Blockchain

This section will give you a very basic understanding of what a Blockchain is and how it works. With that understanding, you will be able to explain why Blockchain technology is important, how it works, and why it is needed to enable the use of Cryptocurrencies. You will also learn simply about the terminology and the required participants to keep a blockchain alive. If you want to understand in detail how the technology behind a Blockchain works, then please move on to the advanced section and read the article 'Technical functionality of a Blockchain'.

Key takeaways

The Blockchain contains unchangeable data
All transactions are transparent and comprehensible for everyone
Data is saved decentralized and is packed into blocks
The blocks are encoded
Blocks are attached one after another
Every block is pointing on the previous block

What is Blockchain?

Blockchain is a technology that allows the use of Cryptocurrencies. The main idea behind Blockchain technology is to manage data in a consensus. That means, that there is no central instance needed like an institution or a company that manages the data. Instead, the data is managed by a group of participants, who commit to verify data if they are right and reject data if it contains errors. That method makes the Blockchain a decentralized infrastructure. The main characteristics of a Blockchain are:

It contains unchangeable data
The transactions are transparent and comprehensible for everyone
The data is saved decentralized

How does Blockchain work?

All data that is added to the Blockchain follows a three-step process:

Data are packed into blocks
Blocks are encoded
Blocks are attached one after another

At first, a certain amount of data has to be collected and then it has to be packed into a block. Let's say we know ten people who transferred Bitcoin to other parties. As an example we would have data of ten people who send Bitcoin, we would also have information about ten people receiving the Bitcoin and we would have information about the amount of Bitcoin that is transferred. All this data is collected and packed into one block. Every new block that is created in a Blockchain is attached to the previous block. That's where the Blockchain has its name from. The first block in a Blockchain is called a genesis block and it is a special block because the data in the genesis- block can not be traced. All blocks that follow can be traced and verified by the previous block because the blocks reference each other. One block always points to the previous block by containing an encrypted form of its data. The only exception is the first block and that's why it is called the genesis-block.

The Blockchain can only work as a decentralized system because it is not saved centralized but instead, every participant of the blockchain has a copy of it on his computer. Each participant that offers computing power to keep the Blockchain alive is called a node. Whenever something is changed on the Blockchain, it does not only have to be changed once but it has to be changed on every copy of every node. That is what makes the Blockchain secure because if someone wants to manipulate data on the blockchain, it has to be manipulated on every node that contains a copy of the Blockchain. And because each block references the previous block, not only one block has to be manipulated on each node but also all the blocks that are following.

Now that we know how it works that the Blockchain can work as a decentralized system and why it is safe from manipulation, let's take a closer look at how the block attachment works. As mentioned before, the consensus mechanism is a central part of the Blockchain and it means that, before a block can be added to the Blockchain, it has to be decided which of the nodes is allowed to add a new block to the Blockchain. Every node is competing on who is allowed to add the next block to the Blockchain and that is because whoever adds a new block will be rewarded. On the Bitcoin Blockchain, you will be rewarded with Bitcoin if you add a new block. This process is called 'mining', and it is the only way how new Bitcoin can be created.

To determine which node or in the case of Bitcoin - which miner - is allowed to add a new block to the Blockchain, a consensus between all nodes has to be created. There are many ways to create a consensus. In the case of Bitcoin, a consensus is created by solving a cryptographic puzzle. The node that solves the puzzle first, is the one that is allowed to add a new block and gain a reward for it. Because this type of consensus requires a lot of computing power, it is called 'Proof of Work' (PoW).

If you have been very attentive, you might ask yourself at this point, why the chosen node wouldn't just manipulate the new block in favor of itself? Let's think about it. If the chosen node tries to manipulate a transaction, he would not only need to manipulate the transaction on his copy of the Blockchain but on every copy on every node of the system. And because every block is encrypted (which we haven't talked about yet in detail), the effort is too big to do the manipulation. In theory, it would be possible, if one node or one hacker had the chance to manipulate blocks on more than 50% of the copies. In practice, no computer has the power to do so up to this day. Not to mention that every attempt to manipulate the Blockchain will remove the right of a node to add a new block and to gain rewards.

A new block can only be added to the Blockchain if more than 50% of the nodes validate the new block. In the example of the above graphic, the new block would be added to the chain, because six out of eight nodes validated the new block.

A manipulation attempt is practically not only impossible for a node that attaches a new block but also for every individual that is sending coins. Bitcoin was the first publicly presented system that had a solution for the double spending problem. The double spending problem means as the name suggests, that a sender could transfer more coins than he actually owns or in other words, a sender could send one money unit twice. The founder of Bitcoin showed a way to solve the double spending problem, by making every transaction on the Blockchain comprehensible and transparent for everyone. It can be easily verified how much money every participant has, because every transaction is documented on the Blockchain.

As an example: If Ronny sends 10 coins to Paul, everyone can see that a transaction of 10 coins takes place from one party to another party and it can also be tracked, when and from who, Ronny received the 10 coins in the past. Ronny sends the coins to Paul but he encrypted his transaction in a way, that only the person can receive the money, who has the keys to open the encryption. Ronny and Paul both know that and therefore Ronny sends his coins directly to Paul who has the right keys to encode and receive the coins. The transaction is traced by every participant on the network while being fully anonymous.