Breaking down the Blockchain
Regulatory flux aside...one thing can be said with certainty. The underlying technology of Blockchain is here to stay. So let's get down to brass tacks.
Regulators of the world, unite!
Well for a change this may be true…
The legality of Blockchain’s many applications (Bitcoin, stable coins, DeFi, programmable money, payment dapps, NFTs et al.) may be suspect…but the core technology is here to stay.
To understand what the whole fuss is all about, here’s a brief explainer to understand what’s what.
Blockchain or Distributed Ledger Technology (DTL) is simply a database but it differs from a conventional one in several aspects. The main underlying difference is the way data is structured. In a DTL technology, information is collected and stored in groups called blocks. These blocks have a certain storage space and once the block is filled it is chained to previous filled blocks using cryptography. Each chained block contains a cryptographic hash of the previous block. The data once recorded can’t be altered.
Blockchain was invented by a person (or group of people) using the name Satoshi Nakamoto in 2008 to serve as the public transaction ledger of the cryptocurrency bitcoin, making it the first digital currency to solve the double-spending problem without the need of a trusted authority or central server.
Let's consider a simple example of Google Doc to understand this analogy better. When we create a document and share it with a group of people the document is distributed and not copied or transferred. This creates a decentralized chain that gives everyone access to the document at the same time. All modifications to the doc are recorded in real-time, making changes completely transparent. Obviously, blockchain is much more complex than just a Google doc. Since this is a distributed ledger no single entity can own the chain. Instead the entire network is decentralized into various entities called as nodes which are the storage points in any blockchain. If one node tries to tamper the data, all other nodes would cross-reference each other and easily pinpoint the node with the incorrect information. This enables the establishment of a transparent order of events.
Components of Blockchain
Blockchain has three components:
1) Blocks: Blocks contain the data and are chained together using a cryptographic hash. Other than data, they include nonce (32-bit randomly generated whole number at the creation of block) and Hash (256-bit number with which it is chained to the existing chain).
2) Miners: They create new blocks on the chain through a process called mining. In a blockchain every block has its own unique nonce and hash and also references the hash of the previous block in the chain, so mining a block isn't easy, especially on large chains. Miners use special software to solve the complex math problem of finding a nonce that generates an accepted hash. Because the nonce is only 32 bits and the hash is 256, there are roughly four billion possible nonce-hash combinations that must be mined before the right one is found. When that happens miners are said to have found the "golden nonce" and their block is added to the chain. Making a change to any block earlier in the chain requires re-mining not just the block with the change, but all of the blocks that come after. This is why it's extremely difficult to manipulate blockchain technology.
3) Nodes: Since blockchain follows a decentralized approach, no single computer/organization can own the chain. Instead it is a distributed ledger via the nodes connected to the chain. Nodes can be any kind of electronic device that maintains copies of the blockchain and keeps the network functioning. Every node has its own copy of the blockchain and the network must algorithmically approve any newly mined block for the chain to be updated, trusted and verified.
Advantages and Disadvantages of blockchain
1) Blockchain is decentralized while TD (Traditional Database) is centralized and controlled by administrators
2) Blockchain uses a DTL (Distributed Ledger Technology) while TD uses a client-server architecture
3) Operations are read and write vs. Read, write, update and deleted in TD
4) Data integrity is higher in a blockchain
5) Blockchain offers transparency as compared to TD where administrator decides who can access the data
1) Not easily scalable as mining a block requires solving highly complex math problems
2) Some blockchains consume a lot of energy
3) Setting up a bitcoin miner on a system is not easy as the ledger can easily cross 100's of GBs, making it inefficient on the data storage part
4) If an entity controls 51% or more of the network nodes, then it can result in control of the network. By doing so, they can modify the data in the ledger
Types of Blockchain
1) Public Blockchain - This is a non-restrictive, permission-less distributed ledger system. Anyone who has access to the internet can sign in on the platform to become an authorized node and be a part of the network. Example: Bitcoin, Ethereum, Litecoin
2) Private Blockchain - Private blockchain is a restricted blockchain operative only in a closed network, usually within an organization/s where only selected members are participants. The level of security, authorizations, permissions, accessibility is in the hands of the controlling organization. These are deployed for voting, supply chain management, digital identity, asset ownership, etc.
3) Consortium Blockchain - Similar to private blockchain except that it is semi-decentralized having more than one controlling organization. These are typically used by banks.
4) Hybrid Blockchain - A hybrid blockchain has a combination of centralized and decentralized features. The exact workings of the chain can vary based on which portions of centralization-decentralization are used.
