HomepageBitesize CoursesDistributed Ledgers5 Principles to Know

5 Principles to Know

7 mins

Traditionally, transactions depend upon a certain level of trust that the agreement in question can, and will, be performed. Typically, this trust is achieved by relying on a centralised intermediary such as a bank (to execute payment instructions and maintain accurate records) or an official registry (to confirm ownership of title). One problem with this model is that it introduces a single point of failure (e.g. through negligence or fraud) and can be costly, inefficient and exclusionary.

Permissionless blockchains (Principle 2) address the challenges of a centralised trust model by enabling parties to rely on (or trust in) the rules of the system itself, rather than on a third party. It does this by creating an append-only ledger that is highly resistant to fraud. Instead of a single database, which can be tampered with, multiple (but synchronised) copies of the ledger are distributed across the whole network, making manipulation extremely difficult and highly visible.

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In addition, the way in which data is added to the ledger also generates system-level trust. Before data is added (as part of a data block), it must be verified by the network in accordance with a pre-determined consensus mechanism (see Principle 4). If verified, the new block is then cryptographically linked to the block before it (see Principle 5). Combined, this verification and linking of blocks, renders the blockchain practically immutable, enabling participants to trust in the ledger data.

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Blockchain technology encompasses a wide range of options in terms of design, particularly when looking at the ability of people to join or view the network. Whilst blockchains are commonly thought to be entirely open (as is the case with the bitcoin blockchain), this is not the only option available. On the contrary, blockchains can be permissioned or permissionless (depending on who can operate the network), and private or public (depending on who can access the network).

On a permissionless (and ordinarily public) ledger, anyone can join and participate in the network. The open nature of public ledgers can raise concerns of confidentiality, especially for regulated industries, as can the pseudonymity of participants (who transact using wallet addresses rather than verifiable identities). However, a public ledger does not mean that data cannot be private or secure (cryptographic techniques such as zero-knowledge proofs can be used to protect certain data).



In permissioned ledgers, nodes must be pre-approved by a network administrator. These ledgers can be public (accessed by anyone) or private (where access is restricted). Permissioned ledgers help to mitigate confidentiality and identity concerns (as the nodes are known to the network), although this comes at a cost of increased centralisation. The often-private nature of these ledgers also reduces the benefit of public scrutiny in identifying, for example, code risks and opportunities.

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Blockchains use public key cryptography to prove ownership and authenticate transactions. Despite its name, public key cryptography uses a pair of keys, one private the other public, to encrypt data and create digital signatures. Whilst the public key is available to anyone, the private key is kept secret by the owner. It is the private key that signifies ownership and must be possessed to transfer the corresponding assets on a blockchain.

Public key cryptography solves the problem of how to authenticate and authorise transactions on a blockchain. Participants authorise a transaction using their private key. The private key is used to create a signature that is inextricably linked with the data being signed (as the signature is an output of both the private key and the data being authorised). This protects transactional integrity as the underlying data cannot be subsequently changed without invalidating the associated signature.

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Once 'signed' anyone holding the public key can verify and validate the signature. However, only a person holding the private key can authorise an asset transfer (regardless of legal ownership). As such, secure custody of private keys is a matter of critical importance, both to prevent fraud (if someone else obtains the key) and to avoid losing the value of the assets associated with the key's wallet address (once the key is lost there is no way to recover the assets).

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Data (including transaction data) is stored on a blockchain in sequential, time-stamped, blocks that are periodically added to the ledger. To be added to the chain, a block must be verified by the network in accordance with a pre-determined consensus mechanism, which both ensures the integrity of the ledger and prevents double-spending from occurring. Whilst various consensus mechanisms exist, two common examples are proof-of-work (POW) and proof-of-stake (POS).

In a POW system, nodes known as miners compete to solve a complex cryptographic challenge, the answer to which is a 'nonce' that is used to generate a target hash. If successful, the miner is rewarded in the ledger's native currency and the relevant block is added to the chain. To reduce the risk of miner fraud the challenge is deliberately difficult to resolve (although easy for the network to verify once solved). In a POS system, rather than solving a cryptographic challenge, miners must demonstrate that they control a certain stake or asset.

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The reliability of these consensus mechanisms faces one important risk. That is, if one miner (or a pool of miners) controls over half of the system’s computing power or relevant assets. In this situation, known as a 51% (or hash) attack, these miners effectively control the consensus mechanism and could verify a fraudulent block. Although not a frequent occurrence, this threshold has been passed several times on permissionless ledgers.

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Each data block in a blockchain is linked to the one preceding it by a cryptographic hash (or digest). The hash is a string of characters of a fixed length that is created by applying a hashing algorithm (SHA-256 in the case of bitcoin) to input data of any length. This cryptographic linking of blocks is a vital characteristic of a blockchain that, combined with the consensus mechanism, creates a reliable and, effectively, tamper-proof (or tamper-evident) record of account.

A hash is (practically) unique to the data that it is created from. Even a minor change to the input data will result in a different hash being produced, meaning it can be thought of as a digital fingerprint for the data it relates to. On a blockchain, a hash is created for each individual block header, with the block's input data including the transactions forming part of that block as well as the hash of the preceding block. As such, any change to this block data will result in a change in the hash.

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By connecting each block in this way, the ledger is practically immutable. If a miner wants to tamper with an earlier transaction, they would have to change not only the transaction data (and therefore hash) of the original block but all that follow it (as the change in the original hash changes the input data of each subsequent block). Whilst technically possible, the complexity of the consensus mechanisms adopted by blockchains effectively prohibits this type of manipulation.

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Terminology

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