How Does Blockchain Work? – Transactions Without An Intermediary


The global blockchain market is growing fast: it is predicted to be worth US$20 billion by 2024 compared to US$ 315.9 million in 2015 but just what is it and how does it work? Here René Bader, Manager of Critical Business Applications & Big Data and Thorsten Deckers, Senior IT Security Consultant at NTT Security provide some explanation.

Blockchain enables transactions in a peer-to-peer network to be validated without the need for an intermediary, thus ensuring traceability and transparency. One of the driving forces of this technology is the “cryptocurrency” Bitcoin. However, beyond this, there are numerous application possibilities for blockchain technology as we will explain later.

Let’s take Bitcoin as an example, Bitcoin is a system that allows value transfers between unknown parties without a financial service provider as a central agent. The technical challenge is to secure the transactions seamlessly, verifiably and transparently and this is achieved using the peer-to-peer architecture of the blockchain technology which is described in more detail below.

The blockchain acts as a public ledger for Bitcoin or all network participants, and while it is not an absolute account it does record all transactions that have ever been executed and validated which can be used to calculate the current account balance. Although the information on the transactions is public, the addresses of the transactions only show as anonymous codes, so the parties involved are also anonymous.

Decentralised database

While traditional payment systems such as banks are typically responsible for checking incoming and outgoing transactions, controlling the account balance and storing them centrally in their systems, the Bitcoin approach is different and documents transactions solely in the blockchain. It is known as a decentralised database because the information on the transactions is distributed and stored completely on all computers that are participating in Bitcoin. Therefore the complete blockchain is owned by no one and thus is public. Currently the blockchain of the Bitcoin network is around 80 gigabytes in size and it is constantly growing with the formation of new blocks.

The transactions for the blockchain are collected and stored in consecutive blocks about every ten minutes – hence the name “blockchain”. A typical block has a maximum size of 1 megabyte and contains several hundred transactions. Each new block is joined to the previous block in chronological order and thus builds a new chain link in the blockchain. Over the course of time the blocks form a chain which continues to expand; the very first block is aptly called the genesis block.

In addition to a time stamp and the actual transaction data, a block also contains two hash values based on the cryptographic hash function SHA-256:

  • a hash value over all the transactions collected in the new block,
  • the hash value of the previous block.

Key in the chain

Before a block is formed and integrated into the blockchain, private and public keys must be created; these are generated by the wallet software as a key pair on the client computer, which is a participant of the Bitcoin network and based on asymmetric encryption. The public key is used to create a 34-character string, visible to everyone, which then acts as a Bitcoin destination address for the further transactions. This is important for the anonymity of the transaction as it is not possible to return the address to the public key.

The private key is used to sign a transaction without which this transaction would be deemed invalid. With the help of the public key attached to the transaction, it shows that the sender of a transaction is in possession of the appropriate private key and is thus actually the originator. The signed transaction is distributed to all nodes in the Bitcoin network after sending and confirmed as “shipped” as soon as a certain number of nodes confirm the receipt.

In the next phase of the processing of a transaction, its validity is checked before blocking, which prevents tampering with the transaction and ensures that the amount is credited to the recipient and debited from the sender. Otherwise an amount could be sent several times or Bitcoins could be output which are not present at all.

Validation by Mining

In blockchain technology there is no central instance for the validation of the transactions. To make a consensus, there is the “Miner” in the Bitcoin blockchain which are computers or pools of computers that provide their computing capacity to the system for the validation of transactions and the formation of the blocks.

To qualify for the task of mining, the “proof-of-work” process is used, in which miners prove their trustworthiness through their work. For this purpose, the miners must solve a computer-intensive cryptographic task – the creation of the hash value – which can only be processed by trial and error. Due to the difficulty of the tasks, the frequency of the block formation is controlled and held for about ten minutes. The calculation effort is to ensure that subsequent modifications of the block chain are excluded; this also means that the blockchain cannot be scaled at will.

Mining is necessarily a complex procedure and consumes considerable resource. By way of motivation miners receive a certain number of Bitcoins as a “reward” when the cryptographic task has been solved. Conversely the computation attempts of the slower miners, which processed the same transaction at the same time, are thus automatically invalid and are cancelled. Once a miner has built a valid block, he sends it to the network where each participant can control the block’s validity and attach the block to the local copy of the blockchain. In this way, the miner validates block-by-block the blockchain, which is deemed trustworthy in the peer-to-peer architecture without a central control instance. Thus, the transaction is ready and irrevocably documented for all blockchain participants.

Mining is the validation and the “money creation” in the Bitcoin system. Originally, 50 Bitcoins could be recreated per block but this figure has now been halved to every 210,000 blocks meaning it is now only 12.5 Bitcoins per block. The maximum number of Bitcoins that can ever be generated is consequently limited to 21 million. If the limit is reached, which will happen in around 2140, no new hashes can be generated and thus no new Bitcoins can be generated.

Bitcoin is probably the most widely known application area of blockchain technology because it ensures secure traceability and transparency without the involvement of a central authority but there are many other areas that the same fundamental requirements in which blockchain could be used as a key technology including:

  • Banks

Blockchain is currently under careful consideration for adoption in the banking sector where it could be used for billing and transferring assets by documenting transactions without the need for validation from a central office which will reduce costs and speed up processes.

  • Smart Contracts

The more complex contracts can be processed using blockchain technology. For example, it’s possible to map the conditions of a contract in the form of an executable program code ensuring automated compliance with the contract determining which condition leads to which decision. Ownership transfers or leasing can be carried out faster and can be carried out without value. As soon as the buyer or tenant has paid the price for the contract to the seller or landlord, it is transferred to him or access is given to the digital key.

  • Insurance (similar to smart contracts)

It’s possible to dynamically adapt insurance conditions in the blockchain based on the habits of the policyholder and to adjust the premium payment accordingly; For example, in motor insurance this could be depending on the driving performance.

  • Music industry

In the music industry, many artists want direct responsibility for their music sales, music rights and the conditions of use. For this purpose, blockchain offers the ideal solution as it can directly linking the use and payment to algorithms embedded in a blockchain.

  • Dialling systems

For digital voting systems, blockchain can ensure the anonymity of the voter as well as protection against tampering.

  • Registering patents

Patents for the relevant administrative offices along with the documents for proof of intellectual property could be filed de-centrally, permanently and without the need for an intermediary in the blockchain. Certificates guaranteed by mathematical encryption would regulate the possession, existence, and integrity of these documents on a global scale.

To recap blockchain is a technology which acts as a ‘trust machine’ for validating the exchange of information without a validation instance. Application examples including Bitcoin itself, show that the solution of the task is not just about the technology but that it has legal and economic implications too and in some cases may need the involvement of third party such as a patent lawyer. Examples such as the conclusion of a blockchain are therefore misleading, since the corresponding administrative act is not exhausted in the secure registration.

Blockchain is a new and innovative technology for which many questions, such as the inheritance of keys in the event of death, remain unanswered, and many of the answers currently available will not be final. However, the fact that it enables traceability and transparency for any transactions is an important first step and means that it could be used in numerous innovative scenarios.