Blockchain is the innovative database technology at the heart of nearly all cryptocurrencies. By distributing identical copies of a database across an entire network, blockchain makes it very difficult to hack or cheat the system. While cryptocurrency is the most popular use for blockchain presently, the technology offers the potential to serve a very wide range of applications.
What Is Blockchain?
At its core, blockchain is a distributed digital ledger that stores data of any kind. A blockchain can record information about cryptocurrency transactions, NFT ownership, or Defi smart contracts.
While any conventional database can store this information, blockchain is unique because it’s decentralized. Rather than being maintained in one location by a centralized administrator—think of an Excel spreadsheet or a bank database—many identical copies of a blockchain database are held on multiple computers across a network. These individual computers are referred to as nodes.
How Does Blockchain Work?
The name blockchain is hardly accidental: The digital ledger is often described as a “chain” made up of individual “blocks” of data. As new data is periodically added to the network, a new “block” is created and attached to the “chain.” This involves all nodes updating their version of the blockchain ledger to be identical.
How these new blocks are created is key to why blockchain is considered highly secure. Most nodes must verify and confirm the legitimacy of the new data before a new block can be added to the ledger. For a cryptocurrency, they might ensure that new transactions in a block were not fraudulent or that coins had not been spent more than once. This differs from a standalone database or spreadsheet, where one person can make changes without oversight.
“Once there is consensus, the block is added to the chain, and the underlying transactions are recorded in the distributed ledger,” says C. Neil Gray, a partner in the fintech practice areas at Duane Morris LLP. “Blocks are securely linked together, forming a secure digital chain from the beginning of the ledger to the present.”
Transactions are typically secured using cryptography, meaning the nodes must solve complex mathematical equations to process a transaction.
“As a reward for their efforts in validating changes to the shared data, nodes are typically rewarded with new amounts of the blockchain’s native currency—e.g., new bitcoin on the bitcoin blockchain,” says Sarah Shtylman, fintech and blockchain counsel with Perkins Coie.
Public Blockchains vs. Private Blockchains
There are both public and private blockchains. In a public blockchain, anyone can participate, meaning they can read, write or audit the data on the blockchain. Notably, altering transactions logged in a public blockchain is difficult as no single authority controls the nodes.
A private blockchain, meanwhile, is controlled by an organization or group. Only it can decide who is invited to the system; it has the authority to go back and alter the blockchain. This private blockchain process is more similar to an in-house data storage system except spread over multiple nodes to increase security.
How Is Blockchain Used?
Blockchain technology is used for many purposes, from financial services to voting systems.
Cryptocurrency
The most common use of blockchain today is as the backbone of cryptocurrencies, like Bitcoin or Ethereum. The transactions are recorded on a blockchain when people buy, exchange, or spend cryptocurrency. The more people use cryptocurrency; the more widespread blockchain could become.
“Cryptocurrencies are volatile; they are not yet used much to purchase goods and services. But that is changing as PayPal, Square, and other money service businesses make digital asset services broadly available to vendors and retail customers,” notes Patrick Daugherty, senior partner of Foley & Lardner and lead of the firm’s blockchain task force.
Banking
Beyond cryptocurrency, blockchain processes transactions in fiat currency, like dollars and euros. This could be faster than sending money through a bank or other financial institution, as the transactions can be verified more quickly and processed outside regular business hours.
Asset Transfers
Blockchain can also be used to record and transfer the ownership of different assets. This is currently very popular with digital assets like NFTs, representing ownership of digital art and videos.
However, blockchain could also be used to process the ownership of real-life assets, like the deed to real estate and vehicles. The two sides of a party would first use the blockchain to verify that one owns the property and the other has the money to buy; then, they could complete and record the sale on the blockchain.
Using this process, they could transfer the property deed without manually submitting paperwork to update the local county’s government records; it would be instantaneously updated in the blockchain.
Smart Contracts
Another blockchain innovation is self-executing contracts, commonly called “smart contracts.” These digital contracts are enacted automatically once conditions are met. For instance, a payment for a good might be released instantly once the buyer and seller have met all specified parameters for a deal.
“We see great potential in smart contracts—using blockchain technology and coded instructions to automate legal contracts,” says Gray. “A properly coded smart legal contract on a distributed ledger can minimize or eliminate the need for outside third parties to verify performance.”
Supply Chain Monitoring
Supply chains involve massive amounts of information, especially as goods go from one part of the world. With traditional data storage methods, it can be hard to trace the source of problems, like which vendor’s poor-quality goods came from. Storing this information on the blockchain would make it easier to go back and monitor the supply chain, such as with IBM’s Food Trust, which uses blockchain technology to track food from its harvest to its consumption.
