Understanding Blockchain: Blockchain Fundamentals

In our Fundamentals section, you will learn what makes a Blockchain so special, how it works and why it has the potential to influence many areas of our lives.

What is blockchain?

In short: A blockchain is comparable to a database that does not belong to anyone and belongs to everyone at the same time. Due to these and other characteristics, the blockchain solves trust problems that often arise in our economy and society. A blockchain is therefore often referred to as “Layer of Trust” or “Trust Machine”.

The blockchain is a new technological development that can fundamentally change the way we communicate and interact around the world. Due to its characteristics, it is said to be able to change entire industries and branches or even make them superfluous. This disruptive approach is based on the way it works. Blockchain should make it possible to guarantee an unlimited exchange of information, values, and goods of any kind without having to resort to intermediary institutions such as corporations, banks or governments. To this end, technology replaces the task of the intermediaries, namely to minimize uncertainty and create trust.

The idea of blockchain was first published in 2008, although the underlying technological concepts go back further. The original idea was to use the blockchain to create a decentralized currency free from the influence of banks and governments. This currency was called Bitcoin and still represents this technology today. To this day, no one knows who really wrote the white paper on Bitcoin, as the only author who was responsible for it was the person or group under the pseudonym, Satoshi Nakamoto.

Bitcoin was the first decentralized currency based on blockchain technology.

Since then Blockchain has become a phenomenon that employs private individuals, governments, companies, and public institutions alike. Both the technological possibilities, disruptive ambitions and financial investment opportunities of the blockchain are attracting great interest. The former, in particular, triggered a gold-rush mood and billions in investments, which is why there is often talk of a speculative bubble. However, these distractions often drown out the actual potential of this revolutionary advancement. Due to the worldwide fascination, the emergence of blockchain is also compared with the emergence of the Internet in the early 90s. It is therefore worth taking a closer look at the technology and its properties.
In summary, Blockchain is a decentralized peer-to-peer network that generates a secure, transparent and optionally anonymous system with the help of cryptography. This minimizes uncertainties and transaction costs, makes trust in system participants obsolete and prevents the exclusion of persons.
In order to make this definition more understandable, the individual points will be examined in more detail below:

Properties of a Blockchain

Decentralization

The shift away from centralization is one of the most important characteristics of blockchain. It describes the power relations within the system, which are evenly distributed. The aim is to prevent the emergence of central parties. Institutions that are in such central positions today are, for example, banks, governments or companies that are in monopolistic structured industries.

Irreversibility

All information that has ever occurred on the blockchain is stored irreversibly.  A block represents a combination of the most current information of the system. They are connected one after the other and form a blockchain, which is constantly extended with new information by further blocks. Once a new block has been concatenated with the previous one, it is stored in an unalterable form along with its stored information.

Transparency

The blockchain is transparent in the sense that all accesses and interactions in the system are openly visible and irreversibly documented. So it is possible to see every piece of information, but not to change it. No information is deleted, but information about the change of circumstances is added so that every change and every access in the system can be traced back to its origin. Since the control over this is distributed in a decentralized way, there can be no non-transparent processes.

Anonymity

One of the most discussed characteristics of the blockchain is the anonymity of its participants. While all access and activities of the participants are transparent, the participants themselves are only represented by cryptographically encrypted number series. Depending on the type of blockchain, it is very difficult or even impossible to trace the real identity of a participant.
The advantages resulting from the above-mentioned characteristics are wide-ranging.

Advantages of Blockchain Technology

Safety and security

The combination of decentralization, irreversibility, and transparency creates, in theory, a perfect fraud-proof system. The blockchain always stores and updates the complete history of information that has ever occurred within the system. The special feature lies in the principle of decentralization, which means that this history is not stored centrally but separately for many individual participants. In order to manipulate this system, it would, therefore, be necessary in theory to manipulate every single block chain of information for countless participants at the same time, which is considered to be virtually impossible and not economically worthwhile. The more participants a blockchain has, the more secure it is as a rule.

