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Blockchain Simplified: What is Blockchain and How Does It Work?

If you are new to the crypto space, you’ve likely heard the term “blockchain” tossed around quite a bit. Blockchain is an important piece of the crypto puzzle. In fact, without blockchain, cryptocurrencies won’t even exist. It is the backbone of cryptocurrencies like Bitcoin, but it’s not just limited to that. Blockchain has sparked innovation and driven changes in the financial landscape and holds the potential to transform industries. But what exactly is it, and how does it work? In this article, we’ll explain blockchain in a beginner-friendly way to make it easier to understand. Let’s jump in!

What is Blockchain?

To understand blockchain, think of it as a digital ledger that logs transactions, but the record of those transactions isn’t kept in one central spot. Instead, it’s scattered across a network of computers. Moreover, this ledger is immutable, meaning it can’t be altered or tampered with. This helps ensure that the information on the ledger is decentralized and is not controlled by a single person, organization, or any sort of entity. This modern digital ledger is what we call Blockchain.

The two key features defining blockchain are its immutability and distribution. Immutability assures that the ledger is reliable, while distribution shields it from potential network threats. Each transaction or entry on the ledger resides in a “block.” This block is connected to the information in the previous block, forming a chain of recorded transactions. This is where the name “blockchain” comes from. In short, blockchain is a secure and transparent way of recording digital transactions that is not controlled by any entity.

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How Does Blockchain Work?

The way blockchain works is somewhat similar to a database where information is input and stored. However, the main difference lies in how the data is structured and accessed.

Within a blockchain, there are programs known as scripts that perform typical database tasks like inputting, accessing, and storing information. The main feature is its distribution; copies are stored on numerous machines, and all must align for the data to be valid.

In blockchain, transaction details are gathered and placed into a block. When the block is full, an encryption algorithm processes the information, generating a unique hexadecimal number known as the hash. This hash is then added to the next block’s header, becoming part of the encryption with other information in that block. This creates a chain of interconnected blocks, thus referred to as blockchain. The secure and linked nature of this process ensures the reliability and transparency of the recorded transactions.

How Does Blockchain Work

Types of Blockchains

Public Blockchain:

A public blockchain is a decentralized ledger system that operates without restrictions or permissions, making it transparent. In this setup, anyone can join the network and validate transactions. The primary use of public blockchains is in cryptocurrency exchange and mining. The Bitcoin blockchain is the obvious example here; it employs a proof-of-work consensus process to confirm transactions and add them to the blockchain.

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Consortium Blockchain:

On the other hand, a consortium blockchain, also known as a federated blockchain, is a private blockchain jointly owned and managed by multiple companies. Multiple organizations collaborate, providing access to pre-selected nodes for reading, writing, and auditing the blockchain. This type of blockchain, such as IBM Food Trust and R3 corda, facilitates cooperation among different entities, building a semi-decentralized network.

Hybrid Blockchain:

The term “hybrid blockchain” refers to a system that integrates features from both public and private blockchains. This architecture allows for complete programmability, with members having the flexibility to determine which transactions are made public and who is granted access to the blockchain. While transactions can be made public for verification purposes, they are often not universally accessible.

Sidechains:

A sidechain is a parallel blockchain that operates alongside the main chain, allowing the movement of digital assets between different blockchains. The use of sidechains improves scalability and efficiency in handling transactions. An example of a sidechain is the Loom Network, which shows how this concept can be implemented to facilitate interaction between different blockchain networks.

Advantages of Blockchain

Blockchain technology offers several benefits that have revolutionized the traditional financial systems. Some of these main benefits include:

Immutability and Trust:

As highlighted above, Immutability is one of the main benefits of this technology. Blockchain ensures the immutability of records, making transactions trustworthy. Parties can engage in trusted transactions without needing to know each other personally. Transactions only occur when pre-programmed conditions are met by both parties, ensuring a secure and automated process.

Tamper-Proof Records:

The records on a blockchain are tamper-proof, and the secure nature of Bitcoin and Ethereum reflects that. Hacking attempts have proven useless, thanks to the highly complicated process of solving and verifying complex mathematical problems before adding a new block. Each block’s unique cryptographic key is created from the previous block’s information, making it consistent and secure.

