Blockchain Guide - What is it, how does it work and how it can be used

Introduction

Blockchain technology has emerged as a groundbreaking innovation with the potential to revolutionize various industries.

At its core, blockchain is a decentralized and immutable ledger that records transactions and stores information across a network of computers. This transparent and secure nature of blockchain has paved the way for exciting developments in the digital realm, including the advent of Web3.

Web3 represents the next evolution of the internet, transforming it from a centralized and data-driven ecosystem to a more decentralized, user-centric paradigm.

With Web3, individuals have greater control over their data and online interactions, as blockchain technology enables peer-to-peer transactions, smart contracts, and decentralized applications (dApps). These dApps leverage the power of blockchain to create new possibilities for finance, governance, digital identity, supply chain management, and much more.

Through the integration of blockchain technology, Web3 aims to foster a more transparent, inclusive, and secure digital environment. It envisions a future where individuals have ownership of their digital assets, can participate in decentralized networks, and have the ability to engage in direct peer-to-peer interactions without relying on intermediaries.

In this era of Web3, blockchain technology serves as the foundational infrastructure that underpins this new digital landscape, offering transparency, security, and trust. It holds the promise of reshaping how we interact, transact, and create value in the online realm, unlocking a world of possibilities for individuals and businesses alike.

What is Blockchain Technology?

Blockchain is, by definition, a distributed immutable digital ledger or database shared among the nodes of a computer network (ledger technology). This ledger technology offers a key innovation in terms of the security and transparency of the data stored within the network.

Unlike traditional centralized systems, blockchain does not rely on a single entity or central authority to manage and validate transactions. Instead, it operates on a decentralized network where multiple participants, or nodes, collectively maintain and validate the integrity of the blockchain.

The core concept of blockchain revolves around the creation of blocks that store individual transactions. Each new transaction is added as a new block to the chain, connecting to the previous block, thus creating a chronological and interconnected sequence of blocks (hence the name). This structure ensures that each transaction can be traced back to its origin and verified by any user connected to the blockchain network.

One of the fascinating aspects of blockchain is its transparency. Anyone can access the blockchain and examine the information stored within it. Each block contains details about the transaction, such as the participating parties, transaction size, and timestamp. This transparency enables users to verify the authenticity and integrity of the data without relying on a centralized third party.

Furthermore, blockchain offers inherent security features. Once a block is added to the chain, it becomes extremely difficult to alter or tamper with the information contained within it.

This is due to the cryptographic algorithms and consensus mechanisms employed by blockchain networks, which ensure the immutability of the data. Consequently, blockchain provides a high level of trust and reliability, making it suitable for various applications where data integrity is paramount.

It is worth noting that the blockchain journey can be traced back to its very first block, known as the Genesis Block. By following the chain of interconnected blocks, it is possible to reach this initial block, which marks the inception of the blockchain network.

How does it work?

Before diving in, let's understand what a Node is:

• A node is a device connected to the blockchain network. Nodes store copies of the blockchain and share all of the data between them. Their purpose is to validate transactions through a consensus mechanism, ensuring the security of the blockchain.
• The consensus mechanism is the foundation of a blockchain's functionality. Every transaction on the blockchain must be validated by the majority of nodes, reaching a consensus among them. Afterward, the transaction information is stored on the blockchain, completing the transaction.

Blockchains employ different algorithms to achieve consensus among validators, each with its advantages and disadvantages. Let's begin with the Proof-of-Work (PoW) model used in the Bitcoin blockchain.

Proof-of-Work (PoW)

The PoW algorithm is the most well-known because it was the first to be implemented, starting with Bitcoin in 2009.  

This model demands substantial computational power from validators, who must solve a puzzle to validate transactions. This puzzle is a mathematical equation, a hash function, which ensures network security using cryptography.

Hash functions are remarkable because they cannot be reversed from the output but can be easily checked using the same input information. Moreover, any slight change in the input yields a completely different output, making them unique.

This property is why hash functions are called collision-free, and it contributes to the safety and transparency of a PoW blockchain.

Validator nodes in PoW are known as miners, a term derived from the computational power they must employ to solve mathematical equations. Upon solving them, a new block is added to the chain, and other miners use the discovered hash input to verify the block's validity. If deemed valid, the miner receives a reward, paid in the blockchain's native coin (e.g., BTC on the Bitcoin blockchain).

A simple analogy to understand hash functions is to think of the hash as a glue or a bridge that connects the blocks on the blockchain.

Some blockchains using the PoW model include Bitcoin, Ethereum Classic, Litecoin, and Dogecoin.

Advantages of Proof-of-Work

• Decentralization:  Anyone can run a validator node, participate in the mining process, compete against other validators, and maintain the network's security.
• Security: To control the blockchain, an individual or entity would need to run over 50% of the validating nodes, which is nearly impossible today for established networks like Bitcoin.

Disadvantages of Proof-of-Work

• Energy consumption: The required computational power consumes large amounts of electricity, which is costly and a controversial topic concerning climate change.
• 51% Attack: While unlikely to occur in consolidated blockchains like Bitcoin, it remains a risk for smaller networks.
• Scalability:  Transactions typically take longer to complete in PoW networks than in other alternatives.

Proof-of-Stake (PoS)

The PoS model was developed as an alternative to PoW. It has gained widespread adoption lately because it does not require the intensive mining computational power of PoW.

Essentially, in PoW, miners are motivated to act honestly and maintain network security due to the computational power required to run a node. In this case, the computational investment is what's at stake for miners. In contrast, PoS validators don't need to invest in external resources; all they need is capital, which will be at stake for the nodes.

