Making Sense of Blockchain
I got a call from my friend, a few Sundays back, and he started asking me about bitcoin and mining. Though I had a vague notion of bitcoins and the technology behind it, I wasn’t familiar with all the terms. As you’ve probably guessed, I wasn’t able to carry out any meaningful discussion on the bitcoin topic. This post is my first attempt at making sense of blockchain, the technology at the heart of digital currency.
Before we dig too deep into blockchain, we need to understand the problem blockchain is trying to solve. Let’s take the example of money transfer where an entity sends an amount of money to a designated recipient through a trusted third party, e.g., Western Union or any bank. In Figure 1, the trusted third party charges a fee of $5 for transferring $100 and takes a couple of days to transfer the funds.
As shown in Figure 2, the blockchain attempts to transfer money by doing away with the third party. In the process, it lowers fees and time (close to real time) to move funds around. The money moved by blockchain is often referred to as digital currency or cryptocurrency or virtual currency. Examples of digital currencies include bitcoin, ether, etc.
Though the idea behind blockchain is not new, bitcoin is the first implementation of blockchain technology by Satoshi Nakamoto.
What is Blockchain?
The broader aim of blockchain is to provide a platform for recording transactions between two parties in an open, efficient, verifiable, and secure manner. In the next few sections, I will go over the basic concepts of blockchain and how it achieves the aforementioned goals.
The blockchain solves the problem of money transfer by introducing the concept of an open ledger. An open ledger keeps track of all money transfers and makes them visible to everyone. Let’s take an example where four parties A, B, C, and D are in a blockchain network. At the beginning, there is a single entry (A = $100) in the ledger where A has $100. The first entry in the ledger is called the genesis entry. In plain English, genesis means start or origin.
A new entry (A → B = $30) is made in the ledger when A transfers $30 to B. This new transaction is not only recorded but also linked with the previous transaction (A = $100). Another entry (B → C = $20) is recorded in the ledger when B transfers $20 to C. Similarly, the new transaction (B → C = $20) is linked with the previous transaction (A → B = $30).
Now if you look at Figure 3(c) again, you will notice the open ledger is just a chain of transactions visible to every node in the blockchain network. Every node knows the balance of every node, i.e., how much digital currency each node has. They can also determine the validity of a transaction. Let’s take the case where C tries to transfer $40 to D. Everyone in the network would immediately know from the open ledger that the new transaction (C → D = $40) is invalid since C has insufficient funds. The invalid transaction will be rejected right away and will not be entered in the open ledger.
Distributed Open Ledger
You will notice a centralized ledger if you refer to Figure 3. However, a blockchain’s goal is a decentralized open ledger in order to remove any single point of failure and also to do away with any central authority (big brother). The blockchain achieves this goal by distributing copies of the open ledger among participating nodes in the network.
This means, A has a copy of the ledger, B has a copy of the ledger, etc. A distributed ledger removes the need for a centralized ledger. A distributed ledger, however, introduces the added complexity of keeping all the ledgers in sync where all transactions are visible to all the nodes in the blockchain network immediately.
Q. How does a node join a blockchain network?
Any computer (process) that connects to a blockchain network is a node. It’s a peer-to-peer network. A node can leave and rejoin the network at will.
The challenge of keeping nodes in sync is mitigated by advancing the concept of miners. A miner is a special node in a blockchain network which has access to the ledger. Any node can be a potential miner.
Let’s take the earlier example of B transferring $20 to C. The transaction (B → C = $20) is not entered in the distributed open ledger until it’s validated. The blockchain network makes the new transaction available to all its nodes. Miners nodes then compete against each other to be the first one to validate the transaction (B → C = $20) and record it in the ledger. The winning miner is rewarded financially with digital currency while the losing miners get nada.
To validate the transaction (B → C = $20), the winning miner has to first ensure that B has enough funds. The miner has to then find a key that allows it to link the new transaction with the previous transaction (A → B = $30). Finding a key is rather difficult as it’s random and takes a lot of computational power and time.
Once a miner records the transaction, it publishes the result to the network. Once the other nodes see the result, they add the new entry to their own ledgers after verifying the entry. Any tampering of the entry will be rejected. This way a consensus is reached among different nodes about the new ledger entry. Other miners find no incentive in wasting computational resources in recreating the key of this verified transaction. The miners now wait for the next unvalidated transaction and a chance to win digital coins.
To reiterate, a distributed open ledger is replicated across many nodes in a blockchain network. Any new entry in one ledger results in simultaneous updates in other ledgers. A ledger entry is recorded by a miner with the incentive of receiving financial rewards in the form of digital currency. The cost of entering a ledger entry is computationally expensive and is termed proof-of-work or mining.
The concept of a distributed open ledger and miners help make blockchain open, efficient, and verifiable. It also solves the issue of security partially by making all ledger entries permanent. Permanency in the sense that it’ll not be easy for an entity to delete or modify a previously recorded transaction in the ledger.
Q. How’s the permanency of open ledger entry achieved?
Each entry has a hash which can be considered as a fingerprint and is unique to the entry. Each hash depends not only on the data contained in the ledger entry but also on the hash of the previous entry. This makes all ledger entries chronological in order and tamperproof. Any change in a ledger entry will result in redoing the proof-of-work. It will generate a new hash which in turn will have a cascading effect of invalidating subsequent entries’ hash. Since proof-of-work is an expensive process, it makes open ledger virtually immune to modifications.
Another way blockchain provides security is by having a distributed ledger and thus preventing a single entity (think government) from manipulating the ledger.
Q. In our earlier example, how do you prevent B from spending A’s money?
Blockchain takes advantage of asymmetric-key encryption which is also known as public-key encryption. In this type of encryption, there is a public key and a private key. The private key is used to create a digital signature while the public key is used to verify that signature.
In blockchain, each node has a public key and a private key. The public key serves as the address of a node and is visible to everyone. Every ledger entry has a sender address (public key), a receiver address (public key), amount transferred, and a digital signature.
When A wants to transfer funds to B, A computes a signature using its private key and then sends the transfer request. B or anyone else can verify the signature using A’s public key. In order for B to steal A’s money, B has to possess A’s private key. A is vulnerable to theft only if it loses its private key.
Implications of Blockchain
According to “The Truth About Blockchain” article published in the Harvard Business Review, the blockchain can be considered more of a foundational technology. It’s not disruptive in the sense of cell phones replacing landline telephones or the take over of 35mm film cameras by digital cameras. The blockchain technology has the potential to have an enormous effect on societies and economies but the process of adoption will be slow. Beyond cryptocurrency, blockchain can be used in electronic medical records, notary, real estate, etc.
I hope you have a slightly better understanding of blockchain now. I plan to address other aspects of blockchain in my next few postings.