I decided to write this introductory guide to blockchain thinking of an audience of newbies who are approaching the subject and are not necessarily technological.
Certainly, in 2021 tutorials and guides are not lacking, but none of these introduces the various themes in a path that makes the topic more accessible. So I wanted to try too.
Let me know what you think!
See also all my articles by topic.
The most effective way to understand blockchain technology and organisations orbiting around is to start from its main purpose, to understand what is meant and what it serves. Only after understanding its objectives, it is possible to appreciate the mechanisms that regulate its operation.
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Blockchain is a generic term used to indicate both the main public networks that provide these services and the technology on which these networks are based, consisting of a set of software that makes it work and allow users to interact and protocols, that are a set of rules and formats that the parties must apply in order to interact correctly with each other.
1. What is it
The fundamental purpose of the blockchain is the reduction of the costs of trust, through the transfer of the same to a homogeneous and often anonymous mass of verifiers.
In the modern world, human relationships depend on complex social interactions. We often have to rely on third-party services, generally operated by people which we do not know, and which require a trusted intermediary.
However, trust brokerage operations introduce risks, and risks come at a cost.
It costs to maintain a bank account, to carry out an economic transaction, to certify the ownership of a good and the correctness of data. To date, these trust operations have been provided by centralised organisations that track information on their own, often private registries, and decide on the costs and methods of consulting and updating these registries.
As we will see shortly, a blockchain provides a decentralized ledger, i.e. controlled by the mass and not by a specific organization, accessible to all, append only (once an information has been written it cannot be deleted or changed), which can in many cases replace centralised registers in the cases mentioned above and others more.
Reading this decentralized ledger is a free operation, writing on the ledger has a cost, generally lower than that of centralised payments.
The limitations of permissioned services
The permissioned services are all those services provided by centralised organisations, which can be interrupted or modified unilaterally.
Sometimes the third-party services we are forced to use to intermediate trust, change their service policies, or become monopolists, applying arbitrary rates or walled garden strategies, where it is not possible to use one’s assets outside the provider’s scope.
Services controlled by governments can become overruled, applying forced withdrawals or freezing them, suspending the availability of value.
In addition, each third-party service is at risk of corruption, tampering, or accident: a bank may fail, a notary can be bribed, or its records may be destroyed, an employee of public service can steal or alter information.
2. Why decentralisation
All these risks and restrictions, especially when evaluated in banking and finance (and thus the management of intangible and digitised assets), pushed hackers and researchers looking for solutions to transform what is the trusted intermediary into a decentralized service, i.e. an aggregation of entities that alone have almost no power, while all together constitute a reliable trustless entity, (it could be seen as a sort of “collective intelligence”) to which to delegate a whole series of services that previously were the sole prerogative of centralised entities(banks, payment circuit operators, notaries, etc).
The blockchain has been the first technology to introduce the concept of trustless, a means of intermediation of trust, that was not built on a single organization but on a group of anonymous entities.
After many experiments and failures, a very promising solution was found in 2008 by Satoshi Nakamoto, as described in his paper “Bitcoin: A Peer to Peer Electronic Cash System” and the subsequent publication of the open source code of the first implementation of this system.
The identity of Satoshi Nakamoto is not known with certainty, probably a pseudonym behind which a group of ethical hackers could hide.
Instead, the reasons for this contribution are well known: Nakamoto wanted to build a digital tool that is free and accessible to all to exchange value and counter the power of traditional financial groups, responsible for various financial crises, including that of subprime mortgages which began in 2006.
Thanks to Nakamoto’s work, today, there is a new class of business models accessible and achievable by individuals and companies, which can interact with dynamics of interest never observed before: trustless services.
3. Who is behind it
Once we understand the potential of trustless services, we can explore the roles of the various actors who provide these services and understand what are the criteria for identifying which services to use.
The blockchain is the technological solution behind Bitcoin. Many variants have been developed from that initial idea, today there are very different blockchain networks in terms of security, participation and performance.
Who manages a Blockchain
A blockchain is a community of individuals, companies, and potentially even institutions that set up machines and software that respects a specific protocol of interaction with the nodes of other organisations, in exchange for direct or indirect economic benefits (organisations formed profit). A blockchain network generally refers to a non-profit organization that is responsible for coordinating the development of the protocol, the code, and following a long-term growth plan.
