A Non-Technical Introduction to Blockchain
Recently, billionaire entrepreneur Mark Cuban was quoted as saying blockchain is the new Internet. While this could mean a million of things (e.g. internet bubble in the late 1990s or the omnipresence of Internet in present days), let’s first take a look at what blockchains really are.
What are blockchains? You may think about blockchains as a set of shared and almost “immutable” ledgers for transactions and recording data and value in a secure manner. In the shared database of records, data transactions are recorded, replicated, shared and synchronized among members of a decentralized network. The database is organized in a way that it can easily be accessed, managed, updated, and virtually impossible to alter without detection. Essentially a blockchain molds the traditional elements such as database, network, and public key infrastructure into one single elegant system!
There are several key terms that are related to blockchains. Let’s look at them one by one below:
Distributed ledger network: Distributed ledger network is an electronic communication platform made of computers called “nodes” with identification versions of the distributed ledger.
Node: A node refers to an individual unit of a processing system that receives and transmits transactions within a distributed ledger network. These are typically computers or electronic devices with 24/7 network connectivity. Nodes on the blockchain independently maintain their own version of the current ledger state.
Protocol: A protocol describes a set of rules and requirements that governs an electronic communication network (e.g. protocol that prohibits double-spending attempts). Double-spending is a potential flaw in the cryptocurrency system in which the same single digital token can be spent more than once. If you are interested, you may read the original paper by Bitcoin inventor Satoshi Nakamoto on the protocol used in Bitcoin to prevent double-spending.
Cryptography: Cryptography refers to the application of mathematics to secure the integrity of information in the blockchain. Transactions on blockchains require digital signature to authorize. The signature is generated through a private key, which is necessary to unlock the transfer from sender’s public address to the receiver’s public address in the blockchain. In the process, the related public addresses are derived from the private key using cryptographic methods. The associated public keys are used by network “nodes” to validate the authenticity of the digital signatures. In the process, a cryptographic hashing function is often used to crate unique digital output from digital input, thereby creating a tampered-evident trail that spans the entire blockchain. Each block added to the blockchain contains the evidence (hash) of the previous block adding further security to previously validated transactions.
Miners: Miners are special-purpose nodes that add transactions to the ledger by hashing blocks. They are the key elements under the proof-of-work decentralized blockchain regime by removing dependency on a single centralized intermediary. In mining, miners follow the blochain’s protocol to ensure transactions are not duplicated. In the process, miners search for and bundle validated transactions into a block and race to hash their block. Usually, the first miner that correctly solves for its block’s hash value is able to claim signature ownership. The hashed block is then broadcasted by the successful miner to the network for validation. If this valid hash approved by the peers, this first miner is rewarded often with the native token in blockchain network.
Consensus: Consensus refers to the mathematical process by which blocks of transactions are validated and appended to the chain ensuring all nodes agree and reflect the same copy of the ledger. When a miner successfully mines a block, they append the newly mined block of transactions to their local copy of the ledger and broadcast to their peers. The peers then check to see if the update is valid according to the consensus protocol, before downloading the block and reconciling their own local copies of the ledger. Early cryptocurrencies (e.g. bitcoin) commonly utilize the proof-of-work consensus model which requires computational work to be performed by miner nodes. The first miner to solve the problem on the proposed block gets to create the next block and is rewarded. Recently, more cryptocurrencies (e.g. Ethereum 2.0) are switching to the proof-of-stake consensus model in which the chances of successfully creating a block and obtaining transaction fees is associated with the amount of tokens ‘staked’ by a node.
Based on how public the ledger record is, blockchains can be divided in three types. The first type is public/permissionless blockchain in which read and access is open for everyone. The vast majority of current blockchain projects around the world (e.g. cryptocurrencies) belongs to this category. The second type is private/permissioned blockchain in which read/write access is permissioned to involved parties only (often within an organization). The third type is a hybrid between the two types. As China bans cryptocurrencies completely, most of the blockchain developments and applications in China will likely belong to the second and third types.
Blockchains could provide a number of benefits, including the relative “immutability” of records and the evasion of central intermediaries. For example, it may be used in tracing the origins of goods in supply chain management or storing records for registries of legal title. In the case of public/permissionless blockchain, it also offers utmost transparency on the trail of all historical records. Bitcoin, the first payment cryptocurrency, is probably the first use case of blockchain technology. What exactly is cryptocurrency? It is basically a digital asset in which cryptographic techniques are used to regulate the generation of units and verify the transfer of units, operating independently of a central bank.
