A recent Financial Times long-read article outlined how diverse financial institutions try to promote the use of blockchain technology to optimize how their transactions are performed. This will allow them to take place instantly, rather than waiting for clearing, around the clock, rather than during working hours, and with automated actions, such as the rebalancing of a tracker fund when asset prices change. Obviously this entails many risks. Although the article tried to explain the basics of how blockchain technology works, it left out many important elements. Read on to learn the absolute essentials of blockchain technology in fewer than 500 simple words.

At its heart, the blockchain is a secure distributed ledger. A way in which through clever use of cryptography, participants agree (reach consensus) on the content and order of the entries stored on it. At its heart, a blockchain is a secure distributed ledger: a way for mutually untrusted participants to agree, through clever cryptographic techniques and a consensus protocol, on the content and order of a shared sequence of transactions. For example, the transactions could record that Alice transferred five beads to Bob, and that Bob subsequently transferred three of those beads to Carol. From these transactions, one can determine that Bob owns (at least) two beads and Carol owns (at least) three.

Blockchains first became widely known as the technology underpinning cryptocurrencies. Although cryptocurrencies remain their most prominent—and, in some circles, controversial—application, the underlying technology has many other uses. Blockchains can also support tokenized assets (read on), decentralized applications, supply-chain tracking, and other systems requiring a shared, tamper-evident ledger.

Assets on a blockchain are represented by digital tokens. Some tokens are native blockchain assets (e.g. cryptocurrencies), while others represent off-chain assets such as equities, bonds, cash, or works of art. Token standards encode properties such as fungibility (e.g. that one dollar is the same as any other dollar) or uniqueness (e.g. that there’s only one Mona Lisa).

Correspondence between blockchain and other assets is established contractually by parties such as custodians and issuers. For example, a custodian can holds the beads exchanged through the blockchain, and hand three of them out to Bob when he asks for them.

Any participant can send out a transaction. The sender signs it with an “unfakable” digital signature (using a so-called private cryptographic key).

Broadcast transactions are independently verified by blockchain participants, who check that the transaction’s digital signature is valid, that the sender is authorized to transfer the token (e.g. in possession of it), and that the transaction follows the protocol rules. Through the blockchain’s consensus mechanism, participants agree on the resulting order of valid transactions. Consensus algorithms deter attacks by making them costly: Proof of Work consumes computational resources and electricity, while Proof of Stake risks the attacker’s staked funds.

Ownership is conceptually established by walking through the blockchain ledger transactions to verify, e.g. Bob has actually received three beads and not transferred them on. In practice blockchain implementations have various mechanisms to make this more efficient, e.g. by storing current account and contract state.

Participants can deploy smart contracts through (again, signed) transactions. A smart contract is code stored on the blockchain that is executed by blockchain participants when triggered by a transaction. During execution the contract can inspect and modify blockchain state, transfer assets under its control, and invoke other smart contracts according to predetermined rules. For example, Alice can deploy a smart contract specifying that, when invoked, it will transfer a one-bead bonus from Alice to Bob if Bob has transferred at least 20 beads during a calendar month.

Because every participant independently verifies and executes transactions according to the same rules, they converge on a single agreed-upon history and current state without relying on a central authority.

—