Blockchain basics: what blockchain is, how it works and how it differs from traditional data storage systems

Blockchain is a technology that has become crucial in the digital era since the introduction of Bitcoin in 2008. Despite its significance, it can be challenging for those without experience in cryptocurrencies and technical innovations to understand what it is all about. In this article, we will break down how blockchain works, compare it with traditional databases, and explore the opportunities it offers.

Our goal is to provide a simple and clear explanation of blockchain, enabling you to better appreciate its potential and its impact on various aspects of our lives. The article will avoid unnecessary technical jargon and focus on the unique features of this innovation, which make it beneficial across all industries.

What is blockchain?

Blockchain is a method of storing information that allows the creation of a chain of data, or blocks, making it immutable and secure. Each block contains data and a reference to the previous block, forming a chain.

Traditionally, data was stored in one place, such as file cabinets, libraries, or city archives. Later, in the era of digital data, servers emerged. For example, Google's servers store all user information. In a blockchain, blocks are stored on multiple computers, called nodes, distributed throughout the network. Hence, it is referred to as a digital distributed ledger.

When new data is added to the blockchain, it is automatically verified by all nodes on the network, ensuring transparency and reliability. Thanks to this structure, blockchain prevents the alteration of data in previous blocks, making it secure against tampering and hacking.

The key difference between blockchain and other data registries lies in the absence of central authority or intermediaries, such as banks, corporations, or governments. Information is stored and controlled by the participants in the network, promoting decentralization and trust.

While blockchain is most commonly associated with cryptocurrencies like Bitcoin or Ethereum, its potential applications extend to various fields, including finance, logistics, healthcare, voting, and more.

How does blockchain work?

To understand how the whole system works, it's essential to grasp the concept of Consensus Mechanism. And we'll make sure that this is the last complex term in this article. Consensus is a way for computers in the network to agree on which data and transactions should be considered valid and added to the shared list.

Let's use an analogy to illustrate this concept. Imagine you're organizing a party, and you and your friends each have copies of one big shopping list. To ensure everyone has the same version of the list, you get on a call and discuss each item. If someone disagrees or spots an error, you collectively decide how to fix the list to make it identical for everyone.

Similarly, in the consensus mechanism, computers in the blockchain collaborate to confirm which transactions and data will be included in the next block. They may use different methods, which we'll discuss below, to select who gets to create the new block and what data it should contain. When computers reach a unanimous decision, a new block is added to the chain, and all computers update their copies of the list to make them identical.

This process ensures reliable and decentralized storage of data, as all network participants work together and agree on building the transaction history correctly.

💡 How transactions are confirmed in the blockchain

There are several consensus mechanisms that govern the operation of blockchains, but we'll discuss the two most well-known ones: Proof-of-Work (PoW) and Proof of Stake (PoS).

Proof-of-Work: This algorithm gained fame through Bitcoin. To confirm transactions, a decentralized network of computers (miners) competes with each other to solve a mathematical problem. The computer that first finds the solution verifies the transaction and creates a new block, receiving a reward for doing so. The main drawbacks of this algorithm are its high energy consumption and low information transfer speed.

Proof-of-Stake: A more environmentally friendly alternative to PoW and Bitcoin. Instead of requiring miners to solve complex mathematical problems, this system has blockchain participants, known as validators, put up their digital coins as a guarantee that the block was recorded correctly. Anyone can become a network validator by staking a certain amount of the native cryptocurrency of the network on their wallet.

Why we love blockchain

Blockchain technology is much more complex than traditional data storage systems, but it is also more efficient, secure, transparent, and faster. Let's break down each point separately.

Security. In a traditional system, information is typically stored in a centralized database, making it vulnerable to hacking attacks and personal data leaks. In contrast, blockchain utilizes a distributed ledger, where data is stored on countless network nodes, practically eliminating the possibility of data manipulation or corruption.

Transparency. Transparency is a major advantage of blockchain technology, as all transactions and data stored in the blockchain are visible and verifiable by all network participants. This means that every person can ensure the accuracy of information, ensuring the system operates honestly and without hidden manipulations.

Speed. Traditional systems may process data slowly and require multiple intermediaries for transactions. Blockchain, however, removes the need for intermediaries and uses a distributed network to process transactions in real-time. This simplifies, accelerates, and enhances efficiency.

Costs. Conventional financial systems can demand expensive equipment, software, and constant maintenance and support. Blockchain technology operates in a decentralized network, eliminating the need for costly infrastructure and reducing ongoing expenses.

How blockchain technology is used

The unique characteristics of blockchain allow its application not only in cryptocurrencies but also in other areas. Here are some of the use cases of blockchain technology:

1. Cryptocurrencies and digital assets. All cryptocurrencies are built on blockchain. The technology enables the issuance, secure storage, buying, and exchanging of cryptocurrencies, providing transparency and decentralization to all transactions.
2. Logistics. Blockchain can be used to manage supply chains, making it easier to track the movement of goods, enhance control over timelines, and plan more efficient routes. The transparency of blockchain helps prevent fraudulent activities, counterfeit products, and builds trust among participants.
3. Healthcare. Blockchain technology can be used to securely store and share medical records and other sensitive information in the healthcare sector, increasing the security and safety of patient data.
4. Voting systems. Blockchain is suitable for any voting process, both in business and government settings. It can create a system free from any manipulation of results, ensuring transparency and integrity.
5. Decentralized Finance (DeFi). This is a rapidly growing sector of blockchain technology that allows for the creation of financial applications operating on a decentralized network, eliminating the need for intermediaries such as banks and reducing costs for clients.

These are just a few examples of how blockchain technology can be applied across various industries, providing enhanced security, transparency, and efficiency.

A few words about Ethereum — one of the most popular blockchains in the DeFi space

Ethereum is a special kind of blockchain that extends the capabilities of blockchain technology beyond cryptocurrencies and data registries. Think of the blockchain as a complex computer network, where you can not only store and exchange data but also create decentralized applications with their own functions. Ethereum is precisely such a network.

For instance, you want to place a bet with someone on the outcome of a sports match. On Ethereum, you can create a smart contract that will automatically send the bet to the winner after the match ends. The smart contract enforces the rules autonomously, without the need to trust anyone else. This is a simple example, but Ethereum allows you to go much further, enabling the creation of your cryptocurrency exchange, deposit insurance agency, fund for researching complex scientific hypotheses, or even an entire metaverse.

Ethereum has its own cryptocurrency called ETH. You can send and receive it within the Ethereum network and use it to pay transaction fees while working with protocols for trading or earning yields from cryptocurrencies.

An example of such a protocol built on Ethereum is Curve Finance. It allows for the exchange of stablecoins with minimal losses during trading. DSF offers its users the opportunity to earn by providing liquidity in Curve. In simpler terms, lending cryptocurrency to the protocol for a certain period and receiving interest in return. Check out this article for more information about liquidity providing, or you can try our app.