S 4 - Block chain – Distributed

Ledger Technology

B B Chakrabarti
Professor of Finance
 How does a Blockchain work?
• https://www.youtube.com/watch?v=SSo_EIwHSd4
• How does a blockchain work - Simply Explained – 5 min. 59
sec.

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 What Is a Blockchain?
• Shared, trusted, public ledger of transactions, that everyone can
inspect but which no single user controls. It is a cryptographed,
secure, tamper-resistant distributed database. It solves a complex
mathematical problem to exist. A blockchain is a perfect place to
store value, identities, agreements, property rights, credentials,
etc. Once you put something like a Bitcoin into it, it will stay there
forever. It is decentralized, disintermediated, cheap and
censorship-resistant.
• A blockchain is digitally recorded data in packages called blocks.
Each block contained a timestamp and a link to the previous
block. The records are saved by each node in the network, which
is owned, maintained and updated by each node. It is a peer-to-
peer system. No central authority manages the transaction flow.
• Blockchain was first used in 2009 as the underlying technology for
Bitcoin.
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Blockchain Technology
 How Blockchain Works?
• An essential feature of blockchain is its ability to encrypt
each "block" of data for a unique hash output that is also
stamped onto the succeeding block, creating a chain of
sequential information which is then verified through a
consensus of activity across a network of participants.
This works in conjunction with digital signatures to prove
identity, authenticity, and enforce data access rights.
• Sharing those encrypted "spreadsheets" to every node or
validator on the network creates a distributed system
where each device can access the transaction data and
make additions to the distributed ledger, which is then
shared with everyone in real time acting as a form of data
security/redundancy.
 How Blockchain Works?
• The process of encrypting blocks is best recognized
as "mining" in cryptocurrency, which uses blockchain
as a proof of work mechanism whereby people can
participate in the network by performing "work"
(your spare computing resources are used to encrypt
and validate blocks).
• Should a machine on the network attempt to alter an
old block, the new data would result in a different
hash for that block, breaking the chain of
successively shared encryption outputs. The rest of
the network participants would recognize this and
reject the corrupt node.
How to Add a Block?
 History of Blockchain
• Consider what’s happened in just the past 12 years:
• The first major blockchain innovation was Bitcoin, a digital
currency experiment. The market cap of Bitcoin is $861 billion
(Jan 24), and is used by millions of people for payments,
including a large and growing remittances market.
• The second innovation was called blockchain, which was
essentially the realization that the underlying technology that
operated bitcoin could be separated from the currency and
used for all kinds of other interorganizational cooperation.
Almost every major financial institution in the world is doing
blockchain research at the moment.
 History of Blockchain
• The third innovation was called the “smart contract,”
embodied in a second-generation blockchain system called
Ethereum, which built little computer programs directly into
blockchain that allowed financial instruments, like loans or
bonds, to be represented, rather than only the cash-like
tokens of the bitcoin. The Ethereum smart contract platform
now has a market cap of around $270 billion (Jan 24)
with hundreds of projects headed toward the market.
• The fourth major innovation, the current cutting edge of
blockchain thinking, is called “proof of stake.” Current
generation blockchains are secured by “proof of work,” in
which the group with the largest total computing power
makes the decisions. These groups are called “miners” and
operate vast data centers to provide this security, in exchange
for cryptocurrency payments.
 History of Blockchain
• The new systems do away with these data centers, replacing
them with complex financial instruments, for a similar or even
higher degree of security.
• Proof of stake is a consensus algorithm that requires miners
stake all or a portion of their coins in order to validate
transactions. Miners are chosen to verify a block randomly
but those who have a larger stake or have been staking longer
have an advantage. The miners chosen must all agree in order
to verify transactions. After they have verified a block, it is
added to the chain and they receive a fee in the form of
cryptos. If they don’t verify it properly, their own stake will be
affected and they will lose some or all of their coins. This
provides more security to the process since there is no
incentive to cheat or steal coins.
 History of Blockchain
• The main upside of proof of work is that it is trusted and has a
long track record while the main upside of proof of stake is
that it requires less energy, is more secure, and is scalable.
• The fifth major innovation on the horizon is called blockchain
scaling. Right now, in the blockchain world, every computer in
the network processes every transaction. This is slow. A scaled
blockchain accelerates the process, without sacrificing
security, by figuring out how many computers are necessary
to validate each transaction and dividing up the work
efficiently. To manage this without compromising the security
and robustness of blockchain is a difficult problem, but not an
intractable one. A scaled blockchain is expected to be fast
enough to power the internet of things and go head-to-head
with the major payment middlemen (VISA and SWIFT) of the
banking world.
 History of Blockchain
• This innovation landscape represents just 12 years of work by
an elite group of computer scientists, cryptographers, and
mathematicians. As the full potential of these breakthroughs
hits society, things are sure to get a little weird.
• These changes, and others, represent a pervasive lowering of
transaction costs. When transaction costs drop past invisible
thresholds, there will be sudden, dramatic, hard-to-predict
aggregations and disaggregations of existing business models.
For example, auctions used to be narrow and local, rather
than universal and global, as they are now on sites like eBay.
As the costs of reaching people dropped, there was a sudden
