Introducing blockchain technology

You might have heard the parable of the blind men and the elephant. It is a folktale about six blind men’s individual descriptions of the same elephant based on their own perceptions from touching particular parts of the animal, each of them giving very different descriptions of what they think the creature looks like. It highlights the fact that different perspectives can lead to distinct viewpoints, emphasizing the limits of perception and the importance of a complete context.

When Satoshi invented Bitcoin, the fundamental concept of its vision was to build a blockchain, a shared public ledger (longest Proof-of-Work (PoW) chain), that verifies and immutably records all transactions through a decentralized computer network (P2P network) and a consensus mechanism with computational proof. Satoshi thus came up with an elegant solution to the double-spend problem in digital money. A double-spend is an attack where someone tries to spend money in a transaction that isn’t actually available anymore as the money has already been spent.

Blockchain is a new elephant in the digital world. To most of the public, blockchain is nothing but an obscure pseudonym for all cryptocurrencies, including Bitcoin, Ethereum, and more. So, what is blockchain? What does a blockchain look like? How does it work? Where can we use blockchain? Do you need a blockchain? There are many ways to describe a blockchain from different perspectives, but there is no universal definition of a blockchain.

On the contrary, there are prevalent debates over the essential attributes or qualities of a blockchain. It is perceived as a new architecture using existing technologies, the next generation of the internet and web, a future database and distributed shared ledger, the new Napster (a P2P file-sharing system used in the 90s) with a pure decentralized P2P network, a cryptocurrency, a trustless secure transaction system, and so on. In reality, it is all of these. Only by combining all of these perspectives can we understand the whole picture of blockchain technologies and get a sense of the true potential of blockchain.

The following picture illustrates different viewpoints of blockchain technology:

Figure 1.1 – Different viewpoints on blockchain technologies

So, what is a blockchain anyway? Think of blockchain as a new architecture paradigm and a new trust protocol. It is a computer science primitive forming the foundation of most cryptocurrencies and decentralized applications. It is a P2P transaction model that can enable two parties to transact in a way that is tamper-resistant and cryptographically proven. As the technology behind Bitcoin and other cryptocurrencies, blockchain is an open, distributed ledger that can be simultaneously used and shared within a large, decentralized, publicly accessible network.

In essence, blockchain is a distributed shared ledger technology supported by three pillars, as shown in the following figure; these are P2P networks, cryptography, and a consensus mechanism:

Figure 1.2 – Key components of blockchain

To understand how blockchain works, let’s start with the fundamental concepts and key building blocks of blockchain technologies. Then, we’ll discuss the key differences between centralized, distributed, and decentralized systems. We will then dive into the blockchain data structure and discuss how transactions, blocks, and chains are maintained and how the network reaches a consensus on the state of the chain, as well as how to secure the blockchain with cryptographic technologies.

The following lists the key building blocks of blockchain technologies:

• Transactions: A transaction is a value transfer between two parties. It could be a transfer of money, tangible assets, or cryptocurrency. Transactions are broadcasted to the blockchain network. They are validated and verified by all nodes and collected into blocks. Once the block reaches a certain depth — in Bitcoin, this is six blocks — those transactions in the block can be considered irreversible.
• Block: All verified transaction records are collected into a data structure called a block. It has a header and body part, where the header contains a cryptographic hash of the previous block, a timestamp, and a Merkle tree root hash of all transactions in the block. The body is the container of transaction data. A Merkle tree is like the digital fingerprint of transactions in the block, which we will discuss extensively later in this section.
• The chain of block (blockchain): A blockchain is a linked list of a chain of blocks. Blocks are linked together using a cryptographic hash as the pointer to the previous block.
• Decentralized P2P network: It is a P2P network in which interconnected nodes share resources between themselves without the use of a central authority or some sort of intermediary.
• Consensus protocol: The consensus protocol in blockchain is a set of rules that all network nodes will enforce when considering the validity of a block and its transactions. The consensus mechanism is the process used by the network nodes to achieve agreement on the network state. It is a fault-tolerant mechanism to ensure the reliability and integrity of the network.
• Mining: Mining is the process by which network nodes in blockchain systems add new blocks to the blockchain and get rewarded with crypto-incentives.

In the next section, we will discuss how P2P networks work.

Decentralized P2P networks

To explain how blockchain works, let’s look at the steps involved with the existing business model for completing a simple payment transaction.

A customer, Alice, needs to pay $10 to Bob, who is in a geographically distant region from Alice and happens to have an account in the same bank as Alice. She can make the payment either by visiting a bank branch or using the web. Let’s say she tries to do it online through the bank’s web portal. She will need to authenticate herself using her username and password and then put the transfer order in and wait for the bank system to confirm whether the transaction is completed.

As shown in the following diagram, in order to support such online banking activities in the traditional world, the bank has to establish an identity, access management system, and authenticate Alice’s login credentials. Behind the scenes, the bank needs to develop a bank web portal and a backend system to verify whether Alice has the right account with the bank and has enough money to pay Bob, upon which the bank can transfer $10 out of Alice’s account and put $10 in Bob’s account. The bank has to maintain a ledger to record the details of the transaction in a database and show the balance each person has.

