Blockchain in action – How does it work?

If you are not aiming to obtain university-level understanding of blockchain functioning but knowledge that’s simply just enough to get added to your office crypto chat group, here is a good place to start!

 

On completing your reading, you’ll be able to:

  • Identify the difference between private, public and permissioned blockchain networks
  • Explain how blockchain network works

 

In continuation to our introduction, the framework on which Bitcoin and other cryptocurrencies were built isn’t overseen by any central institution, rather it lives on a network of thousands of personal computers. A secure, distributed ledger. And that explains the effects of transformative blockchain platforms: by creating a secure database across many different computers, this system removes the need for a bank or any other institution to exist at the centre overseeing and regulating the data. This fundamentally changes how we exchange value, share information, buy and sell things, and verify the authenticity of information we rely on- in every transaction

 

How does blockchain work in practice? A simple analogy

Let us take the example of a healthcare service provider that currently relies on electronic medical records to provide relevant patients health information to doctors and hospitals. For several reasons, these records are often incomplete, erroneous or miss out from recording certain information. Assuming that the healthcare provider adopts blockchain to store this critical information, doctors, hospitals, patients, insurance providers and all associated stakeholders can come together to access and add these medical records in a unified ledger.

Healthcare professionals can easily add records and the doctors and patients can get a comprehensive view of their medical history alike. This transition results in greater trust, simple and faster processing and exchange of patient information.

 

Ledgers in blockchain

Generally, ledgers are a book of record-keeping where all the financial transactions of an organization are recorded. Even simply put, a register. Ledgers in blockchain are very similar record keeping systems to record transactions that take place within a network.

Blockchain works under the principle of Distributed Ledger Technology (DLT) which is essentially an encoded and distributed database that serves as a ledger, where recordings regarding a transaction like exchange of data or money are stored, consensually shared and synchronized amongst the members of a decentralised network.

All participants in the network can have their own identical copy of these recordings shared across the network. All entries can be updated by one, some or all the participants according to the rules governed by the network. Participants govern and agree by consensus on the updates to the records in the ledger. Any changes to the ledger are reflected in all copies. Any two parties can make an exchange and no central authority or third-party mediator, such as a financial institution or clearinghouse, is involved. Every record in the distributed ledger has a timestamp and unique cryptographic signature, thus making the ledger an auditable, immutable history of all transactions in the network.

So, when a node asks for a transaction, the node will need a private key to authorize it. Next, the system will create a block containing all the information, encrypt it, and send it to other nodes for verification. Now blockchain platforms may use various methods to verify the data. Once it’s verified, the blockchain is then added to the ledger, and the transaction is executed.

 

Networks in blockchain

Companies or individuals can decide to share a ledger across a public, private or a permissioned blockchain network.

 

Public networks

As the name implies, they are open to all. Millions of people may participate at any one point in time. These “public ledgers” operate without the need for identity information, and most users adopt pseudonyms.

Bitcoin was the first public blockchain network, and it remains one of the largest. Another example is Ethereum, a platform that can host transactions involving smart contracts.

It is completely decentralised, so anyone can participate in the network. To encourage more and more people to join and contribute to a public network, some networks have incentive mechanisms like offering tokens. Every network contributor can contribute in reading, writing and verifying the blockchain entries. Decision making and validation are carried out by various consensus-mechanisms such as the “Proof of Work” or the “Proof of Stake”. Within a public blockchain, all participants are further allowed to operate a node within the network and to create tokens by mining.

However, a major disadvantage of the public blockchain can be seen in the fact that one of the common validation forms, Proof of Work, requires a lot of computing power. This is because each node must solve a complex, resource-intensive computing problem to reach consensus. In addition, the desired openness and transparency of a public blockchain for certain applications can be seen as a disadvantage because private transactions are not possible.

 

Private Networks

Businesses can also choose to set up a private network, where existing users invite others to transact and interact. In this case, the ledger’s transactions aren’t visible to the public and the very existence of the network itself may be hidden.

It is a managed network where the network administrator has an important function of granting or denying access to participants to the network. Thereby, the network operator is aware of the participants of a private blockchain. The information about a transaction is not publicly viewable, but only to the involved transaction participants. Unlike the public network, the network administrator may grant or deny certain privileges to participants, e.g. write or read permissions. The participants cannot carry out any validations themselves; this is carried out either by the network operator or by a certain group pursuant to the individually defined validation rules. A private blockchain is, therefore, formally not decentralized.

The advantage of the private blockchain is certainly the fast processing of transactions. Private blockchains can process thousands of transactions per second because only a few selected participants need to validate them.

For blockchain experts, the private blockchain contradicts the basic idea of decentralization. From their point of view, this is a disadvantage of the private blockchain.

Examples for private blockchains are Hyperledger and Ripple.

Permissioned Blockchain

A Permissioned Blockchain is the most important type of blockchain network from a business perspective. This network consists of a public ledger and closed group. That is, anyone can see the blockchain unlike the private network, but only identified people can approve transactions. Participants can be added to the permissioned network only by invitation. This prevents anonymous user entry.

