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Introduction to cryptocurrencies
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What is a blockchain?
No introduction to cryptocurrency is complete without a discussion on blockchains. You may have heard this term too - quite a lot. But if you are like the average crypto investor who has only recently entered the market, you may not have a very clear idea of what a blockchain is. Well, you need not worry, because that’s all about to change today. In this chapter, we’ll break down this complex technology into simple blocks and understand how it powers crypto transactions.
What is a blockchain?
The name itself is quite a big hint. A blockchain is simply a chain of blocks, connected together securely. But what is a ‘block?’ And what does it contain?
You see, each ‘block’ in a blockchain is a collection of digital data. This data can be anything. In the context of cryptocurrencies, the data stored on the blockchain pertains to crypto transactions. On the other hand, if blockchain technology is used in real estate applications, information about property ownership records. In healthcare, blockchain tech can be used to store information about patient details and their medical histories.
So, now that we’ve understood what a blockchain is in layman’s terms, let’s take a look at the technical definition of a blockchain. A blockchain is a system of recording data or information digitally, in a manner that makes the details recorded immutable.
This leads us to an important question. If a blockchain is all about simply storing data digitally, how is it different from storing data on a computer server or on a cloud? The distinction lies in the possibility of changing or hacking the data stored. In your average cloud storage or server storage, it is possible to easily alter the data or information. Anyone with access to the server or the cloud can make these changes. Often, these changes cannot be traced too.
In blockchain, which is the technology used to record cryptocurrency transactions, it is impossible to change or hack the data record in each block. You cannot cheat the system. And any change, if made, is instantly noticeable to everybody who has access to the blockchain.
A step-by-step guide to how a blockchain works
Wonder how it is possible to store data on a blockchain in a way that makes it immutable? Well, to understand that, we need to take a closer look at how blockchain technology is used in cryptocurrency.
Step 1: Recording crypto transactions
The first step is the creation of blocks. In the case of cryptocurrencies, this involves recording the crypto transactions that occur on the chain. All the data related to the transactions of the cryptocurrency that the blockchain pertains to is recorded in the form of blocks. Each block on the chain is of a specific size.
For instance, in the case of the Bitcoin blockchain, each block contains 1MB of data. The data on the Bitcoin blockchain includes details of every Bitcoin transaction that has occurred from the time the first Bitcoin was spent or traded.
Step 2: Creating the signature
Once a block has been created, it needs to be chained to the previous block (or in case of the first block, to the next block). Here is where blockchain technology makes use of something called a cryptographic hash function. The function creates a digital signature that is unique to each block.
This hash function creates the input data in a block into a unique output that consists of a string of 64 digits. If even the slightest change is made to the input data, the 64-digit output is changed entirely. So, in short, the cryptographic hash function gives the same 64-digit output for the same input data, and gives a different output in case the input data has been changed - even a little bit.
Step 3: Chaining the blocks together
Once the signature for a specific block has been created using the cryptographic hash function, it is used to link the block to the previous (or the next) block. To understand this better, imagine three blocks of data - Block 1, Block 2 and Block 3.
The signature of Block 1 is added to the data in Block 2. And the signature in Block 2 is added to the data in Block 3. And so on.
- Now, say you make a small change in the data in Block 1. This will naturally change the signature of Block 1.
- But the signature of Block 1 is a part of Block 2’s data. So, the data in Block 2 also automatically changes.
- And a change in Block 2’s data will also change the signature of Block 2.
- Consequently, the data in Block 3 changes.
So, any change in the data in a particular block will cause the data in every successive block to change. And this is easily detectable because blockchain data is publicly accessible. As a result, no change in the blockchain can go undetected.
And that is why blockchains are immutable.
What are the advantages of blockchains?
The blockchain technology is used in cryptocurrency primarily because it has several advantages over traditional methods of storing data. Let us take a closer look at the pros of using blockchain technology.
- No necessity to have third party verifications for transactions
- Cost savings by eliminating the need for third party verifications
- Transparent technology that is easily accessible
- Secure and efficient transactions that are impossible to change or hack
What are the disadvantages of blockchains?
Despite the above advantages, blockchain technology has some limitations or downsides. The biggest among these is the lack of a centralised regulatory body. Aside from this, the technology itself can be quite cost-heavy initially. And another downside is that the amount of data each block can hold is limited.
This sums up what a blockchain is and how it works. This fundamental technology has several uses beyond cryptocurrencies too. The immutability of blockchains makes it valuable for sectors like healthcare, real estate and banking - all of which rely on tons of data on an everyday basis. However, the most prevalent use of blockchain technology continues to be the crypto domain.
A quick recap
- A blockchain is simply a chain of blocks, connected together securely.
- Each ‘block’ in a blockchain is a collection of digital data. This data can be anything. In the context of cryptocurrencies, the data stored on the blockchain pertains to crypto transactions.
- It is impossible to change or hack the data record in each block.
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