What is a blockchain?
Let’s start at the beginning: The blockchain is a distributed ledger that is open to absolutely everyone and is almost impossible to change. What problem does this solve? The blockchain is completely decentralized, which means that not one single organization is in the power of the data on the blockchain. The past has shown many times that there are always people who abuse the power they have over certain data. That is why the Bitcoin network has never been hacked before.
In fact, the blockchain consists of a chain of blocks of information. A new block is added to the chain each time, but the new block always contains information from the previous block, so previous data is never lost. So, you can already guess where the name "blockchain" comes from.
Eventually, blockchains were adapted to better suit the creation of today's most famous cryptocurrency, Bitcoin. The same technology that was used to prevent fraud and ensure transparency for all users is now used to record transactions and secure them over time so that they cannot be manipulated in any way. These transactions are extremely secure and completely irreversible.
How does blockchain work?
Now, let's take a more practical approach and look at how the use of blockchain technology works when buying crypto.
When you make a purchase, the details of that transaction are added to a new block. As the block is filled with this information, it is added to the previous block and the information is made available in the ledger - which is essentially a database of all transactions. But once this information is added, who makes sure the ledger is accurate? Well, this is done by a network of computers called nodes, and each node has access to the ledger. Each node has access to the entire blockchain, which is constantly updated as new blocks are created and added.
Before these blocks are added to the chain, each transaction is verified by miners. They do this by using a series of very complex cryptographic algorithms - this is where the name “crypto” comes from. This process is called a consensus algorithm, which every cryptocurrency has. Each consensus algorithm has its own pros and cons. In this blog, we will tell you more about Proof of Work (PoW), and Proof of Stake (PoS) as they are the most popular consensus algorithms.
Proof of Work (PoW)
Who or which computer gets to add this new block is decided based on a sort of puzzle. The computers are given a problem from the system, the solution of which has to be guessed in order to solve a mathematical equation. Each of these computers is programmed to guess as many and as quickly as possible. As soon as a computer thinks it has the right solution, it is checked by the rest of the network. If the answer is approved by the majority, then this computer gets to add the next block of transactions to the blockchain, and also gets the block rewards.
The person who may add the new block may do so because he or she has found the correct hash. To arrive at this correct answer, countless hashes (calculations) are done. This correct answer is called Proof. But you don't just get that correct answer, because the finder gets rewards, and everyone wants those. So many people do the calculations, and the lucky finder must provide a lot of computing power (hash rate) to stand a chance of getting the winning hash. In other words, he must work for it, which explains the name Proof of Work. Cryptocurrencies that use Proof of Work are Bitcoin (BTC), Ethereum (ETH), Bitcoin Cash (BCH), Litecoin (LTC), and Dogecoin (DOGE).
The drawbacks of Proof of Work
Although the largest cryptocurrencies use Proof of Work (Bitcoin and for now Ethereum), there are still many drawbacks to the algorithm. Therefore, new blockchains often choose to use Proof of Stake, or a variant based on this algorithm. Below are the biggest drawbacks of the Proof of Work consensus algorithm.
The biggest criticism of Proof of Work is regarding the sustainability of this algorithm. This is because all miners in the network are going to validate the same transactions at the same time. As you can probably imagine, this costs a lot of power. Next, only one miner is chosen whose work contributes something to the blockchain. For example: when 10.000 miners are trying to solve the puzzle, eventually the energy of only one miner is being used. So the energy of the other 9.999 was a complete waste.
Not decentralized enough
The miners with the most computer power have the greatest chance of being the first to have all transactions validated. Because hardware is getting better every year, miners always need the best and most hardware to provide as much computing power as possible. This creates many "mining farms": large server rooms full of computers that are mining.
There are also many miners who combine their efforts in a mining pool. A mining pool is a group of miners who work together to validate transactions. In this way, they have a greater chance of being first. The reward is then divided among all the participants in the mining pool, based on the contribution they have made. This creates some large groups that add blocks to the blockchain. This does not exactly help with the decentralization of the network. It would be better if there were many more "small" miners so that the network is much more spread around.
Proof of Stake (PoS)
Proof of Stake (PoS) is a consensus algorithm used by blockchains to validate transactions and add blocks to the blockchains. As you may already know, a blockchain consists of a network of different machines. These machines are all connected and have a copy of the blockchain's history on their hard drives.
A machine that validates transactions within a PoS network is called a validator. To become a validator, you must put up money (in the form of crypto tokens or tokens). This is also called the stake and can be compared to a kind of deposit. There are also evil validators, who accept transactions that should not actually be accepted. These are hackers who try to make a profit. This can be, for example, an own transaction in which money is sent that is not in own possession at all. Or there are validators who are offline for a large part of the time, preventing the network from working properly.
When a validator does something that goes against the rules, such as validating incorrect transactions, the nodes within the network can impose a penalty. This penalty consists of a fine, which is paid from the stake that deployed a validator. As a result, you may have to pay a high fine, because in most cases you have to bet a large amount. It is not that you cannot stake crypto coins or tokens if you do not have a large amount of money in your possession. In fact, you can also stake your coins or tokens through another validator. In that case, it is important to do proper research on the validator, because it is not always without risks.
