What is Blockchain Technology? A Step-by-Step Guide For Beginners

What is blockchain technology? What makes it so important?

Imagine a world where you can send money directly to someone without a bank in seconds instead of days, and you dont pay exorbitant bank fees.

Or one where you store money in an online wallet not tied to a bank, meaning you are your own bank and have complete control over your money. You dont need a banks permission to access or move it, and never have to worry about a third party taking it away, or a governments economic policy manipulating it.

This is not a world of the future; it is a world that an avid but growing number of early adopters live in right now. And these are just a few of the important blockchain technology use cases that are transforming the way we trust and exchange value. Well get into the rest later on.

Yet, for many, blockchain technology is still a mysterious or even intimidating topic. Some even remain skeptical that well use this technology in the future. This skepticism that exists today is understandable because were still very early in the development and widespread adoption of blockchain technology.

2021 is to blockchain what the late 1990s were to the internet. And like the internet, blockchain technology is anything but a fad, its here to stay, and if youre reading this, youre early too.

This post demystifies blockchain technology. This is your intro to blockchain technology 101. A complete, easy-to-understand, step by step beginners blockchain breakdown. Youll learn everything from what blockchain is and why it matters, to how blockchain works (step by step) and what today tomorrows most promising blockchain applications may be.

Youll also walk away from this post confident, and well on your way to making informed, independent blockchain technology investment decisions. And youll be no slouch if you want to hold your own in conversations with family and friends too!

So lets dive in

Blockchain technology is the concept or protocol behind the running of the blockchain. Blockchain technology makes cryptocurrencies (digital currencies secured by cryptography) like Bitcoin work just like the internet makes email possible.

The blockchain is an immutable (unchangeable, meaning a transaction or file recorded cannot be changed) distributed digital ledger (digital record of transactions or data stored in multiple places on a computer network) with many use cases beyond cryptocurrencies.

Immutable and distributed are two fundamental blockchain properties. The immutability of the ledger means you can always trust it to be accurate. Being distributed protects the blockchain from network attacks.

Each transaction or record on the ledger is stored in a block. For example, blocks on the Bitcoin blockchain consist of an average of more than 500 Bitcoin transactions.

The information contained in a block is dependent on and linked to the information in a previous block and, over time, forms a chain of transactions. Hence the word blockchain.

There are four types of blockchains:

Public blockchains are open, decentralized networks of computers accessible to anyone wanting to request or validate a transaction (check for accuracy). Those (miners) who validate transactions receive rewards.

Public blockchains use proof-of-work or proof-of-stake consensus mechanisms (discussed later). Two common examples of public blockchains include the Bitcoin and Ethereum (ETH) blockchains.

Private blockchains are not open, they have access restrictions. People who want to join require permission from the system administrator. They are typically governed by one entity, meaning theyre centralized. For example, Hyperledger is a private, permissioned blockchain.

Consortiums are a combination of public and private blockchains and contain centralized and decentralized features. For example, Energy Web Foundation, Dragonchain, and R3.

Take note: There isnt a 100 percent consensus on whether these are different terms. Some make a distinction between the two, while others consider them the same thing.

A sidechain is a blockchain running parallel to the main chain. It allows users to move digital assets between two different blockchains and improves scalability and efficiency. An example of a sidechain is the Liquid Network.

Blockchain isnt just a database, its a new technology stack with digital trust that is revolutionizing the way we exchange value and information across the internet, by taking out the gatekeepers from the process. For a complete and more detailed deep dive check out our article: A Concise History of Blockchain Technology

Blockchain history goes back farther than you might imagine, but weve condensed it by answering four critical questions:

The first blockchain-like protocol was proposed by cryptographer David Chaum in 1982. Later in 1991, Stuart Haber and W. Scott Stornetta wrote about their work on Consortiums.

But it was Satoshi Nakamoto (presumed pseudonym for a person or group of people) who invented and implemented the first blockchain network after deploying the worlds first digital currency, Bitcoin.

