What Is a Blockchain Protocol in Crypto & How Does It Work?

For beginners and crypto pros alike, understanding blockchain protocols is essential to mastering crypto investments. Read on as Pluto explores everything you need to know.

What Is a Blockchain Protocol in Crypto & How Does It Work?

Disclaimer: This is for informational purposes and is not meant to serve as financial or investing advice.

What Is a Blockchain Protocol?

A blockchain protocol is a set of rules determining how a blockchain operates. Blockchains are used for multiple parties to execute transactions or contracts without needing a third party.

Popular blockchains include Bitcoin and Ethereum. On the protocol level, hundreds of Bitcoin and Ethereum engineers around the globe are working on setting network standards and improving blockchains.

Why Are Blockchain Protocols Necessary?

Security

Blockchain protocols create network security via cryptography and consensus.

Cryptography is used to secure user wallets. In most cryptocurrency networks, a wallet can only be accessed if the user inputs the corresponding private key.

Cryptography is also used to take large amounts of data like blockchain transactions and “hash” it. Hashing takes in large amounts of data and makes it into a unique string of characters or a hash.

Proof-of-work consensus networks like Bitcoin use hashing to ensure a block (or chunk of data) is immutable by including the previous block's unique hash. The blocks are chained together by cryptography.

A network of miners verifies that transactions took place before writing them to the blockchain. This consensus mechanism prevents bad actors from including faulty or malicious data in new blocks.

Decentralization

Blockchains act as decentralized ledgers that settle immutable transactions. Immutable means they can never be unwritten. Blockchain protocols can be upgraded or changed, but truly decentralized chains cannot reverse transactions.

Decentralization is helpful because it enables unrestricted commerce, private banking, and uncensorable transactions.

Historically, a central authority was always necessary to enforce private transactions. The government enforces private transactions via the judicial system, and the banking system facilitates and enforces transactions. Brokers are required in real estate transactions.

Blockchains allow two parties to transact currency without a mediator. Once you agree to transaction terms, it is carried out by computer code and verified by a decentralized network of consensus nodes.

Scalability

As blockchains gain more users and facilitate more transactions, it needs to maintain performance. The ability to maintain performance as users and transactions grow is called scalability.

There are many ways to improve blockchain scalability. This can include layer-two blockchains, sharding, rollups, or zero-knowledge proofs.

Consistency

Blockchains must maintain uptime, have low fees, and settle transactions quickly to keep users. Blockchains handle peoples’ money, after all.

Without scalability mechanisms, it is almost impossible for a truly decentralized blockchain to have all three.

For instance, a way to design a protocol with high consistency is by having fewer network validators. Because fewer validators need to reach a consensus on the state of the blockchain, transactions can go through cheaply and quickly.

However, because there are fewer validators, there is a higher risk of censorship, 51% attacks, or malicious attacks. The network is trading decentralization for consistency.

How Do Blockchain Protocols Work?

All blockchains work by recording lists of transactions in blocks that are linked together as a decentralized ledger in a chain. Each block contains the cryptographic signature of the previous block, ensuring the uniqueness and immutability of the block and its transaction log. Once a transaction is written in the decentralized ledger, it cannot be removed.

In order for a block to be written into the chain, a group of validators must agree that the transactions in the block are all valid transactions. This is called reaching a consensus. It’s important to have many validators so that bad actors can’t pass fraudulent transactions onto the chain.

Blockchains differ in how many validators there are, how consensus is reached and how much miners are incentivized by fees to process transactions.

There are tradeoffs for all decisions at the protocol level. Rules at the protocol level have massive implications for decentralization, fees, scalability, and uptime.

For example, if a blockchain protocol only requires 10 validators to reach consensus, it wouldn’t be decentralized by definition. But, it would be fast and cheap, so it could be great as a permissioned blockchain used by a commercial entity.

What Are the Main Types of Blockchain Protocols?

1. Hyperledger

Hyperledger is an open-source project that provides frameworks, standards, and code to support blockchain protocols. Hyperledger creates distributed ledger technology for enterprise software.

It was created by the Linux Foundation in 2016 and had significant technology contributors like IBM, Intel, and Visa. The most well-known Hyperledger protocol is Hyperledger Fabric which IBM developed.

What Are the Benefits of Hyperledger?

Hyperledger is modular. Different features of Hyperledger can be switched in and out to create a custom enterprise blockchain.

Because Hyperledger is so customizable, businesses can create blockchain solutions for specific use cases. For example, a blockchain that handles authentication and credentialing for employees.

Another benefit of a specialized Hyperledger blockchain is that it doesn’t require cryptocurrency. Private enterprise blockchains are used more like databases than public utilities.

Instead of charging users and paying validators to secure the network, an enterprise or group of enterprises run their own validator nodes. Of course, you can build a public blockchain using Hyperledger and create a token if you want to.

Hyperledger blockchains are great for handling confidential business or user data. Not all transactions are visible to the users, and you can make special private channels. This is great for enterprise handling data in fields like healthcare or finance.

What Are the Downsides of Hyperledger?

Hyperledger is a new technology. There are only so many engineers familiar with the protocol. This means enterprises need to hire from a small talent pool or upskill employees.

It could be risky to build vital system architecture on a protocol that your employees or users cannot troubleshoot.

Hyperledger is only proven for a few specific use cases. It may not make sense for a company to invest time and resources into a protocol if it can’t be used across many business functions.

