Blockchain might seem like magical fairy dust that companies throw about that suddenly sparks interest in their businesses. But the complexities of fairy dust far exceed the real inner workings of blockchain technology.

A blockchain is a distributed public ledger that uses cryptography to ensure the record is practically immutable. The idea was created by an anonymous programmer that goes by the pseudonym Satoshi Nakamoto, and it's the underlying technology that makes peer-to-peer bitcoin transfers possible without the need for financial institutions to verify transactions. But blockchain technology has applications well beyond bitcoin. Anything that relies on access to a database can benefit from using blockchain technology.

Before you can understand how businesses and governments could use blockchain technology in various applications, you first have to understand what exactly a blockchain is. In this article, we'll review:

  1. What exactly a block is
  2. How new entries are written to the public ledger
  3. Why it's called a blockchain
  4. What makes the blockchain secure, and
  5. Potential applications for blockchain technology
A graphic representation of a blockchain.

Image source: Getty Images

What is a block?

A block is simply a collection of data. Theoretically, it can be any kind of data, but typically it includes transactional data.

For example, the block may contain data that says things like party A wants to send money to party B along with proof that party A has that money to send. That's primarily what's included in bitcoin's blockchain -- it's just a public ledger of transactions.

It could also contain more complicated data like a contract -- party A will send party B a certain amount of money if and when X occurs. That's the main idea behind Ethereum, a cryptocurrency platform built on blockchain technology that specializes in "smart contracts."

How data gets added to a block

When a person wants to add data to the public ledger, they must prove that they are authorized to add that data to a block. This is done through a system called public-key encryption.

Each person that's authorized to add data to the blockchain has both a private key and a public key. The private key must be kept secret from everyone else, but the public key is available to anyone with access to the blockchain.

The private key is used in combination with the data a person wants to add to create a digital signature. The computers on the blockchain network can then use a person's public key to verify the private key was used to sign the data. That public key cannot, however, be used to determine the private key.

This cryptography system ensures the data in each block is supposed to be there, which is very important. That's a responsibility typically held by financial institutions or trusted third parties, but blockchain technology eschews intermediaries in favor of a decentralized structure. As you'll see, any additions to the blockchain are very difficult to undo, so it's imperative each transaction is authorized.

Digital chain concept.

Image source: Getty Images

Why is it called a chain?

Each block in the blockchain contains a reference to the block that immediately precedes it in the chain. This ensures that each block is ordered chronologically.

The reference data is generated by a cryptographic hash function, which takes all of the data in the previous block and maps it to a digest -- an alphanumeric string. If any of the data in the block changes, perhaps you want to add a few extra 0s to a number, the hash function will produce an entirely different digest.

By linking blocks together this way, it makes it practically impossible for a single person to change the data in the blockchain. Doing so would require that person to not only change the data in one block but also change it in every block that follows it.

What makes it so hard to make new blocks?

Each block also contains important information that allows the network of computers using the blockchain to verify the validity of the block -- such as a solution to a complex math problem called a proof-of-work. The proof-of-work requires a large amount of computing power to solve, but only a moderate amount is required to verify a solution.

A new block cannot be amended to the blockchain without solving the proof-of-work.

In many cryptocurrency blockchains like bitcoin and Ethereum, computers on the network are incentivized to produce proof-of-work and add blocks to the blockchain through a reward. Some blockchains rely entirely on transaction costs to incentivize people to spend money on computing resources like hardware and electricity to run it.

Thus, a person acting alone would need a large portion of the computing power on a network to even have a moderate chance of adding multiple blocks to a blockchain back-to-back.

An illustration of the distributed nature of blockchain.

Image source: Getty Images

Where is the blockchain stored?

An important characteristic of most blockchains is that they're publicly distributed across the network. That's to say every computer on the network has a copy of the blockchain.

When a computer on the network solves the proof-of-work and adds a block to the blockchain, that new blockchain is immediately distributed to every other computer on the network. The other computers verify transactions in the block, as well as the proof-of-work solution.

