Every business starts with a transaction among participants. Transactions involve the storage and exchange of values. These values are the essence of transactional data. Data must not only be stored securely, at the point of origin, but also must be safeguarded during the exchange as well as storage with other players.
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Let us understand how blockchain works with the help of an example. In a non-digital world of the past, had you bought a house, you would have paid a specific sum of money and would have agreed to pay the rest in installments, let’s say, over five years. You would record the amount paid as a transaction.
You would also keep the record safe and secure in a vault so nobody could tamper with it. Not only that, but you would also encode your record in a manner that even if the record lands in the hands of someone who cannot be trusted, the transaction cannot be interpreted easily.
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Today, in the age of digital technology, record keeping can be made secure with blockchain technologies and for that, it becomes imperative to understand how blockchain works. Blockchain technologies provide a sophisticated system of record keeping.
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Entries are recorded in sets, also called blocks of data. After the block reaches a certain number of records, a new block starts to be formed. Blocks are held together in a chain that forms a digital ledger. Each block is encoded by a mathematical function that generates complex hashes automatically by using the data in that block.
To give you an idea, using the hash function on “Hello World” gives an output as “a591a6d40bf420404a011733cfb7b190d62c65bf0bcda32b57b277d9ad9f146e”.
The hash for each block is stored not only in the block that it belongs but also in the next block in the chain. Now, for an attacker to change data in a block becomes harder. One, changing the data results in the generation of a new hash value. Two, the new hash does not match the hash that was recorded previously in the next block, resulting in the chain rejecting the new value.
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Sharing Information with Participants
Let us get back, for a moment, to the ancient system of book-keeping. The seller of your house would also keep a record of such transactions. You would share your code with the seller, so both of you could understand what was recorded.
Blockchain technologies share information by using Public Key Cryptography that uses a set of cryptographic keys – private and public keys. Private keys are secret keys that are supposed to be held privately. The sender of a message uses the private key to encrypt digitally signed messages.
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These encrypted messages and a hash output can be sent to the receiver securely, using sharable public keys over a network. The receiver can then use the private key that is in possession of the receiver only to decrypt the message and the hash and verify that the right sender indeed sent the message.
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Going back to the original home-buying scenario, a year after you bought your dream home, you probably were blessed by an increase in your income. You wanted to increase the amount of installment to pay off your home loan.
You started paying the increased sum and were excited as you approached the last couple of months before closing the loan. However, during a casual conversation, you were shocked to realize that the seller was confused with the dates.
On tallying the records, the seller stated that you started paying the increased sum of installments on a later date. Now that meant a dispute. Thankfully, a common friend was there when you made the transaction. This common friend came to your rescue and resolved the dispute.
The friend was smart and understood what you could have lost had there been no resolution and now wants a settlement for the service. Not involving an intermediary would have been risky because you would have then either lost your money, or paid an additional amount to retain the house, or possibly have lost your peace of mind over several years resulting from the dispute and the threat looming over your head.
Now think that the common friend had malicious intent. Maybe they were lured into an investment by the seller. The common friend could have resolved the dispute in favor of the seller.
Blockchain technologies resolve all of these issues by using a distributed ledger and a peer-to-peer network. There is no central authority that has control over decisions or disputes. There is no centralized location that has a single copy of all the transactions. The ledger with transactions is distributed among a peer-to-peer network of participants, also called nodes.
Special participants, called miners, add new blocks to the ledger. When a miner adds data in a blockchain, it does not get accepted until all the other participants provide their approval by arriving at a consensus. A set of algorithms help the players to verify transactions by computing immensely complex mathematical puzzles.
Once verified, these transactions are distributed over the entire network to form a strong, large chain that is extremely difficult to break into.
Executing Transactions Automatically with Smart Contracts
While making the actual payment, using paper contracts and physical document management would lead to unnecessary delays. There were high chances of fraud due to the forging of data on paper or disparate systems.
Blockchain technologies provide smart contracts that are contracts coded in the blockchain that help in executing specific transactions automatically after certain conditions are met. Smart contracts can help to sign contracts between completely unknown parties and also execute without an intermediary.
This helps in reducing the delays in payment by automating the release of payment as soon as the conditions for payment are met. This ultimately leads to increased liquidity of financial assets and mitigates delays due to unnecessary paperwork and the risk of fraud.
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Bringing It All Together
Blockchain technology is taking the business world by storm. All of the above-mentioned concepts also tell us about how blockchain works. Blockchain is immutable and provides very high resistance to fraud.
The technology is going to find use in a number of industries. The technology is slated to increase speed and efficiency and will eventually result in reducing costs for a number of businesses. For example, the banking and financial sector involves the exchange of money between trusted partners.
The blockchain technology provides a secure platform for this exchange and helps in reducing costs by eliminating intermediaries. It provides value by eliminating the error-prone process of creating and verifying data manually, which ultimately leads to a reduction in auditing requirements.
Blockchain technologies are going to be a game change done for multi-party transactions across borders, where both global and local laws come into the picture, resulting in long business cycles. By using advanced concepts such as smart contracts, a lot of limitations of traditional systems can be overcome.
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There are numerous other uses of blockchain in other industries, including supply chain management, and logistics to automate purchase and procurement, healthcare for improved access to medical records, identity management to make authentication more secure, and so on.
For advanced learning to know how blockchain works, you can refer to the following courses: