Digital Payments

Q.1
INTRODUCTION
Near-field communication (NFC) is a short-range wireless technology that makes your
smartphone, tablet, wearables, payment cards, and other devices even smarter. Near-field
communication is the ultimate in connectivity. With NFC, you can transfer information
between devices quickly and easily with a single touch—whether paying bills, exchanging
business cards, downloading coupons, or sharing a research paper. Near-field communication
(NFC) is a short-range wireless connectivity technology that lets NFC-enabled devices
communicate with each other. NFC began in the payment-card industry and is evolving to
include applications in numerous industries worldwide. Near-field communication transmits
data through electromagnetic radio fields to enable two devices to communicate with each
other. To work, both devices must contain NFC chips, as transactions take place within a very
short distance. NFC-enabled devices must be either physically touching or within a few
centimeters of each other for data transfer to occur. Because the receiving device reads your
data the instant you send it, near-field communications (NFCs) greatly reduce the chance of
human error. Rest assured, for example, that you cannot purchase something unknowingly
because of a pocket dial or by walking past a location that's embedded with an NFC chip (called
a "smart poster"). With near-field communication, you must perform an action intentionally.
CONCEPT AND APPLICATION
A Secure Element (SE) is a tamper-resistant platform (typically a one-chip secure
microcontroller) capable of securely hosting applications and their confidential and
cryptographic data (e.g., key management) in accordance with the rules and security
requirements set forth by a set of well-identified trusted authorities. Apple Pay uses SE to store
secret information associated with tokenized cards. In the iPhones after iPhone 6, and in Apple
Watch, an SE is embedded into the device’s near-field communication (NFC) chip. This is used
at payment terminals to perform transactions over NFC. SE emulates a payment card during an
Apple Pay transaction. Tokenization as a process is being adopted more and more in the
payments industry. Here we’ll try to understand the basics of Tokenization.

The following is a concise description on Tokenization technology:

Tokenization, when applied to data security, is the process of substituting a sensitive data
element with a non-sensitive equivalent, referred to as a token, that has no extrinsic or
exploitable meaning or value. The token is a reference (i.e., identifier) that maps back to the
sensitive data through a tokenization system. The mapping from original data to a token uses
meth the which renders tokens infeasible to reverse in the absence of the tokenization system
In the context of credit cards and Apple Pay, tokenization is used to replace the Primary
Account Number (PAN, or the credit card number) with a token. A token looks like a normal
credit card number, but it’s not the original PAN. Tokenization stops the original card number
from being used during transactions.
Tokens have no meaning by themselves and are worthless to criminals if a token is stolen.
There is no algorithm to derive the Primary Account Number if you have a token. This makes
it impossible for criminals to reverse engineer the Primary Account Number from a token.
The following diagram describes the transaction flow of Apple Pay. We will discuss these
step by step in the coming sections.

A card can be added to Apple Pay by either scanning the card or by submitting the card
information. Then this information is submitted to Apple servers.

Apple sends the received card information to the relevant card network (Visa, MasterCard,
American Express, Discover, and so on). Then the card network validates the card information
with the issuing bank.
After the validation, the card network acting as a TSP (Token Service Provider) creates a token
(which is called a DAN or a Device Account Number in the context of Apple Pay) and a token
key. This DAN is generated using tokenization and is not the actual card number.

Afterward, this information is sent back to Apple servers. After the device receives this
information from Apple servers, it is saved in the device’s secure element (SE). When you use
your Apple device at a POS terminal to make a payment, the device communicates with the
terminal to initiate a transaction. Apple Pay uses EMVCO’s contactless specification to
communicate with the terminal. If the terminal does not support EMV contactless, Apple Pay
falls back to using contactless MSD (magnetic stripe data) mode.
EMV Contactless mode
When EMV contactless mode is used, the Apple device communicates with the terminal
according to the EMV contactless specification. The secure element on the device generates a
dynamic cryptogram for each transaction using the token, token key, amount, and other
information related to the transaction. This dynamic cryptogram is then sent to the payment
processor along with the token (DAN), transaction amount, and other required information to
process the transaction.
Contactless MSD mode
Contactless MSD exists to support terminals which are still not able to process using EMV
contactless mode. Most of the terminals are still operating using contactless MSD mode. Let’s
take a deeper look at how a transaction goes through using contactless MSD mode.

MSD, or Magnetic Stripe Data, is how older cards store card details. Data is stored as tracks in
magnetic stripe cards. Magnetic stripe cards can have up to 3 tracks, and each track (track1,
track2, track3) has a different format. Please click here for additional information on track data.

In Apple Pay contactless MSD mode, the track2 data format is used to transfer the card data to
the payment processor which then communicates with the card network.

