What Is The Blockchain?

Here’s everything you need to know about the blockchain and how it works.

By
&
Tom Blackstone
Gabe TurnerChief Editor
Last Updated on Jun 2, 2022
By Tom Blackstone & Gabe Turner on Jun 2, 2022
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If you’re interested in tech investing at all, you’ve probably heard of the blockchain by now. For many years, the blockchain has been touted as the next big thing in tech, along with machine learning, quantum computing, artificial intelligence, Internet of Things, and other much-hyped tech phrases.

But what exactly is the blockchain? Everyone knows that it has something to do with Bitcoin. But we also hear that it has something to do with keeping track of birth certificates, deeds, and other records,1 which doesn’t seem to be what Bitcoin does. So you may wonder why there are so many conflicting statements over what blockchain actually does.

In this article, I’m going to explain what a blockchain is and how it works. I’ll go over what makes a blockchain different from a traditional database, what blockchains can be used for, their advantages and disadvantages, and more.

Let’s start with a basic definition.

What Is a Blockchain?

According to IBM, “Blockchain is a shared, immutable ledger that facilitates the process of recording transactions and tracking assets in a business network.”2

A blockchain is a “database.” Some examples of databases you probably use are things like Netflix’s list of movies available in the U.S., your friend’s Twitter feed, or the McDonald’s menu in the DoorDash app.

But a blockchain is different from these traditional databases. As mentioned, it is “distributed” and “shared among the nodes of a computer network.” In contrast, Netflix’s list of movies is centralized. If Netflix’s servers go down, there is no way to stream movies from it. There are no extra copies of Netflix’s catalog on any alternative servers (at least not legal ones).

But if one server on a blockchain network goes down, there are hundreds or even thousands of other copies of the database on computers all over the world. So there are no “outages” for blockchain networks. They are always available.

So that’s what a blockchain is. It’s a database that is distributed across a computer network.

In the next section, I’ll explain how a blockchain works.

FYI: The latest tech trend is to put metaverse items on the blockchain. You can read all about it in my analysis of Crypto in the Metaverse.

How a Blockchain Works

You might wonder how a blockchain can work. If the database is distributed across the network, this means there is no central authority controlling it. But then, how do the servers always agree with each other?

Here is how it works.

How to use a blockchain network

On a blockchain network, users don’t have usernames or passwords, and there is no “login” process. Instead, if you want to post a message to the network, you use a piece of software called a “wallet” to prove who you are.

Let’s say you are creating an account on a blockchain version of Twitter. You post a photo of yourself and announce your name. All of this information is associated with your wallet address, which operates like an “account number” on the network.

This address is tied to a string of characters stored on your PC called a “private key.”

When you want to post a message, you type your message, and hit “post.” Your wallet displays a confirmation box, and you press “confirm.” Once you do this, your wallet uses this private key to produce a signature proving you are the owner of the account.

The servers on the network check this signature to make sure it’s correct. Since you really are posting to your own account, the message is posted.

FYI: This is a very brief explanation of how the process works. If you want more detail, be sure to check out my blockchain users’ guide to cryptography.

If another person tries to use your account without your permission, all of the servers will reject the message because it doesn’t have a valid signature.

But servers can sometimes disagree as to which message came first and which came second. So here is how they agree on the order of messages.

How servers agree on message order

Each server queries all of the other computers on the network. When it sees a transaction, it bundles it into a group called a “block.” A block can only carry a certain amount of data. When the block gets full, the server tries to get everyone else to agree that this block should be added to the database.

Did You Know: A “block” is a group of transactions. When a block is added to the database, it contains a hash that refers to the previous block. Because each block refers to the one before it, this forms a “chain,” linking the blocks together. This is where the “blockchain” gets its name.

Each server has a different, unique block that it wants to add to the database. But only one block can be added at a time.

So how does the network decide which block gets added first?

Different networks have different systems for solving this problem. Some networks make the servers solve a complicated mathematical problem. Whoever solves the problem first gets its block added to the database. This is called “Proof of Work.”

Bitcoin, Litecoin, and Dogecoin are examples of Proof of Work networks.

Other networks choose the block randomly, but the probability of a server getting its block added is higher if it owns more cryptocurrency than the other servers. This is called “Proof of Stake.”

Binance Smart Chain, Cardano, and Avalanche are examples of Proof of Stake networks.

Regardless of which type of network it is, only one block gets added at a time. And all of the servers agree on which block is to be added. All of the servers who didn’t get chosen (who didn’t get their block added) discard their messages and start over.

Messages that haven’t been confirmed yet may end up in the next block that gets added.

