Blockchain Explained: A Simple Explanation of How It Works

If you’ve been following new developments in technology or finance over the past couple of years, you might’ve heard the terms “blockchain” and “bitcoin” thrown around. They’re usually described in some pretty confusing, complicated-sounding ways.

But as it turns out, blockchain and bitcoin are technologies that can actually have an impact on you and your small business.

So are you looking for blockchain explained in plain, simple terms? You’ve come to the right place. Here’s the blockchain explainer for small business owners.

Blockchain Explained: What Is Blockchain?

Blockchain is a technology that allows individuals and companies to make instantaneous transactions on a network without any middlemen (like banks). Transactions made on blockchain are completely secure, and, by function of blockchain technology, are kept as a record of what happened. Strong computer codes ensure that no record of a transaction on blockchain can be altered after the fact.

When giving a blockchain explanation, it’s important to note that blockchain is emerging, which means it’s still being tested. Although the financial services industry in particular has embraced blockchain, with 40 or so of their biggest companies trying it out, many different industries stand to benefit from blockchain.

Including small business.

But the point is that, for now, people are still figuring out how exactly they can use blockchain to cut costs and keep quality products and services around. 

Here’s a more in-depth look at what a blockchain looks like.

Blockchain Explained: A Visualization of How It Works

Funnily enough, you can explain a blockchain as literally a chain of blocks. Those blocks represent data, held all together in a specific order.

You can also imagine it as a ledger—because that’s essentially how most blockchains function. Each block of data represents some new transaction on the ledger, whether that means a contract or a sale or whatever else you’d use a ledger for.

A blockchain is a record of transactions.

Using blockchain, companies (or people!) can both make and verify these transactions. That’s actually two very important concepts lumped together, so let’s take a closer look.

Blockchain Allows Companies to Make Transactions

Let’s say that the lemonade stands in a town are all using blockchain technology to process transactions.

Say John buys a lemonade from Sandy’s lemonade stand. On John’s copy of the blockchain, he marks that transaction down: “John bought Lemonade from Sandy, $2.” His copy gets spread around town to all the lemonade stands and lemonade buyers, who add this transaction to their own copies. By the time John has finished drinking that lemonade, everyone’s blockchain ledger shows that he bought his lemonade from Sandy for $2.

Blockchain Allows Companies to Verify Transactions

Let’s go back to the part where John’s blockchain copy was sent around town. In reality, everybody else wasn’t just adding his new block of data…. They were verifying it. If his transaction had said, “John bought Lemonade from Rishi, $500,” then somebody else would have (automatically!) flagged that transaction. Maybe Rishi isn’t an accredited lemonade salesperson in town, or everybody knows that that price is way too high for a single lemonade. Either way, John’s copy of the blockchain ledger isn’t accepted by everyone, because it doesn’t sync up with the rules of their blockchain network.

A lemonade stand is a bit of a simple way to explain blockchain, but it gets the point across: Adding a transaction to a blockchain involves getting it verified. Whatever your “network” is—whether it’s lemonade stands or big banks—everyone will have agreed to rules that determine which transactions are valid and which are not.

In fact, this “democratic” system of security is one of the biggest reasons why so many people are flocking to blockchain right now. No one can change the records, so blockchain is a trustworthy and fair source of information that any one can verify. 

Blockchain Is Instantaneous

Here’s another thing about blockchain—it’s fast.

Transactions on a blockchain get processed and verified much more quickly than the alternative systems. This might seem counterintuitive, because the lemonade example makes it sound like everyone has to copy everything that happens to the chain….

But in actuality, these transactions get processed by computers in milliseconds.

The reason why blockchain is much faster than the alternative is because it’s decentralized, so let’s talk about that to finish off the definition.

Blockchain Is Decentralized

Blockchain operates with no central authority. This is the kicker. Blockchain lets people or companies add and verify their transactions—without a single governing body making sure everything is okay.

Let’s take a straightforward example:

Paying your rent with a check versus with some sort of blockchain-based currency. (Yup, that’s bitcoin—but we’ll get there!)