When a validator on which you have placed a stake makes a mistake, it could be that you lose your money. On the other hand, when a validator receives a reward for his work, you will also get a part of it. The amount of this portion depends on the size of the stake. The more money you stake, the greater the chance that you will receive a higher reward. Cryptocurrencies that use Proof of Stake are Cardano (ADA), Polkadot (DOT), Tezos (XTZ), Peercoin (PPC), and soon Ethereum (ETH).
Blockchain layers are components of the blockchain, each with its own functionalities. It helps to understand how blockchains are put together. Currently, there are four layers within blockchain technology. In this blog, they are shortly explained.
- Layer 0: ensures that different blockchains that are not made for each other, can still exchange information with each other. Its purpose: to increase scalability and speed. Polkadot (DOT) is a layer 0 blockchain.
- Layer 1: validates transactions from on the network. This layer can be considered the foundation of the blockchain. Bitcoin and Ethereum have layer 1 blockchains.
- Layer 2: was devised to solve the scalability problems of layer 1 blockchains. The layer 2 blockchains collect multiple transactions and convert them into one transaction. In addition, it also improves speed and has lower costs. Polygon and the Bitcoin Lightning Network are layer 2 blockchains.
- Layer 3: This is the layer that the user sees and interacts with the most. This layer can be used to create all kinds of applications, such as dApps, games, and DeFi. Uniswap and Aave are layer 3 blockchains.
Blockchain technology has exciting applications that are being explored and developed all the time. In the future, healthcare professionals can use it to securely share medical information, the music industry can use it to ensure copyrights are being honored, and governments can use it to ensure secure elections. Uses for the technology are being realized every day and new applications are constantly in development. For now, we present the most popular blockchain use cases.
Transactions: The most common use of cryptocurrencies is to transfer information or money. Because the blockchain is decentralized, there is never 1 person in possession of all the data. That is why no one could abuse your data in the process. So, the use of blockchain can be used by many organizations like governments, hospitals, schools, banks, and many more.
Smart contracts: A smart contract is an agreement written in code language, which automatically takes effect when specified conditions are being fulfilled. In this process, it uses facts or values that must be satisfied. After this, the contract is automatically executed. The most important advantage of Smart Contracts is that no third party is involved with the contract. In addition, it is reliable: contracts work on the blockchain, so the data is secure. No one can modify the information and transactions are visible to everyone. Simply said, smart contracts are the fundament of many other blockchain applications.
dApps: Decentralized apps (dApps) work based on smart contracts on the blockchain and are used in real life for games, exchanges, or browsers, among others. The goal behind dApps is to be independent of third parties or companies. The platform is therefore not under the control of one organization that can make changes to the system or make decisions at will. For example, the organization of Twitter can delete certain tweets or block people because they make certain statements that Twitter considers inappropriate. If Twitter was decentralized, this would not be possible.
NFTs: Non-fungible tokens (NFTs) are proof of ownership of digital collectibles. You've probably heard of the monkey pictures that sell for millions of dollars. Yet there are many different uses for NFTs, they can be works of art, music tracks, videos, tickets, and many other forms. All these items are unique from each other and have only one owner and are secured on the blockchain. However, you can trade NFTs, which makes them interesting for investors. A disadvantage is that the price of an NFT is often not very well supported.
These NFTs are also traded by means of a smart contract. When the buyer and seller have signed the smart contract, the change will automatically be made on the blockchain. This is a process that is carried out peer-to-peer, there is no other party to the trade and it is therefore completely decentralized. You are therefore the official owner of the NFT immediately after the transaction. The possibilities of NFTs are endless and there are still many new things to be discovered.
To sum up what the blockchain is:
- The blockchain is completely decentralized, which means that not one single organization is in the power of the data on the blockchain.
- The blockchain is a distributed ledger that is open to absolutely everyone and is almost impossible to change.
- A new block is added to the chain each time, but the new block always contains information from the previous block, so previous data is never lost.
- Before these blocks are added to the chain, each transaction is verified by miners. They do this by using a series of very complex cryptographic algorithms - this is where the name “crypto” comes from.
- Proof of work is a consensus algorithm of cryptographic proof in which one party proves to others that a certain amount of effort has been spent. Validators can then confirm the effort with minimal effort on their part.
- Proof-of-Stake is the validation of transactions and the creation of blocks on the blockchain through the staking of crypto tokens. Unlike Proof-of-Work, where transactions are validated through the deployment of computer power. Proof-of-Stake is popular because it consumes much less energy than Proof-of-Work.
- Blockchain layers are components of the blockchain, each with its own functionalities. It helps to understand how blockchains are put together. Currently, there are four layers within blockchain technology.
- Blockchain makes it possible to make peer-to-peer transactions, but it has many more applications like Smart contracts, Decentralized apps, NFTs, and many more.
With this video and blog post, we hope you learned a lot about blockchains. If you want to learn more about cryptocurrencies, you can check out our other videos regarding crypto. Check out our YouTube channel or our website for other crypto topics.