Friday, September 16, 2022

Blockchain 101

Photo by GuerrillaBuzz Crypto PR on Unsplash



The Blockchain, also called distributed ledger technology (DLT) is an open, distributed database that can record transactions among parties efficiently and in a verifiable and permanent way.  

The primary aim of blockchain technology is to increase the transparency, efficiency, speed and security of a financial transaction as well as lower transaction costs by eliminating the traditional trusted custodian.  

Data within the blockchain are secured by encryption methods. When a transaction takes place on the blockchain, information from the previous block is copied to a new block with the new data, encrypted, and the transaction is verified by validators—called miners—in the network. 

Bitcoin and Ethereum are separate blockchains, together comprising of major share of the crypto market. The information is stored in blocks and connected to form a permanent chain, with each block storing transaction data.  

As the timeframe changes, a new block added to the chain to store the transaction data; each new block is added to the chain with a reference of previous block and hence this is called as chain of blocks (blockchain). This chain of blocks is maintained by a network of independent computers located around the globe who participate in checking and validating each transaction getting recorded on the blockchain.  


Generations of Blockchain  

  • 1st Generation (Bitcoin and Digital Currency): Bitcoin Blockchain - The Bitcoin blockchain was introduced to Public in 2009 by an anonymous developer or group of developers using the name Satoshi Nakamoto 

This was introduced as a P2P electronic cash transaction system eliminating all intermediaries. This feature made the bitcoin blockchain a decentralised system. Therefore, bitcoin is also called the first-generation blockchain. 

After every 10 mins, blockchain is verified and a new block is added to the blockchain. There is a limit defined on the number of bitcoins that will be available for circulation, and the limit is set to 21 million bitcoins.  

Miners (Computers on the bitcoin network) are rewarded in bitcoin every time they mine 1 block. But the rewards given to bitcoin miners are halved after the addition of every 210,000 blocks to the blockchain, or roughly every four years. This reduces the rate at which new bitcoins are released into circulation by 50 percent. As fewer bitcoins are released into the system, the value of each bitcoin increases as it becomes scarcer. 


  • 2nd Generation (Smart Contract): Ethereum Blockchain – The Ethereum blockchain was launched in 2014, in addition to documenting the transactions (done by 1st generation blockchain), introduced smart contracts which are of self-managing nature where actions are triggered based when events occur - date has passed, a certain value is achieved.  

Ethereum blockchain is much faster compared to 1st generation blockchain, each block of information on the Ethereum blockchain is verified and created every 10-20 seconds. 

Native currency on Ethereum blockchain is ETH. Unlike bitcoin, there is no limit on supply of ETH.  


  • 3rd Generation (The Future) Major issue faced by blockchain is scaling, many new digital currencies are attempting to revise their blockchains to resolve this issue. Many new application areas of blockchain are also getting identified and solutions are being implemented.  


Though both Bitcoin and Ethereum blockchains work on principal of distributed ledger and cryptography, there are few differences – The transactions on the Ethereum network include executable code - smart contract, while transactions on Bitcoin network generally keep notes only 

Other difference is regarding time to confirm the transaction - transaction on Ethereum is confirmed in seconds, as compared to Bitcoin blockchain which takes minutes to confirm a transaction. The Bitcoin uses SHA-256 algorithm and Ethereum uses Ethash algorithm. 


Consensus Mechanism –  

In the context of blockchain, the consensus mechanism is extremely critical to ensure bad actors are identified and prevented from carrying out deliberate fraudulent actions, - Double-Spend scenario is prohibited by the consensus mechanism followed by the blockchain nodes.  

Proof-of-work and Proof-of-stake are the two most widely used consensus mechanisms used by the blockchains to operate securely. Both these algorithms are used to determine which node (computer) in the blockchain network can add the next block of transactions to the chain. 


  • Proof of Work (PoW) 

Consider a scenario, Amit is expected to transfer 10 bitcoins to Rahul.  But Amit transfers only 8 bitcoins or Amit actually does not have 10 bitcoins - a fake transaction is being performed or the transaction is being done in incorrect way 

Because there is no bank or central authority to approve the transfer of decentralized currency, some form of verification is needed, and this verification is done by miners.  