So that’s how a blockchain works.

When most people think of blockchains, they imagine public networks like Bitcoin or Ethereum. But not all blockchains are public. In the next section, I’ll go over the three different types of blockchains.

Types of Blockchains

There are three different types of blockchains: public, private, and consortium. All of these have different benefits and disadvantages.

Public blockchain

A public blockchain is the kind most people are familiar with. On a public blockchain, any person can run a server, and every piece of data in the database is completely public. There is no authority that can decide who is allowed to run a server and who isn’t, and there is no such thing as private information.

Public blockchains are best used for applications where privacy is not important. You probably don’t want your family photos or your instant messaging conversations stored on a public blockchain. But maybe you’re OK with your Twitter messages or YouTube comments being stored on it, since these are public anyway.

Public blockchains try to allow for some privacy by letting you use a pseudonym. For example, you don’t have to associate your real name or an actual photo of yourself with your wallet address. You can use a fake name or just use your address itself as your identity.

But in order to maintain your privacy this way, you’ll need to ruthlessly avoid revealing any identifying information while using this wallet address.

FYI: Bitcoin and Ethereum are the two largest public blockchain networks. But there are some other great crypto networks you may not have heard about. We’ve published a list of the best crypto networks to explain the benefits and disadvantages of each.

The bottom line is that public blockchains are great for situations where you don’t need to post private, identifying information; for everything else, you need a private or consortium blockchain.

Private blockchain

On a private blockchain network, some central company or individual controls all of the servers. However, copies of the database are stored by multiple computers spread out geographically, and users connect to it through a wallet instead of logging in with a username and password.

Private blockchains can be much more secure than traditional databases. They don’t require you to log in with a password that can be stolen by hackers.

FYI: Blockchain accounts can still be hacked if you don’t practice the right security habits. I’ve written a beginner’s guide to blockchain wallets to give some tips on how to protect an account.

Private blockchains are also great for storing private data that’s associated with your identity, since this information isn’t revealed in a public block explorer the way it would be on a public network.

The one big flaw in a private blockchain is that the owner of the network can alter the data without your permission, since the owner physically controls all of the servers. So a private blockchain is only useful if you trust the owner not to do this.

The Linux Foundation’s Hyperledger is an example of a private blockchain. Many governments have also considered using private blockchains to create national currencies, including the U.S. government3 and the Chinese government.4

Consortium blockchain

On a consortium blockchain, there is a small group of individuals or companies that are allowed to run servers. This solution is usually offered when there are multiple companies that are party to a business deal, and they don’t completely trust each other.

Facebook’s proposed Libra blockchain was an example of a consortium blockchain. Had it launched, Facebook, PayPal, Visa, Mastercard, Uber, and other companies would have run its servers. If any one participant had tried to falsify data in the database, it would have been caught by the other participants.

Consortium blockchains can sometimes offer advantages over both private and public blockchains. It can allow for private information to be stored, but without completely trusting in one authority.

Now that we’ve gone over what kind of blockchains there are and how they work, let’s consider what they can be used for.

What Blockchain Is Used For

Blockchain can be used for any application where security is extremely important. Most blockchain apps today run on public networks like Ethereum.

A few applications that exist today include:

  • U.S. dollar-backed tokens or “stablecoins” that you can send to others without needing a debit card or bank account (US Dollar Coin, US Dollar Tether, PAX USD)
  • Gold-backed tokens that can be sent using a wallet (PAX Gold, Digix Gold Token)
  • Cryptocurrency exchanges (Uniswap, SushiSwap, PancakeSwap, ViperSwap, TraderJoe.xyz)
  • Lending platforms (Curve Finance, Compound Finance, Tranquil Finance)
  • Yield-maximizing bots (Yearn Finance)
  • Digital art collectibles (Bored Ape Yacht Club, CryptoPunks)
  • Video game items (Gods Unchained, Axie Infinity)
  • NFT marketplaces, where you can trade digital art and video game items (OpenSea, Rarible, Mintable)

The blockchains we have today aren’t capable of storing large amounts of data. But new innovations like the Aleph Network may fix this problem soon.5

Once data storage gets easier, we may see applications like these:

  • Social media sites that can’t be censored
  • Low-cost freelancing sites that match up remote workers with short-term jobs
  • Low-cost ride-sharing services and food delivery services
  • Streaming-video and music sites that allow people to trade ownership of movies and music

These are all applications that are right around the corner.

But what about birth certificates and deed storage on a blockchain? Is that a real thing?

