In Bitcoin’s whitepaper, Satoshi Nakamoto coined a term that has since captivated a generation: “chain of blocks.” Nakamoto used this term to describe the mechanism required to create bona fide internet money. At a high level, the concept proposed a set of programming in which all computers in a peer-to-peer (P2P) network held the same ledger. This was a verifiable catalog of transactions with which all copies could be used to validate past transactions, acting as an immutable point of reference. As laid out in the whitepaper, its function cemented how a blockchain ledger is collectively managed and updated, leveraging game theory and tokens to ensure cooperation.
For the first time, individuals, regardless of their education, background, or geographic location, could have the ability to participate in and own internet money in a permissionless manner.
To understand how the blockchain works, we need to lay out a clear set of definitions for its building blocks. Otherwise, deeper dives into the technology may become too demanding, turning off others without the proper background. The last statement is an assumption but is driven mainly by my own experience 😊
In a blockchain network, token transactions are recorded on “hashed blocks.” A cryptographic hash is a unique digital marker, like an invoice number for a business. Each cryptographic hash is also a record of the previous block’s hash, such that as the transaction list grows, so too does the trail of cryptographic hashes that map transactions in each progressive block.
These cryptographic hashes link all the blocks together to create a ledger of historical state changes. Once a block is hashed, it cannot be changed without changing the hash value of all succeeding blocks. Since all network validators have a copy of the ledger and its block hashes, it is challenging and almost impossible to alter the hash record of the chained blocks. In summary, the blocks are chained together by a history of hashes that yield a verifiable system of record: a ledger.
A ledger, as referenced above, is a system of records verifiable by a history of hashes. This digital file contains records of all transactions made on a particular blockchain in its history. Given that each network validator has a copy of this record, it can be trusted – any manipulation would change the hash value, and as a result, not match the record on each network validator’s copy. This acts as a counterfeit-prevention measure.
A ledger is open for anyone to inspect, but no single person has direct control over it. All ledgers must match, which requires a consensus mechanism for network validators to find alignment in new additions to the chained blocks. Since trust is built into the mechanisms for recording and maintaining the record, the blockchain circumvents the need for centralized institutions to act as a validator of sorts.
These are interesting. From a technical perspective, a token is merely a recorded entry on a ledger that corresponds to a blockchain address (the holder). These tokens can only be accessed by someone with the “private keys” or passphrase corresponding to the wallet that holds the address.
Applying chained blocks, ledgers, and tokens to Bitcoin
As an example, let’s walk through how a network uses these components to send a transaction without any centralized intermediary:
Bitcoin (BTC), a token, can be sent from me to you without a bank because of the mechanisms listed above. The node operators (network validators) check their copies of the distributed ledger against others to maintain validity. Then, through a majority vote or consensus, verify the transaction by performing some mathematical work. All operates are trusted equally. The power of the collective harnesses the validation of an institution without the indirect privacy and permission costs.
A protocol is a set of code that outlines parameters or rules. These parameters define how node validators reach a consensus for a transaction. You can think of a protocol as the rules a bank follows, determining whether a particular transaction is valid. It also defines the rewards network validators are entitled to, typically a protocol’s native token. These rules are not set in stone – parameters can change depending on proposals made to the community of token holders or validators (also depending on the rules) and associated voting rules. Though an imperfect comparison, a protocol is like a nascent nation’s constitution. Rules and procedures are clearly outlined; however, amendments can be proposed or ratified based on the process outlined in the document. This is how blockchains function: through code and its evolution over time.
Cryptography, in a reductive sense, is a coded message. It enables two or more parties to send encrypted messages to each other. Cryptography is why features of the blockchain can include network security, token transfers, and privacy (pseudonymously).
Tokenomics is a new word – even my word processor doesn’t think it’s a real word 😊 Tokenomics has a few constantly evolving definitions. Tokenomics can be defined as a protocol’s application of game theory such that network participants adhere to the rules set forth. This also includes punishments for those who fail to act truthfully. An entire book can be written on tokenomics ranging from supply-side to demand-side analysis, inflation rates, and behavioral economics, but for a general definition, think of it as the designing of the carrot and stick for a protocol.
For the state of a blockchain network to be altered (e.g., a transaction to be hashed and recorded to the ledger), network validators must reach an agreement based on the rules set forth by the protocol. This is considered to reach “consensus.” Protocol tokenomics schemes are designed to assume that all network participants are corrupt. It becomes onerous and costly to manipulate the distributed ledger for a network.
Blockchain Address (Crypto Identity)
A blockchain address represents a pseudonymous digital identity that “owns” the rights to digital tokens. Since the tokens are mapped to a particular blockchain address, only the owner of that address (through private keys) holds the right to transfer those tokens. For the network to validate the owner of the tokens, the owner must “sign” a transaction using a private key. All aspects of deriving and validating a blockchain address and its associated ownership rights are a matter of solving a set of mathematic proofs by network validators. More on this will be outlined in future posts.
Blockchain Transparency: Block Explorers
Since all transactions and their details are public by design, blockchain ledgers can be analyzed and tracked. It is a reason why less than 0.62% of crypto transactions relate to money laundering or other illegal activities, according to Chainalysis. Block explorers like Etherscan allow anyone to analyze on-chain transactions and their data, similar to a search engine indexing its webpages and populating results in a digestible manner. Without a block explorer, you’d need to run a node to be able to download the history of every transaction for a blockchain.
In this article, we took a step back to find alignment of critical definitions and words often used but rarely explicitly defined. We outlined some of the building blocks of web3 in “blocks-chained,” how they come together to build out a ledger of recorded activity, and how tokens fit into the two. We then defined what a protocol is, how it leverages cryptography and game theory to align participants' behaviors, and how it all comes down to achieving consensus. We walked through the consensus mechanism and why it is necessary to execute transactions and trust a ledger’s output. And lastly, we brought it all together with how a blockchain address allows us to interact with the preceding items and how to gain further insights into what had taken place in a blockchain’s history.