Who can use a Blockchain
A self-respecting blockchain is a permissionless tool: it can be used by anyone without signing contracts or requesting authorisations.
A blockchain is freely readable and writable, however, in order to write on it, it is necessary to acquire the assets that enable its use, these assets can be purchased by those who own them or earned by contributing to the network itself through a process that I will explain later, which is called mining.
4. How to use it
In a blockchain network, individuals, companies, and institutions build a global digital network by making available nodes (i.e. computers) on which specific software is installed. These nodes, at the same time, collaborate to maintain a single protocol of operation and compete to acquire an economic reward for this collaboration. The proper functioning of the network builds value for all participants.
The concepts needed to understand how to approach a blockchain user are the assets, the wallets, the addresses, and the transactions.
Assets on the blockchain are not isolated digital entities, but fragments of data and code written in the decentralized ledger and therefore replicated in all nodes. The possession of these entities is represented by the right to move the assets themselves, i.e. the possession of the cryptographic keys necessary to sign the transfer instructions of these assets from their current addresses.
Assets can be the native currency of the blockchain or tokens built on it by a user. The native currency represents the main value asset and allows to:
- represent, store and exchange value, for example, in the Ethereum blockchain, the main asset is its native currency Ether, which has a value and can be bought, traded, and sold;
- use the specific features of the network, for example, it is possible to spend Ether to interact with smart contracts, through the execution of code.
Wallets are software (which may also have hardware security components) installed on users’ devices that guarantee control of the assets to their legitimate owners. The issuance of a transaction takes place through this software, which can be thought of as a keychain containing the keys necessary to sign the necessary authorisations to spend the assets.
Assets are contained in containers called addresses, managed by wallets. Transferring an asset means passing it from the control of a sender address to a recipient address.
Transactions are written operations on the ledger that are performed through the wallets and have an execution cost, a transaction allows you to permanently modify (if you are authorised to do so) the decentralized register.
A transaction contains the order to move a native asset from one address to another and may additionally require the execution of commands provided by a smart contract.
To use a blockchain, it is necessary to own and spend assets or resources produced and kept by that blockchain, the native cryptocurrency. This means that the services provided or built on blockchain are not free, but they tend to be cheaper, they are not subject to monopoly, nobody can impose rules that have not been accepted by a large majority, and they are permissionless.
5. How it works
Bitcoin was the first decentralized network in history able to represent non-duplicable digital assets, and therefore capable of representing a value, to achieve this result, it is necessary that all participating nodes have a unique and shared vision of the register.
The main complexity in making a network of nodes work where no one coordinates the operations is to keep all the nodes on a unified (or synchronised) view of the information, for this purpose, it is necessary to give a global order to all valid transactions performed.
In fact, if there were no such global ordering, a user could take advantage of misalignments in information and spend the same asset several times, for example, by executing two transactions from the same address at the same time to buy something, notifying two very distant parts of the network and hoping none realises it before having received the goods (double-spend).
Before the algorithmic solution proposed by Nakamoto, this ordering problem could only be solved by using a central coordinator, a sort of orchestra master visible and recognised by all who helped the various nodes to synchronise. But this introduced an element of centralisation, and therefore of control and potential compromise.
The great success of Satoshi Nakamoto was to discover an algorithmic method, called Nakamoto Consensus, which allows generating digital assets that cannot be replicated, and therefore unique, not subject to double-spend on a network of peer nodes, then without such central coordination.
The coordination of the nodes of a blockchain based on the Nakamoto Consensus requires that some nodes, called miners, generate an ordering of circulating and not yet confirmed transactions. This ordering is obtained by collecting the transactions awaiting validation in groups called blocks, where a block must refer to one already approved by the network.
Since any node could perform this transaction validation and grouping operation, it was necessary to introduce a competitive mechanism that ensures that issuing a valid block would be a temporally rare event, in order to avoid excessive overlap.
The protocol requires so to perform a mining operation on the candidate block, which consists in solving a computationally very heavy problem. When a miner finds a solution, it propagates it to the network, each receiving node validates the solution and, if correct, propagates again.
