What Is The Blockchain and How It Works? (BEGINNER GUIDE)

If you’re here, then you’re wondering what is the blockchain. First, I want to give you a high-level overview of blockchain technology. I will not go into esoteric details, but there are a few revolutionary concepts of how blockchains are designed that show us social value proposition. Let’s start by looking at a list of some of the most significant consumer-facing tech companies that exist today. What do they all have in common?

Here’s a hint, Uber the world’s largest taxi company owns no taxis. Facebook, the most popular content provider, writes no content. Alibaba, the world’s most valuable retailer, owns no inventory. And Airbnb the world’s largest accommodations provider owns no rental property.

In 1998 we were told not to get into strangers cars and don’t meet people from the internet. In 2016 we literally summoned strangers from the internet to get in their cars. It’s an entirely different world. The answer is that each one of these companies delivers tremendous value in their respective categories, not by owning physical products but by operating trust networks. Connecting riders with drivers, buyers to sellers and travelers to accommodations.

The blockchain and Identity

Together these intermediaries generate over 1 trillion dollars in value facilitating. Trust is good business, and at the core of each trust network, the most valuable and protected ingredient is Ledgers. Ledgers that record detailed information about us and our transactions; ledgers that confirm ownership identity status and authority. Today our Ledgers exist in the form of complex databases and giant data centers. By owning our data and facilitating our transactions, these central authorities now secure most of our digital livelihood.

illustration of the blockchain with bitcoin's encryption

But what happens when our middlemen aren’t secure with our valuable data like in August 2013 when Yahoo reportedly had all three billion of their user accounts hacked and didn’t fully disclose it for three years? Or more recently last September when Equifax servers were compromised releasing half of the U.S. populations’ personal records into the wild. If a publicly traded, ten billion dollar corporation can’t keep our digital records safe, then who can. And what happens when these middlemen have too much power to manipulate our data subversively?

For example, the administration at a local California Community College was given bribes to change grades. It can be tough to ensure authenticity when the middlemen own the only system of record. Lastly, what happens when these central authorities don’t work in the best interest of the people they serve. That happened in 2008 with the subprime mortgage crisis. The trust networks there were banks and hedge funds driven by poor self-regulation and aggressive loan practices. This ended up requiring a complete bailout of the U.S. financial system, injecting cash right back into the very middlemen that caused a global economic crash in the first place.

Bitcoin in response to economic collapse

Bitcoin was developed as a direct response to this catastrophic event. The world’s first digital currency was not controlled by any central authority, with the goal of putting financial control back into our hands. The issue has always been that whoever controls the ledger has undue power and influence over it. Bitcoin proposes in an era of modern technology, “what if we could have rules without rulers” by placing the ledger directly into the currency itself, while creating a digital currency with transparent, open source software algorithms that do the work of traditional middlemen.

a gold piggy bank for coins

This currency wouldn’t be owned or operated by a single entity, but exists solely as a decentralized peer-to-peer software network where anyone could participate by simply downloading and running an app. Each node would maintain a copy of the same global ledger issuing and managing transactions via intelligent group consensus algorithms. Designed with open source software, no one knew at the time but this distributed ledger technology, the backbone of our first digital currency, would come to be known as the blockchain.

What started as a grand experiment in 2009 has grown into the world’s largest bank with no physical cash, and with a market cap of over 200 billion dollars today to put that into perspective. That’s two times the market cap of BOA, Uber, and Airbnb combined. And even more substantial than Goldman Sachs, effectively making Bitcoin tied as a 4th largest financial institution in the United States.

top 5 cryptocurrencies by Market Cap in 2018
Other than Bitcoin and Ethereum, cryptocurrencies often change position.

It’s no wonder Jamie Dimon CEO of JPMorgan Chase called it a fraud last September. It’s like asking a taxi driver what they think of self-driving cars. Bitcoin and its underlying technology are changing what’s now possible in the financial industry, and whether the existing financial middlemen like it or not. And unlike the other entities, Bitcoin has no need to make a profit. But despite the almost ubiquitous buzz about Bitcoin today, it wasn’t an overnight success. Bitcoin had gradually risen from 5 cents a coin in 2009 to over $10,000 per coin today with an all-time high of $20,000 late last year. Every step of the way from 10 cents in 2009 to 10 dollars in 2010 to $10,000 today. Pundants and traditional financial experts have been predicting bitcoins demise despite threats from both governments and hackers alike.