Another “hot” feature of the blockchain technology is “smart contract”. What are smart contracts? They are contracts with predefined conditions that need to be met by specified parties to automatically trigger a predefined transaction on the blockchain based on codes that govern the blockchain. Once posted, the codes generally cannot be changed due to consensus-driven “immutability” of the blockchain. Being autonomous (based on programmed codes without the need for a lawyer or broker) and secure (being encrypted on the ledger), more and more blockchain solutions are incorporating smart contracts. The current dominant blockchain ecosystem that powers smart contracts is Ethereum!
Over the past year or two, DeFi, powered by smart contracts in the Ethereum ecosystem, becomes the hottest thing on Blockchain. What is DeFi? DeFi refers to decentralized finance. It is essentially building financial tools on a blockchain, currently mostly based on the Ethereum ecosystem, in attempts to remove the need for any financial intermediaries. Proponents like its censorship-resistance feature and the potential improved access to financial services. Without the intermediaries extracting profits in the process, DeFi has the potential to improve the efficiency in the financial system and lower the costs for participants on both ends of a transaction. As current DeFI loans are largely all collateralized, we are not sure if it really improves financial access for all (as most people may not have cryptos as collaterals).
With all these developments, there are numerous challenges and limitations on the blockchain technology. The most famous of all is the blockchain trilemma. Blockchain trilemma describes the conundrum that most blockchain projects face. That is, out of the three key features of blockchain (decentralization, security, scalability), most blockchain projects could only manage to achieve two features out of the three. For example, bitcoin is quite decentralized and secure. However, its native technology is not very scalable. Most crypto projects position themselves as somewhere along the triangle, focusing more on two of the features.
Using some nice tools, it is easy to visualize blockchain activities. For example, one may use TxStreet.com to see the current status of activities on both the bitcoin (BTC) and ethereum (ETH) blockchains. One can easily see that bitcoin is not very scalable. It takes about 9 minutes to add a block in the bitcoin (BTC) ecosystem. While the average time to add a block in the ethereum (ETH) system is 14 seconds currently, it is not scalable enough to power all the smart contract transactions around the world. Currently the transaction fee on the ethereum blockchain is rather high, amounting to about USD 4.5 per transactions. The current high transaction fee also limits the development of the entire smart contract ecosystem on Ethereum.
Seeing the limitation, Ethereum is on its way to transform into Ethereum 2.0 to address current deficiencies. Ethereum 2.0 will no longer adopt the proof-of-work regime. Instead, it will be changed to a proof-of-stake model. As the transition is still ongoing, it remains to be seen to what extent it can alleviate the bottleneck in the current system and to what extent transaction fees can be lowered to cater for everyday users on the Ethereum network. At the same time, many alternative challengers emerge to venture their ways into the smart contract and DeFi world. We may describe these alternative challengers in the future.
And indeed, more and more new blockchain projects are no longer utilizing the proof-of-work regime. One severe concern on the proof-of-work regime is its impact on the environment. Mining under proof-of-work consumes an enormous amount of electricity in the computational process. One recent research from Cambridge concludes that Bitcoin mining consumes around 121.36 terawatt-hours (TWh) a year. This amount is more than the energy consumption than Argentina. In other words, blockchain technologies powered by proof-of-work consensus protocol are extremely unfriendly to the environment. If you are a green activist, you should be protesting against all blockchain companies that use proof-of-work consensus protocol.
While bitcoin is arguably quite secure currently under its proof-of-work consensus protocol as many miners are incentivized by its high reward rate, nobody knows whether this is going to sustain in the future. We put quotes around “immutability” when we describe blockchain technologies because it is actually not really immutable. In theory, if a miner or a group miners are able to achieve a hash rate that is over 51% of the network hash rate, it is possible for them to “rewrite” history on the blockchain. This is called 51% attack. 51% attack did happen at least three times in 2020 to Ethereum Classic, which is original Ethereum blockchain before the 2016 hard fork that “splits” it into Ethereum Classic and current Ethereum.
