What is blockchain technology and how does it work?

Publish Date 25 Aug 2021
Blockchain / 13 Min Read
Alex Lielacher / Last Update 02 Jun 2022

Blockchain technology provides an innovative way to securely record, store and transfer data. Blockchain is the technology that makes cryptocurrency possible.

Blockchain technology first emerged as the underlying technology of Bitcoin. Today, there are numerous blockchain networks, with different functionalities created for different use cases.

It's a system of storing and sharing information that can be verified by everyone who has access to the network. Blockchain technology was first developed for Bitcoin, but now there are many different kinds of blockchain networks in use all over the world.

Many people see blockchain as being revolutionary because it solves some problems with how we interact on the internet today - like ensuring privacy or providing transparency across transactions.

In this guide to blockchain technology traders will learn:

What is blockchain technology?

Blockchain technology is defined as a decentralised, distributed & immutable ledger, shared across networks to track assets and record transactions. Blockchain is used most commonly as a way to digitally record financial transactions. It’s a relatively new technology, but it’s become increasingly popular thanks to some unique advantages.

Blockchain is built on what’s known as a distributed network. This simply means there is no single point of authority – like a bank or government – that controls it. Instead, the trust in the system comes from its transparency.   

Anyone within an individual blockchain network can view and verify transactions, creating a level of accountability that is difficult for anyone with bad intentions to get around (at least without anyone else noticing).  

Blockchain example:

Let’s say John owes $30 to Tim, but he only had $10 at the time. John writes a note confirming that he’s going to pay another $20 at a later date and gives the note to Tim as a record of the amount owed.  

Now, the only thing stopping that note from being manipulated is good faith on behalf of John and trusting Tim. But if Tim chose to try and change the amount he was owed – let’s say from the original $20 to $120 – John would have no way to prove it. 

But what would happen if John had made copies of the original note? In that case, there’s increased visibility over the transaction, so it’s easy to see if one party had attempted to manipulate the original document. This transparency and fraud prevention is effectively what blockchain allows, only on a more sophisticated and much larger scale.

In a blockchain, each individual transaction is time-stamped and stored in what’s known as a ‘block’. These blocks are digitally chained together in chronological order, forming the blockchain. Each block can be identified by a hash code – which is similar in nature to an ID card – and there’s no limit to the number of new blocks that can be recorded. 

So does that mean all transactions are eligible to be recorded on a blockchain? Well, no.  

For that, we need to understand the role of miners, whose job it is to validate transactions. But let’s hold off on that for now and dive into the history of blockchain first. 

History of blockchain

The first work on blockchain technology came nearly 18 years before the introduction of Bitcoin when, in 1991, research scientists Stuart Haber and W Scott Stornetta brought the concept into existence. With their understanding of how easily digital media was being modified, they proposed blockchain as a solution by digitally time-stamping documents.

Within a year, they incorporated something called ‘Merkle Tree’ into the blockchain, which added to its security and efficiency. Merkle Tree is a data structure, used in computer science, that makes it possible to record many transactions in a single block, making it faster and easier to verify.

Then came the pivotal moment: the introduction of Bitcoin. In 2008, an online document titled ‘Bitcoin: A Peer-to-Peer Electronic Cash System’ was published under the pseudonym of Satoshi Nakamoto, proposing how digital transactions could take place between two parties, with no centralised authority. The following year, the original white paper on Bitcoin was released and it comprehensively detailed how the Bitcoin blockchain structure worked. Today, it serves as a digital ledger for all Bitcoin transactions across the globe.

Bitcoin got the world talking and ignited the imagination of developers around the world. One such spark led a Canadian developer, Vitalik Buterin, to propose a platform for decentralised value transfers and decentralised software applications. In 2014, along with seven other co-founders, Ethereum was launched on the back of a crowdfunding initiative.

Ethereum brought the concept of ‘smart contracts’ into the blockchain space. These are programs that self-execute once the terms set and agreed upon by both parties are met. This space quickly became a developer’s haven as it provided a platform for them to develop decentralised apps (dApps) and other smart contract-based applications.