Decentralization and Consensus:

Unlike centralized systems, no single entity maintains the blockchain network. Decisions are made through consensus, which makes it both accessible and resilient. Decentralization is vital as it allows easy access for users and minimizes the risk of single points of failure. Also, it ensures that no government or organization can fully control it.

Open-Source Accessibility:

Public blockchains are open source, allowing everyone to access transaction information and source code. This transparency encourages users to build new applications and suggest improvements to the code. The acceptance or rejection of these suggestions is determined through a consensus mechanism and is decided collectively by the community.

Low-Fees:

Cryptocurrencies like Bitcoin enable direct transactions without intermediaries, such as banks, thus removing transaction and handling fees entirely from the picture. This direct peer-to-peer capability allows for cost-effective transactions globally. The only fee you have to pay is the blockchain transfer fee, and that’s it.

Financial Inclusion:

Financial inclusion

Blockchain addresses the issue of financial exclusion by providing access to banking for millions of people worldwide. Since anyone can access the blockchain to store money, it becomes a top-tier tool to give banking access to people who don’t have it. Additionally, it reduces the risk of theft from holding physical money and assets. This will be extremely helpful in locations where crime isn’t managed properly.

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Disadvantages of Blockchain

While blockchains are changing the world with their usefulness, they also come with a few drawbacks that should not be ignored. Let’s take a look at some of the most prominent blockchain drawbacks.

High Energy Consumption:

Blockchain networks, especially those like Bitcoin, consume considerable electricity to validate transactions, raising major environmental concerns. The proof-of-work mechanism in Bitcoin mining threatens climate change goals; it has already raised climate concerns in regions like China.

High energy consumption

Environmental Impact:

The extensive energy usage in blockchain processes contributes to environmental issues. While Bitcoin adheres to higher environmental standards, it is important to acknowledge its impact and the ongoing debate surrounding its sustainability, especially in comparison to traditional financial systems.

Self-Custody Risks:

One of the attractive features of blockchain and cryptocurrencies is self-custody. While this empowers individuals to control their funds like a personal bank, it comes with a significant risk. There is no recourse if you lose your seed phrases and the keys to access and recover your wallets. Your funds are lost in the void forever if you lose your passcodes.

Potential for Unlawful Activity:

Blockchain’s anonymity feature, while advantageous, also presents risks. Some cryptocurrencies are exploited for illegal activities, such as money laundering and buying illegal goods using Bitcoin on platforms like the dark net. However, it’s worth considering that such activities occur with traditional currencies as well, and the narrative that cryptocurrencies are solely used for illicit purposes only delays broader adoption that can benefit millions of people.

Scalability Challenges:

While public blockchains are more efficient than traditional banking systems, the decentralization aspect poses scalability challenges. Growing blockchain networks to a global scale is held back by speed inefficiencies. However, ongoing developments, such as the Lightning Network for Bitcoin and various Layer 2 solutions for Ethereum, aim to enhance scalability and transaction speed in the future.

Is Blockchain Secure?

Blockchain technology ensures security through decentralized mechanisms. Here’s how it works:

Firstly, new blocks are consistently added to the end of the blockchain, maintaining a linear and chronological structure. Once a block is added, it becomes a permanent part of the chain, and alterations to previous blocks are practically impossible.

Any modification to data within a block alters the block’s hash. Since each block contains the hash of the previous one, any change ripples through the entire chain, affecting subsequent blocks. The network detects these discrepancies, and any attempt to tamper with a block is promptly rejected due to the mismatched hashes.

Blocks’ interconnected nature and reliance on cryptographic hashes make them extremely secure. But do keep in mind that not all blockchains are completely safe. A lack of well-developed blockchain can have vulnerabilities that can prove dangerous and be exploited.

Conclusion:

Blockchain offers decentralized security, transparency, and efficiency. Despite its challenges, such as energy consumption, the benefits it offers for multiple industries are undeniable. As companies increasingly recognize its potential, further investment and innovation will likely uncover new applications of blockchain technology in the future. Understanding the fundamentals of blockchain is essential when you are diving into cryptocurrencies, and this guide aims to provide that foundation. Remember always to be safe and take preventive measures while investing in crypto.

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