Whenever we talk about cryptocurrencies or non-fungible tokens (NFTs), the discussion inevitably turns to the blockchain.
After all, the blockchain is the underlying technology that makes cryptocurrencies and NFTs possible. Some even think the blockchain is the next evolution of the Internet, moving us into what’s known as Web3 and setting us up for the metaverse.
But what is a blockchain? And, more importantly, how does blockchain technology actually work?
Let’s take a look at the answers to those questions.
What Is A Blockchain?
A blockchain is composed of “blocks” of data. Data is lumped together in a block that has a predetermined storage capacity. Once that block is full, it’s closed and then added to a chain of blocks. That’s why it’s called a blockchain.
However, it’s not just about the structure of the data. Blockchain technology also makes use of a computer network — usually accessed via the internet — to distribute the data. Every node in the network maintains a copy of the database, which is another property of blockchain technology. It’s a distributed database that is available publicly.
Each block also has a timestamp that helps create a timeline of transactions. The data can be verified, and because it's distributed, it’s also hard to alter the information without the consensus of other nodes in the network.
There are different methods various blockchains use to verify transactions. Additionally, how fast a transaction can be processed depends on how long the chain is, as well as how large the data blocks can be before they’re closed.
How Does Blockchain Technology Work?
Blockchain technology provides a digital record, or ledger, that's widely distributed across nodes in the network. The ledger is meant to be immutable, although some platforms have used various methods to reverse some of the impacts of transactions.
For example, after a hack on the Ethereum main net, a new version of the blockchain was created to get rid of the record of the hack. The new Ethereum blockchain didn’t contain a record of the transaction, while the original chain, denoted Ethereum Classic, still has a record of the hack.
In addition to providing a distributed ledger of transactions, blockchain technology is also designed to be decentralized.
Rather than keeping all of the records in a central location, such as a single server farm, the blockchain is distributed throughout all the participating computer nodes in the network. That way, if there is a failure in one node, it can’t take down all the data.
Additionally, because a blockchain operates using the principle of consensus, the nodes have to agree to the information. If someone tried to change the blockchain at one node, the other nodes in the system would be able to identify the error.
The only reason that Ethereum was able to erase its hack was that enough members of the system agreed to create an alternative chain. However, the record still remains as part of the Ethereum Classic blockchain.
Even though blockchains are known for cryptocurrency transactions, the reality is that they can perform a number of functions, including play-to-earn games and online virtual worlds like Decentraland.
Blockchains often have native tokens that represent various transactions and abilities. It’s a digital representation or file, and can also be a proof of ownership.
Bitcoin is a token native to the Bitcoin network. It’s a digital currency and can be used in exchange for goods and services — or it can be seen as a store of value. When someone wants to use Bitcoin to pay for something, they send it to someone's Bitcoin wallet address. This transaction is largely anonymous because the user is represented by an address or string of letters and numbers.
Here's a personal example: let's say someone wanted to pay me for writing an article using bitcoin (as happened in 2011).
To start this process, I would set up a crypto wallet where I can accept cryptocurrencies like bitcoin as payment.
After I completed the article, the buyer would send me the amount of bitcoin that we agreed upon. This transaction would be recorded in the ledger, and everyone would see that my buyer had transferred ownership of their bitcoin to my unique wallet address.
These days, people use a variety of centralized and decentralized exchanges to send cryptocurrencies to one another. For example, you could open an account with Coinbase or Gemini, buy popular cryptocurrencies, and send them to other people around the world.
But tokens are also used for other purposes. For example, NFTs have become popular because they provide proof of ownership for video, music, and digital files. It’s also possible to tokenize concert tickets and medical records.
Tokens are even used to verify the provenance of wine and could be used to issue real estate deeds. Popular networks that focus on this type of tokenization using NFTs are Ethereum and Solana.
Proof of Work vs. Proof of Stake
In order to validate transactions, and work through consensus, blockchain technology uses reliable actors to lend their computing power.
There are two main consensus mechanisms blockchains use:
- Proof of Work (PoW): Transactions are verified when nodes use computational power to solve a cryptographic puzzle. Putting in the work by lending computing power allows the first node to solve the puzzle to receive a reward. Bitcoin operates using PoW, rewarding miners that solve the puzzles with bitcoin. This increases the amount of bitcoin in circulation and incentivizes miners to validate transactions.
- Proof of Stake (PoS): On the other hand, some blockchains require owning tokens and staking them to help validate blockchain transactions. So, if you had a larger stake in the token, your node has a higher chance to verify a transaction, which pays you cryptocurrency rewards as a result.