How does blockchain work?

Primarily, there are three parts to recording a blockchain transaction:

1. Hash encryption

When a transaction is initiated on a blockchain, it creates a new block which contains three important pieces of information:

  • Data: the details of the transaction
  • Previous hash: this helps connect the current block to the preceding block, building the blockchain
  • Nonce (number only used once): this is a random number used to prevent replay attacks i.e. duplicating the same transaction

Note: Nonce is the only component of a block that a miner can change. All other data is predetermined.

Now, the network itself establishes the digital identity, or signature, for the transaction.

2. Mining

Mining is the way transactions are authenticated and recorded on the blockchain ledger.

To validate a signature, miners need to generate the ‘hash’ output. The hash is like a human fingerprint in that it is unique, therefore it’s difficult to compute. To find the right hash value, miners need to solve complex mathematical puzzles and find the exact nonce number that generates an accepted hash. And given there’s no template to solve these puzzles, miners must use trial-and-error.

After finding the right nonce value, they add the block to the chain. Once this has been done, the miner gets a financial reward – for example, native coins (i.e. Bitcoin) and/or transaction fees of that block.

3. Validation and nodes

After mining, the block needs to be communicated to all the nodes in the network, which validates it. In other words, miners have to confirm the transaction is complete by telling everyone about it.

Nodes play a crucial role in validating a new block, and any electronic device that can hold and distribute copies of the blockchain ledger is considered a node. The use of a consensus algorithm – an agreed set of criteria that legitimises a block – achieves the validation.

After validation, the newest ledger has to be made accessible to everyone in the blockchain’s infrastructure. Nodes allow this while also contributing to the upkeep of the decentralised nature of the technology.

So, after the block has been mined and added to the blockchain, all the nodes in the network exchange the latest version of the digital ledger. By doing this, the nodes have maintained the consistency of the ledger throughout the network, making it impossible for any party to alter the ledger without triggering all the validators in the network about it.

Without nodes or miners, the hallmark principle of blockchain – decentralisation – is not possible. With nodes being a critical piece of the infrastructure, it’s worth understanding them in more detail.

Diagram of how blockchain technology works

How does blockchain mining work?

Mining is an essential part of maintaining and building a proof of work blockchain. People also view it as an avenue for earning crypto tokens as a reward for successful mining. So, let’s dig into how blockchain mining works. 

First off, mining is like forgetting the key combination of a number lock. Traders start with something like 0-0-0 and try different combinations to try and crack the code. Here, they’re using mental energy to find the right code. If they fail, they can also use physical energy to smash the lock into bits and pieces. 

However, mining doesn’t work like that. The network encrypts the block into a cryptographic puzzle where validation is possible only after finding the right hash value. So, how do traders find the hash? This is where mining is more than just solving mathematical problems. As there is no set template for finding the right hash, miners need to adopt a trial-and-error method to discover the exact hash. 

To accomplish this, miners combine the nonce value with the previous block’s header. Here, the header contains information and is not changeable. However, miners can change the nonce value. Changing the nonce value quickly to generate the right hash is known as hashing. 

Confused? Put it this way: to keep changing the nonce number and crack the code, miners need a huge amount of computational power, which requires a huge amount of electricity. This is a key reason why small-scale mining is no longer feasible.

To understand how complex it is to confirm a correct hash value, here’s an example of what one looks like:

682c18061d0e703c6c6ede973d41ff3e82ccc63a3362e9652889f9efd39e27ae

Once the miner eventually generates the right hash value, they transmit the block to all the nodes (participants) within the network. They verify and confirm the block, then add it to the chain of blocks. 

Types of blockchain consensus algorithms

Blockchain consensus algorithms are essentially a process where everyone on a network agrees on the real-time state of the blockchain – and it’s really important. Achieving consensus is necessary to maintain trust, security and reliability in a decentralised setting.

