Blockchain – what is it and how does it work?

Bitcoin. Blockchain. Mining. Cryptocurrency is everywhere at the moment, but what does it all mean? It’s a little complicated, but hopefully this (non-technical) guide can help you understand it a bit better!

A “blockchain” is a distributed (or decentralized) database. What’s one of those? Well, if you have a database on your computer or your website, it is in one single location. All the files are there, and nobody else can see it unless you grant them access. A distributed database, on the other hand, is stored on many different devices, not connected to a central processor (hence “decentralized”). In the case of Bitcoin and other cryptocurrencies, the blockchain is a ledger – a list of financial transactions with timestamps. Only the two people involved in any transaction can edit it – they each have a private key which allows them access to do so – but the record of the transaction is stored on every device in the blockchain.

To illustrate this in banking terms, imagine if instead of all transactions being stored on the bank’s computer, they were all stored on the computers of all the bank’s customers. The only people who could edit any transaction would be the two parties who were involved in that transaction – each of them has a key that’s unique to them and which allows them to edit transactions (i.e. send and receive money) – but the fact that the same records exist on all customers’ computers would mean it would be very difficult to commit fraud without someone noticing immediately.

The blockchain is so called because it’s a chain of “blocks”. If you think of a chain, each link is connected to the link before it and the link after it. That’s the case in the blockchain, too. Records don’t exist independently of each other – they are all linked to other blocks in the chain.

Now, if all cryptocurrency is just information in a database, you may be wondering how it can possibly be secure. Can’t anyone just edit one of their own transactions, giving themselves hundreds of Bitcoins?

Well, yes, but it wouldn’t do them much good. Firstly, because all blocks are linked, if someone wanted to falsify a record they would have to alter other blocks in the chain as well. Secondly, all transactions are verified by third parties – “miners”. You have probably heard that it’s possible to “mine” Bitcoin. What this means in real terms is that you use your computer processing power and electricity to contribute to validating transactions on the blockchain (like a sort of digital auditor). This ensures records are accurate and as a reward for doing this you get small amounts of Bitcoin in return. This is known as “mining”.

In order for a user to create a fake record, they would have to have “consensus”. This has the same meaning in the world of cryptocurrency as it does anywhere else – everyone would have to agree that the transaction was valid. Since this wouldn’t happen, the fake transaction would be discarded. This makes for a very secure system that engenders trust in its users.

That’s not to say there haven’t been instances where it’s gone wrong! However, safeguards can be implemented, for example in order to avoid “double spending” (where someone could make two transactions in quick succession in order to spend money they don’t have prior to the transactions being validated), many companies who accept Bitcoin will wait for 6 additional blocks to be added before a transaction is completed, in order to be sure of the integrity of the funds.

It’s still a very new technology but it’s evolving very quickly, with major banks and other companies investing in blockchain technology. Many of its users believe it’s the future of finance. What do you think?