Blockchain: Definition and How It’s Used in Finance

Blockchain is the latest technology that has gained popularity along with cryptocurrencies. Today, it’s buzzworthy not only in the finance world. Blockchain is already usable for storing and processing personal data, identification, marketing, and computer games.

It’s a continuous sequence of blocks where all transactions are recorded. But, unlike regular databases, you can’t change or delete these records; all you can do is add new ones.

As a result, blockchain technology enables the creation of an immutable or perpetual ledger for tracking orders, payments, invoices, and other transactions. The system offers built-in tools that prevent unauthorized transactions and ensures consistency overall.

Blockchain technology is often referred to as distributed ledger technology because multiple independent users store the complete sequence of transactions and the latest list of owners on their computers. If one or more computers fail, the information remains secure and isn’t lost.

Why blockchain technology is important:

When it comes to accounting for financial transactions, conventional database technologies present several challenges. For instance, selling real estate involves the transfer of ownership to the buyer after the money has been exchanged. Both the buyer and the seller can record monetary transactions independently, but neither can be fully trusted. In such cases, the seller can dispute receiving the money even if they have, and the buyer can claim to have sent the money when they have not.

To circumvent any possible legal complications, a trusted third party is required to oversee and validate transactions. However, the existence of this central authority not only adds complexity to the transaction but also creates a single point of vulnerability. Violations in the central database could result in losses for both parties involved.

By establishing a decentralized and tamper-proof system for recording transactions, blockchain eliminates such issues. In the context of real estate transactions, blockchain generates a unified ledger for both the buyer and seller, where all transactions require the approval of both parties and are automatically updated on their ledgers in real-time. Any inconsistency in the transaction history is reflected across the entire ledger. These unique features of blockchain technology have propelled its popularity in diverse sectors. For instance, blockchain was leveraged to introduce the digital currency Bitcoin.

What blockchain technology can do:

Here are the key features of blockchain technology.

1. Decentralization

Decentralization in blockchain refers to the shift of control and decision-making from a centralized entity (such as an individual, organization, or group) to a distributed network. The transparent nature of decentralized blockchain helps establish a sense of trust among participants. By relinquishing power and control over each other, these networks maintain their functionality and prevent any one entity from exerting too much influence.

2. Immutability

Immutability implies that data can’t be altered. Once a transaction is recorded in the ledger, no participant can modify it. If a record contains an error, a new transaction must be added to rectify it, and both transactions will be visible on the online platform.

3. Consensus

The blockchain system establishes a set of rules by which participants approve transactions. New transactions can be registered only with the consent of the majority of network participants.

Key components that underlie blockchain technology:

Here are the key components of the blockchain architecture.

1. Distributed ledger

A distributed ledger is a database in the blockchain network that stores copies of transactions, e.g., as a common file edited by all participants. In most collaborative text editors, anyone with editing rights can delete an entire file. But distributed ledger technologies have strict rules about who can edit a file and how. For example, you can’t delete records after they have been registered.

2. Smart contracts

Companies leverage smart contracts to conduct commercial transactions independently, without the need for a third-party intermediary. Smart contracts are software programs on the blockchain that execute automatically when specific conditions are met. Transactions are added to the ledger only if they comply with the verification criteria. For instance, a logistics firm might utilize a smart contract that automatically triggers payment once the goods have been received at the designated port.

3. Public key cryptography

This is a security mechanism that enables the identification of participants in a blockchain network. The system generates two distinct keys for each user of the network. One key is public and shared by all network members, while the other is a unique private key. The private and public keys are used in combination to access data stored in the ledger.

How it works:

Here’s a brief overview of how the blockchain works. Blockchain software automates most of the workflow.

1. Recording transactions

A blockchain transaction refers to the transfer of physical or digital assets from one party to another in a blockchain network. This transfer is recorded as a block of data and may contain various pieces of information, such as the parties involved, the details of the transaction, the timing and location of the transaction, the rationale behind the transfer, the number of assets involved, and the preconditions met during the deal.

2. Reaching consensus

For a recorded transaction in a distributed blockchain network to be deemed valid, it must receive confirmation from the majority of network participants. While the rules of the agreement may vary based on the type of network, they are typically established at the outset of the process.

3. Bundle of blocks

Once participants in a blockchain network have reached a consensus, the transactions are written into blocks, which serve as ledger pages. These blocks include a cryptographic hash that acts as a link between them, forming a chain. Any intentional or accidental changes made to a block will alter the hash value, thereby alerting the network of data forgery. The blocks and their corresponding chains are securely linked, making them immutable. The verification of each additional block strengthens the validation of the previous blocks and, as a result, the entire blockchain.

4. Shared access to ledgers

The system distributes the latest copy of the ledger to all participants.

Types of blockchain networks:

There are four main types of decentralized or distributed networks in the blockchain.

1. Public blockchain

Public blockchains are open to anyone who wants to join, without the need for any permission. All participants on the network have equal access to read, edit, and verify information on the blockchain. Some of the most popular cryptocurrencies like Bitcoin, Ethereum, and Litecoin operate primarily on public blockchains.

2. Private blockchain

Private blockchains, also referred to as managed blockchains, are under the control of a single entity. The authorized entity determines the network’s participants and the level of access each participant has. Unlike public blockchains, private blockchains are only partly decentralized due to access restrictions.

3. Hybrid blockchain

A hybrid blockchain is a combination of private and public networks, offering the benefits of both. By implementing both private and public permission systems, companies can manage access to specific data on the blockchain while still allowing public access to other information. Smart contracts are employed to enable public participants to verify the occurrence of private transactions. For instance, hybrid blockchains allow for public access to digital currency while keeping banking currency private.

4. Consortium blockchain

A consortium blockchain is managed by a group of organizations that share responsibility for the proper functioning of the blockchain and the definition of data access rights. Such consortia are popular among like-minded companies that can benefit from shared responsibility.

Advantages of blockchain technology:

Here are some benefits of blockchain technology in managing transactions:

— Assets on the blockchain can be diverse, including but not limited to shares, digital tokens, real estate rights, gold, or books.

— Transactions are almost instantaneous, but their confirmation time is determined by the consensus algorithm of a particular blockchain network.

— Transactions are confidential and anonymous: buyers indicate only the number of their crypto wallets.

— Transaction fees are minimal as they are paid to miners who register transactions instead of centralized intermediaries. Fees are their reward for supporting the operation of the blockchain network.

— Buyers’ rights are protected, and once a transaction is concluded, it can’t be canceled or altered. All transactions are securely recorded in the blockchain.

— Information is securely stored as the history of all operations is recorded and distributed among all network participants, with each block containing information about previous operations.