Blockchain, the technology behind Bitcoin, seems to be the driving technology behind the next generation of Internet, also referred to as the Decentralized Web, or the Web3. Blockchain is a novel solution to the age-old human problem of trust. It provides an architecture for so-called trustless trust. It allows us to trust the outputs of the system without trusting any actor within it.
A Blockchain protocol operates on top of the Internet, on a P2P Network of computers that all run the protocol and hold an identical copy of the ledger of transactions, enabling P2P value transactions without a middleman though machine consensus. Blockchain itself a file – a shared and public ledger of transactions that records all transactions from the genesis block (first block) until today.
Blockchain is a shared, trusted, public ledger of transactions, that everyone can inspect but which no single user controls. It is a distributed database that maintains a continuously growing list of transaction data records, cryptographically secured from tampering and revision.
The ledger is built using a linked list, or chain of blocks, where each block contains a certain number of transactions that were validated by the network in a given timespan.The crypto-economic rulesets of the blockchain protocol (consensus layer) regulate the behavioral rulesets and incentive mechanism of all stakeholders in the network.
This ledger runs on a peer-to-peer (P2P) network of computers. Distributed consensus based on economic incentive mechanisms (game theory) combined with cryptography allows for secure P2P validation of transactions, thus bypassing the need for traditional trusted third parties. It first came to fame in October 2008 as part of a proposal for Bitcoin, with the aim to create P2P money without banks. All network transactions get stored in the blockchain: Imagine Google Docs: Each person has the latest version of the document, and everybody can inspect it. In order to change the contents of the doc, users need to reach a mutual agreement (consensus). As opposed to Google Docs the file is not centrally stored, but each node of the network keeps a copy of the blockchain – the distributed ledger recording all transaction history.
Removing the Middle Man with Machine Consensus
Instead of a single trusted third party validating transactions through their servers with authority (single vote), a peer to peer network of computers running the blockchain protocol validate transactions by consensus (majority vote). The blockchain protocol, therefore, formalizes pre-defined consensus rules for validating transactions on the P2P network, as hard-coded governance rules, managing, and auto enforcing transactions of all participants in the network.
In the case of Bitcoin, instead of bank validating financial transactions – like sending money from A to B – checking the digital ledger of who owns what stored on their server, a P2P network of computers running the bitcoin protocol validate transactions by majority consensus. The consensus rules of the Bitcoin network govern how the participants in the network interact with each other. They define::
- Under which conditions a transaction – sending money from A to B – is valid.
- Transaction costs related to sending money from A to B.
- Game theoretic incentive mechanism for validating transactions with a cryptographic token.
- Rules of how to change current consensus rules.
Blockchain was initially designed for P2P money only. But it soon showed the potential to be used for any kind of P2P value transaction on top of the Internet. The Ethereum project thus introduced the idea of decoupling the contract layer from the blockchain layer, where the ledger itself is used by smart contracts that trigger transactions automatically when certain pre-defined conditions are met. By decoupling the smart contract layer from the blockchain layer, blockchains like Ethereum aim to provide a more flexible development environment than the Bitcoin blockchain.
Blockchain Technology Stack Of Ethereum and similar Blockchains (Inspired by Florian Glatz)
These smart contracts are a piece of code running on top of a blockchain network, where digital assets are controlled by that piece of code implementing arbitrary rules. They have properties of contractual agreements but should not be confused with legal contracts. (For more information on legal question around blockchain visit our Blockchain & Law page).
If and when all parties to the smart contract fulfill the pre-defined arbitrary rules, the smart contract will auto execute the transaction. These smart contracts aim to provide transaction security superior to traditional contract law and reduce transaction costs of coordination and enforcement.
Smart contracts can be used for simple economic transactions like sending money from A to B. They can also be used for registering any kind of ownership and property rights like land registries and intellectual property, or managing smart access control for the sharing economy, just to name a few. Furthermore, smart contracts can be used for more complex transactions like governing a group of people that share the same interests and goals. Decentralized Autonomous Organizations, DAOs, are such an example for more complex smart contracts.
With blockchains and smart contracts, we can now imagine a world in which contracts are embedded in digital code and stored in transparent, shared databases, where they are protected from deletion, tampering, and revision. In this world, every agreement, every process, task, and payment would have a digital record and signature that could be identified, validated, stored, and shared.
Intermediaries like lawyers, brokers, and bankers, and public administrators might no longer be necessary. Individuals, organizations, machines, and algorithms would freely transact and interact with one another with little friction and a fraction of current transaction costs.
Therefore, blockchains & smart contracts:
- Radically reduce transaction costs (bureaucracy) through machine consensus and auto-enforceable code.
- Bypass the traditional principal-agent dilemmas of organizations, thus providing an operating system for what some refer to as “trustless trust”. This means that you don’t have to trust people and organizations, you trust code, which is open source and provides transparent processes.