This blockchain for beginners guide strips down the concept of blockchain to its bare basics. The blockchain technology is at the heart of cryptocurrencies. Blockchain is one of the most sophisticated ways of recording transactions permanently and immutably. So, precisely how does it work? And, first of all, what is blockchain?
- 1. What is Blockchain Technology
- 2. How does Blockchain Work
- 3. The Steps of Recording in a Blockchain Explained
- 4. Consensus Mechanisms in a Blockchain
- 5. Blockchain-Related Terms and Technologies
- 6. Advantages and Disadvantages of Blockchain
- 7. Blockchain for Beginners - FAQs
1. What is Blockchain Technology
Since ancient times, we have been looking for more and more innovative ways to record information or transactions. Information like Bob owes 5 bushels of wheat to Marley needed to be recorded for future reference. As society advanced, we invented much more sophisticated ways of keeping records.
Now, your banking transactions are recorded using sophisticated software systems developed by leading IT companies like Oracle and SAP. However, there is a problem with these centralized systems for record-keeping owned by large corporations. Looks like there is a trust issue along with issues like transparency and security.
You need to have full faith in your bank to keep an accurate record of all your banking transactions. And, you have very little control over it. Also, there are common instances of hackers getting access to credit card data and siphoning off millions of dollars every year. Blockchain promises to solve all these.
A blockchain is the most innovative way of keeping records in a safe, transparent, and permanent way. In a blockchain, transactions are not recorded by a single entity, rather it’s collectively recorded by all the participants in the blockchain network through a voting system called consensus mechanism. So, what blockchain essentially uses is a distributed ledger technology (DLT).
This blockchain for beginners guide breaks down all these complex terms in layman’s words. Remember to check out many of our other guides and get the latest crypto referral codes at our homepage.
2. How does Blockchain Work
A blockchain is exactly what the name suggests - a chain of blocks. In a blockchain, transactions are recorded in a series of blocks connected in chronological order. So, if you send a Bitcoin to your friend at 7.53 PM today, the Bitcoin blockchain will record all these details of the transaction in a block. Each block has a limited capacity. So, each block can only hold a certain amount of transaction data.
When a block is completed, its transactions are validated by the participants of the blockchain. Then, the block is closed and the next block is created. Transactions in each block are visible to all the members of the blockchain. So, in a blockchain, there is complete transparency.
Anyone with enough computing power can participate in a blockchain. You need to simply use the blockchain software and start recording and validating transactions. As we just discussed, these transactions are recorded in blocks, which are visible to every other member of the blockchain. So, how do we ensure that transactions recorded in a blockchain are correct? Here comes the voting system called consensus mechanism (coming to this shortly).
Members of a blockchain ensure that a record is valid and correct through a majority voting system. This ensures that only the right information is recorded on the blockchain. Once a block is completed, it’s encrypted with cryptographic encryption. This ensures that none can alter a record in a block once the block is completed. This means in a blockchain, transactions are immutably recorded.
3. The Steps of Recording in a Blockchain Explained
Transaction data are recorded in the following four steps:
- Recording Transactions: Members of a blockchain record transaction data (like, who paid whom, when, and what amount) in blocks.
- Consensus: Once transaction data are recorded in a block, the majority of members need to arrive at the consensus that the records are true and valid.
- Closure and Encryption: Once a block is filled with transaction data, it’s closed and encrypted through cryptographic encryption. The next block is then linked to the last block to record new data.
- Publish: Once a block is completed, it’s published on the blockchain. This latest version of the entire blockchain is then recorded in all the computers (also called nodes of the participating members). So, everyone now has a copy of the same version of the blockchain. This is transparency at its best.
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4. Consensus Mechanisms in a Blockchain
In a blockchain, transaction data is recorded in a decentralized environment. This means anyone with computing power and access to the blockchain can record transactions in a block. So, we need a strong mechanism to ensure that none can play around with a blockchain and record false information.
A consensus mechanism, which is essentially a complex voting system, does just that. Without going deeper into technical jargon, we can say that a consensus mechanism ensures that the majority of the participants agree on the records in a block.
There are different types of consensus mechanisms depending on their functions. These are the primary two:
- Proof of Work: In this type of consensus mechanism, one needs to solve complex mathematical problems to get the right to complete a block and record transactions.
Solving these mathematical puzzles requires humongous computing power and resources. For example, Bitcoin which runs on a proof of work, requires about 150 terawatt-hours of electricity annually — which is greater than the energy needs of the entire country of Argentina, a country of 45 million people. Discover how to buy Bitcoin safely and where to buy BTC by checking out our article dedicated to Bitcoin.
Since one needs to spend a lot of resources in deploying advanced computers and huge amounts of electricity, the PoW system ensures that only serious members participate in recording transactions. Participants using the PoW mechanism are called miners. The PoW process is called mining because the creation of new blocks leads to the introduction of certain units of cryptocurrency in circulation.
- Proof of Stake: This is a relatively new, more energy-efficient, and simpler consensus mechanism. Rather than solving mathematical puzzles, PoS involves staking a certain amount of cryptocurrency to get a chance to complete blocks. The participants in the PoS mechanism are called validators. These validators stand a chance of losing the staked cryptos if they record the wrong transactions and get rewarded for correctly completing blocks. This incentive mechanism ensures that information is correctly recorded in blocks.