Different blockchains follow different consensus algorithms, and these are the most popular:

Proof of Work (PoW)

Introduced by Satoshi Nakamoto, the inventor of Bitcoin, Proof of Work is the oldest consensus algorithm. It’s built on the concept of mining, which involves nodes or miners solving complex mathematical problems to validate a block, which is then added to the blockchain. Mining requires enormous amounts of computational power to solve the problems. Once it is solved, the network rewards the successful miner before they move onto mining the next block. Cryptocurrencies like Bitcoin, Monero and Litecoin all use this algorithm.

Proof of Stake (PoS)

Proof of Stake appeared in 2011 but really only gained popularity when it was championed by the developers of Ethereum. In PoS, validators replace miners. They can stake digital assets to validate blocks and add them to the blockchain. For every confirmed transaction, the validator receives a reward. By limiting mining power in proportion to the volume of assets staked, PoS is a more resource-friendly algorithm. Polygon (MATIC), Binance and Solana are some of the more recognised crypto projects using PoS algorithms.

Proof of work vs proof of stake

Delegated Proof of Stake (DPoS)

This is a variant of the traditional PoS algorithm, built to add more democracy and efficiency in achieving consensus. Here, participants vote to select a set of nodes or delegates who can validate the blocks on their behalf. The volume of coins held by each participant helps in determining their voting power. In a DPoS system, 21 to 100 delegates are elected to validate the blocks and publish them onto the blockchain. Cardano, Tron and EOS are projects that leverage DPoS algorithms.

Proof of Authority (PoA)

A more recently developed consensus algorithm, PoA relies on awarding authority to qualified nodes to validate blocks. Nodes or participants can gain the right to validate nodes after passing a certain set of criteria. This involves voluntarily disclosing identity and evaluation of the node’s reputation. To qualify, nodes have to prove that they adhere to the defined procedures of validating blocks. PoA is popular in enterprise and private institutional setups as the algorithm attaches the nodes’ right to participate to their reputation. VeChain and Decred are two popular projects that employ the PoA algorithm.

Other notable algorithms include:

  • Practical Byzantine Fault Tolerance (PBFT)
  • Proof of Burn (PoB)
  • Leased Pool of Stake (LPoS)
  • Proof of Capacity (PoC)
  • Proof of Importance (PoI)

Blockchain use cases

Blockchain technology with its inherent qualities of safety, security, and enhanced accessibility make it a tool potent enough to disrupt industries. From transacting currencies without extra permission to documenting land titles, the potential applications for blockchain are enormous. Here are some major industries where blockchain is currently being used at scale.

Financial Services

Blockchain technology has brought transparency and efficiency to the banking sector. Using decentralised exchanges (DEXs), anyone can conduct transactions at lightning speeds without the need for a centralised authority, like a bank. Blockchain is also beginning to revamp the age-old credit system with decentralised lending and borrowing facilities, while initiatives like yield farming and staking are creating more avenues for investment. With smart contracts, blockchain and decentralised finance (DeFi) is disrupting the financial sector and some believe its true potential within this industry is far greater.

Supply Chain

From the factory to the receiver, consignments are being tracked continuously. Since blockchain allows traceability of data and goods, firms can easily engage in real-time verification. This is helping the global market to transact goods of value across borders without worrying about counterfeiting and other common concerns.

Healthcare

Blockchain is replacing the need for paper in documenting a person’s health history. An open-source database, accessible only by registered healthcare centres, is now becoming a reality. Examples of how this might be used include enabling a simple assessment of medical history and helping avoid things like the consumption of falsified drugs.

Real Estate

From tokenisation of properties to efficient verification of tenant identity, blockchain is revamping the way real estate operates. It’s also removing the middleman in the transaction process by automating the transfer of ownership using smart contracts.

How to invest in blockchain?

The blockchain industry is maturing quickly, with more users and institutions adopting the technology and a growing number of services, products and applications being built on blockchain technology. As it becomes more mainstream, investing in blockchain will become more enticing. The diversity of blockchain has given rise to multiple avenues to invest in and leverage the potential of this disruptive industry.

