Blockchain is undoubtedly a transformative technology. But it is easy to become lost in the complications of the way it works, and in the hype around this new way of managing data, decentralising systems and transferring value. Blockchain is typically discussed by reference to Bitcoin, simply because it was the original blockchain model and, being public, open source and several years old, is well documented. The specifics of crypto, however, can make blockchain confusingly cryptic. It is important to understand that the very specific objective of Bitcoin – creating a way to transfer value outside the institutional financial system – underpins many of its component elements. Identifying which parts of the structure drive which characteristics is essential for understanding how best to leverage the power of blockchain without also incorporating unnecessary complexity, constraints or risk.
The Bitcoin structure can be unpacked into four broad layers: the data structure, the consensus protocol, the user interface (access and identification) and a final layer with the functionality for the specific objectives of the particular project in hand.
The data layer
This is the part of the structure which drives the (virtually) immutable, unchangeable characteristics of the data. Information is locked into a block, and each block is locked back to the blocks which precede it, all using hashing encryption. If you want locked-down, (effectively) unchangeable data, then you need this layer. There’s no single accepted definition of “blockchain” but without this layer and the feature of locked-down data, you probably don’t have a blockchain structure at all.
Locking down data brings pros and cons. It is very easy to see whether the data has been tampered with, and the fact that it can’t be changed means that it may be less risky to share the data. However, it also becomes difficult (albeit not impossible) to correct errors, to remove data, or to keep some aspects of the data confidential from some members of the network. If the data concerned is personal or sensitive data, compliance with data privacy rules becomes complicated.
The consensus layer
This part of the blockchain structure comprises the protocol for how the network agrees that a new block should be added to the chain. The consensus mechanism enables decentralisation, which, for those with a distrust of traditional institutional structures, can be a key attraction. You don’t need a central authorising institution or governing entity in your system, because the consensus protocol is structured to generate network-wide approval of new blocks, while also minimising the risk of bad actors corrupting or exploiting the system. For Bitcoin, the consensus mechanism is the “Proof of Work” requirement, which can only be met by deploying huge quantities of power (both energy and computing power) in order to add a new block to the system. This operates as a strong disincentive on bad actors – it’s just too expensive to try to defraud the system.
Alternatives to Proof of Work include “Proof of Stake”. This is also used for cryptocurrency, requiring miners (AKA block verifiers) to have a certain investment in the coin in order to mine it – essentially, “skin in the game” is used as a disincentive to exploit the system. Alternatively, a straightforward poll of those in the network can be used to secure consensus. These mechanisms are based on mathematical theories around managing the risk that bad actors might be able to control the system, but essentially a two-thirds majority should be sufficient to secure reliable consensus and outnumber any rogue participants.
But there is a further point to consider here: do you actually need a decentralised system? A locked-down data structure could potentially be managed by a central authority, in which case the consensus layer might be entirely unnecessary. Blocks could simply be added by the blockchain central authority, with the distributed consensus mechanism being replaced by straightforward central confirmation/verification. Moreover, the intentional difficulty in consensus mechanisms is part of what makes the data layer very difficult to change. A centralised system would make it much easier to correct or remove data – the controlling authority could simply correct the faulty data and then hash the broken blockchain back together. With centralised control, there would not be the same need to protect against the blockchain being manipulated because bad actors wouldn’t have the ability to create blocks.
The user interface layer
Bitcoin is a public, un-permissioned network which anyone can join. It was designed without any controls over, or requirements for, new members wishing to join the system. This reflects the decentralised nature of the project and the fact that to operate as a form of currency, Bitcoin needs to be in wide use and openly available. The uncontrolled access also feeds into the need for a consensus mechanism which protects against bad actors – you can take the risk of letting anyone join because the system works in a way that protects itself from attack. But again, whether a blockchain needs to be open depends on the objectives which it is seeking to achieve. In many cases a closed system will be preferable, with any new member requiring prior authorisation to join. Building a permissioned system can also involve something less than full decentralisation, if a central body is responsible for granting permission to join the system (alternatively, a consensus mechanism could be used to generate decentralised authorisation for new members).
The application-specific layer
Finally, the blockchain structure will have other more specific features which drive the particular objective that it is seeking to achieve. Bitcoin’s objective – at the height of the financial crisis in 2008 – was the transfer of value without banks, so the specifics of Bitcoin are focused on the creation of a digital coin or cryptocurrency. As with the other layers of the blockchain structure, whether you need a coin or token depends on what you wish your blockchain structure to do. Indeed, it is not necessary to have a coin at all to transfer value digitally: digital payment system are well established within the traditional banking system and function for all sizes of payment, at any distance, between any parties. If your central objective does not include bypassing the banks, it would be perfectly possible to have a blockchain structure which uses “normal” digital payment mechanisms. This approach has inherent security benefits – if the blockchain system does not include a valuable coin, this reduces the incentives to hack into the system to steal that value.
The terms “coin” or “cryptocurrency” are potentially misleading. Even Bitcoin is not simply used as a form of currency to make payments and transfer value. Much of the interest around Bitcoin is as a speculative investment – in this respect it is more like a commodity. The ability to sell or transfer the coin in exchange for “fiat” money (i.e. “normal” bank- or government-issued currency) creates this possibility of speculation, and there are numerous cryptocurrency exchanges to facilitate such transactions. Where the value of a coin is linked to the underlying activities of the business which issued it, it operates similarly to stocks or shares, and again is often tradable and can be bought and sold as a speculative asset. At its simplest, the coin could be a voucher, entitling the holder to swap it for defined goods or services. Again, the objectives of the specific project in hand will drive the required functionality (or whether a coin is needed at all).
Finally, new cryptocurrencies are often created as a fundraising structure. A release of new coins – an Initial Coin Offering – is made in exchange for fiat money (or other cryptocurrency funds) which can then be invested into the project concerned. A desire to facilitate a significant increase in value of the new coin, inspired by the surge in Bitcoin’s value, is no doubt behind the decision in many cases to make such coins tradable. The characteristics of the issued coin will drive the extent to which the issue is regulated – in many cases an ICO amounts to an issue of securities, subject to the full associated legal regime. Sometimes the coin or the underlying blockchain will have a wider function, but often, in reality, this is secondary to the fundraising objective.
Blockchain is a hugely variable and versatile structure, with potential applications across the commercial landscape. Understanding the various component elements helps to sift the essential from the optional and to remove some of the potentially cryptic assumptions which are in fact driven by the specifics of cryptocurrency and inherent in blockchain structures more generally.
For more insights on blockchain, see our dedicated blockchain feature page.