Cryptography is a deep and fascinating discipline with a history that goes back further than blockchain. For a richer understanding of how cryptography helps blockchain technology, check out: Why Cryptography Makes Blockchain Unstoppable

Because blockchain technology is the technology behind the blockchain, it cannot be owned. Its like the internet. But anyone can use the technology to run and own their own blockchains.

Satoshi Nakamoto.

Nakamoto sent ten bitcoins to Hal Finney, who built the first reusable proof-of-work system in 2004.

For a more in-depth account of the next section, check out the thorough discussion in: What is Blockchain Technology and How Does it Work?

Lets start with an oversimplification.

As a society, we created ledgers to store informationand they have a variety of applications. For example, we use ledgers in real estate to store a houses records, such as when alterations were made or the house was sold. We also use ledgers in bookkeeping to record all the transactions a company makes.

Bookkeeping mostly relies on double-entry accounting to store transactions. Although this is a step-up from single-entry accounting that lacks transparency and accountability, double-entry accounting also has its pitfalls: Entries are accounted for separately, making it difficult for one counterparty to verify the others records.

Records stored using traditional ledgers are also easy to tamper with, meaning you can easily edit, remove, or add a record. As a result, youre less likely to trust that the information is accurate.

Public blockchains solve both these problems and the way we trust by evolving the traditional bookkeeping model to triple-entry bookkeeping: transactions on a blockchain are cryptographically sealed by a third entry. This creates a tamper-proof record of transactions stored in blocks and verified by a distributed consensus mechanism.

These consensus mechanisms also ensure new blocks get added to any blockchain. An example of a consensus mechanism is proof-of-work (PoW), often referred to as mining.

Mining isnt universal to all blockchains; its just one type of consensus mechanism currently used by Bitcoin and Ethereum, though Ethereum plans to move to anotherproof-of-stake (PoS) by 2022.

Heres how this process works with Bitcoin. When sending Bitcoin, you pay a small fee (in bitcoin) for a network of computers to confirm your transaction is valid. Your transaction is then bundled with other transactions pending in a queue to be added to a new block.

The computers (nodes) then work to validate this list of transactions in the block by solving a complex mathematical problem to come up with a hash, which is a 64-digit hexadecimal number.

Once solved, the block is added to the networkand your fee, combined with all other transaction fees in that block, is the miners reward. Its that simple.

Each new block added to the network is assigned a unique key (via cryptography). To obtain each new key, the previous blocks key and information are inputted into a formula.

As new blocks are continually added through the ongoing mining process, they become increasingly secure and harder to tamper with. Anyone caught trying to edit a record will simply be ignored. All future blocks then depend on information from prior blocksand this dependency from one block to the next forms a secure chain: the blockchain.

You can see this depicted below for house records stored on the blockchain. For example, Block 2 provides a key after taking all the information from Block 1 into account (including the key) and inputting it into a formula. Block 3, in turn, provides a new key after taking all the information from Block 1 and Block 2 into account (including the key) and inputting it into a formula. And so, the process repeats itself indefinitely.

Now, lets dig deeper, exploring proof-of-work (PoW) vs. proof-of-stake (PoS) and the blockchain trilemma, which are fundamental to the public blockchains functioning.

A public blockchain functions through consensus mechanisms: the process for validating transactions without a third party like a bank.

PoW and PoS are two such mechanisms. While their goalto reach a consensus that a transaction is validremains the same, how they get there is a little different.

PoW, the technical term for mining, is the original consensus mechanism. It is still used by Bitcoin and Ethereum as of writing but, as mentioned, Ethereum will move to PoS by 2022. PoW is based on cryptography, which uses mathematical equations only computers can solve.

The example in the previous section of how blocks get added to the Bitcoin Blockchain explains this system.