5) Sidechains - Sidechain or childchain is a separate blockchain that is attached to a parent blockchain using a two-way peg which enables interchangeability of assets at a predetermined rate between the two. Sidechains are emerging mechanisms that allow tokens and other digital assets from one blockchain to be securely used in a separate blockchain and then be moved back to the original blockchain if needed, therefore enhancing the capabilities of existing blockchains.
Popular uses of Blockchain technology other than Cryptocurrency
1) Smart Contracts - Blockchain-based smart contracts can be executed without human interaction using an automated escrow mechanism. They do not need a trusted third party to act as an intermediary between contracting entities. This may reduce friction between entities when transferring value, opening the door to a higher level of transaction automation.
2) Banks - Distributed ledgers can be used in banking to speed up back office settlement systems.
UBS is opening new research labs dedicated to blockchain technology in order to explore how blockchain can be used in financial services to increase efficiency and reduce costs.
3) Supply chain - There have been several different efforts to employ blockchains in supply chain management such as tracking origins of gemstones and precious commodities, enabling retailers and consumers to track meat and other food products from origins to stores and restaurants.
4) Anti-counterfeiting - Useful in detecting counterfeits by associating unique identifiers to products, documents and shipments, and storing records associated with transactions that cannot be forged or altered.
5) Healthcare - In response to the COVID-19 pandemic, The Wall Street Journal reported that E&Y was working on a blockchain to help employers, governments, airlines and others keep track of people who have had antibody tests and could be immune to the virus. Hospitals and vendors also utilized a blockchain for needed medical equipment.
6) Domain names - Offering domain name services via blockchain wherein such domain names can be controlled by the use of a private key, which purport to allow for uncensorable websites. This would also bypass a registrar's ability to suppress domains used for fraud, abuse, or illegal content.
7) Other uses - Blockchain can be used to create a permanent, public, transparent ledger system for compiling data on sales, tracking digital use and payments to content creators, such as wireless users or musicians. New distribution methods are available for the insurance industry such as peer-to-peer insurance, parametric insurance and microinsurance following the adoption of blockchain. IoT is also set to benefit from blockchains because they involve many collaborating peers. Online voting is another application of the blockchain.
What backs up the value of any Cryptocurrency?
Cryptocurrencies in general are not backed by any gold or silver hence do not have any intrinsic value. The value of any currency comes from the backing of the state and the trust that people have over the government. In a somewhat similar way, cryptocurrencies also gain their value based on the scale of community involvement like the user demand, scarcity or coin’s utility.
1) Coin's utility - Any cryptocurrency is primarily a manifestation of using a decentralized digital ledger — blockchain technology. A crypto's utility depends upon its usability within a certain blockchain ecosystem. For ex: One can't use the Ethereum platform without an Ether — a coin, specially tailored to “fuel” the transactions within the Ethereum platform. Accordingly, the value of Ethereum depends on the demand for the platform's services. Cryptocoins’ utility can also include dividend payments, mode of exchange within a blockchain ecosystem, voting rights etc.
2) Scarcity/finite nature of digital coins - In the perfect scenario, the demand should exceed the supply of the coins, to make it more valuable. The finite supply of Bitcoin never goes beyond 21 million coins. As the most popular crypto in the market, Bitcoin thus enjoys great demand and a rise in value. In a bid to fuel the rise in value, some currencies apply a so-called “burning” mechanism, destroying a part of the coin supply.
Recently, Ethereum's co-founder Vitalik Buterin burned around 40% of the total Shiba Inu tokens in circulation by sending them to a dead blockchain, effectively taking them out of circulation forever.
3) Perceived value of the project - Any cryptocurrency's value depends on the overall viability and progress of the project development. Projects that keep developing, achieving one milestone after another, establishing lucrative partnerships or launching user-friendly software becomes more valuable in the eyes of the market. All of these are indicators, largely contributing to the positive sentiment around the project and affecting the value of its cryptocurrency.
4) Node count - Node count is a measurement of how many active wallets on the network exist which can be searched on the internet or the homepage of a currency. By comparing the node count and the total market capitalization of any two cryptocurrencies, one can analyze whether or not a currency has a fair price.
5) Production cost - The direct costs and opportunity costs of producing a coin are also factors which determine the value of a cryptocurrency. Bitcoin, for example, has a high cost of production. The resources and energy that have been put into the mining of bitcoin can be seen as a reason why bitcoin has value. This includes the cost of manufacturing specialized hardware like CPUs/GPUs or servers as well as the cooling systems for such hardware.
Energy costs are also significant. Research shows mining process of bitcoin consumes around 121.36 terawatt-hrs (TWh) per year, more than Argentina, Netherlands, UAE and Norway.