Three parties are involved when you pay by check. Here’s how it goes down:

1. You write up the recipient of your money, the amount of the check, the date of your payment, and so on.
2. You give the check to your landlord.
3. Your landlord deposits the check in the bank.
4. The bank processes the check, taking a few days to verify that all the information is correct, that you’re good for the money you promised to your landlord, and that the check isn’t counterfeit.
5. Finally, your landlord receives their rent money.

This diagram shows the above process, except with stock transactions instead of rent payments:

Meanwhile, if you’re paying with a blockchain-based currency, the transaction is just between you and your landlord:

1. You pay your landlord.

And … that’s it. Your transaction gets recorded on your blockchain, your landlord’s blockchain verifies the transaction, and everything is set.

Blockchain technology essentially cut out the middleman.

Here’s what a blockchain looks like with more than just you and your landlord participating:

When one copy of the blockchain ledger gets changed, they all verify that transaction before adding it to their own ledgers. And blockchain is faster than the alternative, because everybody involved doesn’t have to wait on a single, slow-moving source for verification. It all happens simultaneously.

By now, you’ve got the run-down on blockchain explained. It’s not too complicated, even though it sounds convoluted.

If you’re interested in diving in a bit deeper into what actually makes up a blockchain system, check out the next section.

The Nitty-Gritty of Blockchain Technology Explained

So far, we’ve got that a blockchain is a digital ledger shared between a network of people. Each participant can manipulate that ledger, recording new blocks of data onto the chain, but with each transaction the entire chain gets analyzed by everyone to make sure it’s still accurate.

In other words, everyone has their own copy of the ledger…. But nobody can make a change without everyone agreeing to it. It’s a democratic system.

To really get blockchain explained, let’s break down a blockchain system into its three most important parts:

• A network of computers/participants

• A network protocol

• A consensus mechanism

Depending on the permissions of the blockchain, it can be public, and open to anyone with a computer, or private, accessible only by specific members. Each computer is called a node, and it makes up one part of the network of participants in the blockchain.

A network protocol is, in plain English, a rulebook that determines how those nodes can talk to each other. Typically, each node has its own copy of the general ledger (the blockchain) so there’s protection against mistakes or fraud. That redundancy, called “fault tolerance,” is what makes blockchain unique.

Finally, the consensus mechanism is the process by which a blockchain network verifies transactions and comes to an agreement on what the current, accurate blockchain is.

Remember in our lemonade example, how people in town knew that Rishi wasn’t allowed to sell lemonade and that $500 was way too expensive for a drink made from lemon juice, sugar, and water? Those sorts of rules were agreed upon beforehand by every node in the network—they’re a defining feature of the network. If they didn’t exist, then anyone could sell lemonade for however much they wanted.

Public blockchain networks tend to have pretty high standards for security, while private networks might be a little more trusting. But either way, the rules that form the consensus mechanism are what gives blockchain technology its flexibility and power. Anyone, individually, can check the validity of each transaction and come to a conclusion on whether it’s good or not.

If all this seems a bit over-the-top, don’t worry—it’s not too important to understand unless you’re curious about how it all works.

Just know that generally speaking, a blockchain system requires three things: people or companies dealing with each other, a relationship between those people or companies, and a rulebook they all agree on that explains which transactions are okay and which are not.

The 4 Big Advantages of Blockchain Explained

That’s blockchain explained. Now, the all-important question.…

So what?

Blockchain technology has four big advantages:

1. Transparency: Since everyone in a blockchain network has access to the ledger and the rulebook, nobody involved gets left behind. You can see who owned or paid or gave or did what, at various points in time, whenever you want or need. It’s a totally transparent system.
2. Security: Since everyone has a copy of the ledger that they use to validate the newest version, it’s a democratically secured system, too. There’s no single company or agency with extra power. Everyone is in charge.
3. Instantaneous transactions: Blockchain transactions take way less time than transactions that involve some sort of middleman, simply because they are self-validating.
4. No central authority: This one might sound a bit abstract—who cares if some sort of authority is watching over your transactions? But here’s the deal: When there’s a middleman, that middleman tends to slow things downand skim off the top, taking transaction fees and charging late penalties and all that business.  
5. The double-spend problem is solved: One of the major benefits of blockchain technology is that it solves the double-spend problem. Here’s the short of the double-spend problem: Because digital money is just a computer file, it’s easy to counterfeit with a simple “copy and paste.” Without blockchain, banks keep track of everyone’s money in their accounts, so that no one “double-spends”—or spend the same money twice. Blockchain solves this problem differently and more efficiently than banks: it makes all transactions and accounts public so it’s blatantly obvious when money is being counted or used twice. (Don’t worry, your personal information isn’t included on the blockchain, though.)

