A BLOCKCHAIN is a digital database or ledger of transactions that is maintained by multiple computers.
The goal of blockchain technology is that transactions can be confirmed without the need of a third party or gatekeeper. Blockchains are therefore called "decentralized" since the full blockchain detailing the history of transactions is distributed across a vast network of computers (called “nodes”).
There are public blockchains (accessible by everyone), and private blockchains (only accessible within an organization, sometimes including partners and/or clients.
Blockchains can be used in various applications such as currencies (called then “cryptocurrencies”), smart contracts (contracts that can embed automatic processes), art, etc. (see below for more applications)
The most renowned blockchain that is handling a cryptocurrency is Bitcoin (the same name for the blockchain and the cryptocurrency). We can also cite Ether on Ethereum blockchain or Ada on Cardano. Below is a list of well-known blockchains:
Transactions are stored in blocks of information protected by cryptographic methods. They are validated by a node and propagated to the network. Many blockchains need multiple confirmations from other nodes before the transaction is considered immutable or irreversible. Network confirmations help lessen the risk of any single entity controlling the network, as false transactions propagated to the network will be rejected by other nodes.
Cardano is an example of a decentralized public blockchain, having over 3,000 full nodes who store the full database and validate transactions.
Public blockchains allow any person or entity to authenticate transaction details, whether it be money payments, contracts, ownership of assets, or virtually any other type of information.
One of the earliest influences on blockchain was David Chaum, who in 1983 published a paper about creating anonymous electronic money called eCash, which included the first known proposal for a blockchain protocol. eCash would be digitally stored money on your local computer that was cryptographically signed by a bank. Later in 1991, Stuart Haber and W. Scott Stornetta started work on creating a cryptographically secured chain of blocks with tamper-proof timestamps of documents.
The real revolution of blockchain came from a person, or group of people, who used the pseudonym Satoshi Nakamoto. The identity of Satoshi Nakamato remains a mystery to this day. However, in 2009, Satoshi was able to successfully combine the best of all these previous ideas into a usable solution called Bitcoin, which has become one of the world’s most popular cryptocurrencies. Bitcoin is a decentralized digital currency that can be sent from user to user with no intermediary. In addition, transactions are secured through cryptography and publicly recorded on a blockchain.
Blockchain technology is the foundation of cryptocurrency. In fact, without blockchain technology, decentralized cryptocurrencies like Cardano and Bitcoin wouldn’t be possible. Cryptocurrencies are protocols built on top of the blockchain, using blockchain technology to accurately record transactions. Let’s spend some time learning the basics of blockchain.
A. Blockchain Architecture
Learning blockchain architecture will give you a good understanding of cryptocurrency platforms like Cardano or Bitcoin, which are protocols built on top of blockchains. In a blockchain, the blocks essentially represent a summary of transactions that are added periodically to a chain linked with all other blocks of transactions. With each block, the chain grows longer. For decentralized blockchains, a block of transactions being added to the chain is immutable, which means the transaction cannot be changed or reversed. Let’s look at an illustration of the Cardano public blockchain, which adds a new block of transactions every 20 seconds.
Blockchains are important to cryptocurrencies because they allow a secure, decentralized way for transactions to happen. In decentralized cryptocurrency protocols like Cardano and Bitcoin, a consensus mechanism is used to reject false transactions and validate honest transactions. Below are the steps to submit and finalize a transaction.
- A user submits a new transaction to the network.
- The transaction is submitted on-chain with a unique identifier.
- The transaction is broadcasted or propagated to the network of nodes.
- The nodes validate the transaction. False transactions are rejected.
- The transaction is added to a new block. The new block is then added to the existing blockchain.
- The transaction is executed and completed between the parties.
How Blockchain technology works
Why would nodes spend computing resources to store the full blockchain and validate transactions? For decentralized blockchains, nodes are compensated for adding new blocks to the blockchain.
B. Popular Consensus Mechanisms for Blockchains
Consensus mechanisms are used to validate new transactions that are added to a blockchain. For cryptocurrencies, nodes who validate and add transactions to the blockchain are incentivized to make sure the blockchain only includes valid transactions since they are typically compensated in the native coin of the public blockchain. If the public’s trust in the blockchain declines, so will the value of the coin’s nodes received for adding blocks of transactions.
