Most people today have heard of bitcoin, a cryptocurrency that is still gaining ground. It's currently in the trough of disillusionment in Gartner's Hype Cycle for Emerging Technologies (2015) and is slowly on the uptake to maturity. Because it completely changes certain concept of money handling, and how money attains value it has been the cause of much debate amongst governments and even members of the financial markets sector. In some countries ATMs have been set up and payments in bitcoin are accepted, and in some countries it has yet to be legitimised. What has been of more interest, however, is the enabling technology underlying bitcoin. It is called blockchain, and it has become the subject of intense research for multiple use cases within the finance and banking sectors as well as other sectors as well.
What is blockchain?
In simple terms, blockchain is an electronic ledger of all transactions relating to a particular entity. This ledger is publicly visible and shared within a network of processors called miners. The mining job consists of validating, recording and sharing details of all transactions within the entire network. Miners are essentially servers that do the processing of receiving newly initiated transactions (in sets called blocks), validating them and adding them to a chain of existing, previously validated transactions to form a complete history of all transactions relating to the entity in question. The entity may be bitcoin or any unique document of some kind. The validated transactions are broadcast to all nodes in the network. Each transaction is validated for addition to the relevant blockchain using a private-public key cryptography method based on the SHA-256 hashing algorithm. Blocks are broadcast about every 10 minutes, and the receiving miner looks for what is called proof of work in order to validate the hash keys. This is all a very simplified description of the blockchain concept, but more important is why it has become the subject of so much interest.
Why is it growing?
In almost every financial transaction there is an element of trust involved. Before a seller hands over a good or service in exchange for money they need to be trust that the buyer has enough money to pay for the purchase, the same money is not simultaneously being committed for spending elsewhere, and that the payment will be duly made at the agreed time and mode. In the simplest form it could be a small cash transaction in a shop, and this is simple because the cash is visible, and in-person interaction between the two parties allows each one to quickly decide whether they want to trust the other.
However, when payments are to be done in an online mode the whole scenario changes because physical money is no longer visible. This is where a third party intermediary, like a bank or a financial services company comes in. Based on their relationship with each party, the bank acts as the trustee, certifying to the receiver that either the funds have been received, or that the buyer is credit worthy. Either way, the intermediary acts as the trusted broker and is relied upon to complete the transaction. Obviously, this broker has an operational cost that is paid for by one of the transacting parties. This is a significant cost of banking, and these costs are prevalent no matter what is being exchanged, e.g., money, securities, or any other financial instrument.
The draw of blockchain technology is that it offers the security of transacting without needing a third party trustee. With that one characteristic alone it greatly reduces the costs of financial transacting. But apart from this, blockchain technology can be used beyond bitcoin and can be applied for other purposes as well, such as document verification, secure encypted messaging, and many more applications that need authentication of entities.
How is it secure from fraud and misuse?
The nature of public-private key encryption makes it very secure indeed. Fundamentally, a transaction cannot be validated unless hash keys match in sequence along an entire chain. It is this that makes it very difficult to modify key values or duplicate them for fraudulent purposes. In addition, the availability of a public ledger rather than a centralized one also acts as a preventive for attempts to use the same money or document twice.
It is also very difficult to modify existing blockchain records because of the hash chaining. If anyone wanted to tamper with one record they would need to correspondingly modify all records in the chain as well as the records available across the network to maintain integrity, and that would be so difficult to achieve as to be a complete deterrent.
How are miners paid?
Miners contribute servers and processing power for blockchain transactions. If they are a part of a public network they are usually paid in the form of a percentage of the transaction value, at least for bitcoin transactions. For bitcoin transactions, new bitcoin may be generated for them, the quantity calculated in some proportion to the transaction value. The incentive for all miners to receive and store all broadcast validations is that they will not be able to do any further validations unless they are up to date on the previous ones. This also maintains the integrity of the public nature of the blockchain ledger.