Let’s take a look at some examples track data sent from a terminal to the processor for an Apple
Pay transaction.

370295292756481=220672716078290600047

370295292756481=220672716078290600047

Above is an example of track data received from a terminal which was captured at a payment
gateway.
Let’s understand this data segment by segment,

Highlighted in yellow - This is the Device Account Number or the DAN (The example DAN
here is from an AmericanExpress card. You can validate the bank identification number (BIN),
or initial 6 digits in the credit card number, here).
Highlighted in blue - This is the credit card expiry year and month(yy/mm)
Highlighted in pink - This is the service code. Click here to understand more about this.
Highlighted in purple - This part of data is discretionary to the card network. In case of Apple
Pay, this is used as a dynamic card verification value (CVV).
We learned that in the EMV mode a dynamic cryptogram is generated. Here the dynamic CVV
plays the role of the cryptogram. This is generated using the token key and other transaction-
related data (similar to the generation of a dynamic cryptogram).

The track data shown above is sent to the acquirer along with the transaction amount. The
acquirer forwards this information to the relevant card network (Visa, MasterCard, and so on )
based on the BIN.

Completion of an Apple Pay Transaction

When the card network receives the transaction request, it identifies whether it’s an actual card
number or a tokenized card number. If it is tokenized (which is the case for Apple Pay
transactions), the card network validates the cryptogram (or dynamic CVV) using their copy
of the token key (the card network is acting as a TSP here).

After some other additional validations, the card network de-tokenizes the DAN and obtains
the original PAN (primary account number).

This transaction request is sent to the issuer (the bank or the financial institution who issued
the credit card) along with the original PAN. The issuer authorizes the transaction and sends
back the response which eventually reaches the POS terminal.
Apple Pay is a mobile payment software from Apple, a global tech giant. Like GPay or Google
Pay, Apple Pay is a mobile payment service that allows users to make online purchases by
means of contactless technology.

Apple Pay offers many benefits for Apple users:

1. Payment Made Easy
You can store your debit or credit card in the Apple Wallet for purchases. To make payments
via Apple Pay, simply move the phone close to an NFC scanner, and use the iPhone’s Touch
ID to accept or make purchases. It’s as easy as that. You may no longer need to carry
debit/credit cards anymore, as most stores accept Apple Pay.

2. Secured Connection
Since you don’t need a physical debit/credit card, there’s a reduced risk of someone stealing
your card(s) or their information. In fact, Apple Pay doesn’t use your card number to make a
purchase; rather, it uses a token called a “device account number” to complete the transaction.
This significantly decreases the likelihood of information theft or a security breach.

3. You Can Use It Offline

People love the fact that you don’t need an internet connection to make payments. With Apple
Pay, you can make purchases even when you’re offline, including while your phone is in
airplane mode.

4. No Additional or Hidden Charges

Apple Pay deducts approximately 0.15% from each purchase, which results in less money for
a merchant. But because Apple worked with major credit card companies and banks to give
their users a convenient experience, there are no other hidden or additional charges for using
the app.

5. Privacy
Apple doesn’t monitor your purchases or store details, so you can make payments with
confidence. Also, using device account numbers instead of the credit/debit card or number
itself helps prevent cyberattacks.

6. Availability
Apple Pay is accepted nearly everywhere today, with more stores jumping on the bandwagon
every day.

7. Apple Watch

• Double-click the side button to open your default card

• Scroll down if you want to choose another card.
 • Hold the display of your watch near the contactless reader until you hear a beep.

Security Risks of NFC

With this new contactless technology set to become an important part of our lives, people have
some valid and understandable security concerns. When using new technologies, the best way
to protect yourself against potential pitfalls is to know the risks associated with them.

One of the most common concerns with NFC technology is that of eavesdropping.
Eavesdropping occurs when a third party intercepts the signal sent between two devices. If that
third party intercepted a data transmission between a smartphone and a credit card reader then,
in theory, they would have access to that personal credit card information. They might also
pick up other personal information passed between two smartphones.

Another security concern is data manipulation or corruption. This occurs when a third party
intercepts the signal being sent, alters it, and sends it on its way. The information the receiving
party gets may be corrupt or modified. The attacker may or may not want to steal the
information. In some cases, the attacker simply wants to prevent the correct information from
getting through. This is often known as a denial-of-service attack.

Finally, the last of the security comes in the form of viruses. While smartphone viruses are
currently few and far between, they are growing. Security companies have pointed out that
when smartphones provide little financial gain for hackers, they are targeted less. NFC
technology would allow users to store valuable bank account and credit card information on
their smartphones, thus making them a target.