Trust

The security of the system makes trust in the other participants (intermediaries/brokers) superfluous. Any interaction is therefore free of uncertainty or fear of fraud. What used to be the task of intermediaries such as governments, banks or corporations is now being taken over by blockchain technology. Because of this characteristic, block chains are also known as “trust protocols”.

Low transaction costs

The use of intermediary institutions usually leads to transaction costs. For example, the costs of a service consisting of creating trust and security between actors are charged. Or costs are incurred in the course of the processing or administrative effort. Blockchain technology makes these services in part superfluous and allows direct P2P interaction (P2P = peer to peer) without transaction costs in the form of fees or contributions. The purchase of a used bicycle, the sending of money or the booking of a flight can thus be handled without the fees due today. The transaction costs for participants within a blockchain can consequently be minimized.

Access

The prerequisites for participating in a blockchain system are relatively low. All you need is a device with an Internet connection. More than four billion people worldwide now meet this requirement. That is far more people than, for example, those who currently meet the requirements for a financial service or insurance from a central institution. Blockchain opens up international exchange and trade to a large part of the world’s population that was previously excluded.

How does Blockchain work?

The blockchain is based on a simple P2P database. Within this database, participants can interact directly with each other. There is no central part that takes care of regulation, control, steering or account management.

This characteristic appears trivial at first but is enormously important. Many current applications also seem to allow you to interact directly, but do not in reality. Whether it’s a messenger service like Whatsapp, a payment service like PayPal or an online marketplace like eBay - there’s always a central party involved that stores information charges fees or determines which participants are allowed to participate in the system when an account is opened.

Private Key and Public Address

Among other things, the P2P system (P2P = peer to peer) leads to decentralised account management. In the central system, the account is opened via the intermediary, such as a bank account or the creation of a mail address. The intermediary can avoid duplicate addresses by reconciliation and collect information and data about the person. In the decentralized network of the blockchain, accounts are generated randomly by means of cryptography, without the accounts being reconciled with each other. When an account is created, each participant receives a randomly generated “private key”, a kind of password. There are 2256 ways to create it, which are about as many variations as there are atoms in the universe. A double generated private key is therefore considered virtually impossible. It is usually displayed in hexadecimal form, consisting of a combination of 64 numbers and letters, and looks like this:

5KbhCkNKoSaSjZaKuHZx6feD215q1SwXk61QYqfZunKt3R9eD4u

A so-called “public address” is then derived from this. It behaves similarly to the private key as the mail address behaves to the password and represents the own account in the system. This derivation only works one-way. You cannot derive the private key from the public address. If the information is to be transmitted, for example about the ownership of Bitcoin, it is sent to the public address of a person. For example, if jessica wants to transfer two Bitcoin to Max, she logs into her account with her private key and defines Max’s public address as the new owner. Only Max can now access it using his private key and make further changes.
Independently of this, anyone can view the transactions of all addresses with each other. This transparency is based on the principle of the Distributed Ledger and will be explained in the following section.
Let us note that we are in a P2P system in which participants interact using cryptographically encrypted accounts.

Distributed Ledger

A special feature of the system is the way in which information is processed and documented. This is done using a distributed ledger, which can be interpreted as a distributed accounting ledger. It more or less replaces the central server of the system. Two characteristics of this are decisive. On one hand all new information gets an entry into the accounting book, even if previous information is only to be changed or made void. Once an entry has been made in the ledger it cannot be changed - more on this later. Instead, the adjustment of the previous information is inserted in the new entry. For example, if Jessica has transferred two bitcoins to Max, this information gets an entry. If Max then returns the two bitcoins to Jessica, which would restore the old information, the old entry will not be deleted. Instead, a new entry is added with the information that the two bitcoins were transferred back from Max to Jessica.

At the same time, the complete ledger of accounts is updated with each new entry, copied and made available separately to everyone who is actively involved with the operation of the Blockchain. This ensures an aspect of decentralization. In our example above, if Jessica wants to cheat and says that she never received the refund of the two Bitcoin from Max, she can now be proven guilty of this lie because there is a decentralized and publicly accessible ledger in which all information and transactions are documented.
Remember that we are in a tamper-proof and transparent P2P system where information is decentralized and participants interact using cryptographically encrypted accounts.