While there is a growing number of consensus mechanisms, the two main ones are Proof of Work (PoW) and Proof of Stake (PoS). PoW is used by popular blockchains like Bitcoin. PoS is used by Cardano, Solana, Polkadot, and many others.
Proof of Work (PoW)
A decentralized consensus mechanism that requires members, or miners, of a network to expend effort solving an arbitrary mathematical problem which prevents anyone from gaming the system. The mechanism requires “work” because of the computing power required to solve the mathematical puzzle.
In proof of work blockchains like bitcoin, there are three types of nodes that validate transactions and secure the blockchain.
- Miners—Miners are the nodes that produce the blocks for the blockchain. They don’t maintain the blockchain, but only create the blocks to add to the blockchain. The ledger contains a record of bitcoin transactions, arranged in sequential blocks, which stops any user from spending the same coins twice.
Tampering is prevented using hashes, which is a mathematical function that converts an input of arbitrary length into an encrypted output with a fixed length. Hashing requires the miner to process the data from a block through a mathematical function, which produces an output of a fixed length. By using a fixed-length output, security is increased since anyone trying to decrypt the hash won’t be able to tell how long or short the input is by looking at the length of the output.
Putting a set of data through a hash function, such as the SHA-256 cryptographic hash algorithm that bitcoin uses, will only ever generate one hash. A small change in any portion of the original data set will result in a completely different hash output. The hash is one-way, meaning that the hash output cannot be used to obtain the original data. The hash output can only be used to check that the data that generated the hash matches the original data.
To do so, the miner must produce a value that is hashed, or cryptographically encoded, and is less than or equal to the one used in the most recent block accepted by the bitcoin network. The random set of characters is between 0 and a maximum number of 256-bits.
The miner spends computing power testing numerous sets of values to get the target hash. The difficulty level, or length of the target hash, is adjusted every 2,016 blocks so that a block is mined every 10 minutes on average. This computing power needed to determine the target hash is where the “work” comes from in “proof of work” since electricity and a lot of computing resources are required from each miner.
The first miner to get the correct hash gets to add a new block and is compensated in bitcoin. All other miners who didn’t produce a block essentially wasted computing resources to produce the correct hash. Initially, bitcoin mining could be done using the central processing units (CPUs) on modern desktop computers or laptops. To increase their chance of producing a block, over time people have bought specialized hardware called application-specific integrated circuit (ASIC) miners. ASIC miners, which are computerized devices specifically optimized for mining bitcoin or another cryptocurrency, exceed graphic processing units and CPUs in computing power and lower electricity consumption.
- Full nodes—These nodes store a full copy of a blockchain. Some full nodes also validate and propagate, or relay transactions, to other nodes. The more copies of a blockchain, the more secure the blockchain. Most well-known blockchains like Cardano and Bitcoin have thousands of full nodes.
- Lightweight nodes—These nodes don’t download a full copy of blockchain and rely on full nodes for functionality. In some PoW cryptocurrencies like bitcoin, they download information such as block headers to validate the authenticity of transactions.
Proof of Stake (PoS)
PoS is a consensus mechanism, like PoW, for processing transactions and creating new blocks in a blockchain. PoS was in part formed as a response to the drawbacks of PoW. PoW had very high energy consumption and the decentralization of PoW was questioned for cryptocurrencies like bitcoin as the ASIC miners became more expensive, effectively limiting the mining distribution to entities with substantial capital and energy resources.
Due to high energy costs, many blockchains have moved away from PoW. Below are prominent blockchains, based on market capitalization, and their consensus model:
- Bitcoin – PoW
- Ethereum – PoW (Plans to transition to PoS)
- Cardano – PoS
- Solana – PoS
- Polkadot – PoS
- Avalanche – PoS
- Binance coin – PoS
- Litecoin – PoW
- Dogecoin - PoW
PoS reduces the amount of computing power needed to validate transactions on a blockchain by changing the way validators, who verify and add blocks to the blockchain, are selected. Instead of racing to solve a hash, validators are randomly selected to mine, or validate a block. Since the selection is random, the competitive energy usage miners typically spend in PoW blockchains is eliminated.
PoS models are not homogenous. Many PoS blockchains have variations in their consensus protocols that makes them different from other PoS models.
However, in general for PoS models, a validator’s chance of being selected to add a block is higher based on their amount of “stake”, or total amount of coins they’ve delegated or deposited to the protocol. Staking means you must delegate or deposit the cryptocurrency, or native coin, of the blockchain you are validating. The validator’s interest is aligned with the security of the blockchain because a drop in the value of the coin would reduce the value of the validator’s personal stake.
