Question

How Does Blockchain Work?

Answer

How Does Blockchain Work?

Blockchain is a distributed and immutable ledger that records transactions, tracks assets, and maintains user accounts. The asset tracked by a blockchain does not always have to be a cryptocurrency.

Blockchains can be used to track tangible assets such as real estate, diamonds, and goods, and intangible assets such as intellectual property, patents, and copyrights.

Blockchains get their name by the way they store transactions. A blockchain compiles several transactions into groups called blocks. Each block is linked sequentially to form a chain of blocks. Blocks and transactions are time-stamped and cryptographically secured to prevent tampering.

Let’s talk about how a blockchain functions in detail below:

  1. Transaction Records: When a transaction occurs, the blockchain records all the important information about the transaction, which includes sender information, receiver information, transaction amount, time, and more.
  2. Block Creation: Blocks are created by compiling several transactions together. Blocks are linked to one another sequentially to confirm the exact time and sequence of transactions. Transactions are only considered final when the block they are included in is attached to the blockchain.
  3. Immutable Chain: A new block cannot be inserted between two existing blocks. Therefore, once a new block is added to the tail end of a blockchain, it becomes immutable and tamper-proof. As the blockchain grows, more blocks are added, reinforcing the immutability of older blocks.

What are the Different Types of Blockchains?

There are several types of blockchains that differ primarily in their decentralization properties, security, features, and speed.

Let’s briefly discuss them below:

  1. Public Blockchains: Public blockchains are open, permissionless, and decentralized blockchains that allow anyone to transact on and contribute resources to maintain the blockchain. Cryptocurrency blockchains like Bitcoin (BTC) and Ethereum (ETH) are the two most popular public blockchains in the world. Public blockchains are not operated by a single centralized entity. Instead, they are designed to incentivize people from across the globe to contribute to maintaining and operating the network.
  2. Private Blockchains: Private blockchains are closed blockchains that are maintained by centralized entities. The centralized operator has the power to filter users, censor transactions, and decide the functionality of the network. Private blockchains are typically used within an organization and are optimized to perform specific tasks.
  3. Permissioned Blockchains: Permissioned blockchains are restricted blockchains where the centralized operator allows selected network participants to perform certain tasks. Central bank digital currency (CBDC) blockchains are the best example of permissioned blockchains where the central bank might allow commercial banks and payment service providers to issue tokens, validate blocks, and view transaction history.

How are Public Blockchains Different From Private Blockchains?

Property Public Blockchains Private Blockchains
Decentralization High decentralization is one of the biggest drawbacks of public blockchains. Private blockchains are centralized.
Openness Public blockchains are permissionless. Anyone can contribute to the network or use it to make transactions. The centralized operator has the power to filter users.
Security Public blockchains do not have a single point of failure. The security of private blockchains depends entirely on the centralized operator.
Transparency Transaction data on public blockchains are available for anyone to check and verify. Transaction data is not available to the public.
Speed Public blockchains may suffer from lower transaction speed when decentralization and security are given priority. Private blockchains are optimized to perform fast transactions.
Immutability Public blockchains are immutable. Centralized operators can easily change and alter past transactions on a private blockchain.
Reach Global Within an organization
Crypto use Cryptocurrency rewards are used to incentivize network participation. The usage of crypto tokens can be omitted.
Features May have features such as smart contracts. Depends on the centralized operator.
Example Bitcoin – global peer-to-peer (P2P) payment network Onyx – a blockchain operated by JP Morgan.

How do Proof-of-Work (PoW) Blockchains Work?

Public blockchains can be further categorized into various different types depending on the consensus mechanism they use. The consensus mechanism is the process by which network participants of a public blockchain reach an agreement on the state of the ledger.

Proof-of-work (PoW) and proof-of-stake (PoS) are the two most widely-used consensus mechanisms.

Bitcoin is the biggest PoW blockchain in the world. Bitcoin is operated by thousands of network participants known as miners.

Miners are responsible for verifying transactions, creating blocks, and keeping a check on wallet account balances. In return for their honest duty, miners receive newly created BTC tokens each time they add a new block to the blockchain.

Here is how a PoW blockchain like Bitcoin operates:

  1. Whenever a user sends BTC tokens to another user, the transaction is broadcasted to the entire Bitcoin network.
  2. Miners pick pending transactions to be added to an upcoming block.
  3. Miners are then required to compete with each other to solve a complex mathematical puzzle in a process called proof-of-work (PoW). The first miner to solve the puzzle wins the chance to create the latest block.
  4. The miner broadcasts the new block to the entire network.
  5. The block will only be accepted if all the transactions in it are valid.
  6. Once the network accepts the validity of the newly created block, it is added to the blockchain.
  7. The miner receives block rewards for adding the new block.

How do Proof-of-Stake (PoS) Blockchains Work?

PoS blockchains like Ethereum and Cardano (ADA) operate similarly to PoW blockchains. However, miners are replaced by validators on PoS blockchains.

Anyone with the hardware requirements can become a validator by depositing cryptocurrencies as collateral in a process called staking.

Validators do not have to compete with each other to create new blocks. On PoS blockchains, a validator is picked randomly to become the next block builder.

When a validator successfully creates a new block, they are rewarded with newly minted cryptocurrencies. If a validator behaves maliciously, they are removed from the network, and their staked crypto collateral is forfeited.

What are the Uses of Blockchain?

  1. Blockchain is used to create peer-to-peer (P2P) payment systems.
  2. It is used in supply chain networks to increase transparency, automate processes using smart contracts, and record transactions and vendor details.
  3. The utilization of Blockchain extends to tokenizing real-world assets.
  4. Blockchain is used to create decentralized, peer-to-peer marketplaces for real-world assets and services.
  5. As a transparent and immutable database, blockchain offers a secure foundation for recording transactions and information, ensuring integrity and reliability.
  6. Blockchain is used for faster global payments and foreign remittances.
  7. It is used to create virtual economies in video games and other ecosystems.
  8. Blockchain technology plays a pivotal role in the creation of Central Bank Digital Currencies (CBDCs).

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Mensholong Lepcha

Mensholong Lepcha is a financial journalist specializing in cryptocurrencies and global equity markets. He has worked for reputed firms such as Reuters and Capital.com. Fascinated with blockchain technology, NFTs, and the contrarian school of investing, Mensholong has expertise in analyzing tokenomics, price movement, and technical details of Bitcoin, Ethereum, and other blockchain networks. He has also written articles on a wide range of financial topics including commodities, forex, central bank monetary policies, and other economic news.