There are instances when two computers solve the proof-of-work and try to add a block to the blockchain at the exact same time. And the blocks they add might not have the same data. Some computers get one copy of the chain while others get a different copy.

In this case, each computer keeps the first copy of the chain it received. The next computer to solve a proof-of-work will amend the new block to the copy it received and broadcast that new chain to the rest of the network, breaking the tie. The longest chain is always considered the only valid blockchain.

The rule that the longest chain is the only valid chain is another reason it's incredibly difficult to change a record. A person would not only have to solve the proof-of-work for the block they want to change, but they would also have to solve it for the next block before any other computer on the network solves it.

Since the blockchain is stored on every computer in the network, there's no single point of failure. That adds yet another level of security to the system.

Possible applications for blockchain technology

Any business or system that relies on a database could potentially benefit from blockchain technology to make it more secure and accessible.

Possible applications include:

  • Peer-to-peer money transfers. Satoshi Nakamoto conceived the blockchain as a solution for making bitcoin transactions. Transactions on the blockchain are extremely fast. While it might take days to send money around the world through traditional financial institutions, bitcoin takes a matter of minutes. Other cryptocurrencies are even faster than bitcoin, and developers have built systems such as the lightning network to verify transactions on the bitcoin or Ethereum networks more quickly.
  • Smart contracts. Smart contracts are pieces of computer code that execute themselves upon certain criteria being met. Writing the contract to the blockchain removes the need for an intermediary like a financial institution to enforce the contract. Once the contract is on the public ledger, it's hard to change. An example application of a smart contract is a stock call option, which gives a person the right to buy a stock at a certain price on a certain date in the future. When that date comes, the smart contract executes and the person buys the stock.
  • Other financial services. Smart contracts could be used for transacting with any financial instrument. Blockchain technology could revolutionize stock exchanges as shares could change hands within minutes instead of taking three days to settle. In fact, the Nasdaq Stock Market developed an exchange for private securities called Linq in 2015. Another example is using blockchain technology for insurance claims. A blockchain could document property insured and pay out claims more quickly.
  • Internet of Things (IoT). There's a growing number of things connected to the internet, and they're all producing data. IoT applications range from garage doors you can control with your smartphone to entire cities that have thousands of devices all communicating with each other to control traffic and manage resources efficiently. Using a blockchain can provide security for smart cities to ensure traffic lights continue operating properly and the power stays on when you're at work.
  • Supply chain tracking. Along the same lines as IoT applications, supply chain companies use billions of sensors to track packages from point A to point B. The chronological nature of a blockchain lends itself well to keeping track of items at any point in time.
  • Health records. Keeping individual health records on a blockchain would give doctors all over the world instant access to a person's medical records. So, if you're traveling abroad and get hurt or just seeing a new doctor at home, blockchain could make it a lot easier for a doctor to access your medical history.
  • Voting. With all the worry about hackers tampering with electronic voting in the 2016 U.S. Presidential election, blockchain technology could provide a solution. Since a person must authorize data before it's added to the blockchain, it would be easy to ensure each person votes just once by issuing private keys to eligible voters. Additionally, the hard-to-change nature of the blockchain means it would be tough to tamper with the results. And perhaps best of all, you might not have to wait in line at a polling place to vote if governments used a blockchain and public key encryption for voting.

There are dozens of other potential applications for blockchain technology, and developers will likely continue to think of new ways to use Satoshi Nakamoto's original idea to bypass financial institutions in ways he would never have imagined.

Companies are coming out every week saying they're going to apply blockchain technology to their business. Some of them are legitimate applications while some of them are just PR stunts. With an understanding of what blockchain is, you'll be able to determine whether it actually has a useful application for a business or not.

Adam Levy owns bitcoin. The Motley Fool recommends Nasdaq. The Motley Fool has a disclosure policy.