Bitcoin births the blockchain revolution

Bitcoin and its ledger technology have successfully secured billions of dollars of digital value for almost a decade without fail. And one even strong-armed communist governments failed to stamp out this new democratic technology within their country. It’s beginning to earn the respect of even some of its fiercest opponents. Last year, even Jamie Dimon publicly stated that he regrets calling Bitcoin a fraud and says he believes in the technology behind it. This nearly decade-long success has proven Bitcoin’s ledger technology works spurring the creation of an entire new blockchain industry.

Supported by hundreds of new blockchain based digital currencies, these new coins dubbed cryptocurrencies have names like Ethereum, Ripple, and Neo. And all of the cryptocurrencies are running their own public blockchains. They contribute to a new decentralized token commodity market with a market cap of over five hundred billion dollars today and is expected to exceed one trillion dollars very soon.

These cryptocurrencies built on Bitcoin’s foundation offer new innovations that are taking blockchain technology to the next level. Like Ripple, a cryptocurrency platform that the Gates Foundation’s Financial Services for The Poor has recently partnered with. Gates uses Ripple’s open source technology to level the economic playing field for the two billion people globally who are trapped in poverty without access to a bank account or other basic financial services. Unlike traditional banks, Ripple enables secure global and nearly instant financial transactions at close-to-zero cost thanks to its blockchain technology. Ripple also provides trusted payment gateways without the need for a bank allowing any organization or person to act as their own payment gateway.

And financial applications for cryptocurrencies are just the tip of the iceberg. These new blockchain networks offer compelling new ways of rethinking not only fiat currency systems, but ownership governance, corruption, and censorship. Bitcoin is the originator of all these blockchain potentials.

So, what is the blockchain and why it matters

And before we dive further into specifics, we really need to answer the big question. What is the blockchain, how does it actually work, how is it doing something new that we haven’t already done before? To understand blockchain technology it first helps to understand the philosophy of what it’s trying to achieve. It’s trying to accomplish a social value proposition which is incorruptible and can be a transparent system of record in a digital world where it’s been traditionally impossible to do so. As we’ve noticed, having centralized gatekeepers responsible for our operations of records in any and all systems create the potential for insecurity and corruption. Our “trust failures” that exist today are often at the most basic level the blockchain. These set out to develop a new paradigm of trust, blockchains can replace traditional trust with cryptographic proof and group consensus.

It’s based on three simple tenants that are easy to understand. The first is that there’s no alchemy. Nothing on the blockchain can be produced out of thin air or faked, including the currency that powers the system. There is always transparent proof or transactional evidence of why and how a record was produced to know if it was altered. As a tamper-proof system, the blockchain is designed to be an immutable system of record. That means records can only be added, never modified or deleted. And third no impersonation blockchains are designed to be trusted, but always verify.

Blockchain encryption

This technology uses cryptography as its form of encryption so that you are who you say you are and nobody can impersonate you even if your account is anonymous. With those concepts in mind, the blockchain in its simplest form is an ever-expanding transactional ledger. It’s a global ledger full of everyone’s transactions on the network. Since the beginning of time, anyone running the software can see this ledger. But that doesn’t mean there’s no privacy.

the blockchain cannot be hacked as represented by this Skull and crossbones made of 1's and 0's
The Blockchain cannot be hacked.

For example, in Bitcoin’s blockchain ledger we don’t see people’s full names but transactions from one digital wallet address to another. The transactions then become public record, but the wallet addresses are essentially anonymous.

Blockchain guarantees against fraud

But here’s where things get really interesting. Newer block chains take things a bit further than Bitcoin. As blockchains can store more than just payment transactions, they can record transactions for anything of value from land and home titles, medical records, school transcripts to grades, and learning progress because ledgers are immutable. It ensures a particular home can only be owned by one person, that a student can’t change their grades, or a person can’t vote twice. This doesn’t prevent updates if a grade needs to be replaced for example. Then a new transaction is added to the bottom of the ledger with a new timestamp that the old grades still exist for record-keeping at this point.