change in the system. Blockchain is reasonably expected to
trigger as many of these cascades as e-commerce has done
since it was invented, in the late 1990s.
 History of Blockchain
• Predicting what direction it will take is hard. Did anybody see
social media coming? Predictors usually overestimate how
fast things will happen and underestimate the long-term
impacts. But the sense of scale inside the blockchain industry
is that the changes coming will be “as large as the original
invention of the internet,” and this may not be overstated.
• What we can predict is that as blockchain matures and more
people catch on to this new mode of collaboration, it will
extend into everything from supply chains to financial services
to land records to voting systems and many others.
• And given how far blockchain has come in 12 years, perhaps
the future could indeed arrive sooner than any of us think.
 Immutable Blockchain?
• What makes blockchains “secure” in principle.
• Bitcoin is a good example. In Bitcoin’s blockchain, the shared
data is the history of every Bitcoin transaction ever made: an
accounting ledger. The ledger is stored in multiple copies on a
network of computers, called “nodes.” Bitcoin network has
more than 15,788 nodes and 435 GB size (Jan 2024).
• Each time someone submits a transaction to the ledger, the
nodes check to make sure the transaction is valid—that
whoever spent a Bitcoin had a Bitcoin to spend. A subset of
them compete to package valid transactions into “blocks” and
add them to a chain of previous ones.
• The owners of these nodes are called miners. Miners who
successfully add new blocks to the chain earn Bitcoins as a
reward.
 Immutable Blockchain?
• What makes this system theoretically tamperproof is two
things: a cryptographic fingerprint unique to each block, and
a “consensus protocol,” the process by which the nodes in the
network agree on a shared history.
• The fingerprint, called a hash, takes a lot of computing time
and energy to generate initially. It thus serves as proof that
the miner who added the block to the blockchain did the
computational work to earn a Bitcoin reward (for this reason,
Bitcoin is said to use a “proof-of-work” protocol). It also serves
as a kind of seal, since altering the block would require
generating a new hash. Verifying whether or not the hash
matches its block, however, is easy, and once the nodes have
done so they update their respective copies of the blockchain
with the new block. This is the consensus protocol.
 Immutable Blockchain?
• The final security element is that the hashes also serve as the
links in the blockchain: each block includes the previous
block’s unique hash. So if you want to change an entry in the
ledger retroactively, you have to calculate a new hash not only
for the block it’s in but also for every subsequent block. And
you have to do this faster than the other nodes can add new
blocks to the chain.
• So unless you have computers that are more powerful than
the rest of the nodes combined (and even then, success isn’t
guaranteed), any blocks you add will conflict with existing
ones, and the other nodes will automatically reject your
alterations. This is what makes the blockchain tamperproof, or
“immutable.”
 Immutable Blockchain?
• Nonetheless, it's important to remember that each node is
running on a computer system owned and controlled by a
particular person or organization, so the blockchain cannot
force it to do anything.
• The purpose of the chain is to help honest nodes to stay in
sync, but if enough of its participants choose to change the
rules, no earthly power can stop them. That's why a particular
blockchain is not truly and absolutely immutable.
 Immutable Blockchain?
• 51% attack
• 51% attack refers to an attack on a blockchain –
usually Bitcoin's, for which such an attack is still hypothetical –
by a group of miners controlling more than 50% of the
network's mining hashrate, or computing power. The attackers
would be able to prevent new transactions from gaining
confirmations, allowing them to halt payments between some
or all users. They would also be able to reverse transactions
that were completed while they were in control of the
network, meaning they could double-spend coins.
 Blockchain Scalability
• The supported frequency of transactions on a blockchain have
been an ongoing limitation compared to traditional financial
networks, which can support tens of thousands of
transactions per second versus single digits for most
blockchain-based infrastructure.
• Startups including Billion and Zilliqa have introduced
developments such as sharding (splitting the network into
smaller pieces) to increase that throughput, but much of the
issue surrounding scalability currently boils down to a
compromise between performance and security.
BCT – Benefits and Unknowns
BCT - Applications
 Blockchain Terminology
• Consensus protocol - A blockchain is a decentralized peer-to-
peer system with no central authority figure. While this creates a
system that is devoid of corruption from a single source, it still
creates a major problem : How are any decisions made?
• Consensus is a dynamic way of reaching agreement in a group.
Blockchains use Proof-of-Work mechanism for this purpose.
• Proof-of-Work protocol in a blockchain:
• The miners solve cryptographic puzzles to “mine” a block in
order to add to the blockchain.
• This process requires immense amount of energy and
computational usage. Bitcoin network consumes 91TWhrs
annually.
• The puzzles have been designed in a way which makes it hard
and taxing on the system. When a miner solves the puzzle, he
presents his block to the network.
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 Blockchain Terminology
• Genesis Block - The very first block in the blockchain.
• Node - A computer on a blockchain network.
• SHA (Secure Hash Algorithm) is a family of cryptographic hash
functions published by the National Institute of Standards and
Technology (NIST) as a U.S. Federal Information Processing
Standard (FIPS). SHA256 is an algorithm used in Bitcoin that
takes an input of any size which can be any form of data(text,
jpeg, pdf, etc.), mixes it up and creates a fixed size output(a
hash) which is 256-bit (32-byte, 64 characters) long .
• You can think of the hash as the fingerprint of the data.
Hashes are one-way functions – they cannot be decrypted
back. One will need sqrt(2^256) or 2^128 trials to decrypt
with 50% probability.

