To recap, last week
We defined blockchain as a SYSTEM that allows a NETWORK of connected computers to maintain a SINGLE, UPDATED and SECURED ledger
We defined a ledger
We compared some aspects of traditional banking system with a blockchain. Why was blockchain compared to a bank? This comparison was done as banks move value across markets and societies through their financial intermediation function. More on financial intermediation here. Blockchain has the capability to do the same in the digital realm.
In a blockchain, there are no banks or any central authority to
verify or authenticate transactions
prevent double spending or
maintain records.
So, how does a blockchain function?
Let us take an example of four people who got funding to start their business
- Four businessmen who didn't know each other got funding of $50 each
- They record the amount received in a common ledger which they all share (DECENTRALIZED). So each of them show a balance of $ 50 which all can see
- A wants to pay $10 to D
- A asks B,C & D to add the transaction to their ledgers (COMMUNICATION)
The following checks are done by B, C & D
a. Does A have the requisite balance in his ledger?
b. If yes, has A actually authorized the transaction?
If both the above conditions are true, then the transaction is added to the common ledger (TRUST).
Both the below diagrams summarize the above
Now the ledger has become popular that more people start using the common ledger since people need not trust each other. They only need to trust the process governing the ledger. The volume of transactions start to increase. Everyone still checks each transaction. Transactions are now grouped into pages and everyone need to agree on which page to include in the common ledger.
To ensure the transactions in the pages added are not tampered with, the pages are water marked with a seal so no one can modify any entry subsequently (IMMUTABILITY). Also, the pages are numbered so that it is possible to trace any amount from the time it enters the ledger till its final destination.
To ensure all the participants stay honest and process transactions by checking and adding more pages, a reward mechanism was initiated to reward those who add pages to the ledger to ensure that only the right transactions are added to the ledger after relevant checks and controls are followed.
This in a nutshell is how a blockchain functions. I have referenced points discussed last week (comparing blockchain with traditional banking) in brackets. If you go back and read the parameters again, it should make more sense now.
Let us go down the rabbit hole and analyze how each function is carried out in an actual blockchain!!