Blockchain Explained: The Technology Behind Crypto

A blockchain is a shared database with an unusual property: once records are added, they are extremely hard to change, and no single party controls the copy everyone relies on. That is the whole idea. Most of the complexity in the field comes from the different ways of achieving it, and the trade-offs each one makes.

Blocks and hashes

Records are grouped into blocks. Each block contains a hash of the previous block. A hash is the output of a mathematical function that turns any input into a fixed-length fingerprint; change even one character of the input and the fingerprint changes completely. Because each block includes the previous block's fingerprint, the blocks form a chain. Altering an old record changes that block's hash, which breaks the link to the next block, and the next, and so on. Anyone holding a copy can detect the tampering instantly.

Detecting tampering is not the same as preventing it. That requires a way for many independent participants to agree on which version of the chain is the real one. This is the job of a consensus mechanism.

Consensus: proof of work and proof of stake

In proof of work, used by Bitcoin, participants called miners compete to solve a computational puzzle to add the next block. Rewriting history would require outspending the rest of the network on computing power. It is secure on large networks but consumes a great deal of electricity.

In proof of stake, used by Ethereum since its switch in September 2022, participants called validators lock up the network's own currency as collateral. Validators are chosen to propose and attest to blocks, and those who act dishonestly can lose part of their stake. This uses far less energy than proof of work. Its critics argue that it gives more influence to those who already hold the most coins.

Public and permissioned blockchains

Public blockchains, such as Bitcoin and Ethereum, let anyone read the ledger, send transactions, and take part in consensus without asking permission. Permissioned blockchains restrict who can participate, usually to a known group of organisations. They give up some decentralisation in exchange for control, speed, and privacy, and are mostly used for record-keeping between businesses, such as trade finance or supply chains, rather than as currencies.

Smart contracts

Some blockchains, most notably Ethereum, can run small programs called smart contracts. A smart contract holds funds and releases them automatically when its coded conditions are met — for example, swapping one token for another at a price set by a formula. Applications built from smart contracts include decentralised exchanges, lending platforms, and token issuance. The flexibility is real, but so are the risks: a bug in a smart contract can be exploited, and because transactions are irreversible, stolen funds are usually not recovered.

A walk-through: how a new block gets added

Picture a network with thousands of participants, each holding a full copy of the ledger. Someone submits a transaction, signed with their private key. Every participant who receives it checks two things: that the signature is valid, and that the sender actually has the funds according to the existing ledger. Valid transactions are gathered into a candidate block. Through the consensus mechanism, one participant gets the right to propose the next block; the others verify it and, if it follows the rules, add it to their copy of the chain. Anyone who tries to add an invalid block is simply ignored by honest participants.

Occasionally two valid blocks are produced at nearly the same time, and the chain briefly splits. Participants then follow whichever branch grows longer (or, in proof-of-stake systems, whichever the consensus rules favour), and the other branch is abandoned. This is why a transaction in the very latest block is treated as less final than one buried under several later blocks.

Common misconceptions

• 'Blockchain makes data true.' It makes data hard to change after it is recorded; it does not verify that the data was accurate to begin with.
• 'Everything on a blockchain is anonymous.' Public blockchains are usually pseudonymous: addresses are not names, but every transaction is visible to everyone forever, and addresses can often be linked to real identities through exchanges and analysis.
• 'A blockchain cannot be changed.' The rules of a blockchain can be changed if enough participants agree to run new software; what is hard is changing the record unilaterally.
• 'Any system with a token is decentralised.' Many projects with tradable tokens are controlled in practice by a small team or a few large holders.

What blockchains are good and bad at

• Good at: keeping a shared record among parties who do not fully trust each other; making tampering evident; running rules that no single party can change on its own.
• Bad at: speed and cost at large scale, compared with a conventional database; correcting mistakes, because reversibility is deliberately difficult; knowing whether data entered into the chain was true in the first place.

The last point matters more than it first appears. A blockchain can prove that a record has not been changed since it was added. It cannot prove that the record was accurate when it was added. If a supplier records a false shipment, the blockchain preserves the false record perfectly.

Blockchain is not the same as crypto, or as a CBDC

Cryptocurrencies are one application of blockchain technology, not the technology itself. Many businesses use permissioned ledgers without any tradable token. Separately, central banks including the Reserve Bank of India have been developing central bank digital currencies. A CBDC is digital legal tender issued by the central bank; it does not need to run on a public blockchain, and it is a liability of the central bank, unlike a cryptocurrency, which is nobody's liability.

Separating the technology from the price

It is easy to merge two different questions: whether a blockchain is useful for a particular job, and whether the token associated with it is fairly priced. A network can be technically sound and widely used while its token is still heavily overvalued, or the reverse. Hype around the technology has often been used to promote tokens that had little to do with it. Judging one does not settle the other.

The Reserve Bank of India has cautioned users of virtual currencies about the risks of holding and trading them, and those cautions apply regardless of how promising the underlying technology may be.