency that uses a blockchain technology to record transactions.

When you need to make a payment to someone, instead of transacting with regular fiat currency (e.g. pounds, euros, and dollars), you will need to use the cryptocurrency supported on that blockchain. For example, the bitcoin currency sits on top of the Bitcoin blockchain. You cannot have a cryptocurrency without a blockchain.

The ‘crypto’ in cryptocurrency refers to cryptography. Cryptography is the process of encrypting information so that it cannot be read by anyone other than who it is intended for. Children passing coded notes in class that the teacher can’t understand is a basic form of cryptography, the Enigma code used by Germany in World War 2 is a much more advanced example.

When something has been encrypted, third parties can see it’s there but can’t understand it. This is how cryptocurrency moves on the blockchain. When coins are transferred between people, the blockchain publicly displays how much cryptocurrency was moved, but not the identities of the people involved in the transaction.

To understand this revolutionary form of digital currency further, it’s time to move on and look at the cryptocurrency that started it all: Bitcoin.

By Harry Atkins
Harry joined us in 2019 to lead our Editorial Team. Drawing on more than a decade writing, editing and managing high-profile content for blue chip companies, Harry’s considerable experience in the finance sector encompasses work for high street and investment banks, insurance companies and trading platforms.

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