They are called miners because in PoW the new coins come in circulation through miners - when a miner verifies a transaction and adds a block in the blockchain they get coins as a reward this way new coins come in to the circulation. This process is called mining and the node performing the operation is called miner. The miner can be anyone who is part of that bitcoin network whose work is to verify the transactions also called transaction validation.  

In PoW, to validate a transaction, miners must solve a complex mathematical puzzle which requires very high computational power. Many miners compete to solve the mathematical puzzle but only one miner wins and gets to add a block in the blockchain, and other miners must compete next time again for some other transaction 

This is the main drawback of PoW - to validate one transaction, so many miners end up spending their computational power, but only one of them wins and computational power spent by others is wasted.  

Because solving of mathematical puzzle requires high computational power, many miners work together to form a mining pool which combines their mining power. This increases their chance of getting block reward and the received reward is distributed amongst all participating miners in the mining pool as per their computational power.  

Analogy to explain the complex mathematical puzzle – It is easy to multiply two 10 digits numbers but much difficult to predict which two numbers can be multiplied together to get 398054854052345.  

Miner must identify the two numbers by performing trials to confirm the solution. Once confirmed, the miner presents the solution to all miners in the network who can easily verify the proposed solution.  

The miner who has solved the puzzle first, is allowed to create a new block and publish to the nodes in the network who will individually perform audit of the existing ledger and the new block. If validation is successful then the new bock is added to the blockchain, and miner is rewarded with new bitcoins as well as transaction fee.  


Mining pool helps small miners (with low computational power) to participate in the mining process. Large mining pool tend to get centralized and move away from de-centralization as having large computational power leads to higher chance of mining. PoW is used by many famous crypto like bitcoin, litecoin, dogecoin, etc.  


  • Proof of Stake (PoS) 

This consensus mechanism is used to reduce the high energy consumption caused by PoW and to increase scalability. This process includes validators instead of miners.  

Validators perform the same job as done by the miners in the PoW. The key difference is validators do not compete against other validators by spending their computational power, instead, for verifying a transaction there is only one validator selected to verify the transaction.  

Validator can be anyone who is part of the blockchain network and who has coins to stake as a security. The minimum number of coins to be staked is defined by the blockchain network and whichever node can stake the required number of coins will be considered as a validator.  

Using an algorithm, one of the validators is selected randomly to verify the transaction. The one with higher stake has higher probability of being a validator.  

Considering only one validator verifies the transaction, there is a chance of wrong transaction being verified, but in such case all the coins of the validator which are at stake are confiscated and this process is referred as slashing. In case of failure to complete the verification due to technical issues like power cut, etc., even in such case slashing happens and validator does not get back his coins at stake.  

Considering all network nodes do not participate in the verification process, the scalability and speed is enhanced with usage of less computational power, and even a normal computer can perform this validation.  

Like mining pool in PoW, there are staking pools in PoS, where many nodes combiner their coins together and participate as a validator. Main advantage of staking pool is nodes who do not have enough coins to stake can join together and participate as a staking pool by meeting a minimum requirement of becoming a validator. But the disadvantage of staking pool is weakening of de-centralization because node having higher stake has a higher chance of being a validator.  


Key differences - 

PoW requires large investment in terms of high-end hardware to generate computational power, whereas PoS requires coins worth minimum staking value to become eligible for being a validator. 

PoS is more de-centralized as compared to PoW due to staking pool as it is comparatively easier to pool coins to stake than investing in high-end hardware to generate computational power. Hence only larger players can afford to participate in PoW 

In PoW, after adding a block, nodes get coins as reward along with transaction fee, in PoS only transaction fee is received by the validator.  

PoW consumes lots of energy whereas PoS requires significantly less amount of energy - about 99% less energy. Due to the same reason, Ethereum is moving from using PoW to PoS as consensus mechanism. Movement of Ethereum from PoW to PoS is referred as Ethereum Merge. This merge is planned to happen around 14-15 Sep 2022 

Though PoW consumes higher amount of energy, this mechanism is well tested over the past few years and adopted by big crypto currencies like bitcoin keeping them secure and decentralized. PoS is relatively in its initial days and less tested as compared to PoW.