In general, PoW is more time and energy-intensive than PoS. This is why PoS cryptocurrencies like Solana are more efficient than PoW cryptos like Ethereum and can process transactions much faster.
Solana also utilizes Proof of History (PoH) alongside Proof of Stake, which is yet another type of consensus mechanism.
This might all sound like jargon, but its these types of consensus mechanisms that let blockchains validate transactions and remain decentralized.
If you want to learn more about the different blockchain consensus mechanisms, you can read our article on Proof of Work vs. Proof of Stake vs. Proof of History for an in-depth explaination.
Transparency & Security
The main idea behind blockchain technology is to provide a secure and transparent way to send and record data.
Everyone on the platform can see a record of the transactions. However, because the parties are labeled using their addresses, which are just strings of characters, you might not be able to see who owns the wallets in question.
Sometimes blockchain transactions are considered semi-anonymous. As a result, it’s possible to know which address sent a bitcoin or an NFT, and which now owns that token, but you might not be able to see the “real” person behind those addresses.
Part of the security of the blockchain comes from the fact that every block in the chain has what’s known as hash. Each hash is unique. The hash is the result of a mathematical function to turn data into a specific output.
The function used on the same data will provide the same hash, so it’s possible to validate data from different sources. However, if someone tries to alter the data, the hash will be different. Finally, hashes can’t be reverse-engineered.
Basically, in order for a hacker or some other bad actor to steal cryptocurrency or alter the terms of a smart contract, they would have to control more than 50% of the copies on the blockchain. Otherwise, the copies that don’t match the majority — the consensus — are discarded and not added to the chain.
This is known as a 51% attack, although for major cryptocurrencies, obtaining 51% or more of the circulating crypto is unrealistic due to the financial cost.
In short, in order to change the blockchain, resulting in what is known as a fork, there has to be a consensus to do so, such as when Ethereum deviated from Ethereum Classic.
Examples Of Blockchain Technology
When most people think of blockchain technology, they also think about cryptocurrency.
However, blockchain technology isn't just for crypto. Rather, the concept of a decentralized, distributed public ledger that's trustless has implications for plenty of other industries.
Here are a few examples of how blockchain technology is being used across different industries:
- IBM Food Trust: IBM is using blockchain technology to help monitor the food supply chain to improve efficiency and safety.
- Spotify: This music streaming giant acquired blockchain startup Mediachain Labs to help implement blockchain technology into its ecosystem.
- Walmart: Like IBM, Walmart is also experimenting with blockchain technology to improve its food tracing and safety monitoring.
These are just a few examples of blockchain in action. In reality, this technology is already being used across sectors like food, healthcare, and retail.
And let's not forget about the potential for blockchain technology to impact the financial industry. Sending money abroad or even domestically can take days to settle, and money-transfers often have steep fees as well.
Pros & Cons Of Blockchain Technology
As it stands, widespread adoption of cryptocurrency and blockchain technology has a ways to go.
But despite current drawbacks like network fees and some scalability concerns, blockchain technology is here to stay.
Right now, over 1.7 billion adults don't have an account with a financial institution or money provider according to The World Bank.
But through blockchain technology and decentralized finance (DeFi), these "unbanked" groups can access financial tools like banking, investing, and have greater wealth generation opportunities overall.
The Bottom Line
There are many different uses being proposed for blockchain technology. Some of the issues that need to be overcome — and are being tackled by some projects — include the scalability and interoperability of some blockchains.
But as a potential cryptocurrency investor, it's imperative to understand what blockchain technology is and why it matters. Additionally, know that the world of DeFi has plenty of exciting opportunities.
For example, you can now use crypto savings accounts or lending platforms like Celsius to generate passive income with your crypto. Blockchain technology is also letting people leverage their crypto to take out loans, all without relying on a middleman to oversee the process.
The bottom line is that blockchain technology has incredible potential to change the world, and it already is to some extent. And, as long as you understand what blockchain technology is and how it works, you're better prepared to take advantage of the exciting changes our future holds.
Miranda Marquit, MBA, has been covering personal finance, investing and business topics for more than 15 years, and covering crypto topics for more than 10 years. She has contributed to numerous outlets, including NPR, Marketwatch, U.S. News & World Report and HuffPost. She is an avid podcaster, co-hosting the podcast at Money Talks News. Miranda lives in Idaho, where she enjoys spending time with her son playing board games, travel and the outdoors.