What in the name of God is a blockchain
Blockchains are distributed ledger technology. In this section, we’ll go over what that means, discuss the benefits and drawbacks of blockchain-based applications, and outline how you can use blockchain analysis to your advantage.
– Ok, what is a distributed ledger?
How does everyone know that the same bitcoin hasn’t been spent twice? Bitcoins are represented only as transactions, and have no physical form. We know who owns which bitcoins because there is a public ledger with records of every bitcoin transaction ever made. Bitcoin’s proof of work, where miners compete to solve math problems and choose the next block, acts as a consensus mechanism. All the nodes and miners need to agree on what the next block is going to be.
Once a block has been appended to the blockchain, it and all the transactions it contains are there permanently. Blockchains are immutable – once data is on there, it cannot be altered or removed.
In order to validate transactions and blocks, nodes and miners need to have a full and up to date copy of the Bitcoin blockchain accessible. There are upwards of 11,000 nodes active worldwide at the time of writing.1 Full copies of the blockchain are distributed around the world.
One way of understanding the blockchain is by conceptualizing it as a spreadsheet. After all, all blockchains are databases (though not all databases are blockchains). This spreadsheet is publicly viewable, but no one can remove entries. Anyone can suggest a new entry, but it needs to be checked and verified before it’s added to the spreadsheet. Thousands of people have constantly updated copies of the spreadsheet. If someone who hated spreadsheets decided to take it offline, they would be faced with the steep challenge of finding and shutting down every single server that hosted the spreadsheet.
Bitcoin was the first example of a working blockchain, but Bitcoin is not the blockchain – it is a protocol that runs using blockchain technology. There is no such thing as the blockchain, in the same way as there is no such thing as the computer, the postal service, or the pizza joint. There are many computers, postal services, and pizza joints, all of which are unique and distinct entities.
Blockchain Pros and Cons
– What are the benefits of blockchains?
– A (sort of) trustless system
Most traditional payment systems rely on some form of trusted intermediary, whether that’s a bank, a broker, or a credit card company. Trust is usually reinforced by the institution’s reputation. Some commentators have said that Blockchain technology was created as a response to the wave of mistrust in financial institutions that swept the world after the 2008 economic crisis. 2
In contrast, blockchains are described as trustless, since there is no need for an intermediary. Instead, trust is placed in the protocol, which in the case of Bitcoin is open source and easily auditable. The system is predictable and regulated, and can be relied on. A distributed network of nodes verifies transactions and reaches consensus on a peer-to-peer basis, with no third parties.
Blockchains also offer economic incentives for honest behavior. It is profitable to provide network security, act in the best interest of the many, unprofitable to go against it. The reasoning is that people can be trusted to act in their best interests, and blockchain technology tries to engineer a situation so the best interest of the individual is the best interest of the many.
Open and transparent
The Bitcoin blockchain works because every single transaction is verifiable and visible. Despite the anarchic leanings of early Bitcoiners, blockchain technology is a valuable tool for law enforcement.
Every block has a type of digital fingerprint, called a hash. It provides proof that a miner earned the right to create a new block, and takes a lot of computing power to create. It also acts like a wax seal on a letter. The cryptographic tools used by the Bitcoin blockchain ensure that altering an entry in any way invalidates all preceding entries. 3
If the block is altered, a new hash is generated. In order to verify whether a block is legitimate, all you need to do is check the hash on the block in question with the same block on a different ledger. Same hash? It’s the real deal. It’s also difficult to change entries in the ledger retroactively, since that would then change the hash for every subsequent block. 4
In traditional financial systems, there are numerous expensive, error-prone, and time consuming processes that result from having multiple records. Thin confirmations, actualization of volumes, and all the different forms of reconciliation. Companies are dealing with greater demands for reporting and transparency, which in turn requires meticulous records. Some blockchain proponents argue that a single shared ledger radically increases efficiency. 5
Drawbacks of blockchain
Residual points of centralization
Every node requires a copy of Blockchain software to in any way interact with the system. While there are upwards of 11,000 nodes validating transactions and confirming blocks, nearly 95% of them use the same software – Bitcoin Core. The Bitcoin Core developers hold quite a bit of influence over the network.
Bitcoin mining has also become less decentralized over the years. People now use a specific type of hardware, called an ASIC (Application Specific Integration Chips), which is more efficient at crunching hashes than a general-purpose computer. Bitcoin mining now has a barrier to entry in the form of specialized, expensive hardware. 6
Miners also rarely operate alone. In order to maximize profits, miners join mining pools. As a result, large, centralized mining organizations now control a startling amount of the Bitcoin network’s hashing power.
As we discussed previously, one theoretical threat to the Bitcoin network is called the 51% attack. If a group of attackers gains control of more than half of the network’s mining power, they would be able to prevent new transactions from gaining confirmations. They would be able to halt payments between users and reverse transactions completed while they were in control of the network, enabling them to double-spend coins. 7
– Will it scale?
With the number of transactions per month growing exponentially, the Bitcoin network is facing a scalability problem. The network is limited by the hardcoded size of blocks, and 10 minute block creation time. The average transaction processing speed is between 3.3 and 7 transactions per second. If the network gets too clogged, transactions can slow to a crawl. Ironically, the more Blockchain succeeds and is adopted, the more urgent the scaling problem has become.
- The Basics of Bitcoins and Blockchains, Anthony Lewis.