Why the name Blockchain?

Let us now look at the entries in the account book that give the blockchain its name. Each entry consists of several pieces of information, which together form a block. These blocks are arranged one after the other by cryptographically concatenating the most recent block with the previous one. This creates an unchangeable chain in which older entries can no longer be changed. This is due to the type of connection, which is based on a unidirectional cryptographic concatenation. When each block is created, certain information is added to it, including a header, an ID, a time value, a so-called hash value, and a reference to the hash value of the previous block.

Hash values and cryptography

The hash is a value derived from a digital content by means of complex mathematical calculations, in this case the information of a block. The hash value is always identical if the content does not change and the same hash value can always be calculated from the content. However, you cannot derive the content from the hash value the other way round.

A simplified example shows the sum of the digits. If the content of a block consists of the numbers 1,3,4, the checksum, more or less the hash 8. The checksum can be derived from the content again and again simply the hash. However, this is not possible the other way round, since the checksum 8 can also consist of other number combinations such as 2,2,4 or 1,1,6. In reality, the formulas for calculating the hash value are much more complex, so that a change in the data is immediately noticeable.

Bitcoin, for example, uses the SHA-256 method. An important point here is that the hash function used provides what is known as collision resistance, which makes it impossible for different contents to create the same hash value. Each block has a digital fingerprint that uniquely identifies it and also links it invariably to the neighboring blocks. If one would change the information from an old block, all subsequent blocks would “notice” this, since the respective hash changes with each one.

Remember, we are in a tamper-proof and transparent P2P system where information is decentralized and immutable and participants interact using cryptographically encrypted accounts. The blockchain represents the blocks interlinked by hash values, which contain the information of the distributed ledger.

Mining - Blockchain Reward System

The value of the blockchain is thus based, amongst other things, entirely on the secure documentation of information within the blocks. In order to create such a block including its hash value, a considerable amount of computing power is required. The larger a blockchain becomes, the more complex the process gets. The question that arises is who provides the computing power to generate the blocks and keep the system running? For this, we turn to the so-called miners.
The miners are participants in the blockchain network who voluntarily make their computing power available to validate information and create blocks from it. They are existential for the system. A financial incentive is offered to ensure that there are enough miners. Each miner receives a defined amount of cryptocurrency (Bitcoin) for his performance, which can be monetized.
Since there can be several participants within a blockchain who want to perform profitable computing work, there is then a competition. On the one hand, this ensures that only one block is attached to the chain at a time. On the other hand, the competition determines which participant is awarded the prize. This agreement between the miners is called consensus. There are several ways to reach a consensus.

Proof of work

Currently, we refer to the variant on which Bitcoin is based on as: Proof of Work (POW). Here, the time and effort determines who is awarded a specific amount of bitcoin. To achieve this, participants (or their hardware) must complete complex arithmetic tasks that basically consist of guessing complicated hash values (the calculations run automatically by computing power).

Whoever solves the task first is awarded the prize for the creation of a block. As soon as the winner has created the block, he passes it on to other miners in the system for control. After a certain number of checks, the block and the underlying information are considered valid. This process is initiated on a new basis for each block.
The POW algorithm (and the resulting computing effort) also prevents so-called Sybil attacks. In a Sybil attack, countless fake participants are generated in order to influence majority votes (e.g. whether a block is valid or not) within the blockchain. 

To summarise: It is important to remember that we are in a tamper-proof and transparent P2P system in which information is decentralized and immutable and participants interact using cryptographically encrypted accounts. The blockchain represents the blocks linked by hash values, which contain the information of the distributed account book. The blocks are created by participants of the system (so-called “miners”) who receive cryptocurrencies (e.g. Bitcoin) as a reward. A consensus algorithm (e.g. proof of work) uses a special procedure to determine which participants are selected.

What are Smart Contracts?

Smart Contracts, also called intelligent contracts, constitute a functional extension to classic blockchain systems and are attributed to the second generation of blockchain. The Ethereum blockchain, in particular, represents the use of smart contracts, as it was one of the first technologies to create the technical prerequisites for their full use.

