In order to understand how cryptocurrencies work, we first should have a clear understanding of how blockchains work. Blockchains are a method of storing data in a distributed, decentralized way across many nodes, the term given to participating computers. Trust that the data is accurate comes from consensus rather than a central authority. Once data is added to the blockchain, it cannot be changed, giving it the property known as immutability. This is highly desirable for data which you want to remain stable, such as financial records.
The mainstream financial system has central authorities. In the USA, for example, there is the Federal Reserve as the central bank which manipulates money supply in order to influence the stability of unemployment and inflation. The Fed works closely with the major banks, which have the conflicting goals of maximizing returns for their owners and minimizing risks for their customers. We have to trust that these major banks honestly report their financial records and clearly communicate their risk posture through auditors and shareholder meetings. Unsurprisingly, a more optimistic than realistic picture is usually painted. This is how we end up with bubbles in the economy which create a lot of damage when they pop. Blockchains are a way to sidestep trusting central authorities with conflicting interests by making the data replicate across many nodes around the world, so that every node knows the accurate record. But how is this accomplished?
You may be familiar with spreadsheets or databases. A blockchain works a lot like these, but instead of being stored at one central node (often a server or workstation PC) the records are duplicated across all nodes in the system. When a transaction is received by the blockchain, it stores it in a block - similar to a row in a spreadsheet. Once a certain number of transactions are added to the block to fill it up, it is run through an encryption algorithm creating a value known as a hash.
Hashing is a way to mathematically represent the value of a data input. Some common examples of hashing algorithms are MD5, SHA-1, SHA-2, and NTLM. Often when one downloads an image (ISO) file from a Linux distribution’s website (as mentioned in my post comparing Linux and crypto), beside the image files will be files containing the hash values for those images. The idea is for you to run a hash algorithm on the image file you download and then compare that hash value with the one provided by the developers. This helps ensure that you have the same exact data they released which has not been tampered with, corrupted, or otherwise altered.
Back on the blockchain, the hash value is added to the header of the next block, allowing the cycle of that block being filled with transactions and being hashed to begin. In cryptocurrencies, different hash algorithms and different ways of prompting the miners to calculate these hashes are used, some more computationally demanding than others. But that’s a topic for another post.
So why is this method preferable to the centralized authority method?
Having many identical copies distributed all over ensures that redundancy and integrity of the data are maintained.
Anyone can verify the contents of the blockchain. This transparency combined with the consensus across all nodes means that nobody can secretly tamper with the data trying to alter it. If they tried to provide their different hash, the other nodes would reject it.
For a rogue actor to get around the consensus enforcement, they would have to control at least 51% of all the machines acting as nodes on the blockchain network. But since anyone can contribute their computing power to the mining process and there are huge numbers of nodes which are acting legitimately, this would be impractical.
Blockchains are not only used for cryptocurrency transactions. They can also be used to store data about healthcare records, property ownership, supply chains, voting, smart contracts, and this blog is stored on a blockchain as well! The possibilities unlocked by this new way of storing data are changing the way things are accomplished in many places around the world. Some companies are even being run through blockchains rather than a centralized board of directors.
In future posts on this blog, I’ll go more into the various services which can be built on blockchains. So if you’re eager to read more, subscribe to get notified of new posts, and please consider collecting this post to financially support the blog!