In addition, some protocols have implemented slashing, which is a mechanism in some PoS protocols that discourages validator misbehaviors by reducing a predefined percentage of the validator’s stake. Slashing is used to ensure network participation and security by penalizing validators in certain situations. In most blockchains, slashing is based on two conditions: downtime and double signing. Downtime is when validators are not available for a certain amount of time online to sign transactions. Double signing is when validators sign two blocks simultaneously, which results in the network having to work harder to reach consensus. Downtime and double signing may occur because of a node’s operational setup instead of illicit intent. Other conditions that could lead to slashing includes signing false transactions, attacking the network, or running modified software. Polkadot and Ethereum are two protocols that have implemented slashing for the PoS consensus mechanisms.
Blockchain has many applications beyond a medium for transferring an asset of value. Blockchain features such as smart contracts, decentralization, transparency, security, and immutability can be used in many ways. Below are some applications for blockchain:
- Money Transfer — One of the original innovations of blockchain technology was decentralized money transfer services. Cryptocurrencies like Cardano and Bitcoin allowed unrestricted cross-border payments and remittances faster and cheaper than using traditional money transfer services or banks.
- DeFi — DeFi, or decentralized finance, uses smart contracts, which are agreements enforced by code, to create complex peer-to-peer financial services on public blockchains without intermediaries. DeFi protocols include borrowing/lending, insurance, and data decentralized exchanges. Oftentimes, these services offered when using the blockchain have cheaper costs than banks or insurance companies that offer similar services.
- Digital Identity — Identity fraud has remained a persistent issue around the world. However, blockchain technology allows for the creation of decentralized digital identities, or DIDs, which can’t be replicated or tampered with due to the security of the blockchain. In addition to people having verifiable identities, other things that can be linked to a DID include school grades, diplomas or degrees, and work credentials.
- Securing Property Rights — In many countries, property rights remain elusive. The government, corrupt officials, or companies can take property or land, leaving victims with no recourse or way to prove they owned the land. Having land titles or deeds that verify ownership of a property on the blockchain is immutable and can’t be altered.
- Data Storage — Instead of storing your data on centralized cloud computing platforms like Amazon Web Services who have full control over your data, you could use decentralized storage solutions like Iagon. Iagon is creating a decentralized storage network where each user’s data is encrypted.
- Liquidity of illiquid assets — To sell a house or artwork, there is typically an arduous process to undertake. What if you could sell your house online using distributed ledger technology and have the ownership and transfer of an asset verified and secured by the blockchain? Platforms like Ledgity will provide users the ability to transact unlisted assets like real estate or artwork.
- Medical Health Records — Imagine traveling to another country getting sick and going to the hospital, but the doctor and medical staff don’t have any information about your medical history and can’t get the data due to privacy laws. A blockchain solution could have your medical records linked to your DID. Then the medical records could only be seen by doctors through your permission and the verification of the doctor. Due to the speed that this verification can happen through the blockchain, global healthcare and the efficiency of treatments could increase significantly.
- Supply chain management — Tracking products or materials is a cumbersome experience, especially when dealing with different companies that have limited visibility on their partners’ inventory. If all companies in a supply chain use the same blockchain, they could synchronize their logistics data and tracking of shipments, leading to more efficient operations.
- Digital Voting — In many countries there is election fraud or a lack of public trust in elections. With DIDs and the blockchain, voting can take place on a public ledger where all votes are publicly listed. Voters could then verify that their vote hasn’t been changed. With this system, the public wouldn’t have to trust the government to correctly count the votes because an immutable record of each vote would be available for anyone to verify.
The legality of decentralized blockchains used in cryptocurrencies that have no government oversight has some political backlash to the asset. Unlike fiat money like the United States dollar or Chinese yuan, no government can control cryptocurrencies like Cardano or Bitcoin. Even if a country banned its citizens from being validators or miners, the cryptocurrency would continue if other full nodes around the world exist. Here are some issues with decentralized blockchains:
Public Policy— Due to the ability of blockchain to make some technologies, such as cryptocurrencies decentralized, it limits the impact of countries’ economic sanctions.
