This article is a part of EqualOcean's 'Blockchain, China's Story' report. Read more about it or download the sample and check out the contents.

In a narrow sense, blockchain is a special version of Distributed Ledger Technology (DLT) that combines blocks – which contains time-stamped data – in chronological order, and employs encryption algorithms to help ensure that they are unchangeable and unforgeable. Data is recorded and stored by all nodes in the system.

Simply put, blockchain facilitates a trusted network that enables multiple parties to exchange data, information and assets directly without the need for a third party (i.e., disintermediation).

The fundamental pillars of blockchain

Blockchain is more or less a combination of existing technologies, leveraging encryption, consensus and distributed mechanisms to achieve immutability, decentralization and transparency.

Encryption – Immutability

Blockchain uses asymmetric encryption to record the data in the blocks securely and to ensure the data are immutable in the transmission process.

Under this mechanism, different keys are employed in the encryption and decryption process, namely public keys and private keys. In a blockchain network, each node has its unique pair of public and private keys.

Simply put, the public key is like a bank account number that can be issued to anyone who requests it, while the private key is like its pin code that can only be kept by a single party and cannot be leaked. Information encrypted by the public key can only be decrypted by the corresponding private key and vice versa.

The private key is in the form of numbers or strings, and the public key is represented by two coordinates and is mathematically linked to the private key through certain algorithms. Typical asymmetric encryption algorithms in blockchain are RSA (Rivest–Shamir–Adleman) and ECC (Elliptic-Curve Cryptography), while some Chinese companies also use domestically developed algorithms to support anti-systemic risk control.

Compared with the symmetric encryption algorithm, the asymmetric method has a considerably higher security level but tends to be less efficient in terms of the encryption and decryption process.

A central application of asymmetric encryption in the blockchain is digital signatures. Simply put, it has two functions: 1. To prove that the message is indeed signed and sent by the sender; 2. To examine the completeness of the message.

The process for the sender to generate the signature and distribute the message to the receiver involves two steps: First, encrypt the abstract – which extracts from the original message through a hash function – with the private key of the sender. Then, it will be encrypted with the public key of the receiver in together with the original text, and sent to the receiver.

On the other hand, the process for the receiver to verify the message, in a nutshell, is to compare the two abstracts – one is decrypted from the sender's digital signature, the other is obtained from the plaintext by going through the hash function. If the two are consistent with each other, then it implies that the message received is a complete one and has not been tampered with during transmission.

Distributed – Transparency

Every participant in a blockchain network who runs a full node keeps a complete copy of the unique ledger, i.e., a full copy of all the transaction history on the blockchain, and updates with new transactions as they occur.

Compared to the traditional double-entry bookkeeping system, where each participant only maintains the accounts related to themselves, the distributed mechanism tends to have three main advantages:

1. Controls costs and improves efficiency by saving heavy labor costs in reconciliation and liquidation;

2. Higher fault tolerance and lower risk of crashes – as each full node maintains a complete copy of the ledger, even if some of the nodes report error or under attack, it will not affect the regular operation of the entire network;

3. Data and information are transparent and traceable among the blockchain participants – all parts of the ledger can be reviewed by any participants.

Consensus – Decentralization

Consensus protocols – which determine the rules and mechanisms that blockchain networks operate – are among the most central elements of blockchain technology.

It shapes the structure of business relationships in the distributed network; and makes it capable of removing the need for governance by a central authority. This is key to supporting a decentralized environment.

It is worth noting that centralization and decentralization do not constitute a binary system; in fact, different consensus provides different levels of decentralization. Along with other technologies like authority management, parties on a particular blockchain network can work under the level of decentralization that best suits their case.

Currently, typical consensus structures in blockchain networks include Proof of Work (POW), Proof of Stake (POS), Delegated Proof of Stake (DPOS – which are commonly applied in public blockchains – and practical Byzantine Fault Tolerance (pBFT), which is mainly used by permission blockchains.

Mainstream public blockchain consensus protocols

1. POW (Proof of Work)

Computing power determines who has the right to write the next block. It has some characteristics of socialism – an equal playing field in which the nodes must collaborate constantly to confirm the network structure.

Main advantages: 1. The mechanism itself proposes a relatively fair approach to distributing the right to write blocks, making it easy to incentivize more nodes to engage; 2. Relatively safe; destroying the system requires huge investments in hardware.

Main disadvantages: 1. The calculation process of the hash function reduces the transaction efficiency of the system; 2. The gradual centralization of computing power reduces the engagement incentive of individual users, which also increases the risk of 51% attacks to happen; 3. Massive waste in computing power and electricity.

Typical application: Bitcoin

2. POS (Proof of Stake)

Stakes (the number of coins) and seniority (the number of days the coins have been held) determine who has the right to write the next block. It shows some similarities to a ‘shareholding system.’

Main advantages – it solves the cons of POW: 1. The motivation of miners and coin owners tends to be more consistent; 2. Lower delay and shorter confirmation speed; 3. No waste of resources.

Main disadvantages – but at the costs of giving up the pros of POW: 1. Low voting costs cause security issues, for example, Nothing at Stake Attacks (the issue might be solved by imposing certain additional conditions on top of the traditional POS algorithms though); 2. The reusable and transferable nature of voting rights causes long-range attacks, which also downgrades the security level of the system.

Typical application: Ethereum

3. Delegated Proof of Stake (DPOS)

The right to write the next block is determined through an election, where the number of coins acts as the votes. It works akin to a ‘parliamentary democracy.’

Main advantage: There are many fewer bookkeeping nodes in the system compared to POW and POS – for example, EOS runs on only 21 nodes that check and validate new transactions – this significantly elevates the speed and scalability of the system.

Main disadvantage: 1. As there are fewer people are in charge of keeping the operation of the network, it is exposed to security risks; 2. It is rather easy for the delegates to form cartels, and at the same time, it is hard to detect whether different delegates are actually controlled by different individuals or entities, which largely restricts the resilience of the network.

Typical application: EOS

Mainstream permission blockchain protocol – pBFT (practical Byzantine Fault Tolerance)

pBFT is a consensus algorithm that was designed to work efficiently in asynchronous systems and to reach consensus even when some of the nodes in the network fail to respond or respond with incorrect information.

If there are 3m+1 correctly working processors, a consensus can be reached if at most ‘m’ processors are faulty, i.e., to keep a normal operation of the network, more than two-thirds of the total number of processors should be honest.

Although pBFT, which improved on BFT, greatly improved processing speed and scalability, it has put forward strict requirements on the number and quality of the nodes. Therefore, the qualified nodes in a network tend to be very limited under pBFT, and in fact, to keep the processing speed of the entire network, the number of nodes is required to be controlled within a small range. In this case, we see that pBFT is more commonly employed in permission blockchains – like Hyperledger – where parties seek strong consistency.

The development path of blockchain technology

The development of blockchain technology has been through three stages. Throughout the decade, we have seen that blockchain emerged as a supporting technology for cryptocurrencies; it was discovered by industry actors to have the potential to become a core element in enhancing IT infrastructure, and so they worked on ‘decoupling’ it from the token bubble to attract attention in the financial sector; it started to be adopted in the pilot projects in various of real-world business scenarios and moved towards platformization.