Blockchain technology is a distributed database management system that first became known in 2009 as the basis for the cryptocurrency Bitcoin. Over the years, however, it became apparent that there are other possibilities in which a so-called blockchain can find application. But what exactly is blockchain technology, how does it work and what are the advantages and disadvantages? On this page you will learn everything about the definition and functioning of the blockchain – simply explained.
What is a blockchain?
A blockchain is a sequence of data records (so-called blocks or nodes) in which a large amount of information is stored. It starts with an originating block and is constantly extended by new data blocks in chronological order. Because of this, it is referred to as a blockchain.
Unlike databases at savings banks or banks, the blockchain is managed in a decentralized manner via a large network of computers. The data stored on the blockchain and its effects on contractual partners can be viewed anonymously by all participants. Clear readability of the data by other participants is prevented by storing the names of the contractual partners in encrypted and anonymized form. This works via an individual and unique code (hash value). Decryption is then only possible for the sender and the recipient of the transaction. The degree of confidentiality can thus be flexibly designed.
As a decentralized database, blockchain is used primarily in connection with cryptocurrencies. However, cryptocurrency is not the only area in which blockchain technology is used. The technology is also used, for example, in healthcare, food trade or logistics.
The system behind the blockchain
A blockchain is often equated with the so-called distributed ledger technology. In principle, the blockchain can be thought of as a written cash book or ledger in which all transactions are recorded from day one. However, this cash book or blockchain does not exist only once. All participants who have carried out at least one transaction have an exact copy of the ledger – hence the distributed ledger. This is also true with the blockchain. New blocks are added to each copy of the blockchain. The system would not be feasible with physical ledgers, but it is via a digital network.
What types of blockchains are there?
Storing the blockchain on multiple computers, called nodes, creates the possibility of decentralized management. This publicly accessible form is most commonly used. However, there are also use cases where access authorization is restricted. There, the blockchain is managed centrally or at least semi-centrally. This applies to so-called private, hybrid, and consortium blockchains:
Public Blockchain technology, in English Public Blockchain, is used by many cryptocurrencies. Any person who has a computer with enough processing power and a stable internet connection can participate in a blockchain. This makes it public. All blocks are equal and every participant has the same permissions. The permissions relate to reading the information in the data blocks, executing and confirming transactions, and ensuring data integrity. Simply put, ensuring that no tampering is done.
A private blockchain is a centralized database that is managed by an entity or at least a limited number of participants. This means that the individual nodes can be given different rights and can also only be read by certain people invited to do so.
The hybrid blockchain combines the functions of a private and public blockchain. For example, a company’s data can be distributed over a public network, but certain parts can be restricted to a small group of participants. In this way, companies can control access to individual pieces of data on the blockchain, while making the rest of the data available to the public.
With consortium blockchain, no single person or company determines who can transact or access data. Instead, a group of companies or representative individuals share decision-making power. In this context, it also applies to the consortium Blockchain that some parts can be made publicly accessible and others privately accessible.
Technology: How does a blockchain work?
A blockchain basically works as a kind of chain that gets longer and longer. Each transaction, e.g. investing in Bitcoin, is stored in its own chain link, which is linked to the Bitcoin blockchain in chronological order. Thus, every single transaction with the cryptocurrency can be tracked. The data stored in the blocks is encrypted and assigned a unique code, the hash value. As a result, the technology offers a high level of anonymity and transparency.
Encryption contributes to the security of the blockchain. Names, amounts or other data cannot be easily exchanged to manipulate the blockchain. In addition, the blockchain brings very special properties that make it almost completely tamper-proof:
Each new block contains both the data of the new transaction and a copy of the entire blockchain up to that point.
In addition, each transaction must be confirmed by a majority of the participants.
An example: The genesis block, i.e. the very first block in a blockchain, contains the information about the first transaction, e.g. with Bitcoin. The second transaction creates a new block that contains the data for transaction 1 and transaction 2. The next block stores all the information from transaction 1, 2 and 3. And so the blocks continue in the blockchain. This means that if someone wants to manipulate a transaction in the blockchain or slip a fake block somewhere in between, this must happen not just in one block, but in all of them – or at least in so many that it would no longer be noticeable in a trace. The limit at which manipulation remains undetected cannot be defined across the board.
In addition, a copy of the entire blockchain is stored on every computer connected to the blockchain network. Manipulation is thus extremely complicated and therefore almost impossible. In addition, the consent of many participants is required for a change or a new transaction. Depending on the blockchain, the confirmation procedure differs. In the case of the Bitcoin currency, those with the greatest computing power can decide.
Although the blockchain technology is very secure, investing in cryptocurrencies like Bitcoin is still associated with high risks in the form of price fluctuations – especially if you bet on individual currencies.
The function of the blockchain in connection with cryptocurrencies.
Two different methods form the basis for producing a block for cryptocurrencies. The so-called proof-of-stake and the proof-of-work method (also called mining).
In the proof-of-work (PoW) method, which is used for Bitcoin, for example, computers connected in a network solve complex arithmetic operations. This is done via a trial-and-error process. In this process, computers search for the solution by trying it out many times. Once a solution is found, it is checked and verified. The first person to discover the solution receives the block and can attach it to the blockchain. However, solving the complex computational tasks requires a lot of time and computing power. Thus, it is relatively cost-intensive. On the Bitcoin blockchain, the current validation time for a single transaction is about one hour. This consumes about as much electricity as a German single-family home consumes in an entire month. For this reason, the proof-of-stake (PoS) method was developed.
The Proof-of-Stake method is similar to a voting system and is a consensus mechanism on the blockchain. Through this consensus mechanism, the validation of blocks is not tied to computational power, but to the share of coins (the “stake”). So-called “stakers” provide cryptocurrencies as collateral to validate transactions. Coin holders with deployed cryptocurrencies then become “validators.” The “validators” are then randomly selected to validate the block. Once the accuracy of a transaction and the underlying information is ensured, the blockchain rewards the “validators” with cryptocurrencies. This process requires about 99% less energy than the proof-of-work mechanism.
How does a hash value work?
A hash value is calculated by a so-called hash function. This reduces large amounts of data to a smaller string of characters with a fixed length. In this way, any data, such as passwords, can be represented in a compressed form. However, only the hash values are stored and not the passwords themselves.
To decrypt the data again, the original password must be used. The data is then calculated using the same hash function and compared with the stored hash value. If the hash values match, the user is considered authenticated.
The origin of the blockchain
In 2009, the anonymous developer of Bitcoin, known by the pseudonym Satoshi Nakamoto, laid the foundation for the blockchain as a distributed database management system. Nakamoto published the Genesis block of the Bitcoin blockchain at that time. The new technology aimed to enable payment transactions without third parties. That is, no banks or other financial institutions should be involved in a transaction. In this way, Satoshi Nakamoto wanted to create more anonymity and avoid regulation by central banks and the co-earning of middlemen and intermediaries.
However, the main reason why blockchain is gaining attention and application in more and more industries is rather the encryption and tamper-resistance. This is because sensitive data can be securely stored digitally and accessed at any time, but not altered. In addition, no intermediaries are needed to establish trust between the two contracting parties by monitoring and documenting the transaction. Blockchain technology takes care of this part automatically. As a result, the information is also only exchanged between the parties that have concluded a contract with each other.
However, blockchain technology is not yet suitable for mass use. Verification of individual transactions currently still requires a very high level of computing power, which not only takes a long time, but also consumes a lot of electricity. The effort required varies depending on the blockchain.