The two big problems with PoW are that it uses a lot of electricity and can only process a limited number of transactions simultaneously (seven for Bitcoin). Transactions typically take at least ten minutes to complete, with this delay increasing when the network is congested. Though compared to the days-long wait required to wire money across the globe, or even to clear a check, Bitcoins ten-minute delay is quite remarkable.

Other consensus mechanisms were created to solve these PoW problems; the most popular being PoS.

PoS still uses cryptographic algorithms for validation, but transactions get validated by a chosen validator based on how many coins they hold, also known as their stake.

Individuals arent technically mining, and theres no block reward. Instead, blocks are forged. Those participating in this process lock a specific number of coins on the network.

The bigger a persons stake, the more mining power they haveand the higher the chances theyll be selected as the validator for the next block.

To ensure those with the most coins arent always selected, other selection methods are used. These include randomized block selection (forgers with the highest stake and lowest hash value are chosen) and coin age selection (forgers are selected based on how long theyve held their coins)

The results are faster transaction times and lower costs. The NEO and Dash cryptocurrencies, for example, can send and receive transactions in seconds.

Most blockchain projects are built around three core properties: decentralization, scalability, and security. Developers are constantly trying to balance these aspects, so one isnt compromised.

But they often have to sacrifice one for the others. The blockchain trilemma, concept was first coined the scalability trilemma by Ethereum founder, Vitalik Buterin.

Lets look at these concepts in more detail and explore the tradeoffs:

Decentralization means theres no central point of control. Instead, decisions are made via consensus over a distributed network of computers.

There is, however, one significant tradeoff: speed. Sending transactions takes longer because multiple confirmations are required to validate a transaction. Hence why Bitcoin is slow.

Scalability is the ability of the system to cope with a growing number of transactions. Scalability is crucial for mass adoption because any system needs to operate efficiently as more people use it.

Below is a rough breakdown of how many transactions Ethereum, Bitcoin, and credit card companies can process per second:

But achieving scalability often comes at the expense of decentralization. EOS, for example, promises a maximum of 4000 TPS but has come under criticism for being too centralized.

Security is the ability of a blockchain to be protected from attacks. Unfortunately, exchanges and source code have been hacked on many occasions, suggesting that many developers focus on scalability and decentralization at the expense of security.

Bitcoin and Etherum are the two biggest cryptocurrencies and blockchains, so discussing and comparing them makes sense.

The Bitcoin network is a public, decentralized peer-to-peer payment network that allows users to send and receive bitcoins without a bank getting involved. The digital currency or bitcoin token uses the ticker symbol BTC, and is the only cryptocurrency traded on the Bitcoin network.

Transactions are recorded using a digital ledger, and nodes ensure the PoW consensus mechanism is followed (or that mining happens). For many, Bitcoin seems complicated, but it isnt when you view it as a combination of three things:

In 2013, after traveling, meeting with bitcoin developers, and discovering Bitcoins limitations, Vitlaik Buterin decided to improve upon the Bitcoin blockchain and built Ethereum.

The Ethereum network is a public, decentralized peer-to-peer network. Like Bitcoin, it uses nodes and allows users to send and receive cryptocurrencyin this case, Ether.

The network is much more than a payment systemit was primarily created to deploy decentralized applications (dapps) and smart contracts.

Dapps are simply decentralized apps, or computer programs that interact with the Ethereum blockchain. Smart contracts, however, operate on the Ethereum blockchain, and are contracts that automatically execute without an intermediary once certain conditions (written into computer code) are met. For example, a smart contract could be programmed to send a designated person a portion of your Bitcoin when you die.

In summary, Bitcoin and Ethereum networks are public, decentralized peer-to-peer networks with their own tokens: bitcoins and Ether. Both rely on cryptography, and both use digital ledger technology. For a complete Ethereum vs. Bitcoin match up check out our deep dive post: Ethereum Vs Bitcoin: Whats the Difference?

