No, blogs blockchain expert Dennis de Vries, but it does to blockchain. This is how blockchain works at Bitcoin.
Blockchain has the potential to change the world on a scale comparable to the advent of the internet. No wonder everyone wants to know what blockchain is. Last week I explained the principles and functioning of blockchain to insurers. Before that, I spoke to accountants, bankers, IT auditors, tax specialists and the likes.
It makes sense that most audiences were curious about the possibilities of blockchain. But to understand that, you first have to know what exactly blockchain is. And without simplifications, understanding it is quite complicated.
Blockchain can best be explained using its first and best-know application: Bitcoin. Bitcoin is, in fact, nothing other than a digital coin (the bitcoin) with a digital ledger that contains all the bitcoin transactions. The ledger, or rather, the logbook with all the transactions, is the blockchain.
Bitcoin is unique in that everyone who participates has a copy of the ledger on his/her computer (a distributed ledger). This means that everyone can see everyone else’s transactions. With each transaction, everyone’s ledgers on all the participating computers are updated and visible to everyone. This is different from a bank, where only the bank itself has access to accounts and transactions.
People now entrust their money and transactions to banks because they trust the banks to actually carry out the payments. However, how do you ensure the payment system can be trusted in a public network, such as Bitcoin? In other words: how do you make sure that accountholders actually have the money that they transfer? The answer is: you can’t. Bitcoin is designed in a way that does not require trust.
Here is how it works: whoever wants to pay in bitcoins has to install a bitcoin wallet (a program) on his or her computer and receives a personal code (the so-called private key) for the wallet. You use the private to sign your transactions. Each transaction gets its own unique signature and all the computers on the network check whether the transaction is real by testing the accompanying private key. This ensures that the payer is also the actual payer.
But that’s not enough. The computers on the network also have to verify that the payer has the necessary funds to make the payment. At banks, this is done by looking at the balance. The Bitcoin network, however, goes much further. It checks all the receipts and payments of all the participants by going back on all the transactions, right down to the first transaction in 2009. This is how the network calculates whether the payer has received enough and hasn’t spent too much to still pay for something.
Once the payer’s identity and worth has been verified, it is certain that the transaction is valid. But there’s still one last catch, and that is the essence of blockchain: the sequence of the transactions. Not all transactions pass equally quickly through all the computers, so how do you prevent someone from spending the same bitcoin (BTC) twice?
Person A has 5 BTC and buys something from person B for 5 BTC, and uses the same 5 BTC to buy something from person C. B and C dispatch the products before the transaction has been verified. However, the transaction with C is verified before the one with B. The computers then reject the transaction with B because all the money’s been spent. B loses his product and doesn’t receive any money. To stop this from happening, all the computers on the network must verify transactions in the same sequence.
The solution is to put transactions together in blocks. The transaction logbook therefore actually consists of blocks that, together, form a chain of blocks, the blockchain. So how do the computers know which block comes first? Well, each block is provided with a cryptographic puzzle. This puzzle, the cryptographic hash, has to be resolved by software using a complex algorithm before the transactions are released for verification. Think of this as a combination safe that has to be opened using a code.
It is impossible to calculate the solution to the puzzle. The software has to find the answer by guessing. A single computer takes years to guess this, but a computer network with Bitcoin software takes an average of ten minutes to do it. When a puzzle has been resolved, all the computers on the Bitcoin network receive a signal that the cracked transaction block may proceed, after which they then start on the puzzle for the next block. In fact, solving the puzzles is also how new bitcoins are released to the market; small computer networks solve the puzzles and the so-called miners, the computers’ owners, receive bitcoins if they win the puzzle race.
So in the example above B and C would be wise to wait until the block with their transactions has been verified before dispatching their product. It is practically impossible to manipulate the sequence because the code of the solved block is included in the subsequent block, as shown in this animation. You’ll have to make sure that you’re the first one every time to solve the puzzle. That requires more computing power than half of all the computers on the network and then you still only have a 50 per cent chance.
Bitcoin, in other words, does not revolve around trust but around the certainty that the system is safe. The transactions are protected by cryptography. The sequence is protected by blockchain technology. And the entire system is safe because everything is public and, therefore, everyone – or, rather, everyone’s computer – helps monitoring it. The fact that not a single transaction has been manipulated or lost since the launch in 2009 is proof that it works. And hackers? They too have not succeeded in hacking the public programmed system (see also the box ‘Open source works’).
And yet, I don’t think the future belongs to bitcoins. Coins, also bitcoins, only have a value because we believe that they’re worth something. And with around five million downloaded bitcoin wallets, the number of the faithful is negligible on a global scale. Besides, ‘we’ don’t even agree about the value, as shown in the massive price fluctuations. The future of blockchain, however, is a different story.
The blockchain technology hides an enormous promise. Just as the internet changed the transfer of information, blockchain can change the transfer of value payments. In the archaic banking system, funds transfers, certainly to foreign countries, take time and cost a good deal of money. On top of this, banks on average face two hundred outages a year. With blockchain technology, payments are instantaneous at very low transaction costs and without the chance of errors or outages.
And that’s not the end of it. Taking out mortgages, registering wills, taking out insurance; these procedures could be arranged via blockchain without the intervention of professional service providers. Checks and balances, after all, can be replaced by blockchain technology, but more about that in other blogs. This is my first of many blogs about blockchain. What is important now: blockchain has proven itself, but is still in its infancy. You can compare it with the internet in 1995, and we all know how big the impact of the world wide web is.
Author: Dennis De Vries, senior manager at KPMG