We will need big advancements in the field of private and consortium blockchains to make these possible. They require extreme levels of privacy, and it’s not clear yet that blockchain gives these applications advantages that are better than what we already have from centralized systems.6

Pro Tip: One of the biggest uses for blockchains right now is decentralized finance (DeFi). It often allows savers to earn much higher yields than traditional financial apps do. If you want to learn more, be sure to check out our beginner’s guide to DeFi.

So we’ll probably have to wait a while for these more exotic applications of the blockchain, which may never be developed. But there are still plenty of things we can use blockchains for right now.

Now that we’ve covered how the blockchain works and what it can be used for, you may still wonder what this has to do with Bitcoin. I’ll explain that in the next section.

Bitcoin Blockchain

Bitcoin was the first blockchain network. It records the balances of every Bitcoin wallet address, and it keeps track of each transaction that happens on the network.

A “bitcoin” is a digital asset created by burning electricity in a process called “mining.” In the beginning, each bitcoin cost less than a penny to produce. But the software is designed to make the cost of production increase as more computers attempt to mine it. Over the past 14 years, Bitcoin mining has become wildly popular, and the cost of producing it has risen to over $30,000 per coin. The price has gone up just as much, making many early miners and collectors rich.

Bitcoin was officially designed as a new currency and payment platform. Users can send Bitcoin from one person to another using a wallet. There is no login process on the network. There is also no central server. So it has all of the characteristics we now recognize as being a “blockchain.”

Pro Tip: Many scammers will try to take advantage of new Bitcoin users. We’ve published this complete guide to investing in crypto safely to explain how to protect crypto assets.

Aside from Bitcoin, Ethereum is the other blockchain network that nearly everyone has heard about. I’ll explain how it works next.

Ethereum Blockchain

In 2014, a bunch of programmers who were fans of Bitcoin became unhappy with the fact that users couldn’t program loops on it. So they created a separate network called Ethereum.

Like Bitcoin, Ethereum has no login process and no central server. Users connect to the network with a wallet. So it’s a blockchain, just like Bitcoin.

But the main difference between the two is that Ethereum has a turing-complete programming language called “Solidity.” Developers can program loops in Solidity, which means that most of the apps we are familiar with can be made to run on Ethereum.

FYI: A “turing-complete” programming language is a language that can find the answer to any logical problem. Most of the apps we are familiar with (Facebook, Twitter, YouTube, etc.) are written in Turing-complete languages like PHP, C++, Ruby on Rails, or Python.

So that’s what blockchain is, how it got started, and where it is headed now.

Wrapping Up

Blockchains are still in an early stage of development. The two biggest networks, Bitcoin and Ethereum, can each only process about 1.3 million transactions per day.7 And each block only holds around 1 MB of data.

Compare this to Twitter, which does billions of transactions per day, or YouTube, which can store files that are over 200 gigabytes.

Because of these storage and throughput constraints, the kind of apps that can be put on a blockchain are pretty limited right now. It mostly consists of crypto exchanges or financial apps like Compound and Curve.

But as these technical limitations are overcome, we may see a greater variety of blockchain apps. For example, we may see apps that allow users to send text messages, post images, and do other non-financial tasks.

At that point, blockchain will have gone mainstream, and everyone will know what it is. But in the meantime, before it becomes “cool,” you can use this article to understand what a blockchain is and how it works.

Citations
  1. New York Post. (2022, May 16). Eric Adams: Using blockchain for birth certificates, deeds ‘way of the future’.
    nypost.com/2022/05/16/eric-adams-blockchain-for-birth-certificates-way-of-the-future/

  2. IBM. What is blockchain technology?
    ibm.com/topics/what-is-blockchain

  3. Federal Reserve. (2022, May 23). Central Bank Digital Currency (CBDC).
    federalreserve.gov/central-bank-digital-currency.htm

  4. Atlantic Council. (2022, Mar 1). A Report Card on China’s Central Bank Digital Currency: the e-CNY.
    atlanticcouncil.org/blogs/econographics/a-report-card-on-chinas-central-bank-digital-currency-the-e-cny/

  5. CoinDesk. (2022, Jan 20). A Report Card on China’s Central Bank Digital Currency: the e-CNY.
    coindesk.com/business/2022/01/20/alephim-raises-10m-to-compete-with-amazons-storage-and-computing-service/

  6. Blake Hall. (2017, Jul 6). 5 Identity Problems Blockchain Doesn’t Solve.
    blake-hall.medium.com/5-identity-problems-blockchain-doesnt-solve-ed4badb94398

  7. YCharts. (2022). Ethereum Transactions Per Day.
    ycharts.com/indicators/ethereum_transactions_per_day