What is distributed ledger technology, and how does a blockchain work?

#What is a ledger, and what makes one 'distributed'?

A ledger is simply a record book: who owns what, and who paid whom. Your bank keeps a ledger of your account; a stock exchange's depository keeps a ledger of who owns which shares. Normally one organisation holds the master copy and everyone trusts it.

A distributed ledger is shared instead. The EU's crypto law defines it as an information repository that keeps records of transactions and that is shared across, and synchronised between, a set of network computers (called nodes) using a consensus mechanism⁠^[1]. Distributed ledger technology (DLT) is the technology that makes such ledgers work⁠^[1]. The Committee on Payments and Market Infrastructures at the BIS has published a framework for central banks to analyse how distributed ledgers might be used in payment, clearing and settlement⁠^[2].

#How does a blockchain work, step by step?

A blockchain is the best-known kind of distributed ledger. The US National Institute of Standards and Technology (NIST) describes blockchains as tamper-evident and tamper-resistant digital ledgers implemented in a distributed fashion, usually without a central authority such as a bank, company or government⁠^[3]. Each block has a header with information about the block and a body containing validated transactions, and every block header except the first contains a cryptographic link to the previous block's header⁠^[3].

#What is a hash, and why does it make tampering obvious?

A hash function turns any input into a short, fixed-length fingerprint called a digest. NIST explains that even the smallest change to the input, such as a single bit, produces a completely different digest, and names SHA-256, a hash with a 256-bit output, as one used in many blockchain implementations⁠^[3]. Because each block stores the previous block's hash, changing an old transaction would change its block's hash and break every link after it.

#How do the computers agree on what is true?

That is the job of the consensus mechanism: the rules and procedures by which nodes agree that a transaction is validated⁠^[1]. NIST describes two common families. In proof of work, a user publishes the next block by being the first to solve a computationally intensive puzzle. In proof of stake, the idea is that users with more value staked in the system are less likely to want to subvert it⁠^[3]. Each has trade-offs: NIST notes, for example, that proof of work carries the potential for a '51% attack' by someone who obtains enough computing power⁠^[3].

#What is the difference between permissionless and permissioned ledgers?

NIST draws the line by who may publish records. Permissionless networks are open to anyone publishing blocks without needing permission from any authority; permissioned networks require publishers to be authorised by some authority⁠^[3]. Public cryptocurrencies use permissionless designs. Banks and central banks testing DLT usually choose permissioned ones, so they know who runs each node.

#How is DLT used in finance today?

The main uses are stablecoins, crypto-assets and tokenized real-world assets. Central banks are experimenting too. The BIS proposes a 'unified ledger', which may or may not use DLT, bringing tokenised central bank reserves, commercial bank money and financial assets together⁠^[4]. Its Project Agorá, with eight central banks and over 40 financial institutions, is testing a shared programmable platform for wholesale cross-border payments⁠^[5]. The Financial Stability Board notes that tokenisation based on DLT is still small, with very low adoption⁠^[6].