Since the PoS mechanism involves no mining, it’s immensely energy efficient. For example, after Ethereum moved to PoS in 2022, its energy needs fell by a whopping 99.99% making it completely environment friendly.
For a more in-depth look at PoW vs PoS protocols, check out our article on the subject. In addition to PoW and PoS, some of the other consensus mechanisms are Proof of Importance (PoI), Proof of Capacity (PoC), Proof of Authority (PoA), and Proof of History (PoH).
In this blockchain for beginners guide, let’s now look at some of the key terms related to blockchain that you are going to frequently encounter. Here we go:
- Distributor Ledger Technology (DLT): A ledger is centralized when records in it are managed only by a single authority, like in a bank. However, blockchain uses a distributed ledger in which the records are entered and managed by all the participants in the blockchain in a distributed way. The participants are located in different geographies across the world. Terms like distributed ledger, public ledger, and decentralized ledger are often used interchangeably.
- Nodes: In blockchains, nodes are the devices run by participants in the blockchain. So, a node is simply a computer that runs the blockchain software and participates in managing the blockchain.
- Mining: Mining is the activity related to the PoW consensus mechanism in which new cryptos are introduced when participants complete blocks.
- Decentralization: Decentralization is core to the functioning of a blockchain. It implies that records in a blockchain are managed by a large number of participants rather than a central authority.
- Cryptocurrency: Cryptocurrency is the native digital currency of a blockchain. It’s like a general currency like the dollar except that it exists on the blockchain in digital form and no bank controls it.
- Crypto Wallet: A crypto wallet is a digital wallet for storing cryptocurrencies. Cryptos can be transferred from one wallet to another.
Crypto wallets are another of the many topics to research if you are interested in trading and storing cryptocurrencies safely. Knowing the difference between hot and cold wallets and which wallet will work best for you are something to consider and learn more about.
5.1 Types of Blockchains
There are two primary types of blockchains, which are:
- Public Blockchain: A public blockchain is a permissionless blockchain in which anyone with computing resources can participate. For example: Bitcoin and Ethereum. You can participate in the Bitcoin network to record transactions and manage the blockchain without any permission.
- Private Blockchain: A private blockchain is a permissioned blockchain in which only the members having permission are allowed to access. These blockchains have an access control layer to ensure that only the members with permission can access it.
In addition to these two types, there is also a hybrid blockchain which includes features of both private and public blockchains. In addition, there is a consortium blockchain, which is basically a collection of private blockchains belonging to different organizations. For further information, our team of experts recommend reading guides such as "What is Cryptocurrency?" to enhance your knowledge of blockchains and other important topics related to cryptocurrencies.
6. Advantages and Disadvantages of Blockchain
Here are the main advantages of using blockchains:
- Decentralization: Blockchains bypass centralization or central authority by allowing all its members to democratically manage and govern the blockchain. This means no single authority can control an entire blockchain.
- Transparency: In a blockchain, the transactions, and records are visible to all members. You can literally track the movement of a Bitcoin or any other crypto through a blockchain.
- Security: None can unilaterally record transactions or alter blocks in a blockchain. Also, bad parties cannot control a blockchain without having access to more than 50% of the computer resources in a blockchain. This is literally impossible in a large blockchain like Bitcoin. Also, blockchain transactions are visible to all members, which makes it extremely secure.
- Anonymity: In a blockchain, the participants are identified through addresses having long chains of letters and numbers. These addresses are not related to the real-life identity of a person.
- Immutability: On a blockchain, once a block is created it can never be deleted or altered. If we want to reverse a transaction in a previous block, a new block has to be created. This means all transactions on blockchains are recorded permanently.
In addition to these, some other advantages of a blockchain are the speed of transactions, low cost, enhanced privacy, and more trust. Let’s now look at a blockchain’s drawbacks:
- Blockchains involve extremely difficult concepts related to mathematics and computing, which may be intimidating for lay users.
- Blockchains running on the PoW mechanism require a gigantic amount of energy. They also have a significant carbon footprint.
- The anonymous nature of blockchain may make it highly convenient for criminal activities like terrorism financing.
- Many blockchains are not scalable to support a high volume of real-world transactions.
In this blockchain for beginners guide, we just touched the tip of the iceberg. In addition to these blockchain basics, there is a plethora of concepts and technologies related to blockchain and cryptography which we will cover in future posts. Until then, we invite you to check out our list of the top crypto exchanges for 2023.
7. Blockchain for Beginners - FAQs
7.1 🤔Is there a difference between blockchain and Bitcoin?
Yes. Bitcoin is the native cryptocurrency of the Bitcoin blockchain. Bitcoin is a digital currency that can be spent like paper money. The Bitcoin blockchain keeps a record of all Bitcoin-related transactions.
7.2 🔗Are all cryptocurrencies based on the blockchain technology?
No. While most cryptos are based on blockchain, there are cryptos like IOTA which are not based on blockchain.
7.3 🔮Is blockchain the future of finance?
Blockchain is often described as the future of finance. With all its potential, blockchain technology needs to mature and address issues like security and scalability to be applied to real-world financial transactions. The blockchain for beginners guide explains some of the disadvantages that need to be addressed.