But they differ significantly in purpose and capability. Bitcoin is a decentralized payment system and a store of value. Its blockchain is a database of all bitcoin transactions and tracks their ownership. Ethereum is more than a payment system and allows smart contracts and apps to be built on it, making it a more sophisticated blockchain.

Public open source blockchains are not without their hazards and challenges. Here is a list of the top concerns:

Blockchain networks like Bitcoin use a lot of electricity to validate transactions, leading to environmental concerns. For example, Bitcoin consumes more electricity than a small, medium-sized European country, and Bitcoin mining is threatening Chinas climate change goals.

However, many would argue that Bitcoin is held to higher environmental standards than anyone and anything. This may be true, especially if you consider that the blockchain and Bitcoin are an alternative to the traditional finance system that uses much more electricity and has a much larger environmental impact.

A study by Galaxy Digital suggests Bitcoin energy consumption is less than half that of the traditional banking system. If anything, you could argue that Bitcoin is a step in the right direction for the environment.

No one is saying that making strides to lowering the carbon footprint shouldnt be on the agenda (this is already happening with some mining farms shifting to renewable energy sources like solar panels and the El Salvadoran President calling for a plan to use geothermal energy (volcanoes) to mine Bitcoin).

But its crucial to maintain a balanced view when viewing the cost, environmental impact, and blockchain benefits.

One of blockchains and cryptocurrencies most significant advantages is also its biggest weakness. When you invest in public open-source blockchains by mining or buying cryptocurrencies and store it in your cryptocurrency wallet (your wallet is like your bank account, except only you can access it and have the passwords), only you control your money.

You are your own bank and this is great! But if you lose your seed phrases the list of words that give you access to recover your wallets there is no recourse (compared to banks where you can reset your password). Your money is lost forever.

Unsurprisingly, a large portion of Bitcoin remains permanently lost. According to some estimates, 20% or 3.7 million of the currently minted Bitcoin is probably lost forever.

Even though public blockchains remain more efficient than traditional banking systems, decentralization comes at the cost of scalability. Trying to grow blockchain networks to global capacity, in turn, is the root cause of speed inefficiencies. Its why, as we saw, Bitcoin and Ethereum can only process a maximum of seven and 30 transactions, respectively, compared to Visas 24,000.

Luckily solutions are being built to improve scalability and the speed of transactions. For example, the lightning network allows transactions to happen off the Bitcoin blockchain to speed up transactions. On Ethereum, many innovative Layer 2 (L2) solutions are being developed to improve scalability and speed including rollups, zero-knowledge proofs and side chains.

Some cryptocurrencies are undoubtedly used in unlawful activity. The most famous example is Silk Road: people laundered money and bought drugs on the platform using Bitcoin.

However, this is no different from the illegal activity that constantly happens when people use other currencies like the Dollar.

This false narrative that cryptocurrencies are only or mainly used for illicit activities only delays their inevitable adoption, which can hugely benefit everyone, including the financial system.

For an even more in-depth discussion of the most interesting and disruptive blockchain use cases as of 2021 check our guide: Disruptive Blockchain Technology Use Cases 2021

Blockchain technology is currently used across various industries like supply chain, healthcare, retail, media and advertising, financial services, insurance, travel and transportation, oil and gas, and gaming.

Here are some promising use cases:

With blockchain offering some promising use cases, helping many companies become more efficient, and attracting big companies like Amazon and Tesla, it can be an attractive investment.

But there are risks: Its a new technology, and many projects will not pan out. So, invest only what you can afford to lose, do your own research to determine if the project (or initial coin offering) is worth investing in, and decide what level of exposure you want.

For example, you can get more exposure by investing in cryptocurrencies directly instead of an exchange-traded fund (ETF).

That being said, here are a variety of ways you can invest in the blockchain depending on your goals and risk tolerance:

If youre looking to get started with crypto investing, weve created a comprehensive step-by-step guide you can follow to get started here: How To Invest in Cryptocurrencies: The Ultimate Beginners Guide