You might ask how we can guarantee that entries haven’t been changed or hacked discreetly? That’s where a key part of the blockchain architecture comes into play, tamper-proof design. A tamper-proof design so smart that the technology is named after it. Transactions are never actually recorded directly to the ledger but are first bundled into a block of transactions on a set interval. These blocks are given a block ID that is an encrypted digital fingerprint of the contents of that block. In computer science terms this is known as a hash.

Fingerprint representation with a 1's and 0's to show encryption of the blockchain
A node on the blockchain is as unique as a fingerprint.

This means that if the contents of the block ever changed even by a single letter, its unique ID will also change letting the network know that this block was modified. But what prevents someone from just deleting the whole block or sneaking in their own block? The blockchain also addresses this by making the ID of every block not just a hash of its own content but also mixes in the ID of the previous block that came right before it. This means if someone were to try to modify an old transaction, delete an entire block of transactions, or even insert a fake block of made-up transactions it would break the fingerprint relationship it has with its own preceding blocks.

This chain of tamper-proof digital fingerprints is where the “chain” in blockchain comes from. Zooming out back to the decentralized peer-to-peer network aspect of the blockchain network, the ledger we just talked about doesn’t just exist on one machine, but it’s identical across every computer running the blockchain software. Each node receives new transactions at the same time ensuring the ledger is always available, and when a new block of transactions needs to be processed, every computer on the network verifies it independently through its own historical blockchain. This ensures no node is required to trust any other node. This is how we can maintain trust. Any Network powered by strangers any node that doesn’t come up with the same majority consensus as everyone else gets pushed out of the network. This keeps nefarious hackers out of the system.

Cryptocurrency mining layer in the blockchain

There’s just one last key component to this blockchain ecosystem. To help complete the loop, every time a new blockchain of transactions is created it needs a secure hash ID which we talked about earlier. The first node in the network to compute the hash ID is awarded newly minted digital tokens by the network. This process is called cryptocurrency mining from its similarity to mining actual minerals out of the ground. A node gets rewarded for its time and energy doing valuable work by receiving an asset of value.

This makes cryptocurrency a critical component for public blockchains. It’s the incentive that drives people to host a node and mine blocks not just as a volunteer but for personal profit. The act of mining helps secure block chains because it’s computationally very hard to do this. This is intentional so that no single computer is strong enough to mine every block first. A whole global network of computers in direct competition mining also gives the system a fair and limiting way of distributing its digital coins. This means every coin in circulation today came from someone who mined that coin. Mining creates the final incentive loop that keeps the blockchain well adopted and running.

The concepts we’ve used to describe the blockchain so far are simplified. They give us enough of a solid understanding of this technology to get us to the real value. But let’s look at the father, Bitcoin.

in 2010 a forum user claimed to have bought two pizzas with 10,000 Bitcoins
They’re probably crying now.

Ethereum: the next iteration of Bitcoin’s blockchain

Bitcoin was created in 1999 and gave us the whole concept of the blockchain and its ability to decentralize trust on the Internet. Though people are still doing notable things with the Bitcoin blockchain, even verifying college transcripts on it, it really wasn’t built for more than managing its own digital currency. Though bitcoin is still the most well-known cryptocurrency and largest by market cap, Bitcoin can now be considered the beginning of blockchain today. Ethereum is the second largest cryptocurrency platform after Bitcoin. With around a hundred billion dollar market cap when it came out in 2015. With even larger aspirations than Bitcoin, Ethereum introduced a blockchain with a vision to move past being a world ledger to being a world computer. It does this by introducing the concept of smart contracts.

What are smart contracts?

Smart contracts are powerful self-executing custom lines of computer code that handle the enforcement, management performance, and payments of contracts between people and companies. Ethereum introduced the concept of hosting entire applications called decentralized apps or daps on the blockchain. By way of these smart contracts, its blockchain is essentially a blockchain based distributed computing platform. There are now over a thousand Etherium daps to date though most are early prototypes and experiments. Ethereum functions like a decentralized app store where anyone can publish applications directly to the blockchain bypassing proprietary software distribution channels like Apple, Google, Microsoft, and their subsequent restrictions licensing and fees.

For example, imagine a decentralized Twitter that’s resistant to censorship. Or the ultimate open source education platform that is free from corporate ownership and influence. The apps are typically open-source and operate autonomously. They can’t be taken down or censored as they exist across an entire global public blockchain network not on a centralized server.

