The Basics of Blockchain

Bitcoin’s pseudonymous creator Satoshi Nakamoto was the first to popularise a real world description of what we now call a blockchain, in the original white paper published in 2009. But while Satoshi Nakamoto used the work “block” and “chain” liberally in the paper, at no stage did the word “blockchain” appear.

Blockchain entered Oxford University’s online dictionary in 2015 with the entry: “A digital ledger in which transactions made in bitcoin or another cryptocurrency are recorded chronologically and publicly”. Now, not a day goes by when blockchain technology isn’t referred to somewhere as an important innovation with significant potential to disrupt financial and other markets.

But before Satoshi Nakamoto took the concept to another level, two researchers working at Bell Labs in 1991 came up with the idea. Stuart Haber and Scott Stornetta were looking at ways to protect the immutability of digital records.

Having realised that the future of information storage and dissemination was going to be digital, they decided to use cryptography to securely “sign” a document, to be able to timestamp a signed document so that any attempt to tamper with it later on would be revealed, and even to link documents in a kind of series (or chain) to create a historical record.

Satoshi Nakamoto would employ these ideas twenty years later in the creation of Bitcoin. The blockchain began as an innovative way to decentralise digital money for a digital age and is now evolving into platforms for a variety of uses. Given the extent of investment and intellectual firepower being invested in blockchain projects, the space will either generate significant future rewards or be seen in hindsight as a period of irrational exuberance.

Blockchain 101

So what exactly is a blockchain? Bitcoin’s blockchain will illustrate.

Imagine that Alan wants to buy some bitcoin at an online exchange and then transfer it to his own wallet. Assume he has both setup an account at an exchange and purchased a physical hardware wallet to secure his bitcoin. And finally, he wants to transfer some of this bitcoin to Bob.

The very first step for Alan is to buy some bitcoin at the online exchange, which will appear in his online account, much like using an online share exchange. Now he can transfer this bitcoin from his online account to his physical hardware wallet over the Bitcoin network, via Bitcoin’s blockchain.

Opening his hardware wallet, Alan will choose to “receive” some bitcoin. His wallet will first generate a private key which is a bit like a PIN to a bank account and exists typically as a 64-digit number. Being like a PIN, it ultimately unlocks access to any bitcoin associated with it, so its privacy is important.

Then, Alan’s wallet will use the private key to generate a public key, and from there, an address (typically between 26 and 35 alphanumeric characters). The address is a bit like a bank account number in that it is the beneficiary destination inside Alan’s wallet which will receive the bitcoin transferred from Alan’s account on exchange.

Going from the private key to the public key to the wallet address is a one-way trip. The process employs cryptographic techniques which are practically impossible to reverse. Alan can then share his wallet address freely with Bob or anyone else because of this feature.

After Alan gives his wallet address to the exchange, the exchange will send the bitcoin to Alan’s address via a transaction. When Alan’s wallet receives the bitcoin, the Bitcoin network will keep a small fee which will be paid to the miner that verifies the transaction. This is a bit like a bank fee that might be retained during a funds transfer.

The exchange “sends” the bitcoin by publishing the transaction to the Bitcoin network, which currently consists of roughly 80,000 server “nodes” around the world. Each node acts as a kind of messenger, receiving a transaction and passing it onto the nearest other node. Within a few seconds or so (the time it takes for the transaction to propagate across the whole network), the node associated with Alan’s wallet will “see” the transaction and recognise it as being for Alan from the address (and the fact that Alan’s wallet can “unlock” the bitcoin received at that address using its own key).

The bitcoin arriving from the exchange to Alan’s wallet is called an unspent transaction output (UTXO), until Alan “spends” it, say, by subsequently paying Bob. UTXOs are an important aspect of Bitcoin because they can be analysed to shed light on transaction activity, which in turn may help investors to draw conclusions about Bitcoin’s price (among other things).

But before Alan can spend the bitcoin by paying Bob, the Bitcoin network needs to confirm the transaction and add it to a shared ledger which contains a record of every confirmed Bitcoin transaction in history.

This ledger is called the blockchain because transactions are stored in blocks, and transactions are “chained” together for all time by virtue of one transaction’s output being the next transaction’s input.

The job of verifying transactions falls to the miners. Miners race against each other to verify a block of new transactions that have been performed since the last verified block. Miners also get to add a transaction to the block they’re verifying which will pay them some bitcoin called a “block reward”.

Verifying the new block is the “proof of work” needed for the block reward to become “spendable” by the miner, and for the block to be added to the blockchain. The Bitcoin protocol designed by Satoshi Nakamoto determines how much bitcoin is paid out as a reward, and the schedule is fixed until the last new bitcoin is mined in around 2140 or so.

Alan’s transaction (transferring bitcoin from the exchange to Alan’s wallet) is confirmed once the block containing the transaction is verified. Each subsequent block is considered another confirmation. Most Bitcoin participants consider between 3-6 confirmations to be sufficient, usually based on the value of the bitcoin transferred.

As each block gets added, the amount of computer power needed to go back and reverse, alter or invalidate a transaction becomes enormous. This is because all blocks after the block containing the transaction would need to be re-computed. It is precisely because blocks (and their transactions within) are chained together mathematically that gives the blockchain its immutability. The blockchain ledger is effectively set in stone, practically speaking.

Once Alan’s transaction is sufficiently confirmed, the bitcoin received from the exchange now sitting in his wallet as a UTXO, becomes “spendable”. This means Alan can now pay Bob using that very same bitcoin (or other bitcoin residing as other UTXOs in his wallet).

This time, Bob gives his wallet address to Alan. This time it is Alan’s wallet that creates and propagates the transaction onto the Bitcoin network. And it is Bob’s wallet that recognises the transaction as being intended for Bob, because it holds the key to unlock the bitcoin sent to that address. And once a miner verifies the block containing Alan’s transaction and adds it to the blockchain, it is confirmed (and set in stone once enough subsequent blocks are added).

And on it goes, block-after-block …as it has done uninterrupted since 2009.

Byzantine Generals

Satoshi Nakamoto’s innovative combination of a blockchain secured by proof-of-work solved a longstanding puzzle called the “Byzantine General’s” problem. The puzzle is that several generals surround Byzantium with their armies but cannot decide when to attack in unison because their lines of communication can’t be trusted (Byzantine spies have infiltrated the lines).

The blockchain solves this dilemma for decentralised digital networks because every node sees the “official” ledger at the same time due to the peer-to-peer network, and the blockchain itself (being linked blocks of transactions) is secured by cryptography.

Satoshi Nakamoto then added further innovations such as the fixed and predictable block reward supply schedule and the difficulty adjustment (to keep the time between blocks roughly ten minutes no matter how much computing power the network has or doesn’t have).

Numerous other projects have since emerged based on blockchain concepts, including many looking to solve non-monetary problems (such as property titles or food provenance). Even IBM is getting in on the act with its Hyperledger blockchain.

They all owe a debt to Satoshi Nakamoto’s creation. The term “blockchain” has become part of the lexicon, if not part of everyday language.