The underlying technology in cryptocurrencies is called blockchain technology. The industry has slowly adopted this term in lieu of “cryptocurrency” or “bitcoin” in part to reflect that blockchain technology has applications beyond digital currencies.
A blockchain is a ledger of transactions that no one can retroactively change and is transparent to everyone. In this article, we’ll explain how that works. We’ll avoid technical details, but at the end, we’ll provide some additional resources for the avid reader.
A Blockchain is a Ledger of Information
Let’s start with “blockchain.”
Imagine pages of a ledger recording transactions as a ‘block’ of entries showing who paid whom, when, and how much. Let’s say someone named Alice wants to pay someone named Bob. The ledger might read Alice’s account transferred to Bob’s account a total of $10 USD at 9:00 UTC May 1, 2016. The next entry might read Bob’s account transferred to Carla’s account a total of $5 USD at 9:014 UTC on May 1, 2016. And so on, until the page of the ledger is full, and you turn to start on the next page. Each of these pages laid in sequence on the ground would form a ‘chain’ of ‘blocks.’
Together, they are a complete ledger – a blockchain. If we wanted to know the balance of Alice’s account, we would add up all of the incoming transactions and subtract the outgoing transactions.
At the most straightforward and fundamental level, a blockchain is a digital ledger connected to a network of people who are using it.
A Blockchain is a Distributed Ledger
One challenge with a normal digital ledger is that someone has to store and maintain it, and both Alice and Bob would need to trust whoever maintained it.
This is how it works today with banks: central services maintain digital databases of account balances and transactions that change those balances. They are supposed to make sure records are accurate and that whoever wants to send money from Alice’s account is actually Alice. Banks can make mistakes, fail to detect fraud, or manipulate records, and a very complex system of oversight exists to prevent this from happening.
A blockchain, in contrast, is a digital ledger shared by people in the network. There are multiple copies, even among people who don’t trust each other. Whenever someone makes a transaction, they send it to everyone in the network who is maintaining a copy of the ledger. For the sake of this discussion, we will call them ‘ledger holders’ [note: this function exists in all blockchains, but it called different things in different blockchains] The ledger holders receive transactions, package them into a new page in the ledger (a block), and send the updated ledger to the network.
A Blockchain is a Secure Distributed Ledger
One security challenge with a distributed digital ledger is that all versions among the ledger holders need to be the same and users need to trust that the version hasn’t been tampered with.
A blockchain addresses these problems through some clever uses of cryptography to create a digital ledger that can’t be retroactively changed and is easily verifiable. Whenever a miner sends around a new version of the ledger, all other miners can make sure the information it contains is accurate.
Each page in the ledger (block in the blockchain) gets turned into a random (but unique) sequence of information called a “hash.” Changing one piece of information on that page will result in another random (but unique) hash. The hash of each page is then included in the next page and goes into creating the next hash. This means trying to change one entry in the ledger from two years ago would result in a new hash for that block, which would then change every additional hash, making it obvious that the new version isn’t the same.
The second security challenge with a distributed blockchain is verifying that whoever tries to spend money actually has the authority to spend it. Is this really Alice?
A blockchain relies on a method of encryption in which Alice has a unique digital signature, and she signs transactions. Without this digital signature, the transaction will be rejected by the ledger holders.
The Blockchain Beyond Cryptocurrencies
Bitcoin was the first use of a blockchain, and many other currencies followed. But currencies aren’t the only use case. Any information can be stored and exchanged. A blockchain is just a secure distributed ledger: this means people who don’t trust each other can meaningfully exchange any information without relying on a trusted third party.
There are many cases in which relying on a trusted third party is either expensive, risky, or impossible.
Here are some examples of other things people are doing with blockchains.
- Digital ledger of land titles (Bitlands)
- Distributed file storage system (Maidsafe, Zeronet)
- Digital ledger of asset ownership (colored coins, colu, other applications of the value web)
- Energy usage (TransActive Grid, Sun Exchange)
The Bitcoin Blockchain
There are a couple features of the blockchain used in Bitcoin that are worth mentioning. They are specific to Bitcoin, but they don’t necessarily apply to all instances of blockchains.
- It is open, so anyone with an internet connection can create ‘accounts’ and start transacting. You don’t have to prove your real-world identity to get ‘let in.’ You don’t need permission.
- It is pseudonymous – you can see different accounts on the network but you don’t really know who owns which account. Alice and Bob probably own many accounts, called “addresses” in Bitcoin.
- The blockchain is secured through competitive mining. All the miners mentioned above (who receive transactions) compete to create new pages in the ledger, and the first who creates a page that meets certain conditions gets rewarded.
Further Reading (more technical content)
- The original Bitcoin paper, which includes some technical details
- Bitcoin developer documentation
- Economist explanation of how blockchains work
- Popular short video of how bitcoin works under the hood