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Basics of blockchain

To understand NFTs, we must first understand the blockchain technology that supports them.
Glowing neon blocks cover in binary code, linked together with chain
© RMIT 2022

We have seen a few ways that NFTs have been successful thus far. Now let’s look closer at what NFTs are, starting with the blockchain technology that supports them.

What is blockchain?

Blockchain is a new technology used for storing data and transactions. As the world becomes more digitalised, data can include anything from bank account details to GPS tracking coordinates to digital art and x-ray images. Similarly, transactions can represent payments, delivery confirmations and updates to health records. Blockchain uses networks of computers to securely store data and validate transactions which reduces the risk of relying on any single company, central computer, or server to maintain the ‘source of truth’. Because of the way blockchain securely validates the data, both data and transactions are stored permanently and their history cannot be altered.

In more technical terms ‘blockchain is a distributed, append-only ledger that is governed by a consensus protocol in a peer-to-peer network’. The term ‘blockchain’ comes from how the data is structured. Transactions are grouped and stored in ‘blocks’ that are time stamped and cryptographically linked to secure the data. ‘Consensus protocol’ refers to how the different computers in the network agree on which blocks should be added to the ledger. ‘Peer-to-peer’ refers to a network of computers rather than a central computer or server.

When a block is filled, it is sealed with a cryptographic signature known as a ‘hash’ that is generated by an algorithm and based on the data in the block. A new block is then started, and the new block will begin with that same hash (signature) from the previous block to ensure that there has been no manipulation of the encrypted information. When that next block is filled, it is sealed with its own cryptographic hash, which is included in the first record of the next new block and so on, forming a chain of blocks – hence the term blockchain.

Blocks being added to the chain, each with their own unique hash and the hash of the previous block

As an append-only ledger, blocks can only be added to a chain and removing or altering a transaction retrospectively from a blockchain becomes almost impossible. It is the global consensus mechanism and the near impossibility of changing records that ensures trust in the data, making blockchain technology exceptionally attractive for a range of applications.

As the largest application of blockchain, cryptofinance has attracted the interest of the entire financial sector including banks, insurance companies, exchanges, clearing and settlement companies and governments. Deloitte’s 2020 Global Blockchain Survey revealed that nearly 40 per cent of global respondents have blockchain in production, affirming blockchain’s maturity, and 55 per cent of respondents viewed blockchain as a top strategic priority. In the same survey, 83 per cent of respondents said that their organisation or project would lose a competitive advantage if they did not adopt blockchain technology (Deloitte 2020).

No introduction to Blockchain would be complete without an overview of its origins and the first case of its use – Bitcoin and other cryptocurrencies.

Cryptocurrencies

Cryptocurrency is a form of digital currency that is typically blockchain-based, with all the security and validation features of blockchains. Digital currencies are not so new – the term is the blanket term used to describe ‘electronic’ money. It includes both virtual currency (e.g. in-game currencies such as Linden Dollars in the game Second Life or World of Warcraft Gold in the World of Warcraft gaming franchise) and cryptocurrency, which can be regulated or unregulated and, as distinct from fiat money (money typically declared by a government to be legal tender), can be issued by anyone with the means to do so.

Bitcoin is the first and most widely recognised cryptocurrency, although many more have emerged since Bitcoin’s inception. The common characteristic of Bitcoin and other cryptocurrencies is that they are forms of digital currency that have been designed as alternatives or competitors to fiat money and centralised, state-controlled payment systems.

Bitcoin

Bitcoin is the first blockchain-based, decentralised cryptocurrency. Created in 2009 by the pseudonymous developer Satoshi Nakamoto, Bitcoins are neither issued nor backed by any banks or governments. Bitcoin is popular, and while not legal tender in most jurisdictions, is accepted as a medium of exchange in many places, including cafes, bars, retail outlets and health services, among others. Bitcoin’s price has been subject to spectacular volatility in recent years and this volatility has resulted in a lack of confidence in Bitcoin as a medium of exchange, or as a store of value, and raised concerns among central banks as to the viability of cryptocurrencies. Ethereum (ETH), Litecoin, Dash, and Monero are other examples of cryptocurrencies that operate on their own blockchain platforms.

How does Blockchain enable NFTs?

Like cryptocurrencies, Non-Fungible Tokens (NFTs) represent a unit of data stored on a blockchain, in a form of digital ledger, that can be sold and traded. Unlike cryptocurrencies where ‘tokens’ are generally confined to types of digital money, NFT data units may be associated with a range of digital files such as images, photos, videos, badges and audio. While there are fundamental similarities between cryptocurrencies and NFTs, it is the ‘uniqueness’ of each unit that distinguishes NFTs from blockchain cryptocurrencies such as Bitcoin, which do not have that property. This goes to the fungible vs non-fungible part, which will be explored more in the next step.

NFT technology has for the most part evolved through digital art (Beeple, Cryptopunks) and collectibles (NBA Topshots), some of which have been used as highly speculative digital assets. NFTs have drawn criticism for the energy cost and carbon footprint associated with validating blockchain transactions as well as their use in scams. Certainly NFTs are gaining ground and there are many other ways of using the potential of NFTs, including credentials, identity records, and fractional ownership of assets, which will be explored in the next section.

© RMIT 2022
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