In practical business cases to cater enterprise needs, businesses require to know who they are doing business with. Blockchain has the potential to protect businesses against corruption and money laundering by encouraging a wider coalition of stakeholders to participate and monitor transactions. And permissioned blockchain supports this structure.

Verification and Consensus

With both types of network, any changes to the ledger must take place through consensus — that is, records can only be altered if a majority of the ecosystem (network participants) agrees that a change should be made.

Usually, networks agree upfront on a definition of what this means in practice. With bitcoin, for example, participants must follow a detailed set of rules that set out exactly what constitutes a “valid” transaction or block.

With most blockchain ecosystems, certain mechanisms are put in place to make it extremely hard for individual bad actors to tamper with the records.

These rules of approval of a blockchain transaction by the network participants comes from a process known as consensus. Consensus is an agreement between all the nodes on the blockchain as to what is the valid chain. A block gets added to the chain only when 51 percent of the nodes agree on a transaction’s validity. Nodes compare chains to validate transactions and the longest chain is the valid chain.

On the flip side, this method can be corrupt if more than half of the blockchain’s nodes are controlled by one party.

Consensus algorithms

Every blockchain network is different and so they cannot use the same consensus mechanism as different outcomes are desirable with different applications. Organizations and blockchain developers must make informed decisions while choosing a blockchain consensus mechanism. There are an array of consensus mechanisms for blockchain to follow. Here are some of the commonly followed algorithms among the many:

Proof of Work (PoW)

Proof of Work (PoW) was the original consensus algorithm in blockchain. This consensus mechanism is popularly known as mining and the participating nodes are known as miners. Miners solve complicated mathematical puzzles that require extensive computational power. For this purpose, miners utilize multiple mining methods like CPU mining, GPU mining, FPGA mining, mining pools, ASIC mining, and many more. After solving mathematical puzzles, a miner receives a block as reward if they are the first one to find the solution. Additionally, the puzzles can only be solved with trial and error. Hence, miners require an increasing amount of computational power for finding solutions quickly.

The level of difficulty for the puzzles changes according to the speed at which the blocks are being mined. In case the blocks are created quickly, then the puzzles would get difficult and vice versa. Therefore, new blocks have to be created within a particular time frame to carefully adjust the difficulty level of puzzles. Several popular cryptocurrencies like Bitcoin utilize Proof of Work process. However, Proof of Work consensus mechanism consumes resources at a staggering rate. A study states that Bitcoin’s current estimated annual power consumption is 51.13 TWh. Hence, this approach can be expensive.

Proof of Stake (PoS)

Proof of Stake (PoS) mining consensus with a mechanism where blocks are validated based on the stake of the network participants. Here, unlike running hash functions, validators stake resources primarily in the form of digital money or tokens. The validator of every block is then randomly selected from the stakeholders based on the amount of computational power allocated.

Each PoS system may implement the algorithm in different ways, but, in general, the blockchain is secured by a pseudo-random election process that considers a node’s allocation and the allocation– determining the commitment of the party to ensure the network. Blockchain networks are switching from PoW algorithm PoS in an attempt to increase the network’s scalability and reduce excessive electricity wastage

Delegated Proof of Stake (DPoS)

The Delegated Proof of Stake (DPoS) process is based on a voting system where users can stake their coins and vote for delegates. Each voter’s power is proportional to the size of their stake in the network. For instance, if a user ‘X’ stakes 20 coins for a delegate and another user ‘Y’ stakes 2 coins, then X’s vote will have more weight compared to that of Y. The delegate that receives the highest number of votes gets a chance to produce new blocks. Delegates get rewarded with transaction fees or a specific amount of coins just like other blockchain consensus mechanisms such as Proof of Stake.Delegated Proof of Stake (DPoS) mechanism is one of the fastest blockchain consensus mechanisms. It can handle a higher number of transactions compared to the Proof of Work mechanism. Due to its stake-weighted voting system, DPoS is often considered as a digital democracy.

Proof of Elapsed Time (PoET)

Proof of Elapsed Time (PoET) consensus system relies on a randomised timer system for network participants rather than using mining hardware as in the case of Proof of Work (PoW). Each participating blockchain node in the network is needed to wait for a randomly chosen period, and whoever completes the wait first, wins the new block and validates it.

Proof of Authority (PoA)

Proof of Authority (PoA) is a consensus algorithm based on the reputation of trusted parties in a blockchain network. PoA consensus algorithm is based on the value of identities within a network- and in a system block, validators do not stake resources like PoS, but their own identities and reputation. So, PoA blockchain networks are secured by the validating nodes that are arbitrarily chosen as trustworthy parties.

The Proof of Authority model works on a fixed number of block validators, and only the nodes that become validators are the ones allowed to produce new blocks. This makes PoA an easily scalable blockchain system because transactions are checked by already-approved network participants.

In conclusion

DLT is poised to be one of the fastest growing digital technologies and evolutions for several years to come and has a key role in ample relevant use cases in the digital transformation of several processes and industries.

The buzz around Blockchain technology also leads to a big difference between what a technology could possibly do and what it really does. However, there is no doubt about it: Distributed Ledger Technology (DLT) is becoming big in business. While it is still in its nascent stages, the technology definitely holds vast promise and something to watch for, in the future.

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