Cryptocurrency might be the biggest financial story of 2021 — and the most misunderstood. While cryptocurrencies such as Bitcoin, Ethereum and Dogecoin continue to grab headlines — largely because of their volatility — chances are most people don’t understand the underlying technology.
That technology, called blockchain, has spurred billions of dollars in private investment. It’s also been referred to as the most transformative technology since the internet, yet it remains a mystery to a large swath of the population.
Keep reading to learn more about blockchain, how it works, and some of its strengths and weaknesses.
What Is Blockchain Technology?
One way to think of blockchain is as a permanent, shared record book in digital form. It is essentially a decentralized ledger of transactions conducted over peer-to-peer networks. The ledger tracks transactions and also aims to build a consensus about whether the transaction data is valid. With blockchain technology, users can confirm transactions without requiring a central clearing authority, which is how most financial transactions work.
Traditional databases have one master transaction log, but also require constant updates by trusted parties to prevent duplication and forgery, which takes both time and staff. The idea behind blockchain is to improve business processes that occur between companies but without the expensive and time-consuming “cost of trust.” The ultimate aim is often much higher returns on every dollar invested than from traditional internal investments.
Why Is Blockchain Important?
Information is the lifeblood of business, but it is only useful if it’s speedy and accurate. Blockchain aims to deliver stored information immediately and transparently on a ledger that can only be accessed by network members. Members share a single view of orders, payments, accounts and other information, which helps build trust, efficiency and financial opportunities.
Blockchain eliminates the need for central recordkeeping, and because the ledger is made public, everyone involved can easily gain access. This transparency helps accelerate the verification process, reduce the need for back-office functions, and promote security.
How Does Blockchain Work?
One key element of blockchain is that every transaction requires a security measure to protect the identities of transacting parties. To secure transactions of Bitcoin and other cryptocurrencies, two keys are required — a private and a public key.
The public key is shared permanently in the log. It can be used to sign and encrypt a message. The private key is only known to users and acts as a pin code. A recipient uses this key to decrypt a transaction.
The combination of these two keys creates a digital signature. When you use your public key, a person can send you bitcoin. The currency is then locked in a digital safe, called a block, which can only be unlocked by the private key.
When you add up all these digital blocks chronologically — and all of the corresponding transactions — it builds what is known as the blockchain. This also ensures that anyone using the blockchain can verify a transaction record across a peer-to-peer network rather than just a central authority.
Benefits of Blockchain
Although blockchain technology might be hard to grasp for novices, its benefits will ring familiar to just about anyone who handles assets. Here’s a quick look at some of the advantages blockchain technology brings to the table.
A major reason cryptocurrency and blockchain exist in the first place is to address certain inefficiencies in the current banking system. For example, when you transfer money overseas with traditional banking, you might face significant delays due to the verification process. This isn’t a problem with blockchain, which is designed to provide an immediate response.
Similarly, banks must process cross-border payments, and so the bank — as the clearing mechanism — will take a cut of the transferred money. Blockchain technology enables payment processing without requiring a traditional middleman, which can reduce the associated processing costs.
Another key benefit of blockchain technology is the enhanced security it offers. Because counterparties no longer require third-party processing, users are less likely to be exposed to data security and privacy concerns. Blockchain is not-hack proof, but its decentralized nature ensures that no single entity can get control of the cryptocurrency and its corresponding blockchain.
Drawbacks of Blockchain
Perhaps the biggest drawback of blockchain is its impact on the environment. Blockchain technology depends on encryption to provide its security as well as to reach consensus over a distributed network. This requires complex algorithms, which in turn require massive amounts of computing power. An analysis by Cambridge University estimates that Bitcoin alone uses more electricity every year than the entire country of Argentina.
Another drawback of blockchain technology, at least for now, is its lack of regulation. This is mainly a problem with Bitcoin and other value-based blockchain networks.
Good To Know
In the United States, for example, cryptocurrency doesn’t fall into any neat financial category that would put it under the umbrella of a specific authority such as the U.S. Securities and Exchange Commission, Federal Reserve, Federal Deposit Insurance Corporation or Commodity Futures Trading Commission. Because of blockchain’s lack of regulatory oversight, scams and market manipulation are not uncommon.
What’s Ahead For Blockchain Technology?
Blockchain technology doesn’t have to be restricted to the financial world. It can be applied to any multi-step transaction that requires visibility and traceability. In this respect, blockchain can be leveraged in other areas, such as supply chain, to help manage contracts and audit products. It could also be leveraged for titles and deed management.
Meg Alderman, a manager at Deloitte and Certified Supply Chain Professional, said on the company’s website that “the exponential and disruptive growth of Blockchain will come from the convergence of public and private blockchains to an ecosystem where firms, customers and suppliers can collaborate in a secure, auditable and virtual way.”
Garrett Baldwin contributed to the reporting for this article.