The following diagram shows a centralized bank system model:

Figure 1.3 – Centralized bank system model

As the business grows, customers needs change with it. The traditional brick-and-mortar business model is being replaced by the digital banking and commerce model. This requires technological changes in the bank system too. Banks nowadays deploy a distributed system model to serve the ever-growing needs of their customers.

The following diagram shows the distributed bank system model:

Figure 1.4 – Distributed bank system model

The fundamental issue with the preceding centralized or distributed system model is the risk from single points of failure. Failure could come from malicious network attacks, system failures, or security and privacy breaches; it could come from business failures in the bank itself, which can cause millions of people to lose their homes due to the bankruptcy of big banks during a global financial crisis. It could happen due currency failure, such as the currency collapse in Venezuela, where the lifetime savings of average citizens suddenly became worthless overnight. Also, payments can be blocked due to government censorship.

Satoshi Nakamoto believed that the root problem with the traditional fiat system is all the trust required to make it work. Citizens have to trust the central bank not to devalue the currency. Consumers have to trust the bank to manage their money. But history has shown again and again that this trust is often breached.

Satoshi designed an elegant decentralized P2P electronic cash system, and the technology behind that, blockchain, is the solution, where transactions are maintained in a distributed shared ledger and replicated across a global P2P network. Security and privacy are ensured with cryptographic technologies, and transaction integrity is achieved through a consensus mechanism.

The following diagram shows a decentralized bank system model:

Figure 1.5 – Decentralized bank system model

As new transactions are made, they are broadcasted to all network nodes, and over time all transactions that have occurred are sequenced together in the public ledger and made available on all replicated network nodes, as shown in the following diagram:

Figure 1.6 – Decentralized public ledger

Now that we understand the difference between centralized and decentralized models, let’s see how blockchain works.

How does blockchain work?

Using the previous example, as shown in the following diagram, let’s assume Alice wants to buy something from Bob and she agrees to pay Bob 10 bitcoins (BTC):

Figure 1.7 – Money transfer between two parties

Let’s walk through the high-level processes step by step to demonstrate how blockchain works:

1. Create blockchain transactions: A transaction is a value transfer between two parties. When Alice sends 10 BTC to Bob, it will create a transaction with one or more inputs and two or more outputs, where the inputs reflect Alice’s account, and the outputs reflect which account(s) Alice intends to transfer to. The transaction is then digitally signed with Alice’s private key and broadcasted to the P2P network. The receiver will use the digital signature to verify the ownership of Alice’s funds. We will discuss digital signatures and cryptographic hash functions in detail in later sections.
2. Validate the transactions and add to the transaction pool: Once the transaction is submitted to the blockchain network, the bookkeeper node (usually a full node in a P2P network that receives the transactions) will validate it according to protocol rules defined by the blockchain network. If the transaction is valid, the bookkeeper will add it to the transaction pool and relay the transaction to the peers in the network.
3. Create the candidate blocks: Transactions in the transaction pool are collected into the block periodically. In a Bitcoin network, every 10 minutes, a subset of network nodes, called mining nodes or miners, will collect all valid transactions from the transaction pool and create the candidate blocks. The following diagram shows the structure of a candidate block:

Figure 1.8 – Creation of candidate blocks

As illustrated in the preceding diagram, the high-level processes are as follows:

• The candidate block packages the recent valid transactions into the block structure based on block specifications.
• For each transaction in the package, it creates a cryptographic hash of the transaction data, recursively calculates the hash out of existing hashes, and creates a Merkle root of all transactions, as depicted in the following diagram:

Figure 1.9 – Merkle tree

The miner node looks for the latest block on the blockchain and adds its hash to the block header of the candidate block as the reference from the candidate block it intends to link to.

1. Mine the new block: Once the candidate block is created, the race starts for the chance to add new blocks and win the rewards. The process for such a race is called mining. The winning of the race is determined by the consensus mechanism. We will discuss different consensus mechanisms in later sections. In blockchain systems such as Bitcoin or Ethereum 1.0, the PoW consensus mechanism is applied to mining. Miners will keep trying to find a random number, the nonce in the block header structure, until the hash meets certain challenging conditions. For example, one such challenging condition is, the resulting block hash is smaller than a target number, or in some cases, the hash has a few leading zeros. In practice, every random number has the same chance to win the race, so practically, you can just start a loop through from 1 to 232 until it finds such a nonce, the unique hash meeting the condition. It requires huge CPU hashing power to find such a nonce. The challenging condition, called difficulty, can be adjusted based on the target number or bits in the block header structure. The difficulty in winning the race grows exponentially the smaller the target number is or the fewer bits are in the block header structure.
2. Add a new block to the blockchain: The first winning node will announce the new block to the rest of the network for verification. Once the block is verified and approved by the majority of the network miners, it will be accepted and becomes the new head of the chain. Since all blocks are chained together by linking the hash to the previous block, any tampering with the ledger becomes impossible since it will require PoW on all previous transitions.

All miners have the chance to solve the puzzle, but only the winning miner has the authority to add the block to the chain and claim the bounty. Once the new block is added to the blockchain, all in-progress miners will stop their mining efforts on the newly added block and start the race again on a new block.

The following diagram summarizes the step-by-step process when new transactions are submitted to the blockchain network:

Figure 1.10 – How blockchain works in one picture

Cryptography plays a critical role in maintaining the transaction state in the blockchain and ensuring immutability. Cryptography is not new. In the next section, we will go over some key concepts in cryptography.