Validators can use ordinary computers to secure the blockchain. They simply need to offer the blockchain's tokens as collateral, and after doing so, they become eligible to validate blocks and receive rewards.

It's worth mentioning that the more capital a validator stakes, the greater their chances of being chosen to validate a block. The minimum amount of capital required depends on the blockchain. For example, on Ethereum, a node must stake 32 ETH to be eligible to validate blocks.

The required amount is often unattainable for most retail investors, so platforms like Lido Finance have introduced liquid staking features, allowing anyone to contribute to a validator pool, with rewards distributed proportionally.

Leading blockchains using the PoS algorithm include Ethereum, Near Protocol, Avalanche, Polygon, and Algorand.

Advantages of Proof-of-Stake

• Environmentally Friendly: Validators don't need to constantly upgrade technology or consume more energy to solve hash functions.
• Faster Transactions: Transactions are validated more quickly than in PoW, primarily because there's no need to solve complex equations (although not on a global scale for some blockchains, like Ethereum).
• Staking: Validators receive interest for staking their assets rather than mining.
• Security: The likelihood of a 51% attack is minimal, as a malicious node would need to control over half of the blockchain's total token supply.

Disadvantages of Proof-of-Stake:

• Barrier to Entry: A large amount of capital is required to become a validator, which can lead to arguments that PoS makes the network less decentralized, as major players can wield significant power on the blockchain.
• Relative Novelty: PoS is newer compared to PoW, meaning it has been around for a shorter period. However, many projects already use PoS, and it is widely endorsed by a substantial portion of the crypto community.

Other Consensus Mechanisms:

Proof of Authority (PoA)

PoA offers a solution for better blockchain scalability than PoW and PoS. In PoA, validators don't need to stake or mine coins/tokens; their reputation and identity are at stake.

In a PoA blockchain, a limited number of nodes are pre-selected to participate in the consensus process. Due to the small number of nodes, the blockchain can complete transactions more rapidly.

To become a selected node, certain requirements must be met:

• Validators must confirm their real identity.
• Validators must be willing to invest money and stake their reputation.

PoA is a suitable consensus algorithm for private use, particularly by companies that want to benefit from blockchain technology while maintaining control and privacy. It essentially provides a means of making centralized systems more efficient.

Examples of PoA blockchains include VeChain and Binance Smart Chain.

Other less-adopted consensus mechanisms:

• Proof-of-History
• Proof-of-Capacity
• Proof-of-Activity.

Is the Blockchain really safe?

After reading an overview and some technical details about blockchain, let's examine some examples and understand why they are secure.

Imagine a malicious validator running a node, intending to steal cryptocurrencies from other users by altering the blockchain data. Validators store copies of the blockchain, so if a malicious node changes its copy, other validators would recognize it as illegitimate since they all collaborate to reach a consensus and ensure network safety.

To successfully hack a blockchain and gain control, a validator would need to own more than 50% of the nodes and simultaneously alter the copies stored within them. By doing so, the majority of validator nodes would agree that the copy is accurate, allowing the attack to succeed.

In a PoW mechanism, this would be extremely costly due to the computational power needed. Moreover, the attacker would have to re-process every block on the chain since they would have different hash codes and timestamps after modification.

It's also worth noting that if such a massive event occurred, honest validators would perform a hard fork on the network. This means they would update their client nodes to a blockchain version on which they all agree, creating a parallel network where the attacker's changes are invalid.

Subsequently, the value of the digital currency on the attacker's blockchain would plummet, as no one would trust the system anymore, rendering all the effort worthless.

Blockchain Use Cases:

Blockchain is here to stay, as the technology offers numerous valuable applications for the public. Let's explore some of the use cases that developers have created and people are currently using.

DeFi

DeFi, or Decentralized Finance, is a robust sector in the crypto market. Within DeFi, users can interact with various financial tools without the need for intermediaries like banks or brokerages.

Some sectors within DeFi include Lending and Borrowing, Asset Management, Decentralized exchanges (DEXs), and Derivatives.

NFTs

NFTs, or Non-Fungible Tokens, gained popularity in 2021, especially after influencers shared their profits and promoted projects, attracting many non-crypto users to the space.

NFTs represent cryptographic assets stored on the blockchain with unique identities. Initially, NFTs had limited use cases, primarily showcasing unique cryptographic art. However, developers have since expanded the potential of NFTs, with projects in real estate, music, and gaming.

OpenSea is currently the largest marketplace for purchasing NFTs. A famous NFT project, Bored Ape Yacht Club (BAYC), has been endorsed by many influential people. Owning a BAYC NFT grants exclusivities like access to private online spaces, exclusive merchandise, and members-only events, such as private yacht parties.

Games

Blockchain games differ from traditional ones by allowing players to use their in-game earnings in other blockchain applications. Centralized games typically enable players to earn XP, which can be used to upgrade their character or other aspects within the centralized ecosystem.

NFTs have been integrated into blockchain games, allowing players to have unique identities that can be purchased and featured in the game.

Leading blockchain games today include Axie Infinity (AXS), The Sandbox (SAND), and Decentraland (MANA).

Smart Contracts

Smart Contracts enable the development of all these applications and many others. Initially, with Bitcoin, people viewed cryptocurrencies solely as a means of transacting money via blockchain technology. However, the introduction of Ethereum and smart contracts has paved the way for numerous other applications.

Final Message

After reading this article, you should have a clearer understanding of blockchain and the crypto market. Nonetheless, it is a complex industry that continually updates and introduces new applications.

Feel free to read our other guides to dive deeper into the cryptoverse intricacies.