With the onset of the internet and digitization, a large part of our transactions have become 1’s and 0’s floating around the virtual world. Very few transactions require physical transfers of anything, be it cash or any other asset. However, there are a lot of intermediaries involved in these transactions. Let us take the example of a transaction on the stock exchange. Apart from the buyer, seller and exchange, there are nine intermediaries involved in the transaction – the buyer’s broker, seller’s broker, bank, depository, buyer side custodian, seller side custodian, buyer’s side bank, seller’s side bank and clearing house. While the nature of entry may vary on which end of the transaction the entity is, each of these participants need to record and reconcile this transaction.
While there have been many unsuccessful attempts in the past to launch cryptocurrencies, towards the end of 2008, Satoshi Nakamoto came out with a paper titled “Bitcoin: A Peer-to-Peer Electronic Cash System” outlining the workings of a vision – “A purely peer-to-peer version of electronic cash would allow online payments to be sent directly from one party to another without going through a financial institution.”. Creating a Decentralized Autonomous Organization (DAO as it is now called), where there is no intermediary or centralized authority to control and manage flows required a self-governing system. This underlying system or principle is called Blockchain or Distributed Ledger.
Given the sensitive nature of the financial system, there haven’t been too many innovations in this sector. The players and processes remain fairly the same. Given digitization in the industry, a few changes have been made. But by and large, the workings have remained the same. In 2014, the potential such a technology has to disrupt the way business is done caught the attention of institutions in the financial world. There has been a lot of buzz around this technology ever since.
This brings us to the most basic questions, what is Blockchain and how does it work?
Blockchain is a globally distributed ledger, which facilitates the movement of assets across the world as long as they can be represented digitally. At a very basic level, Blockchain can be view as a list of participants and their balances. This list of balances is made available to all the participants, hence the term distributed ledger. By broadcasting these logs across the network, a single version of the truth is created and used by all participants. It is this version of the truth which enables all transactions. Each time a transaction takes places, the balances in the participant’s ledger changes and this information is then broadcasted to every participant in the network. It has an inbuilt cryptographic security which makes a transaction tamper proof.
It is important to understand the concept of a hash. A hash is an output which is received by running an input through a certain algorithm that anonymizes it. A slight variation in input will result in a very different output. The important feature is it is a one-way function. The output cannot be run through the algorithm to derive its input. This is what ensures its security.
There are five stages to a transaction on the Blockchain:
- Transaction Definition
Transaction definition involves defining the receiver and the amount/asset. The system protects the identity of its participants by issuing a private key through which multiple public keys can be created. The Public and Private key pair comprise of two uniquely related cryptographic keys (basically long random numbers). Because the key pair is mathematically related, whatever is encrypted with a Public Key may only be decrypted by its corresponding Private Key and vice versa. This is how encryption is used in creating and verifying digital signatures. A digital signature is created based on the transaction details and the sender’s private key. The other systems on the network verify this by using the contents of transaction, the sender’s public key and the signature.
1/0 = F(message, public key, signature)
The signature is unique for each transaction as the transaction details will differ.
There is also a concept of transaction inputs and outputs. For the transaction to take place, certain inputs are referenced to check the validity of the balance and the ability to make the transaction. These transactions were again a function of previous transaction that had occurred to see if the balance is valid for the transaction to go ahead. It must be kept in mind this is different from the Blockchain.
- Transaction Authentication
Transaction authentication involves the nodes receiving these messages and verifying their authenticity as also verifying the unspent transactions to see if the transaction is valid. The transaction is then placed in a pool of transactions.
- Block creation
Based on a lottery, transactions are picked from the pool of transactions and put into one block which is time stamped. The block is secured with a cryptographic problem which a “miner” must solve as a proof of work. Each block is linked to the previous block all the way to the first block called the Genesis block. This is how a version of history of transactions is created.
- Block validation
On the bitcoin Blockchain, the miner runs the entire contents of the block plus the previous Block’s has and some additional text, called nonce, which is run through something known as a “cryptographic hash” to ensure the output is below a certain value. The difficulty level of this problem can be adjusted by adjusting the value. The cryptographic problem which is created must be solved by the miner to ensure the block is valid.
Once the cryptographic problem is solved, the block is then added to the Blockchain and broadcasted to all the participants. There is a possibility, though mathematically very low, that multiple blocks maybe solved at the same time. In such a case the tie is broken when another block is solved and added to the chain and the Blockchain stabilizes. The new state of the Blockchain is then broadcasted to all participants.