What Is Blockchain Technology and How Does It Work?

by Hitendra Patil | Nov 08, 2017

Like how the email software uses the internet, Bitcoins use blockchain technology. In other words, blockchain is not an application. Blockchain is a foundational technology. One can build applications to use this technology. Blockchain is not one single software platform. There are, and will be, multiple blockchain networks. Essentially, blockchain is a type of database that keeps recording transactions (a ledger). That database keeps getting copied and synchronized onto all the computers (called nodes) in the participating network. Hence, it becomes kind of a distributed ledger.

The Blocks

Blockchain has fixed structures called blocks that store the transaction-related data periodically. In Bitcoins, the time in between mined blocks is about 10 minutes. Each block contains a header, the actual transactions data, as well as some technical stuff. The header consists of identifiers such as a reference number or the unique block number, the link that forms the chain of blocks, information from the previous block, and the timestamp (the date and time the block was created). The transactions data can contain, depending on the use case, a validated list of digital assets and the transaction-related instructions, such as amounts, rates, quantities, the unique identifiers of the transacting parties, etc.

Security and Ownership

On the internet, we currently use usernames and passwords to protect our identity and data. Blockchain uses cryptography or encryption technology. Cryptography works with public keys and private keys. A public key is a long, randomly generated string of alphanumeric values. It is the address on the blockchain network. For example, when you send a Bitcoin to someone, you are sending it to the public key. Others send Bitcoins to your public key, serving as your address. The private key mathematically “derives” the public key.

Hashing technology turns an alphanumeric input via computational process into another alphanumeric value of a predetermined length, to produce the address that other people can see. Thus, when someone sends you transactions over the Blockchain network, they send you a “hashed” version of the public key. To prove to the receiver that you actually own the digital asset/value (say, a bitcoin), you need to prove that you are its true owner. So you, the sender, use your private key and the transaction message to create a digital signature, “signing the transaction” and proving the ownership.

Using a different mathematical computation, other nodes in the blockchain network use the digital signature to verify that it corresponds to your public key. The private key is like your password for a bank login and the digital signature proves to the bank (intermediary) that you have the password, without the need to actually reveal the password.

Transaction Validation

Blockchain does not need third-party, centralized intermediaries like banks. Several nodes in the network do that job in a decentralized way to collectively confirm that you are the owner of a digital asset and that you are not double-spending it.

The “distributed ledger” is like an open book in a room (the public blockchain network). Those in the room can read it. The identities of transacting parties in a public network are pseudonymous.

The beauty of blockchain is that, because each node in the participating network has an identical copy of the database, if for any reason the database on any node is deleted, reinstalling the database on that node will synchronize all blocks from scratch and update itself to the latest validated block in the network!

The (proof of work) process of validating transaction records to add to the public ledger, linking them to blocks of past transactions is called mining. Those who invest and use their resources (time, computing power, electricity) are called miners and they are “rewarded” for validating transaction records.

Public vs Private Networks

The participating network of a blockchain can be a public network—accessible to any person with Internet access—or a private, permissioned network—with access to only those authorized. There can and will be multiple blockchain networks, e.g., Bitcoin, Ethereum, etc. Private blockchain networks can be based on industry, profession, vendor-customer networks, etc. wherein the public will not have access and only permitted entities will be authorized to access this network. Blockchain technology is, therefore, being explored to create peer-to-peer (without involving third-party central administrators) smart contracts via decentralized application platforms. The indelibility of transaction records will make it the trusted source of information.

This information appeared within the Should You Worry About Blockchain? article in the fall 2017 issue of the WashingtonCPA Magazine. Read more here.

Hitendra Patil headshotHitendra R. Patil is one of Accounting Today's 2017 Top 100 Most Influential Persons in Accounting; the Author of “Accountaneur: The Enterpreneurial Accountant” and the Director of Practice Development at AccountantsWorld. You can connect with him on LinkedIn or contact him by email.

This article appeared in the fall 2017 issue of the WashingtonCPA Magazine. Read more here.

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