Public key has two uses: 1) it serves as an address on the blockchain network; and 2) it is used to verify a digital signature / validate the identity of the sender.
On the Bitcoin blockchain, this translates into the following example. Suppose that Anna wants to send 100 Bitcoins to Jeff, then first of all she will have to digitally sign this transaction using her private key (which is only known to her). She will have to address the transaction to Jeff’s public key, which is Jeff’s address on the Bitcoin network.
Next, the transaction, which will be collated into a “transaction block”, will have to be verified by the nodes within the Bitcoin network. Here, Anna’s public key will be used to verify her signature. If Anna’s signature is valid, the network will process the transaction, add the block to the chain and transfer 100 Bitcoins from Anna to Jeff. A user’s public and private keys are kept in a digital wallet or e-wallet. Such wallet can be stored or saved online (online storage is often referred to as “hot storage”) and/or offline (offline storage is commonly referred to as “cold storage”).
c. Bye-bye middleman? One of the key advantages of blockchain technology is that it allows to simplify the execution of a wide array of transactions that would normally require the intermediation of a third party (e.g. a custodian, a bank, a securities settlement system, broker-dealers, a trade repository, …). In essence, blockchain is all about decentralizing trust and enabling decentralized authentication of transactions.
Simply put, it allows to cut out the “middleman”.30 In many cases this will likely lead to efficiency gains. However, it is important to underscore that it may also expose interacting parties to certain risks that were previously managed by these intermediaries.
For instance, the Bank for International Settlements (“BIS”) recently warned in a report of 2017 titled Distributed ledger technology in payment, clearing and settlement, that the adoption of blockchain technology could introduce new liquidity risks. More in general it seems that when an intermediary functions as a buffer against important risks, such as systemic risk, he cannot simply be replaced by blockchain technology.
The blockchain consensus mechanisms In principle, any node within a blockchain network can propose the addition of new information to the blockchain. In order to validate whether this addition of information (for example a transaction record) is legitimate, the nodes have to reach some form of agreement. Here a “consensus mechanism” comes into play. In short, a consensus mechanism is a predefined specific (cryptographic) validation method that ensures a correct sequencing of transactions on the blockchain.
In the case of cryptocurrencies, such sequencing is required to address the issue of “double-spending” (i.e. the issue that one and the same payment instrument or asset can be transferred more than once if transfers are not registered and controlled centrally).
A consensus mechanism can be structured in a number of ways. Hereinafter, the two best-known — and in the context of cryptocurrencies also most commonly used — examples of consensus mechanisms will be briefly discussed: the Proof of Work (“PoW”) mechanism and the Proof of Stake (“PoS”) mechanism.
a. Proof of Work (PoW) In a PoW system, network participants have to solve so-called “cryptographic puzzles” to be allowed to add new “blocks” to the blockchain. This puzzle-solving process is commonly referred to as “mining”. In simple terms, these cryptographic puzzles are made up out of all information previously recorded on the blockchain and a new set of transactions to be added to the next “block”. Because the input of each puzzle becomes larger over time (resulting in a more complex calculation), the PoW mechanism requires a vast amount of computing resources, which consume a significant amount of electricity.