What Is Blockchain and How Does It Work?

Blockchain is the technology that underpins bitcoin and dozens of other cryptocurrencies, and it has a lot of promise outside of digital currencies.

What is blockchain, exactly?

A blockchain is a public digital log of transactions that is impossible to hack or manipulate. Individuals can now transact securely with one another without the need for an intermediary like as a government, bank, or other third party.

Cryptography is used to link the expanding list of records, known as blocks. Each transaction is independently validated, time-stamped, and contributed to a growing chain of data using peer-to-peer computer networks. The info can't be changed once it's been recorded.

While bitcoin, ethereum, and other cryptocurrencies have gained popularity, blockchain technology has potential uses in legal contracts, property sales, medical records, and any other field that requires the authorization and recording of a series of activities or transactions.

What is the mechanism behind blockchain?

Here's how blockchain, also known as distributed ledger technology, works using the Bitcoin system as an example:

Bitcoin transactions are entered and broadcast by a network of powerful computers known as nodes.

Using computer algorithms, this network of thousands of nodes throughout the world competes to confirm the transaction. Bitcoin mining is the term for this. The miner that completes a new block first is rewarded with bitcoin for their efforts. Network fees, which are passed on to the buyer and seller, pay for these benefits. Depending on the volume of transactions, the costs may increase or decrease.

The sale is added to a block on the distributed ledger after it is cryptographically confirmed. In a process known as "proof of work," the majority of the network must next confirm the sale.

The sale is finalised after the block is permanently connected to all prior blocks of bitcoin transactions using a cryptographic fingerprint known as a hash.

The notion of blockchain technology was first mentioned in a dissertation published in 1982 that discussed “the architecture of a distributed computer system that may be built, maintained, and trusted by mutually suspicious groups.” But it was Satoshi Nakamoto's pseudonymous paper "Bitcoin: A Peer-to-Peer Electronic Cash System" from 2008 that put an academic idea into practise.

Pros and cons of blockchain technology

Using bitcoin as an example, here are some of the pros and cons of blockchain technology when applied to cryptocurrencies:

Pros

Decentralization

While the Federal Reserve issues and oversees the US currency, no government entity issues or regulates bitcoin or other cryptocurrencies. This also means that no single government or agency will be able to decide the fate of a public blockchain. The lack of intermediaries lowers costs by eliminating the fees associated with third-party transactions. Another benefit of decentralisation is time efficiency: unlike banks and other intermediaries, the blockchain is open for business 24 hours a day, 365 days a year.

Transparency combined with anonymity

On the Bitcoin blockchain, all transactions are recorded on all computers connected to the network. Because the address and transaction history of Bitcoin wallets, which house the cryptocurrency, are publicly available, transactions are entirely transparent. However, the owners of each wallet connected to those public addresses remain anonymous and are not recorded.

Precision and safety

There is a lesser risk of error because the transaction involves little human involvement. The potential of information being manipulated or altered is eliminated because each transaction must be confirmed by a majority of network nodes and recorded across the whole blockchain. Counterfeiting (sometimes known as the "double-spending" problem) is also prevented.

Beyond cryptocurrencies, blockchain has a wide range of applications.

Blockchain technology has the potential to provide efficiencies that go well beyond digital money. While cryptocurrencies such as bitcoin use a public blockchain, private blockchain networks can be used to generate a variety of corporate applications:

Cons

Crypto is popular with criminals.

Some of the initial users of new technologies, like many others, have been criminal businesses. They use cryptocurrencies like bitcoin as payment as well as to target bitcoin holders for scams because of the secrecy they provide. Customers of Silk Road, a black market online shopping network for illegal narcotics and other unlawful services that was shut down by the FBI in 2013, utilised bitcoin, for example. Colonial Pipeline paid $4.4 million in cryptocurrencies to unlock its computer systems following a recent ransomware attack.

Meanwhile, bitcoin investment fraud has increased in lockstep with the currency's recent record ascent. The Federal Trade Commission estimated that almost 7,000 consumers lost $80 million in quick-return scams between October 2020 and March 2021, a roughly 1,000 percent increase in reported losses year over year.

Cryptocurrencies on the blockchain are extremely volatile.

Cryptocurrency's popularity skyrocketed in 2021, with bitcoin hitting a new high of about $65,000 in April. However, due to its inherent volatility, bitcoin's price had plunged roughly 50% by early June. Bitcoin reached a prior high of nearly $20,000 in December 2017, but it was trading below $3,500 by December 2018.

Cryptocurrency usage is still uncommon.

Many more exchanges, brokerages, and payment apps now sell bitcoin, and many organisations accept bitcoin as payment, including PayPal and Microsoft. Purchases made with blockchain currencies like bitcoin, however, are still the exception rather than the rule. Furthermore, users must pay capital gains taxes on bitcoin sold for purchases on cash apps like PayPal, in addition to any state and local taxes paid on the product or service.

The impact on the environment is under question.

Bitcoin mining is done via a network of high-speed computers that use a lot of energy. According to the University of Cambridge Electricity Consumption Index, if Bitcoin were a country, it would be the 34th largest electricity consumer, after the Netherlands and ahead of the Philippines. Elon Musk, the CEO of Tesla, declared in May that the company would stop accepting bitcoin until it could find solutions to minimise its carbon footprint.

The Bitcoin blockchain is quite sluggish.

The Bitcoin blockchain can handle approximately seven new transactions per second. Visa, on the other hand, claims to be capable of processing 24,000 transactions per second. This creates a scalability issue for the Bitcoin system. This issue is being addressed by other types of blockchain-based cryptocurrencies. Ethereum 2.0, a widely awaited upgrade to the Ethereum system, is predicted to be capable of handling 10,000 transactions per second, up from the present rate of 30 transactions per second.