Voting
Experts are looking into ways to apply blockchain to prevent fraud in voting. In theory, blockchain voting would allow people to submit votes that couldn’t be tampered with, as well as would remove the need to have people manually collect and verify paper ballots.
Advantages of Blockchain
Higher Accuracy of Transactions
Because multiple nodes must verify a blockchain transaction, this can reduce error. If one node has a mistake in the database, the others would see it’s different and catch the error.
In contrast, in a traditional database, if someone makes a mistake, it may be more likely to go through. In addition, every asset is individually identified and tracked on the blockchain ledger, so there is no chance of double spending it (like a person overdrawing their bank account, thereby spending money twice).
No Need for Intermediaries
Using blockchain, two parties in a transaction can confirm and complete something without working through a third party. This saves time and the cost of paying for an intermediary like a bank.
“It can bring greater efficiency to all digital commerce, increase financial empowerment to the unbanked or underbanked populations of the world, and power a new generation of internet applications as a result,” says Shtylman.
Extra Security
Theoretically, a decentralized network, like a blockchain, makes it nearly impossible for someone to make fraudulent transactions. To enter forged transactions, they must hack every node and change every ledger. While this isn’t necessarily impossible, many cryptocurrency blockchain systems use proof-of-stake or proof-of-work transaction verification methods, making it difficult and not in participants’ best interests to add fraudulent transactions.
More Efficient Transfers
Since blockchains operate 24/7, people can make more efficient financial and asset transfers, especially internationally. They don’t need to wait days for a bank or a government agency to confirm everything manually.
Disadvantages of Blockchain
Limit on Transactions per Second
Since blockchain depends on a more extensive network to approve transactions, there’s a limit to how quickly it can move. For example, with Visa, Bitcoin can only process 4.6 transactions per second versus 1,700 per second. In addition, increasing numbers of transactions can create network speed issues. Until this improves, scalability is a challenge.
High Energy Costs
Having all the nodes working to verify transactions takes significantly more electricity than a single database or spreadsheet. Not only does this make blockchain-based transactions more expensive, but it also creates a significant carbon burden on the environment.
Because of this, some industry leaders are beginning to move away from certain blockchain technologies, like Bitcoin: For instance, Elon Musk recently said Tesla would stop accepting Bitcoin partly because he was concerned about the environmental damage.
Risk of Asset Loss
Some digital assets are secured using a cryptographic key, like cryptocurrency in a blockchain wallet. You need to guard this key carefully.
“If the owner of a digital asset loses the private cryptographic key that gives them access to their asset, currently there is no way to recover it—the asset is gone permanently,” says Gray. Because the system is decentralized, you can’t call a central authority, like your bank, to ask to regain access.
Potential for Illegal Activity
Blockchain’s decentralization adds more privacy and confidentiality, which, unfortunately, makes it appealing to criminals. Tracing illicit transactions on the blockchain is more complicated than bank transactions tied to a name.
How to Invest in Blockchain
You can’t invest in the blockchain itself since it’s merely a system for storing and processing transactions. However, you can invest in assets and companies using this technology.
“The easiest way is to purchase cryptocurrencies, like Bitcoin, Ethereum, and other tokens that run on a blockchain,” says Gray.
Another option is to invest in blockchain companies using this technology. For example, Santander Bank is experimenting with blockchain-based financial products, and if you are interested in gaining exposure to blockchain technology in your portfolio, you might buy its stock.
For a more diversified approach, you could buy into an exchange-traded fund (ETF) that invests in blockchain assets and companies, like the Amplify Transformational Data Sharing ETF (BLOK), which puts at least 80% of its assets in blockchain companies.
The Bottom Line
Despite its promise, blockchain remains something of a niche technology. Gray sees the potential for blockchain to be used in more situations, but it depends on future government policies. “It remains to be seen when regulators like the SEC take action. One thing is evident—the goal will be to protect markets and investors,” he says.
Shtylman likens blockchain to the early stages of the internet. “It took about 15 years of having the internet before we saw the first version of Google and over 20 for Facebook. It’s hard to predict where blockchain technology will be in another 10 or 15 years, but much like the internet, it will significantly transform how we transact and interact with each other in the future.”
Hurdles remain, especially with the transaction limits and energy costs, but for investors who see the potential of the technology, blockchain-based investments may be a bet worth taking.