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One of the most engaging topics in finance right now is the rise of cryptocurrencies. Cryptocurrencies are based on a technology called blockchain. So, what really is the blockchain and what makes it such a revolutionary technology? Understanding blockchain has to be taken in short steps. Before we can understand what the blockchain is, we must understand what a distributed or decentralised ledger is.

What is a decentralised ledger?

Conventionally, most financial networks are centralised. Clearing and settling payment requests by banks, for example, are done using a centralised ledger. A ledger is a written or computerised account of all the transactions a business completes. A centralised ledger, therefore, is a record of all the transactions conducted by a set of companies. In the banking sector, that would include all the banks, NBFCs, etc.

Once a transaction has been recorded on the centralised ledger, the companies involved in the transaction adjust the levels in their own internal ledgers to reflect the change. It is absolutely imperative, therefore, that the centralised ledger is updated accurately and safely, and in a timely manner so as to maintain the integrity of the system that is based on it.

Now, a newer form of ledger-keeping has been emerging over the last decade or more, where there are more participants in the actual maintenance and updation of the ledger. A decentralised ledger is when these tasks are assigned to some of the entities in a network while a distributed ledger is when these tasks are assigned to everyone on the network. Blockchains, depending on how they are set up, can be either decentralised or distributed ledgers.

What is Blockchain and how does Blockchain work?

In simple terms, blockchain technology is a secure software architecture that allows data to be saved in a safe and decentralised manner.

What makes such a system particularly useful is that each transaction—called a ‘block’—is updated in real time and added to the ‘chain’ of transactions simultaneously on each node. Hence the name ‘blockchain’. What is even more useful is that the chain is immutable. That is, it cannot be changed, altered, deleted or in any way modified. So, once a transaction is recorded on the blockchain, it’s there for everybody to see forever.

In these kinds of networks, any changes to the ledger—additions, subtractions, etc—must be approved by the majority of the entities on that network. That is, if a change is proposed, then most of the nodes on the network have to agree that this is a legitimate change and that is must be recorded on the blockchain. Each of these changes, once approved and legitimised, joined the blockchain as an additional block.

Different networks have different rules on what kind of consensus mechanism they want to employ. Smaller networks can afford to require a full consensus, where a transaction is approved only when all the nodes approve it. Larger networks, with thousands, if not millions, of nodes cannot afford such a strict protocol as each transaction would then take a very long time to be verified. Instead, they adopt a majority consensus protocol, where a transaction is approved if a majority of the nodes agree that it should be approved.

These consensus protocols make it very difficult for a bad actor to falsify a block. In smaller networks, where a miscreant might be able to gain control of more than 50% of the nodes, the requirement of a full consensus protects the network. Similarly, larger networks are relatively safer because gaining control of more than 50% of the nodes would be next to impossible.

Types of Blockchains: What are public and private blockchains?

Blockchain technology is incredibly versatile and can be applied in varied use-cases. In general, these blockchains can be divided into two broad categories: public and private blockchains. Public blockchains are open to any who would like to participate. Bitcoin was the very first public blockchain network and is one of the largest, with research showing that there are about 5 million Bitcoin users in the world. Public blockchains also are laxer in terms of identity information and most users often use pseudonyms.

Businesses also often use private blockchains, were membership is limited to only those invited onto the network. In such blockchains, the transactions on the blockchain, while visible to members, are not visible to those outside the blockchain. Several companies have begun to use these to conduct internal transactions between branches of the same company.

Cryptocurrencies and Blockchain

As stated above, blockchains are very versatile tools and so they can be applied in a variety of ways and in multiple sectors. Smart contracts are one essential way in which blockchains are used. However, the most popular application of blockchain technology by far is in cryptocurrencies.

The next article in this series will delve further into the topic of blockchains to see what exactly makes them work, how the nodes can verify to such a high degree of surety that a transaction has taken place, and how they are so secure.

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