Cryptocurrencies

By far the most popular application of blockchain tech is cryptocurrency. To date, over 10,000 cryptocurrencies are being traded publicly and each of them has its own use, ranging from buying digital art to funding movies. With more industries and sectors adopting blockchain technology, an increase in demand for digital currencies is likely.

Since most cryptocurrencies are dependent on a blockchain, they are a straightforward avenue to invest in. Given the speed to market and the well-known volatility of these currencies, potential investors should do plenty of research and due diligence. Reading the white paper or official documents of the associated project is a good way to begin understanding its credibility. If traders are interested in purchasing cryptocurrencies, they should first learn about the crypto spot market.

Cryptocurrency CFD Trading

Short for “Contract For Difference”, a CFD is a contract between a trader and a broker, where traders speculate on the change in a coin’s price.

In cryptocurrency CFD trading, the level of investment is often low when compared with directly investing in coins. This is due to traders only having to invest a percentage of the whole value of the trade to gain full exposure to it. So, if their prediction is correct, they gain profits for 100% of the trade value. However, if their prediction fails, they have to bear the entire loss.

Example

Traders are trading bitcoin CFDs with a trade value of $10,000. If they think Bitcoin will rise in value they would place a buy order (go long), if they think it will fall then they would place a sell order (go short). 

Traders only have to pay a small deposit from their initial $10,000 upfront – let’s say $100. Despite that, traders will still enjoy the profit based on the entire $10,000 – if their prediction is correct. But if their prediction is incorrect, they will have to pay the losses accrued on the total of $10,000.

Example of bitcoin cfd trade

Learn more about the difference between trading cryptocurrency on the spot market and cryptocurrency CFDs.

Firms providing blockchain services

Many established companies (think IBM, Microsoft and Amazon) provide blockchain services on their platforms, and many more multinational corporations are investing in this technology to diversify their services. With decentralised solutions popping up across the world, these services are likely to be in high demand for streamlining processes and reducing human error. So, investing in these firms is like dipping some toes in the blockchain market without staking their livelihood. And because these firms are not entirely reliant on blockchain, the risk is comparatively low.

Pure blockchain firms

Unlike the firms mentioned above, several companies have incorporated blockchain technology as their core competency; Microstrategy, Coinbase and Silvergate Capital are pure blockchain and crypto-related firms. They facilitate trading, decentralised applications, and other ventures that solve real-life problems using blockchain.

How is blockchain secure?

Many people tout blockchain as the future of industry and data storage, so its security is of paramount importance. Here are some critical factors required to maintain the integrity of the blockchain:

  • Distributed ledger

Blockchain uses a distributed network to record and store data. This means there is no single point of weakness that can be used as a loophole by a potential hacker.

  • Immutable

The blockchain allows its participants, or nodes, to perform only two functions: read and write. That leaves zero chance for a node to conduct fraudulent activities by altering the transaction records.

  • Cryptography

Mining nodes encrypt every block on the blockchain with unique digital signatures. The proof of ownership sits only with the true owner, hence theft is highly unlikely.

  • Consensus

Transactions recorded in the blockchain require approval by a series of nodes in the network. Only after achieving consensus and verifying the block can it be added to the chain. This prevents the manipulation of transactions and the ability to leverage them to commit fraud.

  • Perpetual recording

Blockchain is a dynamic ledger that keeps recording transactions endlessly. Since it’s also immutable, rolling back the ledger to edit blocks is difficult.

Cryptocurrency

What is a blockchain wallet?

A blockchain wallet is a digital wallet that allows users to transact on a blockchain, manage transactions and track the value of digital currencies. It works in a similar way to a bank account, with each wallet having a unique cryptographic address (similar to an account number) which is used to send, receive, and exchange cryptocurrencies.