When during his mining work, a miner receives a block from the network coming from another miner who solved the problem before him, he, after verifying the validity of the proposed solution, abandons the work done up to them and starts again from scratch, building a new block with transactions not yet validated and starting a new search for the solution, also adding the newly validated block to its local blockchain.
If, on the other hand, the node is not a miner, it simply checks the block with the information it has and, if valid, adds it at the head of the chain.
Sometimes there may be temporary forks in the blockchain, there may be multiple branches that stretch in parallel for a while, but statistically, one of the branches will become longer than the others, and these will be abandoned.
The nodes of a blockchain also listen to new transactions (not yet confirmed), verify that they are valid with respect to what they know of previously confirmed transactions, and repay them to the nodes they know.
Nodes that are also miner, in addition to the validation, operations run also an activity of block resolution: new valid transactions received are grouped together into new candidate blocks, these blocks are then linked to the last known valid block, thus forming a chain of blocks.
In the case of Proof of Work, the solution of the block is an always unique mathematical problem which depends on the data contained in such a block and which requires a certain effort (that can be expressed in elapsed time) to be calculated. The first node that finds the solution propagates it to all the other nodes that verify it and re-propagate it in turn, interrupting the searches in progress based on the same parent block.
The Proof of Work is a statistical process, the exact time needed to find a solution for a specific input cannot be calculated, but you can probabilistically estimate how long it takes depending on your mining power and the level of complexity required. The difficulty varies over time, as we will see shortly.
Conceptually, with the Proof of Work, everyone has the opportunity to participate in the construction of a new block, but the more powerful their hardware, the greater the probability of success, which is why miners do not operate alone (they would have the possibility to find a solution, i.e., solve a single block every several years) but they join with other miners to share load and reward in proportion to the effort done. These groups are called mining pools.
In case consensus algorithms such as Proof of Stake are used, the application of a new block by the miners (which with these algorithms are sometimes called validators) does not require particularly high computational costs or dedicated hardware, however, to ensure a correct distribution of the opportunity to build a block, it is required that the blocks proposed by a miner are accepted according to their amount of stakes and the time elapsed since the last block issued.
Transactions in a blockchain, as we have seen previously, are not confirmed in the reception phase, as happens in centralised systems, but must be confirmed by the network through consensus.
A transaction has an incremental confirmation level (or depth), becoming more secure over time. When a transaction exceeds a certain number of confirmations (which depends on the network), it can be considered non-reversible and therefore definitive.
Technically a transaction is confirmed when it enters a block and is considered safe when a sufficient number of other blocks are built on top of the block that contains it (for example, in Bitcoin this number is conventionally 6).
The confirmation of a transaction is a probabilistic operation, it is not possible to estimate the exact time that a transaction will require to be considered definitive, you can only have a temporal estimate, for example, in Bitcoin, there is an average block every 10 minutes, to have 6 confirmations necessary to assume a transaction as finalised, so you have to wait on average 60 minutes.
The block reward mechanism and fees make up the economic incentive that miners receive when they contribute to creating new blocks. Many blockchains, including Bitcoin, define a maximum number of native coins that can be generated (limited supply).
In this regard they have introduced a mechanism that reduces over time the amount of new coins that are generated in a block reward, generally by halving such reward every N blocks.
This means that for these blockchains the block reward is a temporary mechanism that goes towards exhaustion and that the fees remain the long-term reward mechanism.
When a miner receives a valid block built on the same block that he is also using to build its candidate block, he knows that he has lost the competition for that block, and he can only abort the current job, add the new received block at its current blockchain and start solving a new candidate block, linked to the last block it has just validated. And this process is repeated forever.
When a new block is mined, the issuing node assigns itself a reward, as established by the protocol. When this block is approved by the individual nodes of the network, this reward becomes effective. If a node instead tried to propagate a block invalid according to the protocol observed by the majority, this block would simply be ignored by the receiving nodes and not propagated further.
The main public blockchains base their Consensus mechanism on the construction of transaction blocks. These blocks, for performance reasons, have a predetermined maximum size, consequently, the number of transactions per unit of time that can be carried out on a blockchain is limited.