- United States— The United States remains the world’s reserve currency, used for international trade by most countries and with oil and gas sales around the world. This has enabled the US economy to enjoy the strength of the US dollar in trade. In addition, the US government has had unparalleled power to place economic sanctions on countries or entities by shutting off any dollar-based trade. However, research shows that foreign central banks’ reserves held in U.S. dollars have decreased from 71% in 1999 to 59% in 2021. While some countries have purposefully focused on being less dependent on the US dollar trade, the growth of blockchain based digital assets has hastened the decline in the US dollar dominance. The US government has stated that the rise of cryptocurrencies as an alternative payment system is potentially reducing the efficacy of US financial sanctions.
KYC / AML (Know-Your-Customer/Anti-Money Laundering)— The Financial Action Task Force (FATF), an independent inter-governmental body that develops and promotes policies to protect the global financial system against money laundering published its update on cryptocurrencies and virtual asset providers in 2021.
- Unhosted Wallets - Unhosted wallets, or non-custodial wallets, are wallets where the user controls the private keys to wallet, which means the user has full control on access and how they can use the digital assets. Custodial wallets are held by regulated entities such as banks or centralized exchanges like Coinbase or Kraken. Unhosted wallets, or Virtual Asset Service Providers, may be violating the “Travel Rule”, which attempts to reduce illicit transactions of $1,000 or more by providing details on both the sender and recipient to counterparts. FATF recommendations would require VASPs, such as Yoroi, MetaMask, or Eternl, to observe the Travel Rule and operate under the same anti-money laundering regulations as other financial institutions.
Most personal crypto wallets do not collect identifying information of their users and therefore do not observe the Travel Rule. Many governmental entities, such as the European Union (EU), have passed laws to enact some of FATF recommendations. The EU is moving forward with legislation requiring VASPs, including unhosted wallets, to include information on the source of the asset and its beneficiary for crypto transfers of any value.
Can blockchain based cryptocurrencies be banned? — Due to the decentralized architecture of cryptocurrencies, it would be hard to stop all nodes from maintaining a public blockchain. First, the code behind major cryptocurrencies like Cardano, Ethereum, and Bitcoin are open source. The code behind popular crypto-wallets such as Yoroi, MetaMask, and Trezor are open-source as well. If many countries banned cryptocurrencies, other countries could be motivated to support the technology and attract its intellectual property, capital, and business to their country. This factor makes it unlikely that cryptocurrencies would be banned everywhere in the world, and in fact would mean that cryptocurrencies won’t be banned in many places as countries would not want to lose the technological and economic advantages provided by cryptocurrencies. For example, El Salvador and Puerto Rico have passed laws which would incentivize businesses or individuals to relocate to their countries for tax benefits and a more crypto-friendly environment.
If the development companies behind a blockchain or unhosted wallet were compelled to update their software to include regulatory guidelines, anyone could use the code of the blockchain or wallet to create another blockchain or wallet without the new code.
Ethics relate to the moral principles behind one’s actions or behaviors, regardless of whether that action or behavior is illegal. There are often decisions a person could make that may be legal, but unethical. By creating blockchain based platforms or applications that can avoid government oversight, are the developers making an unethical decision by easing the ability to conduct illicit transactions? Below are a few ethical dilemmas related to blockchain technology.
- Tax Evasion— One of the biggest concerns for governments is cryptocurrencies being used to evade taxes. Unlike a bank account, cryptocurrency assets are much harder to track. However, the added benefit is that more people globally have access to decentralized money, economically empowering over 1 billion people who are currently unbanked.
- Illicit transactions— Due to not being within the normal banking systems, there is a concern that cryptocurrencies could be used to fund criminal activities and or groups sanctioned by other governments. But the concerns seem overstated. However, Chainanalysis published research showing that only 0.15% of cryptocurrency volume in 2021 was involved with illicit addresses.
- Developing Markets and Inflation—In developing countries and some developed countries, high inflation harms customer’s ability to save and reduces the purchasing power of their current income. Regulation that reduces the efficacy of cryptocurrencies harms citizens of countries that don’t have a stable domestic country. According to Gemini’s 2022 Global State of Crypto report, cryptocurrency ownership among citizens is higher in countries that have experienced rapid inflation. For example, The Brazilian Real depreciation over 200% against the US dollar from 2011 to 2021. Consequently, Brazil is the global leader in adoption, where 41% of adults report owning cryptocurrency and where 66% of the population believe cryptocurrency is the future of money. In addition, 46% of respondents in Latin America and Africa view cryptocurrencies as a hedge against inflation.