Blockchain wallets are secured by a private key (a 256-bit number). Knowing this number will allow direct access to any funds held in the wallet, so it should not be shared. Make sure don’t forget it because, thanks to the decentralised nature of blockchain, there’s no ‘forgot my password’ service – if traders forget their private key, they’ll be locked out of their digital wallet forever!

There are two major types of blockchain wallets:

Hot wallet

In general, any wallet connected to the internet is a hot wallet. All crypto exchanges, apps and websites that facilitate trading come under this category.

Cold wallet

Any wallet that stores crypto without connecting to the internet is a cold wallet. It uses the internet only when traders are conducting a transaction. USB drives, paper wallets, and hardware not connected to the internet can act as cold wallets. 

A combination of hot and cold wallets can be a great way to secure coins while still being able to conduct transactions.  

Cryptocurrency wallet

Advantages of blockchain

Explore the five key advantages of blockchain below:

Decentralised structure

Using blockchain, people, organisations, machines, and even bots can transact and interact with each other with negligible friction. There’s no need for an intermediary to conduct a transaction. Similar to the way e-mail enables people to message with no geographical barrier, blockchain enables peer-to-peer interaction with no centralised authority.

Increased transparency

The immutable nature of blockchain makes it a shining example of transparency. Being a distributed ledger, data is recorded and time-and-date stamped before making it accessible to everyone. By decentralising the data storage, the chances of manipulation and fraud are minimised. This is why many people believe blockchain to be crucial for governments around the world to enable online voting.

Speed and efficiency

Blockchain can streamline and automate processes, which leads to increased speed and efficiency.

For example, how efficient would it be if patients could walk into any hospital, anywhere and get diagnosed? That’s what is envisioned if doctors have the patient’s medical history, sourced from a public health database. By attaching all the medical history to the individual’s public key, both time and effort are saved.

Enhanced security

Data on any blockchain is encrypted and immutable. Any effort to alter or steal data sets off the alarm to the entire blockchain as the records will no longer match. And since traceability of the record is possible, fraud detection is easy. All these contribute to making blockchain a secure technology.

Accessibility

The internet is making the world smaller with ease of communication across geographical barriers, yet achieving this inclusiveness in the financial sector has a long way to go. Using decentralisation, blockchain enables financial inclusivity as anyone with a basic internet connection can access its services.

Disadvantages of blockchain

We've explored the advantages now let us cover the disadvantages of blockchain:

Scalability

Bitcoin, on average, conducts 5-7 transactions per second (TPS). Comparing it with a centralised system like PayPal, which boasts of an average TPS of 1700, shows the problem of blockchain scalability. However, today’s third-generation blockchains can conduct transactions almost instantaneously. To put this into perspective, Solana, a new-age blockchain, can conduct 65,000 TPS.

As each transaction needs to be transmitted to all the nodes in the blockchain, a lot of time goes to waste. The growing volume of transactions has also adversely affected the fees, ease of mining, and block size. All of this contributes to blockchain potentially being slow, expensive and unsustainable.

Storage

From the first to the latest transaction, a mountain of data needs to be stored by all nodes. For example, the entire transaction history on the Ethereum blockchain has recently crossed 300GB; every node on the network storing 300+ GB worth of data is not feasible. With the blockchain touted to grow more in the coming years, the life span of the blockchain is questionable.

Security

The concept of security in the blockchain is like democracy. If the majority accept a lie as truth, then that lie is now a truth for the entire population. In cryptocurrency circles, it is referred to as a ‘51% Attack’. The need for computing power for mining is increasing by the day, and this is reflected in small-scale miners leaving the network. This provides a window for large-scale miners or mining institutions to collude and compromise the entire network.

But the probability of a 51% attack on large-scale blockchains such as Ethereum or Bitcoin is generally perceived to be minuscule. Coordinating an attack of this volume is extremely difficult, given the breadth of the networks and their diversity.

Pseudo anonymity

We know the ledger records every transaction and is accessible by anyone on the network. Imagine traders transfer 1 Ethereum to their child. In reality, they are letting them know all of their previous transactions that are linked to their wallet address. So, alongside 1 Ethereum, traders are also transferring their financial history to them.