The short story?

Using blockchain can potentially speed up transactions while cutting costs associated with third-party banks and lowering the risk of fraud. That means more speed, affordability, and security for everyone.

Are There Any Disadvantages?

Great question. This wouldn’t be blockchain explained if we didn’t scrutinize the potential drawbacks.

There are a couple challenges to implementing blockchain….

1. For blockchain to work, everyone needs to cooperate.

In order to belong to a blockchain network, each company needs to be upfront and forthcoming about their own security protocols. Transactions added to the blockchain need to be transparent to everyone else, so they can verify the blockchain—that’s the point.

Which means that, while a blockchain can be encrypted to protect itself against hackers, the data in each block can’t be.

Companies might be understandably hesitant about removing some of their safety features in order to accommodate blockchain technologies, and for good reason.

Getting everyone on a blockchain network to “agree” to certain kinds and levels could be difficult—and implementing those additional security layers to make sure everyone is up to snuff is another hurdle altogether.

2. Blockchain isn’t regulated just yet.

Blockchain is “emerging,” remember?

Or in other words, the government isn’t quite sure how to handle it—and neither are many companies. It’ll take some time before regulations and laws governing the use of blockchain get written, especially in the financial sector, but they’re bound to come up sooner or later.

And that’s an uncertainty that not everyone is comfortable with.

3. Blockchain could be hacked, raising security issues.

Blockchain as an idea is pretty secure…. Everyone double-checks their records to make sure there’s no fraud going on.

But what about hacking? If a bank gets robbed, it just loses its own cash—but if a blockchain gets hacked into and 40 banks are on that network, then a lot more damage could be done. The potential dangers here haven’t been fleshed out completely, but it’s something to keep an eye on.  

That’s Blockchain Explained … But Who Uses It?

Here’s a brief list of some industries looking to incorporate blockchain technology:

• As we discussed, banks and financial services are using blockchain to cut out the middlemen—and a lot of time, money, and risk—when dealing with monetary transactions.   
• Industries that are high risk for fraud are starting to use blockchain to verify their wares. A few companies are implementing blockchain to prevent the false certification or sale of blood diamonds and stolen art, for example.
• Digital content like music, movies, and online ads could use blockchain to prevent piracy. By using new file formats that can play the media andencode blockchain data that reflects intellectual property and payment history, musicians and filmmakers wouldn’t be losing out on millions.
• In medicine, blockchain technology can be used to prevent the theft of pills through the supply chain and give medical history ownership back to patients (who can distribute it to their doctors, for certain amounts of time, as they want or need).
• In the food and drink industry, farmers could use blockchain to monitor their crops—and trace where and when food recalls occur.
• Insurance could be dramatically changed. Imagine a world where you can get insurance that lasts for a few hours, like if you’re doing some extreme sport. Or where Uber and Lyft drivers can bypass insurance companies by combining their money together on a blockchain and creating a safety net for themselves.

Blockchain is a development that lends itself to creativity—so we’ll likely see some very interesting uses in the future.

If you’re curious, check out this list for more in-depth explanations.

Small Business and Blockchain Explained: What’s in It for You?

It’s true: Blockchain, at the moment, is a tough technology to adopt for most small business owners. Unless you’re a startup looking to disrupt an industry, it probably won’t directly impact your business.

But over the course of blockchain technology explained, we hinted at something that could actually make an impact on your business.

That’s right … a blockchain-based currency called bitcoin.

Bitcoin is a strange concept to wrap your head around—unless you understand blockchain, that is.