2. Corda

Like Hyperledger, Corda is a private, permissioned blockchain framework used for enterprise. Corda is maintained by a banking consortium of over 300 members of the financial services industry.

It is used strictly by financial institutions for

What Are the Benefits of Corda?

A significant component of the Corda protocol is privacy. It is designed to verify financial records using a distributed ledger without exposing that data to validators or other users.

An excellent example was ING Bank implementing zero-knowledge proofs on Corda as part of their notary process.

This means ING Bank transactions could be verified as valid and unique by blockchain validators in a consensus network without exposing customer information to the network. This prevents double-spending transactions.

What Are the Downsides of Corda?

Corda is a very specialized protocol, meaning only a few people know how to use it. Financial institutions have to invest in its development, implementation, and maintenance.

Whereas with generalized protocols like Ethereum or Polygon, the open-source code development and maintenance is funded by ecosystem fees.

Another area for improvement of hyper-specialized blockchain protocols is that even though they are open source, only a few people are stress-testing or debugging them. Thousands of users and programmers are constantly testing permissionless blockchains.

Vulnerabilities may only be found in specialized Corda use cases once in production, which is a problem if you handle private financial data.

3. Enterprise Ethereum

Enterprise Ethereum is the private version of the Ethereum blockchain. It allows businesses to create smart contracts and decentralized applications (dApps).

What Are the Benefits of Enterprise Ethereum?

The most significant benefit of Enterprise Ethereum is it allows companies to leverage Ethereum’s robust ecosystem of developers, tools, and services in a private blockchain.

What Are the Downsides of Enterprise Ethereum?

A private Ethereum blockchain is more expensive to implement and maintain than simply using the existing public network. And it requires careful design of the validator and consensus schema to operate privately.

4. Multichain

Multichain is an off-the-shelf enterprise blockchain solution.

What Are the Benefits of Multichain?

Because it is off-the-shelf software, it requires little minimal development investment and resources.

Multichain is built to be hosted by Azure and other cloud hosting providers making implementation even simpler.

What Are the Downsides of Multichain?

Multichain enterprise plans start at $25,000/year. And if you want more nodes, it will cost $7,500/node.

Another problem with the off-the-shelf model is depending on a third party to develop the underlying protocol. If the third party goes bankrupt or changes business direction, your blockchain will no longer have technical support.

5. Quorum

Quorum is an enterprise blockchain developed by JP Morgan that ConsenSys now owns. It is a fork of the Ethereum blockchain.

What Are the Benefits of Quorum?

Quorum’s “RAFT” consensus mechanism allows for more transactions per second than Ethereum or Bitcoin.

Quorum also eliminates transaction costs. Users can benefit from the Ethereum network’s tools and features without paying fees.

Quorum includes a mix of public and private transactions, unlike Ethereum, which only facilitates public transactions.

What Are the Downsides of Quorum?

Because Quorum is off-the-shelf software, you outsource development, maintenance, and IT support to ConsenSys. There are better options than this if you want more control over your blockchain infrastructure.

How Do Bitcoin Protocol and Ethereum Protocol Differ?

Bitcoin and Ethereum are both publicly distributed ledgers. But they differ in architecture and philosophy.

The Bitcoin blockchain is designed to be a medium of exchange where users can send and receive Bitcoin anonymously. You can check out a brief history of Bitcoin on our Youtube channel.

The Ethereum network is a programmable blockchain designed to be a decentralized global computer. While Bitcoin is for peer-to-peer payments, Ethereum’s programmable smart contracts enable decentralized finance or “DeFi.” You can develop personalized DeFi investing strategies on our website.

Bitcoin uses a proof-of-work consensus design. Network validators must use computing power and hardware resources to solve computational problems and mine each new block.

Because these computations are complex, bitcoin mining rigs use a lot of electricity. Bitcoin proponents say the electrical use of the proof-of-work model secures the network and gives it value.

Ethereum recently switched from proof-of-work consensus to proof-of-stake. Instead of using electricity to solve computations, miners must stake 32 ether (eth) to operate a validator node. This reduces Ethereum’s energy usage significantly.

The Bottom Line

There are multiple solutions for every problem that can be solved with blockchain technology. It depends on what the end user values most.

Enterprise blockchains are great for privacy and reliability. Public blockchains are great for consistency and scalability. And, of course, public blockchains were created to promote decentralized banking and transactions.

Blockchain protocol knowledge is crucial to investing in the crypto ecosystem. Understanding how a protocol works can help you determine who the end user is, where revenue comes from and if there is a market fit.

If you can understand blockchain systems' building blocks, you may notice patterns in different blockchain startups. Projects with similar building blocks attract similar users and developers.

For example, if you know that a new blockchain is “EVM-friendly,” it uses Ethereum’s smart contract infrastructure. This means that applications that exist on Ethereum can be ported over to the new blockchain. Does this give more value to the application? To the new blockchain? Some investing insights can only come from technical knowledge. So get to studying.

Check out Pluto’s Youtube channel for more information on blockchain protocols and investing.

Sources:

What Is Proof of Work (PoW) in Blockchain? | Investopedia

What is Hyperledger? Everything You Need to Know | Tech Target

Corda Permissioned Distributed Ledger Technology (DLT) | R3

ING Bank Devises Privacy Fix for R3's Corda Blockchain | Coindesk

Enterprise Ethereum Alliance

Multichain Pricing

Quorum Blockchain | GeeksforGeeks