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Introduction to Blockchain
August 6, 2021

Unless you've been living under a rock, you've probably heard of Bitcoin, Ethereum, and other cryptocurrencies. Fortunes have been made and lost trading these “mysterious” digital coins. But what is the technology behind them? What is a blockchain and how do they work? We will explore these topics below in part one of our series on blockchain technology.

The History of Blockchain Technology

In 1991, Stuart Haber and W. Scott Stornetta introduced the concept of a cryptographically secured chain of blocks. These blocks would add a timestamp to digital documents to prevent tampering. The idea mainly went unused until Satoshi Nakamoto adapted it in 2009 to create a decentralized, peer-to-peer electronic cash system called Bitcoin. In 2013, Vitalik Buterin developed a new blockchain-based distributed computing platform called Ethereum. Today, Bitcoin and Ethereum are the largest and most widely-known blockchains.

What is Blockchain? 

A blockchain is a digital shared ledger system that gives stakeholders shared access and control of data. It is like a giant Google spreadsheet that users can access and edit. However, there is one key difference. Unlike a shared Google Sheets file, a blockchain is not stored in one centralized location. Instead, it is decentralized, meaning that the information stored in a blockchain is owned and verified by every node in the network. This makes blockchains much less susceptible to hacking. If a hacker gains control of one node and attempts to edit the data, all the other nodes would reject the attempt. Thus, there is no single point of failure. Once data is entered onto a blockchain, it is nearly impossible to change it. This feature is known as immutability.

How Blockchain Works

Let's look at an example of how a blockchain processes a transaction:

  1. First, someone sends a request for a transaction to a peer-to-peer network consisting of computers, known as nodes.
  2. The network of nodes validates the transactions and the user's status using a mathematical algorithm. A verified transaction can involve cryptocurrency, contracts, records, or other information.
  3. Once verified, the transaction is combined with others to create a new block of data for the ledger.
  4. The system then adds the new block to the chain, and the transaction is complete. The critical difference between blockchain and, for example, a peer-to-peer cash app is that it relies on the publicly known algorithm rather than a third party or banking institution.

Key Benefits of Blockchain Technology

Blockchain technology's chief benefits include decentralization, immutability, accessibility, and transparency. Decentralization and immutability, as discussed above, are features that increase security. Blockchain's accessibility means that anyone with internet access can use it, which is particularly useful for citizens of less-developed countries with less access to trusted third parties. Public blockchains are transparent, meaning that their contents are visible to anyone with access to the network. Each time a new node joins the network, they receive a full copy of the blockchain. Thus, blockchains are known as being distributed. This characteristic adds another layer of security.

Challenges of Blockchain Technology

Challenges associated with blockchain technology include environmental impact, the threat of “51% attacks," regulation, and hacking.

  • The most popular algorithm that blockchains use to validate transactions is "proof-of-work." This method involves nodes racing to solve complex mathematical puzzles. This process, known as "mining," is highly energy-intensive. The newer "proof-of-stake" algorithm attempts to address this problem. We will explore these algorithms in greater depth in a future post.
  • 51% attacks refer to the fact that if any individual or group gains control of 51% of a blockchain, they can edit the data and cause network disruption.
  • Regulation may also pose a challenge. Governments may decide to curb or restrict the usage of this new technology.
  • Finally, even though blockchains themselves are relatively secure, many high-profile cases of hacking and theft have occurred on major exchanges where people hold cryptocurrencies. 

Blockchain technology has many exciting features as well as obstacles to overcome. Understanding how blockchain works is essential because it is the foundation of the digital assets that have ballooned in popularity. Our next post will dive deeper into different blockchain algorithms and begin our discussion of blockchain digital assets

This article was written by Matthew Lui, CFA, CAIA, Vice President, Investment Research. As a member of Canterbury’s Research Group, Mr. Lui is responsible for sourcing, evaluating, and monitoring traditional, long-only equity managers. Mr. Lui serves as the chair of Canterbury's Global Equity Manager Research Committee and the vice chair of the Hedge Funds Committee. He also sits on the Capital Markets Committee. Prior to joining Canterbury, Mr. Lui was a trader and research analyst at Knightsbridge Asset Management. He received his Bachelor of Arts in economics from University of California, Berkeley. Mr. Lui is a CFA® charterholder and a Chartered Alternative Investment Analyst.