How do Smart Contracts work?

Basically, Smart Contracts are small programs that run on a blockchain and are based on a simple if-then function that they can execute automatically. Similar to a traditional contract, conditions and actions are defined. Intelligent contracts benefit from the properties of the blockchain and are unchangeable, transparent and do not require an intermediary for processing. Instead, the functionality of the blockchain ensures secure execution of contracts at minimal cost. The advantages are versatile. Smart contracts can be executed automatically and without loss of time, without being dependent on intermediaries or high transaction costs.
Within a blockchain, a smart contract functions as a separate account with a public address, but without a holder. Virtually nobody owns the private key to this account. Once it has been created, no one can access it or make any changes. Instead, the contents of the contract are laid down in the form of conditions and actions that the account automatically executes. It can also connect to other accounts with which it is expected to interact. To do this, the respective account holders must accept the contracts in advance using their digital fingerprint.

How can Smart Contracts be used?

The fields of application for Smart Contracts are immense. Some simple examples are illustrated below.
The use of repetitive payments should help make this approach clear. In the conventional blockchain system, for example, Jessica can carry out her monthly rent by transferring two bitcoins to her landlord and in return is granted the right to move into the apartment. However, she would have to repeat this process every month, similar to an automated bank transfer. With a Smart Contract, Jessica can conclude a contract with her landlord that carries out a recurring and automated payment. To do this, she first defines the condition that the first day of each month must pass. If this condition is met, a corresponding transaction is initiated from her account via the Smart Contract to the landlord’s account. If the landlord and Jessica agree to this contract, the smart contract will connect to the respective accounts.

What sounds like a simple transaction at a bank is now possible without any intermediary, in this case, the bank. Theoretically, further flatmates could be added to the Smart Contract. Or it could be defined that additional cost repayments remain on the Smart Contract account in order to offset them against future rents.

Ethereum is the most popular and best-known blockchain for Smart Contracts.

Another interesting case is decentralized power generation, in which private solar power companies and consumers without intermediaries connect with each other. The blockchain can document both the amount of energy used by the consumer and the amount of solar production in a decentralized and tamper-proof manner. This is done, for example, with intelligent light bulbs that feed information about electricity consumption directly into the blockchain. Smart Contracts could automatically initiate the corresponding payments from consumers to producers. In such a system, electricity companies would be superfluous, since trust is created by the blockchain and smart contracts take over the contractual terms and automatic payments.
The actual possibilities for smart contracts go far beyond the examples above. Smart Contracts can be designed as complex as necessary and can contain numerous parties and conditions. As soon as conditions and actions are defined and digitized, Smart Contracts can take over this work.
As digitalization progresses, the work of lawyers, notaries or authorities, for example, would be made easier or even redundant. The Internet of Things could use the interface to the blockchain to automate invoicing and payments in real time.

Initial coin offerings and DAPP’s

Smart Contracts are already in use in the area of ICOs (Initial Coin Offerings). These are swarm investments made by companies in which a payment to a specific account directly initiates a repayment in the form of tokens. Smart Contracts can even automate entire businesses.
If several Smart Contracts are linked together, complex programs can be designed that are decentralized through the blockchain. These applications are called Decentralized Apps (DAPP’s). One of many examples would be Golem, a decentralized network for renting and leasing computing power.

Essentially, many cryptocurrencies that do not have their own blockchain infrastructure are merely complex DApp’s that run as a program on an existing blockchain. One can compare this model with that of an online web service, for which one pays. A good example of this is the Ethereum blockchain, which provides its sophisticated operating system called Ethereum Virtual Machine (EVM). So that the tenants can run their programs or applications on the EVM, they have to pay for gas. In the EVM, gas is paid for in the currency of Ethereum (Ether), at which point the program code of the applications is executed in the entire Ethereum network and the tenants can run their programs on the EVM.

Moreover, since most blockchain technologies are based on the open source principle, the possibility to create innovative DApps is available to everyone. It will, therefore, be exciting to observe which decentralized applications will influence the private as well as the professional environment in the future.