What is Blockchain?

The simplest and most simplistic definition of a blockchain is that it is a chain of blocks. That’s somewhat like calling a naval destroyer a big boat. This simple definition belies the tremendous power of blockchain to transform whole industries. What gives the blockchain the power? Why do we need it? What caused it to engage the public imagination? Why is it so polarizing? Let’s explore this idea a bit.

From a technical perspective, a blockchain is a list of blocks linked to each other, where each block contains a number of transactions. This is where the story gets interesting. The transaction data is immutably locked using cryptographic methods. It is virtually impossible to modify the data without incurring tremendous expense or collusion between the participants.

There is more to it than that – the blockchain is not just an immutable database. It is also a processing powerhouse. Smart contracts drive the verification of participants and the validation of transactions through a consensus mechanism before cryptographically locking the transaction data into immutable records. Moreover, smart contracts can perform many types of processing tasks just like any computer code, but with the difference that the parties to the transaction and other responsible parties must agree and approve the processing steps. This agreement and approval, formally called consensus, is a powerful concept. We will see why shortly.

There are two types of blockchains, broadly speaking: public and permissioned. In a public blockchain, anyone can participate. The classic examples are Bitcoin and Ethereum. In a permissioned blockchain, those who want to participate must obtain permission. Permissioned blockchains are more appropriate for business use or for those applications where the participants are subject to regulatory oversight. Examples of permissioned chains include Hyperledger Fabric, Corda, and Quorum.

All blockchains have three important components: cryptography, distributed systems, and consensus. Cryptographic methods are vital for storing data securely. Distributed systems technology is essential for processing data and transactions across a widely distributed and loosely coupled group of participants. Finally, consensus ensures that only data and processing that is accepted by the majority of the stakeholders is immutably recorded on the chain.

Bitcoin is the first and most widely recognized application of blockchain technology, but is only an application built on blockchain; Bitcoin is not synonymous with blockchain. There are many other applications built on both public and permissioned blockchains.

To understand the business appeal of blockhcain, consider the simple paper-based ledger. Many decades ago, I had the good fortune of training under an auditor. My task was to examine double-entry accounting ledgers and certify their accuracy. On every page of a ledger there were a bunch of transactions (debits and credits). The column totals were recorded at the bottom, signed by the accounting assistant, and countersigned by the accounting supervisor. These debit and credit totals were carried forward to the top of the next page. New accounting entries were added to the next page. When that page was full, the debit and credit totals (which included the totals from the previous page) were recorded at the bottom of that page. And so on.

If the company that we were auditing wanted to fudge the numbers on one of the accounting entries, it would be practically impossible to do it in an undetectable way (all entries were made in ink). Suppose a crooked accountant managed to do it, they would then have to re-compute the debit and credit totals at the bottom of that page, change the brought-forward totals at the top of the next page, recompute and change the totals at the bottom of the next page, and so on. Tearing out an entire page of entries would also be easily detectable in a paper-based ledger since the method of binding the pages would make it very difficult to tear out the pages in an detectable way. Besides, the page numbers wouldn’t match.

In short, the paper-based ledger was practically fool-proof. Crooked companies found it easier to just maintain two ledgers, one for the auditors and one for the “real” transactions.

When computers and databases became widespread, the paper-based accounting system gave way to an electronic ledger. While system safeguards are built into electronic ledgers, it was much easier to make alterations in the database through “backdoor traps” and by people who had direct access to the systems.

Blockchain technology changed all that. It combined the efficiency of modern computer technology with the fool-proof nature of paper-based ledgers, but in a much more sophisticated way. The whole blockchain (viewing it as a database) is the ledger itself. Blocks that make up the blockchain are like the pages of a paper-based ledger. The blocks are linked together through cryptographic links, similar to the page numbers of a paper-based ledger. Each block records a number of transactions (similar to the rows of accounting entries in a paper-based ledger). Transactions inside each block are cryptographically bound together using sophisticated mechanisms such as Merkle trees.

The analogy to a paper-based ledger makes it easy to understand why blockchains are much more secure than just regular databases. The story gets better: paper-based ledgers, while reasonably secure from tampering, suffer from two disadvantages: they can be destroyed in a fire or stolen, and they represent the “truth” only from the viewpoint of the company that owns the ledger. The counterparties to each transaction (for every debit there is a counterparty creditor, and vice versa) may not agree with the recorded numbers. This raises the thorny problem of reconciliation. Companies spend enormous amounts of time and money performing reconciliation and settlements.

To overcome these two disadvantages, imagine if the ledger has multiple copies stored with distributed parties. Moreover, every block (“page”) of transactions are replicated in real-time. This makes it a real-time distributed ledger. Finally, assume that entries in the ledger can be made only when both (or all, or a majority of) parties agree that the numbers are correct. This is an agreement by consensus, which avoids post-facto reconciliation.

This is why a blockchain is also called a distributed ledger. The benefits are enormous: instant reconciliation, settlement, immutability, multiple copies, and agreement by consensus.

This is only scratching the surface of the benefits of a blockchain. There’s more, with smart contracts that perform distributed processing, removing some of the inefficiencies of intermediary processing. Blockchain technology is really a combination of distributed data and distributed processing. These fundamental capabilities enable many fascinating applications that are not possible through traditional and legacy technologies. More on that later!