How Does Blockchain Work?
The term “blockchain” isn’t coincidental; it’s a literal description of how the technology functions. This digital ledger is often described as a “chain” made up of individual “blocks” of data. As new data is added to the network, a new “block” is created and linked to the existing “chain,” ensuring all nodes on the network have an identical copy of the blockchain ledger.
The process of creating these new blocks is central to blockchain’s security. A majority of nodes must verify and confirm the legitimacy of the new data before a block is added to the ledger. For cryptocurrencies, this might involve ensuring that transactions in a block are legitimate, such as verifying that coins haven’t been spent more than once. This differs from traditional databases, where a single individual can make changes without oversight.
“Once consensus is reached, the block is added to the chain, and the transactions are recorded in the distributed ledger,” explains C. Neil Gray, partner in the fintech practice at Duane Morris LLP. “Blocks are securely linked together, forming an unbroken digital chain from the ledger’s inception to the present.”
Transactions on the blockchain are typically secured using cryptography, requiring nodes to solve complex mathematical problems to validate each transaction.
“As a reward for validating changes to the shared data, nodes are typically compensated with new units of the blockchain’s native currency—like new bitcoin on the Bitcoin blockchain,” says Sarah Shtylman, fintech and blockchain counsel at Perkins Coie.
Public Blockchains vs. Private Blockchains
Blockchains can be either public or private. In a public blockchain, anyone can participate, meaning they can read, write, or audit the data on the blockchain. Notably, altering transactions in a public blockchain is incredibly difficult because no single authority controls the nodes.
On the other hand, a private blockchain is managed by an organization or group, which controls who can participate. This entity also has the authority to modify the blockchain, making the process more similar to traditional in-house data storage systems, though spread across multiple nodes for enhanced security.
How Is Blockchain Used?
Blockchain technology has a wide range of applications, from financial services to voting systems.
Cryptocurrency: The most common use of blockchain today is as the foundation for cryptocurrencies like Bitcoin and Ethereum. When people buy, exchange, or spend cryptocurrency, the transactions are recorded on a blockchain. As cryptocurrency adoption grows, so too does the use of blockchain.
“Because cryptocurrencies are volatile, they aren’t yet widely used for purchasing goods and services. However, that’s changing as companies like PayPal and Square make digital asset services more accessible to vendors and consumers,” notes Patrick Daugherty, senior partner at Foley & Lardner and head of the firm’s blockchain task force.
Banking: Beyond cryptocurrency, blockchain is being used to process transactions in traditional currencies, like dollars and euros. Blockchain can verify transactions more quickly and operate outside of normal banking hours, potentially speeding up transfers.
Asset Transfers: Blockchain can also record and transfer ownership of assets, such as digital items like NFTs or even real-world assets like real estate or vehicles. This technology allows parties to verify ownership and transfer property without the need for traditional paperwork.
Smart Contracts: Smart contracts are self-executing contracts where the terms are automatically enforced once specific conditions are met. For example, payment for a product might be automatically released once all agreed-upon conditions are satisfied.
“We see great potential in smart contracts—using blockchain technology and coded instructions to automate legal agreements,” says Gray. “Properly coded smart contracts can minimize, or even eliminate, the need for third-party verification.”
Supply Chain Monitoring: Blockchain is also being used to track and monitor supply chains, making it easier to trace the source of problems, such as identifying which vendor supplied poor-quality goods. IBM’s Food Trust, for example, uses blockchain technology to track food from harvest to consumption.
Voting: Experts are exploring the use of blockchain to secure voting systems. Blockchain voting could theoretically prevent fraud by allowing people to submit tamper-proof votes, reducing the need for manual ballot verification.
Advantages of Blockchain
Higher Transaction Accuracy: Because blockchain transactions must be verified by multiple nodes, errors are less likely to go unnoticed. In a traditional database, a mistake might be more likely to slip through.
No Need for Intermediaries: Blockchain enables two parties to confirm and complete a transaction without needing a third-party intermediary, saving time and reducing costs.
“It can bring greater efficiency to digital commerce, increase financial inclusion for unbanked populations, and power a new generation of internet applications,” says Shtylman.
Increased Security: Blockchain’s decentralized nature makes it extremely difficult for someone to fraudulently alter transactions, as they would need to hack every node and modify every ledger.
More Efficient Transfers: Blockchains operate around the clock, allowing for quicker financial and asset transfers, especially across borders, without waiting for banks or government agencies to process the transactions.
Disadvantages of Blockchain
Limitations on Transactions per Second: Blockchain’s reliance on network consensus can slow down transaction speeds. For example, Bitcoin can process only 4.6 transactions per second, compared to Visa’s 1,700 transactions per second.
High Energy Costs: Verifying blockchain transactions requires significant computational power, leading to high energy consumption. This not only makes blockchain transactions more expensive but also has a substantial environmental impact.
Risk of Asset Loss: Digital assets on the blockchain are secured with cryptographic keys. If an owner loses their private key, they lose access to their assets permanently, with no central authority to help recover them.
Potential for Illegal Activity: The privacy and security offered by blockchain make it appealing to criminals, as it’s harder to trace illicit transactions than through traditional banking systems.
How to Invest in Blockchain
You can’t invest directly in blockchain technology, but you can invest in assets and companies that utilize blockchain.
“The easiest way is to purchase cryptocurrencies like Bitcoin, Ethereum, or other tokens that run on a blockchain,” says Gray.
Alternatively, you can invest in companies that are exploring blockchain technology. For instance, Santander Bank is experimenting with blockchain-based financial products, and buying its stock could give you exposure to blockchain.
For a more diversified approach, consider investing in an exchange-traded fund (ETF) that focuses on blockchain assets and companies, such as the Amplify Transformational Data Sharing ETF (BLOK), which allocates at least 80% of its assets to blockchain-related investments.
The Bottom Line
While blockchain holds great promise, it remains a niche technology. Gray believes blockchain’s future depends on regulatory developments. “It remains to be seen when and if regulators like the SEC will take action. The goal will be to protect markets and investors,” he says.
Shtylman compares blockchain to the early days of the internet: “It took about 15 years for the internet to give us the first version of Google and over 20 for Facebook. It’s hard to predict where blockchain will be in 10 or 15 years, but like the internet, it will significantly transform how we transact and interact in the future.”
Despite challenges such as transaction limits and energy costs, blockchain-based investments may be worth considering for those who see the technology’s potential.
This revised version presents the information in a clear, concise manner while retaining all the essential details.
