Blockchain technology has revolutionized the thought and practice of finance forever. It is faster, cheaper and more democratic than traditional finance. However, there are some drawbacks too.
This article by Blockchain Lab, explores blockchain technology, its related components, advantages, drawbacks and some applications and compares them with traditional finance.
Table of Contents
Overview
Blockchain technology is a decentralized system of keeping transaction records in an immutable ledger. A blockchain is a chain of blocks, each of which contains transaction records. Several transaction records make a block and a series of blocks make a blockchain.
How Blockchain Technology Works?
Blockchain technology works in a decentralized manner. Each transaction is sent to a pool of transactions called the memory pool or the “mempool“. Each transaction is picked by a validator who validates the transaction and adds them to a block. After the validator validates the transaction, it is broadcasted to the network for others to agree that the transaction is valid.
Finally, after then trasaction is validated by a certain number of nodes(or validators) it is finalized in the block and the block is added to a blockchain. There may be slight variation in different consensus mechanisms but the basic principle is the same.
10 Key Components of a Blockchain
Now that we have a basic understanding of how a blockchain works, let us take a slightly deeper understanding of each component involved in a blockchain.
We have used the Ethereum blockchain to make a list of these components. Some parts such as Smart Contracts might not be present in other blockchains like Bitcoin, Litecoin and Dogecoin.
1. Tokens, Coins and Cryptocurrencies
Tokens are the small transferable units of a blockchain. They are highly fungible (i.e., can be divided into smaller parts) like 1 Bitcoin can be divided into 100 Million Satoshis.
Let us understand what makes a token different from a coin.
Coin vs Token
A cryptocurrency which exists in its native blockchain is called a coin. A coin is the native token of its blockchain. Ether(ETH) is the native token or coin of the Ethereum blockchain. They are used to pay the transaction costs in a blockchain, though account abstraction will change that.
A cryptocurrency that exists on a different blockchain is called a token. It might have been transferred from a different blockchain (using bridges) or might be created on a pre-existing blockchain (like USDT on Ethereum as a ERC-20 Token).
2. Blocks
Blocks are a collection of transactions that have veen verfied and finalized. A finalization is the point where the entire consensus algorithm has validated the transaction.
3. Addresses and Public Keys
Addresses are similar to bank accounts and hold your cryptocurrencies. They can be single use addresses like the Lightning Network which only stores Bitcoin or they can be multi-token addresses like Trust Wallet which store a huge variety of cryptocurrencies.
4. Private Keys
Private keys are the passwords which anyone uses to access their accounts on the blockchain. Once compromised, there is no way to recover lost funds. However, when a majority or large number of accounts are compromised, hardforks can be done to reverse all those transactions.
5. Nodes, Validators and Miners
In blockchain technology, nodes, validators, and miners are used synonymously.
Nodes are the fundamental units of a blockchain system. A set of interconnected nodes form up the blockchain.
The term Validator is often used in a proof-of-stake blockchain like Ethereum to describe someone whi validates transactions.
A transaction verifier in a Proof-of-Work blockchain is called a miner. They solve complex computations to arrive at nonce values which are numbers added to each transactions’s hash.
6. Mempool
A Mempool or a Memory Pool is a collection of unconfirmed transactions that are waiting to get picked by a node or a validator.
7. Network
A network is a collection of nodes that are interconnected in such a way that each node is attached to a group of nodes at any given time.
The connections are executed and maintained through the blockchain software. Safety and security depends on the consensus mechanism and cryptographic protocols like SHA256, which is used in Bitcoin.
8. Smart Contracts
Smart contracts are pieces of code that are executed on the blockchain using some prior conditions.
For example, you could create a smart contract that will release monthly funds from your blockchain address to another address, or you could send funds to a smart contract that will give you a monthly return on your investments.
9. Blockchain Software
Blockchain technology primarily runs on softwares that are installed in local machines such as computers or even mobile phones. These softwares help convert your computer into a blockchain node / validator and help receive transactions that you will verify as a validator.
An example is the Bitcoin Core which is setup in every Bitcoin Node computer.
10. Virtual Machines
Virtual machines are processing units of blockchains which pool computing power from several node computers and process transactions, run the blockchain and execute smart contracts.
An example is the Ethereum Virtual Machine that is used widely by several blockchains.
Advantages over Traditional Finance
With several advantages, blockchain technology and its decentralized finance ecosystem has challenged traditional finance. It has compelled several traditional finance institutions such as JP Morgan to rethink their technology choices.
1. Faster Transactions
When I receive payments via PayPal, it generally takes 2 business days to credit to my local bank account. Bitcoin, which is one of the slowest blockchain takes max 1 hour to confirm transactions and credit funds to beneficiary’s accounts. Faster blockchains like Solana and Algorand only take a few seconds.
2. Lower Transaction Costs
Blockchain transactions have significantly lower costs than traditional banking systems. When used in cross-border payments, SWIFT systems often cost from a few dollars to a few hundred dollars per transaction.
Whereas blockchain technology helps reduce transaction costs to a few cents.
3. Decentralized Ledger
Blockchain technology supports decentralized record keeping which reduced the risk of a single point failure taking down the entire system. Each node is powerful enough to keep the entire system up albeit at a low capacity.
4. Anonymous Transaction Records
Blockchain transcations are braodcasted in public but none of these transactions are associated with the account holders, except in cases of publicly well known accounts such as exchanges.
5. Enhanced Security
Blockchain systems are often more secure due to their distributed nature and help easy detection of malicious or false transactions. Since each transcation is verfied by a number of verifiers, it becomes easy to detect if some node has done some mischief with any transcation record.
Even if funds are stolen, they can be recovered by hard forks as was done by Ethereum when The DAO was hacked.
Key Challenges
1. Non-Reversible Transactions
The immutability of blockchain transactions can be both an advantage and a challenge. While it ensures transparency and trust, it also means that once a transaction is recorded on the blockchain, it cannot be easily reversed or modified. This can be problematic in cases of fraudulent or erroneous transactions, where traditional financial systems may allow for some level of recourse.
2. Money Laundering
Blockchain’s pseudonymous nature can create challenges for regulatory bodies in identifying and tracking individuals involved in illicit activities like money laundering. Cryptocurrencies and blockchain-based systems can be used to transfer funds without the need for traditional financial intermediaries, making it challenging to trace the flow of funds and detect suspicious transactions.
This has been one of the core concerns of governments, worldwide.
3. User Experience
The user experience of interacting with blockchain applications can be complex and confusing for non-technical users. Improving the user interface and making blockchain applications more user-friendly is necessary to broaden adoption and reach mainstream audiences.
4. Lost Access to Accounts, Forgotten Passwords
If a user forgets their login credentials (private keys and recovery phrases), they may be unable to access their account and the assets it holds. However, that is expected to be solved with the arrival of account abstraction.