What Is Bitcoin?

Created in 2009, bitcoin is an all-digital “cryptocurrency” that doesn’t pay attention to banks, governments, or international borders. There’s a cap of 21 million bitcoins—so inflation is not possible—and the current bitcoin market is valued at $298 million, with each bitcoin clocking in at around $3,516 right now.  

By using blockchain technology, the inventor(s) of bitcoin (a mysterious person or group known only as Satoshi Nakamoto) gave their currency the ability to exist without some sort regulatory oversight.

Every person who participates in the bitcoin network—everyone who buys with, sells in, or owns bitcoins—has their own copy of the bitcoin blockchain.

See where is this going?

Whether you’re an individual buying a lemonade or a multinational lemonade company selling your beverages, each transaction you add to the blockchain is checked against everyone else’s blockchain ledgers. This system prevents anyone from using the same bitcoin more than once—which was the biggest problem with all-digital currencies before bitcoin came along.

Since bitcoin is a purely person-to-person digital currency model, anyone using bitcoin can make fast, secure, low-fee transactions whenever they want, to anyone in the world.

It’s a universal currency.

Acquiring bitcoin is as easy as buying some (like exchanging money for foreign currency) or accepting some from others (if they want to buy your lemonade in bitcoin, for example).

Bitcoin Miners and Your Financial Security

With a market that large—spanning the entire Earth!—then how does the bitcoin blockchain get monitored? After all, the whole point is that the blockchain gives bitcoin its stability and security, right?

Great question.

And here’s the answer:

People called bitcoin miners get paid in bitcoin in exchange for running complex algorithms on their super-powered computers to verify bitcoin transactions for other people.

Bitcoin transactions are subject to very small fees that add up to pay these miners, who essentially keep the market going. Without bitcoin miners, the bitcoin blockchain couldn’t check itself….

And there would be no bitcoin.

The catch? You need an incredibly powerful computer to double-check the bitcoin blockchain.

With the unique “miner” addition, the bitcoin marketplace made it possible for a global blockchain to support this all-digital, no-regulation currency that anyone can buy or sell.

6 Reasons Why Small Business Owners Should Consider Accepting Bitcoins

That bitcoin and blockchain explanation is all well and good, but how can youuse bitcoin to help your small business?

It’s a contentious topic, but over 100,000 businesses small and large around the world accept bitcoin as payment.

That simply entails….

• Advertising that you accept bitcoin
• Figuring out how you want customers to be able to pay (through an online merchant solution, an in-person touch-screen app, or a QR code, for example)
• Working with your accountant to understand how to incorporate bitcoin into your finances
• Setting prices often to accommodate for bitcoin value fluctuations

Otherwise, it’s fairly straightforward—bitcoin works a lot like cash, but it requires more technological know-how.

As it turns out, bitcoin has lots of the same advantages that blockchain also has. Here are a few reasons you might want to consider accepting bitcoin as payment from customers:

1. It’s cheaper.

Unlike big corporations, small businesses don’t have a lot of bargaining power over things like credit card fees and transaction fees. With bitcoin, these fees are drastically reduced, saving mom-and-pop stores a lot of money.

And since there’s no central authority controlling the amount of bitcoins in the market—there’s up to 21 million bitcoins, and no more, available—it’s not a currency that can undergo artificial inflation.  

2. It’s fast.

Compared to credit card transactions, which can take days because they rely on centralized authorities like banks, bitcoin transactions can take seconds or minutes to get verified.

This means your business can receive its payments right away … easing up your cash flow.

3. It’s border-proof.

Does your small business export to other countries? Using bitcoin means you don’t need to deal with foreign currencies or exchange rates. It’s a borderless world to the bitcoin user.

4. You can hold onto them as an investment.

If you’re concerned about business taxes, know that you generally only need to pay on bitcoin exchanges when you cash in your bitcoins for dollars or spend them on something else. Check your local laws to make sure this is the case for you! (We’ll go more in-depth into taxes in the next section.)

However, the value of bitcoins can be pretty fluid—so if you’re waiting for an increase in their worth, you can hold onto bitcoins without paying any penalties.  