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 Blockchain Terminology
• Smart contract - Smart contracts help you exchange money,
property, shares, or anything of value in a transparent,
conflict-free way while avoiding the services of a middleman.
• In 1994, Nick Szabo, a legal scholar, and cryptographer,
realized that the decentralized ledger could be used for smart
contracts, otherwise called self-executing contracts,
blockchain contracts, or digital contracts. In this format,
contracts could be converted to computer code, stored and
replicated on the system and supervised by the network of
computers that run the blockchain.
• Ex: Suppose you rent an apartment from me. You can do this
through the blockchain by paying in cryptocurrency. You get a
receipt which is held in our virtual contract; I give you the
digital entry key which comes to you by a specified date.
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 Limitations of Blockchain Tech. / DLS

• Limited Scalability: Blockchains have consensus mechanisms which

require every participating node to verify transaction. This limits the
total number of transactions a blockchain network can process.
Currently Bitcoin can process 7 TPS at maximum. Ethereum 27 TPS.
• Privacy: In case of public blockchains, transactions on blockchains might
appear private since it is not directly tied to your identity. But since they
are recorded on public ledger, transactional patterns can be observed
and it is possible to link your identity to the address.
• Storage Constraints: Storing information on a blockchain database
means that the data is: a) Stored by every full node in the network.
b) Stored indefinitely since the blockchain database is append-only and
immutable.
• Therefore, data storage imposes a huge cost on a decentralized network
where every full node has to store more and more data into infinity. As
a result, storage remains a huge hurdle for any realistic application that
gets built on the blockchain. For reference, size of Bitcoin and Ethereum
blockchains are 435 GB and 1000 GB respectively (Jan 24).
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 Limitations of Blockchain Tech. / DLS
• Access to external data: Blockchain services cannot inherently make
arbitrary network requests to access data outside the network. Suppose if
blockchain service retrieves some information from an external source,
this retrieval is then to be performed repeatedly and separately by each
node. But because this source is outside of the blockchain, there is no
guarantee that every node will receive the same answer. Perhaps the
source will change its response in the time between requests from
different nodes, or perhaps it will become temporarily unavailable. Either
way, the consensus is broken and the entire blockchain dies. Therefore
blockchain interactions are limited to on chain data.
• Unavoidable security flaws: There is one notable security flaw in Bitcoin
and other Blockchains: if more than half of the computers working as
nodes to service the network tell a lie, the lie will become the truth. This is
called a '51% attack' and was highlighted by Satoshi Nakamoto when he
launched Bitcoin. For this reason, Bitcoin mining pools are monitored
closely by the community, ensuring no one unknowingly gains such
network influence.
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 Limitations of Blockchain Tech. / DLS
• Unsustainable consensus mechanisms: Blockchain have known
issues with consensus protocols like proof-of-work schemes. In
POW consensus protocol, miners carry out computationally
expensive calculations. However POW isn’t perfect. Only 1 block
gets mined each second in BitCoin blockchain. This means that
the rest of the computational power spent on creating a new
block has no value. According to Digiconomist’s
Bitcoin Energy Consumption Index, Bitcoin’s current estimated
annual electricity consumption stands at 91TWhr. Roughly Bitcoin
mining is now using more electricity than 159 individual countries.
• All of the above represents challenges for the success of
Blockchain technology. Nevertheless consistent efforts are being
made out by developers to knock the problems out of the
blockchain space.

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 Public, Private and Consortium Blockchains
• Public blockchains
• A public blockchain has absolutely no access restrictions. Anyone
with an internet connection can send transactions to it as well as
become a validator (i.e., participate in the execution of
a consensus protocol. Usually, such networks offer economic
incentives for those who secure them and utilize some type of
a Proof of Stake or Proof of Work algorithm.
• Some of the largest, most known public blockchains are Bitcoin
and Ethereum.
• Private blockchains
• A private blockchain is permissioned.One cannot join it unless
invited by the network administrators. Participant and validator
access is restricted.
 Public, Private and Consortium Blockchains
• This type of blockchains can be considered a middle-ground for
companies that are interested in the blockchain technology in
general but are not comfortable with a level of control offered
by public networks. Typically, they seek to incorporate
blockchain into their accounting and record-keeping procedures
without sacrificing autonomy and running the risk of exposing
sensitive data to the public internet.
• Consortium blockchains
• A consortium blockchain is often said to be semi-decentralized.
It, too, is permissioned but instead of a single organization
controlling it, a number of companies might each operate
a node on such a network. The administrators of a consortium
chain restrict users' reading rights as they see fit and only allow a
limited set of trusted nodes to execute a consensus protocol.