Miners, in selecting the transactions to be included in the next candidate block they will process, will be able to choose those that guarantee higher fees.
So users who need to transact on the blockchain at a given time have to compete to buy the available slots, and this actually constitutes the transaction fees. Given that fees tend to be extremely variable, they constitute an element of friction in the adoption of decentralised solutions.
The difficulty is a numerical value that indicates the minimum computational effort required by the mining process to generate blocks that can be accepted by the network. If a miner were to resolve and propagate a block below the difficulty level the network has settled on, it would be ignored.
The difficulty with which it solves a block cannot remain constant. In fact, if in a public network over time, the mining power supplied by miners, for example, were to double, the average time needed to solve a block would be halved. Variations in hashpower would cause variations in the average production time of the blocks, and the temporal distance between the blocks would become unpredictable.
Furthermore, if the solution times between blocks become too narrow, the consensus protocol of the network could become unstable, because the blockchain, instead of developing linearly, would start to develop concurrent branches. Some branches would then be eliminated, however, this process would cause delays in the finalisation of the blocks, dispersion of the global hash power, and therefore lengthening in the confirmation times of the transactions.
In order to avoid these unwanted ramifications, the main mining protocols, such as that of Bitcoin, ensure that the average time to solve a block remains much larger than the average time to propagate a block to all nodes in the network, so as to ensure stability and poor branching of the blockchain.
To achieve this effect, an adaptive difficulty is used, designed to keep the average block generation time constant. The difficulty, therefore, increases as the average hash power expressed by the network increases and decreases as it decreases.
Since the search time of each block solution is statistically constant (i.e. it takes about the same time to make a block), the blocks will be issued by the miners on a regular basis, going to build a sort of global clock, supported by the miners’ competition.
6. When to Use It
One of the most complex issues for those who approach blockchain ecosystems is to understand when it is worth using these technologies to carry out a project. Since 2017 there has been an excess of enthusiasm in the use of blockchains and tokenisation solutions, often in technically unsuitable contexts and without a real logic of value generation.
In principle, it may make sense to use the blockchain if the project we are developing has very important trust aspects.
I wrote a dedicated article that helps to evaluate how much it is really necessary to apply a blockchain solution to your model of business: https://hardest.medium.com/does-my-business-model-need-a-blockchain-21a556afca38
7. Which Blockchain
To date, there is no blockchain suitable for all needs, it is necessary to understand which, among those available, is more compatible with our project objectives. There is no exact formula to calculate the compatibility level, but semi-formal decision-making methods can be applied to better evaluate all aspects.
Once a tokenised business model has been defined, and the on-chain interactions with the various stakeholders have been identified, the choice of a blockchain depends on various factors such as the average cost and speed of the transaction, the level of security required by the project, the level of perception of the market and other factors that are often more emotional than technical.
Fees and, therefore, the average transaction cost greatly impact the selection of a blockchain substrate, unfortunately, more than the security aspects.
For example, following the capitalisation growth of the crypto markets and the consequent increase in value and transaction volumes observed in Q1 2021, the use of networks such as Ethereum has become very expensive. Many companies have therefore started sponsoring alternative networks to Ethereum, which is the main substrate for decentralized finance, proposing poorly decentralized clones (controlled by a few companies often in business with each other) with controlled usage fees.
The mass adoption of these “low-cost networks” by entire sectors (which operate mainly in DeFi, Decentralized Finance) demonstrates how even today the average user is more sensitive to usability rather than to the reliability of a network, and that there is a need for greater understanding of technology and its risks.
Blockchain is one of the most complex and least-understood topics of recent years, combining advanced concepts of distributed networks, cryptography, and programming with social and economic dynamics. This often causes misunderstanding and irrational or biased approaches even for many professionals.
The best way to orient yourself in this world is to understand the fundamental concepts introduced in this article, without being influenced too much by the storytelling built by some actors to differentiate themselves from “competitors,” but which does not introduce significant strategic advantages.
If you want to learn more about the topics introduced in this article, I recommend that you also read my articles:
- A Blockchain Terminology Concept Map
- Blockchain: the 100+ most common questions
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