5. Like with cash, bitcoin transactions are final.

That means an unhappy customer can’t dispute your payment like they could with a credit card, and it means that you get your money, irreversibly, right away. Even though it’s a digital currency, bitcoin doesn’t rely on credit.

6. It has marketing potential.

Some small businesses have found that “accepting bitcoin” can attract younger clientele, even if it’s not used too often as a payment method. It says something about your business and your brand if you’re willing to step into the next biggest thing in financial technology.

5 Potential Drawbacks of Small Businesses Using Bitcoin

You’ve got blockchain explained and you’re ready to adopt it for your small business? Hold on a moment—there are downsides for you to consider.

That said, there are some potential problems you should take into account when thinking of accepting bitcoins. Many of them overlap with the disadvantages of blockchain explained in our earlier section.

1. It’s unregulated.

There’s nothing stopping bitcoin from completely shutting down tomorrow.

Okay, that’s a bit alarmist, and probably wouldn’t happen—but as an unregulated form of currency, bitcoin is naturally a riskier investment than good old dollar bills. That’s one reason why some countries have placed bans or restrictions on the use of bitcoin, in fact.

2. Its value fluctuates.

This is a selling point and a danger of using bitcoin—and is probably one of the biggest impacts bitcoin would have on your business.

The value of bitcoins changes every day. Although the U.S. dollar (and every other currency) also fluctuates regularly, those shifts are small and more predictable. On a month-to-month basis, the value of a bitcoin can rise from $350 to $1,250, then drop down to $600.

In fact, in the later half of 2018, bitcoin’s valuation has really been tumbling. There’s no reason to believe the trend won’t turn around, but it’s important to watch the bitcoin market if you’ve invested in this for your business.

What does this mean for your business?

It’s entirely possible that the bitcoins you own today are worth much less tomorrow … leaving you out in the cold.

But on the other hand, you could receive some bitcoins whose value then skyrocket a few months later, providing you with a nice cash flow windfall.

The point is: Accepting bitcoin is far less predictable, but much more lucrative, than just accepting dollar bills. Whether your business can or should take the risk is up to you.

(That said, if you’re willing and able to pay for it, there are services that will immediately convert bitcoin transactions into U.S. dollars—making your decision quite a bit easier.)

3. Taxes and financial planning can get complicated.

Although you can hold onto bitcoins as investments instead of cashing out, it can be tough to plan your business finances around your bitcoin income, since the value fluctuates so often. If you’re drawing up a cash flow analysis for a business loan application, for example, you might struggle with figuring out how to account for your bitcoin sales.

Plus, dealing with the IRS if you accept a lot of bitcoin in exchange for your goods and services might be more complicated than you want. Technically, the IRS sees bitcoin as a property, not a currency. This can get messy, since a bitcoin exchange can involve a gain or a loss in U.S. dollars, even if you’re gaining bitcoins. Talk to your accountant before diving into the world of bitcoin, and keep an eye out for future developments regarding bitcoin regulation.

4. So can pricing.

If you have customers from all over the world buying your goods and services with bitcoin, when bitcoin itself holds a different value from day to day … what should you charge? You might need to constantly update your pricing to reflect the shifts in bitcoin valuation.

Some point of sale services that deal in bitcoins could help you price your products, but those generally are not free services. You have to make a tradeoff based on how much you expect to make in bitcoin and how well the market is doing.

5. You have to be comfortable with technology.

It might go without saying, but incorporating bitcoin into your business model means you have to feel pretty comfortable dealing with technology. If that doesn’t sound like you, it might be best to stay away.

Blockchain Explained: The Bottom Line

There it is—that’s blockchain explained.

Hopefully now you’ve got a solid grasp on what blockchain is, why everyone’s talking about it, and how it can impact your small business. Whether or not you decide to accept bitcoins as a form of payment depends on you and your small business needs.

About the Author

Ben Rashkovich

Content Strategy Manager at Fundera

Ben is a former content strategy manager at Fundera. He has a bachelor's degree in English literature and is currently enrolled in Yale Law School. Ben has also written for eBay's curatorial team.