Part 2: How Blockchain Works?

This is 4 part series covering about the basics of Blockchain:

Part 1: Blockchain Fundamentals

Part 2: How Blockchain Works?

Part 3: Propelling Business with Blockchains

Part 4: Blockchain in Action

In this Part 2, we will cover about the how Blockchain works.

While Part 1 gives you a general understanding of what blockchain is and an appreciation of what it can do, you may be wondering how it works. In this part 2, I tackle that topic by taking you behind the scenes of a blockchain network without getting overly technical.

Here, you get a glimpse of how blockchain stores transactions in a way that prevents recorded transactions from being changed. You discover the four concepts that form the foundation of a blockchain for business, and you meet the network participants and find out about the various roles they play.

Why it's called Blockchain?

Blockchain owes its name to the way it stores transaction data — in blocks that are linked together to form a chain (see Figure below). As the number of transactions grows, so does the blockchain. Blocks record and confirm the time and sequence of transactions, which are then logged into the blockchain, within a discrete network governed by rules agreed on by the network participants.

Each block contains a hash (a digital fingerprint or unique identifier), timestamped batches of recent valid transactions, and the hash of the previous block. The previous block hash links the blocks together and prevents any block from being altered or a block being inserted between two existing blocks. In this way, each subsequent block strengthens the verification of the previous block and hence the entire blockchain. The method renders the blockchain tamper-evident, lending to the key attribute of immutability.

To be clear, while the blockchain contains transaction data, it’s not a replacement for databases, messaging technology, transaction processing, or business processes. The blockchain contains verified proof of transactions. However, while blockchain essentially serves as a database for recording transactions, its benefits extend far beyond those of a traditional database.

What Makes a Blockchain Suitable for Business?

Instead of having a blockchain that relies on the exchange of cryptocurrencies with anonymous users on a public network (as is the case with bitcoin), a blockchain for business is a private, permissioned network with known identities and without the need for cryptocurrencies.

To further understand how a blockchain for business works, and to appreciate its potential for revolutionizing business networks, you need to understand the four key concepts of blockchain for business, shown in Figure below.

Shared ledger:

Ledgers are nothing new; they’ve been used in double-entry bookkeeping since the 13th century. What is new is the concept of a shared, distributed ledger — an immutable record of all transactions on the network, a record that all network participants can access. With a shared ledger, transactions are recorded only once, eliminating the duplication of effort that’s typical of traditional business networks. The shared ledger has the following characteristics:

• Records all transactions across the business network; the shared ledger is the system of record, the single source of truth.
• Is shared among all participants in the network; through replication, each participant has a duplicate copy of the ledger.
• Is permissioned, so participants see only those transactions they’re authorized to view. Participants have identities that link them to transactions, but they can choose the transaction information that other participants are authorized to view.

Permissions

Blockchains can be permissioned or permissionless. With a permissioned blockchain, each participant has a unique identity, which enables the use of policies to constrain network participation and access to transaction details. With the ability to constrain network participation, organizations can more easily comply with data protection regulations, such as those stipulated in the Health Insurance Portability and Accountability Act (HIPAA). Permissioned blockchains are also more effective at controlling the consistency of the data that gets appended to the blockchain.

With the ability to restrict access to transaction details, more transaction detail can be stored in the blockchain, and participants can specify the transaction information they’re willing to allow others to view. In addition, some participants may be authorized to view only certain transactions, while others, such as auditors, may be given access to a broader range of transactions. (With a public blockchain, the level of transaction detail may be limited to protect confidentiality and anonymity.)

For example, if Party A transfers an asset to Party B, both Party A and Party B can see the details of the transaction. Party C can see that A and B have transacted but can’t see the details of the asset transfer. If an auditor or regulator joins the network, privacy services can ensure that they see full details of all transactions on the network. Cryptographic technology — this time through the use of digital certificates — makes this possible.

Just like a passport, a digital certificate provides identifying information, is forgery resistant, and can be verified because it was issued by a trusted agency. The blockchain network will include a certification authority who issues the digital certificate.

Consensus:

In a business network where participants are known and trusted, transactions can be verified and committed to the ledger through various means of consensus (agreement), including the following:

• Proof of stake: To validate transactions, validators must hold a certain percentage of the network’s total value. Proof-of-stake might provide increased protection from a malicious attack on the network by reducing incentives for attack and making it very expensive to execute attacks.
• Multi-signature: A majority of validators (for example, three out of five) must agree that a transaction is valid.
• Practical Byzantine Fault Tolerance (PBFT): An algorithm designed to settle disputes among computing nodes (network participants) when one node in a set of nodes generates different output from the others in the set.

Blockchain for business features pluggable consensus — a way to implement whichever consensus mechanism is deemed best for any given industry segment.

PROOF OF WORK: AN UNNECESSARY EXPENSE FOR A BLOCKCHAIN FOR BUSINESS:

When participants are anonymous (such as in the bitcoin world), commitment is expensive. On the bitcoin network, consensus is reached through proof of work. The network challenges every machine that stores a copy of the ledger to solve a complex puzzle based on its version of the ledger. Machines with identical copies of the ledger “team up” to solve the puzzle they’ve been given. The first team to solve the puzzle wins, and all other machines update their ledgers to match that of the winning team. The idea is that the majority wins because it has the most computing power to solve its puzzle first.

Proof of work is useful on a public blockchain, such as the one used for bitcoin, but it consumes considerable computing power and electricity, making it an expensive way to reach consensus. Such an expense is unnecessary on a private business network where all participants are known.

Smart contracts:

A smart contract is an agreement or set of rules that govern a business transaction; it’s stored on the blockchain and is executed automatically as part of a transaction. Smart contracts may have many contractual clauses that could be made partially or fully self-executing, self-enforcing, or both. Their purpose is to provide security superior to traditional contract law while reducing the costs and delays associated with traditional contracts.

For example, a smart contract may define contractual conditions under which corporate bond transfer occurs or it may encapsulate the terms and conditions of travel insurance, which may be executed automatically when, for example, a flight is delayed by more than six hours.

Identifying Participants and Their Roles:

Various participants on a blockchain network play a role in its operation. Following are descriptions of each of the participants:

Blockchain user: A participant (typically a business user) with permissions to join the blockchain network and conduct transactions with other network participants. Blockchain technology operates in the background, so the blockchain user has no awareness of it. There are typically multiple users on any one business network.

Regulator: A blockchain user with special permissions to oversee the transactions happening within the network. Regulators may be prohibited from conducting transactions.

Blockchain developer: Programmers who create the applications and smart contracts that enable blockchain users to conduct transactions on the blockchain network.

Applications serve as a conduit between users and the blockchain.

Blockchain network operator: Individuals who have special permissions and authority to define, create, manage, and monitor the blockchain network. Each business on a

blockchain network has a blockchain network operator.

Traditional processing platforms: Existing computer systems that may be used by the blockchain to augment processing. This system may also need to initiate requests

into the blockchain.

Traditional data sources: Existing data systems that may provide data to influence the behavior of smart contracts and help to define how communications and data transfer will occur between traditional applications/data and the blockchain — via API calls, thru MQ style cloud messaging, or both.

Certificate authority: An individual who issues and manages the different types of certificates required to run a permissioned blockchain. For example, certificates may need to be issued to blockchain users or to individual transactions.

What Next?
Part 3: Propelling Business with Blockchains