Some examples of the power of blockchain technology

The Brave Browser is an example of another feature that makes Ethereum unique. The ability to make application specific tokens on its blockchain that means Brave doesn’t have to set up and manage its own separate blockchain network but piggyback on Ethereum’s instead. Brave is a web browser with an alternative advertising model. It works by tracking and paying users further ad watching in cryptocurrency. The browser awards users in its own currency called the Basic Attention Token or BAT coin. In Braves ecosystem, the bat token is used as a unit of account between advertisers, publishers, and users. Brave was created by Brendan Eich, former Mozilla CEO and creator of the JavaScript programming language.

File Coin (FIL) is a great example of how the buying, earning, and spending of a utility token can help regulate an incentive-based ecosystem from within a platform. File coin is a decentralized data storage network. Think of it as a peer-to-peer Dropbox. As well as the name of its actual currency, anyone can earn File Coins by running software to automatically rent out this space on their computer. Other users can utilize the service by buying and spending File Coin to host their files. This relationship allows anyone to make money from their free hard drive space while also giving other users who need it a way cheaper alternative to Dropbox.

Everipedia is a great example of a cryptocurrency used as an incentive-based solution to a problem with existing applications. They’ve been developing a new take on Wikipedia that solves two main problems. For instance, articles are created by unpaid volunteers which leads to the quality of Wikipedia’s content varying wildly. Everipedia uses tokes called IQ, and good content editors use these IQ tokens to submit articles and edits for more tokens. These tokens can be redeemed for Bitcoin or other cryptocurrencies at any time if the article is approved by fellow editors in good standing. The user gets awarded more IQ tokens as her reputation improves. If the article or edit is rejected by her peers, the editor loses her submission token and eventually can’t submit any more articles unless he buys more. In this way, Everipedia ensures that editors are shareholders of the platform.

Larry Sanger, the co-founder of Wikipedia, liked the concept so much that he joined the company as CIO. These are just two examples out of a sea of new token-based applications, though most are still experimental. It’s important to note that outside of their use in creating sustainable ecosystems within blockchain applications these utility tokens have had a tremendous impact in the startup space.

From the Blockchain to Initial Coin Offerings

In another way by revolutionizing the model for how startups are funded and bootstrapped, this new form of bootstrapping involves startups pre-mining an allotment of tokens and selling them to the public in a process called a crowd sale. This is done via a pre-launch offering period called an initial coin offering or ICO. Though these tokens are meant to pay for access and usage of the future blockchain service, they are generally sold at a fraction of their potential future value so are picked up by investors as an indirect means of investing in the company. In this way, blockchain startups can raise funds in a decentralized manner without the need for traditional venture capital. This is yet another novel idea introduced by the blockchain.

Here’s a great video explaining the pros and cons of Initial Coin Offerings:

 

Solving the startup bootstrap problem via the token economy, ICOs exploded in popularity in 2017 with token sales rising over a billion dollars globally by last September. That’s more than the equivalent venture capital funding during the same period. Though this has caused a rapid, growing pool of low quality and fraudulent coin sales, and with regulation still murky, most tokens still aren’t considered securities by the SEC. Despite the controversy, many people in the blockchain community think that ICOs are a long-awaited solution for nonprofit foundations to raise capital, especially if they want to build open source software. ICOs are a new way to fund shared infrastructure projects that couldn’t easily be funded before.

For example, Ethereum itself raised 18 million dollars in its original 2014 crowd sale, the largest ever at the time. Brave Browser generated 35 million dollars for its BAT ICO in May in about 30 seconds compared to the 7 million dollars it’s raised using traditional venture funding. Some experts believe that this tokenize economy will be a major component of our decentralized future and even old global brands are starting to reinvent themselves using ICOs.

The white paper details the commercial technological and financial details of the project and coin offering. It lists everything from the problem it is addressing to the vision of the team, its budget allocation, and how its tokens will be used internally and how a token will be distributed. Simply, a white paper put everything you need to know about the currency before making your mind up on if you want to invest purchase or use it. The white paper is a cornerstone of diligence, but investors look at many other clues of quality blockchain investments, too.

Some projects die, others get stalled for months and years, and some were just never good, to begin with. One big question is, is it really a smart blockchain and cryptocurrency project with a real reason for a cryptocurrency or is it just creating an ICO for quick money? Other obvious questions include is there a strong team with a proven track record a solid working product or proof-of-concept and active GitHub repository to back it up. What about social media brand presence and following? Is the outline market cap and amount of funds being collected realistic for the product being developed? These are the same general concepts as investing in any standard startup.