This contradicts the argument that blockchain helps upkeep the privacy of individuals. Seeing this at an institutional level, the collateral damage could be catastrophic.

However, exceptions remain, as projects such as Monera and ZCash are working towards a completely anonymous ecosystem with no chance of traceability.

What is cryptocurrency?

Diagram of cryptocurrencies

Cryptocurrencies, also known as coins or tokens, are encrypted digital currencies. Since no government regulates them, cryptocurrency is the basis of a decentralised financial system. Most of these coins use blockchain technology to record their transactions.

With a smartphone and internet access, anyone can buy, sell, and exchange cryptocurrencies with no input from a bank. This peer-to-peer transaction method is a core advantage of cryptocurrencies as they are time-efficient and more secure than traditional banking systems.

There are over 10,000 coins available to trade in the crypto market, with each of them having a variety of uses. Bitcoin and Ethereum are two of the most famous cryptocurrencies in the current market. As Bitcoin continues solidifying its place as a credible store of value, Ethereum is fueling the use of smart contracts in the space.

The general view of cryptocurrency as a speculative asset is reducing as coins are becoming more widely used as a store of value. While cryptocurrencies are known to be volatile, as awareness and understanding of the market grow, the market is likely to become more stable.

A final word

Blockchain and cryptocurrencies like Bitcoin are here to stay. The sooner traders learn about how these technologies work the quicker traders will be able to adopt them as they become increasingly integrated into our lives.

FAQ


How is blockchain decentralised?

‘Decentralisation’ is a buzzword commonly associated with blockchain technology, but how does it actually work?

Let’s take the example of banks. They store data like users’ personal details, transaction history, and credit history in a single database. Likewise, they facilitate transactions in their individual server or network. Here, the bank is in complete control of the database and the server.

In a decentralised system, data is shared across several computers with no geographical consistency. Since all the computers maintaining the blockchain ledger are not under one roof, no single authority or group can collude and perpetrate fraud. If a particular computer attempts to tamper the records, all the other computers in the blockchain can cross-reference with each other to hold an accurate set of records. This system firmly establishes decentralisation and disallows fraudulent activities.


What is the difference between blockchain and cryptocurrency?

Simply put, blockchain is the technology that makes cryptocurrencies possible. But, the exponential growth of cryptocurrencies has made them synonymous with the technology itself.

A classic example to show the difference is gambling chips used in a casino. Here, the casino acts like the blockchain technology, where the chips are the token of value used to take part in transactions. When you’re outside the casino – i.e. outside the blockchain network – the chips or coins have no value.

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We hope that this guide will help traders on their journey to buying, owning and trading crypto. To start trading cryptocurrency CFDs with Axi, click here.



Alex Lielacher

Cryptocurrency Content Contributor

Alex Lielacher is a ‘banker-turned-bitcoiner’ who exchanged the bond trading desk for a laptop in a co-working space to provide engaging and educational content for leading companies in the blockchain technology space.

 

 

The information is not to be construed as a recommendation; or an offer to buy or sell; or the solicitation of an offer to buy or sell any security, financial product, or instrument; or to participate in any trading strategy. Readers should seek their own advice. Reproduction or redistribution of this information is not permitted.

Cryptocurrencies (such as Bitcoin) are extremely volatile and can move or jump in price with no apparent reason due to lack of liquidity and ad hoc news. There is little or no fundamental reasoning behind its pricing and as such trading CFDs in cryptocurrencies poses a significant risk to clients. For any Cryptocurrency CFDs that we limit to Monday – Friday trading, it is important to note that the underlying market will continue to trade over the weekend, meaning there could be a significant price change between Close of Business on Friday and open for business on Monday. Therefore, these symbols should be traded by clients with sufficient experience to  understand that, subject to negative balance protection (where available), they risk losing all their investment, or more, in a  short period of  time, and only a very  small part of their portfolio should be allocated.


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