What are Private Blockchain Networks?

Let’s talk about private blockchain networks. These run more traditionally on paid cloud servers that avoid the need for volunteer peer-to-peer networks and cryptocurrency. These platforms defer on the more rigid tenants of block chains decentralized security principles but are optimized for corporate use and have started to get some major adoption. Most commonly these take the form of blockchain as-a-service cloud platforms hosted by our tech giants like Microsoft, Oracle, and IBM. These platforms make it easy for organizations and even governments to set up trusted private blockchain networks supporting diverse use cases in industries from finance, healthcare, support chain rights management, to government insurance. And often handhold their customers through the entire process. Today the enterprise market leader is IBM’s blockchain for business platform. It took three years to develop and is set to employ 1,500 employees. IBM’s blockchain is built on top of hyper ledger fabric an open source collaboration version of block chains focused on business-oriented use cases not cryptocurrencies.

IBM’s Hyper Ledger is an active repository of these open-source blockchain platforms. It was created in 2015 by the Linux Foundation with member contributions and guidance from everyone from IBM and Cisco to JP Morgan, Wells Fargo, and Accenture. IBM has many high-profile partnerships that are showing off not only what is possible but what is actually being implemented and tested by active pilots. For example, IBM’s blockchain platform is working with the US Food and Drug Administration and the Center for Disease Control who are exploring the use of blockchain for the secure storage and exchange of electronic medical records. IBM is also working with the government of Dubai to increase safety and efficiency of cross-agency data sharing.

As an aside, Dubai has set itself a goal of becoming the world’s first blockchain powered government to utilize the technology for all transactions by 2020.

143 million social security numbers were compromised by the Equifax hack. It put the spotlight on the fact that Americans national identity system is untenable. Digital identity is another area where blockchain can help. IBM is partnering with Secure Key Technologies to build the first-ever digital identity network in Canada. The network will be designed to make it easier for consumers to verify they are who they say they are in a privacy-enhanced, security-rich and efficient way.

Consumers can use a network to instantly verify their identity for services such as new bank accounts, driver’s license, or utilities. IBM has even partnered with Walmart who is spearheading a blockchain-based food safety initiative. They are working on using blockchain to improve transparency and traceability in their food supply chain along with nine food giants including Unilever, Nestle, and Dole. Using the blockchain, they’re working on revamping the way their data is managed across a complex network of farmers, brokers, distributors, processors, and retailers. Their goal is to cut investigations into foodborne illnesses like last summer’s fatal salmonella outbreak from weeks down to seconds.

Along with streamlining food safety, IBM experts believe we may even see these systems marketed similarly on food labels improving customer confidence in what they buy with a blockchain non-GMO USDA organic or Fairtrade coffee. These could be backed by an instant reinsurance of a blockchain logo certifying provenance.

IBM’s blockchain supports smart contracts – they’re actively used in their partnership with Maersk, the world’s largest shipping firm. In March, Maersk completed its first pilot to track its cargo on the blockchain. A study conducted by Maersk in 2014 showed that on average about 30 organizations are involved in the shipment of a product resulting in over 200 separate interactions. By moving the expensive, time-consuming paperwork for each transaction to a blockchain-based smart contract system, they plan to cut shipping fraud and save costs. The critical thing is that the entire process from when the purchase order is made all the way to when goods are delivered are captured as smart contracts on the blockchain. IBM has a goal of capturing data on as many as 10 million containers by the end of 2017.

Conclusion and future of the blockchain

Bitcoin as is Ethereum have shown us things we considered impossible before. But the wave of innovation is still quite early for blockchain technology which just like cryptocurrency itself is just now entering mainstream consciousness. Through all of this, we must remember that Google wasn’t the first search engine and Facebook wasn’t the first social media network. We will see success and failures as cryptocurrencies and the blockchain advance forward with new synergies into other existing technologies. Only one thing is for certain, the blockchain is quickly becoming a permanent part of our future though no technology is a silver bullet the revolutionary concepts and enthusiasm now behind this technology are on the cusp.

Image art credit: Ahmed
Video source: Initial Coin Offering: Cutting Through The Bullshit – YouTube

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