NFC compatible devices can only communicate when they are within four centimeters of each
other.
NFC tags do not power themselves. Instead, they rely on power from the smartphone or other
device interacting with them.
The first smartphone virus, a Trojan, was detected in October 2010 and several more have
appeared sync
CONCLUSION
NFC would enable all the users to make payments simply by tapping their mobile phones with
mobile phone reader like debit card or credit card transactions. Many banks, mobile operators,
vendors and companies are implementing NFC technology. But NFC has been failed to make
an impact so far. Since it is new technology therefore users need to learn about this technology
on how it works. NFC needs collaboration among banks, merchants and mobile companies to
provide a secured platform to users that support NFC technology. But it is very crucial to set
up a secured platform for NFC so that users could adopt this technology easily.
Q.2
INTRODUCTION
Digital payments are transactions that take place via digital or online modes, with no physical
exchange of money involved. This means that both parties, the payer and the payee, use
electronic mediums to exchange money. The Government of India has been undertaking
several measures to promote and encourage digital payments in the country. As part of the
‘Digital India’ campaign, the government has an aim to create a ‘digitally empowered’
economy that is ‘Faceless, Paperless, Cashless’. There are various types and methods of digital
payments. Please note that digital payments can take place on the internet as well as on physical
premises. For example, if you buy something from Amazon and pay for it via UPI, it qualifies
as a digital payment. Similarly, if you purchase something from your local Kirana store and
choose to pay via UPI instead of handing over cash, that also is a digital payment.
CONCEPT AND APPLICATION
Digital payments offer increased convenience as they are much faster than the traditional
methods of payment such as cash or cheques. People do not have any constraint of time or
location in the case of online payments. They can easily make payments from anywhere in the
world at any time, which often leads to better experiences. Digital financial payments also
facilitate record-keeping and improve the transparency of financial transfers by creating an
easily traceable electronic trail that can reduce financial leakages. The electronic trail also
improves and hastens dispute resolution other initiatives such as the Account Aggregator
platform enables broader inclusivity of all segments of India. It enables everyone to have access
to finances irrespective of where they are or in what segment they are. Digital payment adoption
should certainly increase in the country as using the electronic payment system has several
added advantages that range from faster payments, transparency, increased security, broader
inclusivity, to better customer convenience.
Digital payment is referred to as those payments that take place using the various types of
electronic medium. These methods do not require payment to be made in the form of cash or
providing cheque.
There are different modes and types of digital payments that are prevalent in India, which
are discussed in detail in the following lines.

1. Banking Cards
2. USSD (Unstructured Supplementary Service Data)
3. UPI (United Payment Interface)
4. AEPS (Aadhaar enabled Payment System)
5. Mobile wallets
6. Point of Sale Machines (PoS)
7. Mobile Banking
8. Internet Banking

1. Banking Cards: Banking cards are the most widely used digital payment system in
India. It offers a great set of features that provides convenience as well as security to
the users. Cards offer the flexibility of making other types of digital payments.
Customers can store card information in the mobile application and pay for the services
using the stored card information.

Banking cards (debit and credit cards) can be used for a variety of digital transactions
like PoS terminals, online transactions, as a payment medium in mobile apps, which
provide any kind of service like grocery, healthcare, rental cab booking, flight tickets,
etc.

The most popular cards are issued by service providers like VISA, MASTERCARD,
RuPay, AMEX etc.

2. USSD (Unstructured Supplementary Service Data): USSD is another popular digital

payment method. It can be used for carrying out cashless transactions using mobile,
without the need of installing any banking app.

The good thing about USSD is that it works without the requirement of mobile data.
The main aim of this digital payment service is to include those sections of people of
the society who are not included in the mainstream.

The striking feature of the USSD is that it can be availed in Hindi. The USSD can be
used for the following types of activities:

a. Initiating fund transfers

b. Making balance enquiries

c. Getting the bank statements

 3. AEPS (Aadhaar enabled payment system): AEPS can be used for all the following
banking transactions such as balance enquiries, cash withdrawal, cash deposit, Aadhaar
to Aadhaar fund transfers. All such transactions are carried out through a banking
correspondent which is based on Aadhaar verification.

This service can be availed if the Aadhaar is registered with the bank where an
individual has a bank account.

4. UPI (Unified Payment Interface): UPI is the latest digital payment standard where
the user having a bank account can transfer money to any other bank account using UPI
based app. UPI enabled payments occur throughout the day and all 365 days in a year.

Payment can be done using a Virtual Payment Address (VPA). To use UPI services,
one must have a bank account and a mobile number registered with that bank account.

5. Mobile Wallets: Mobile wallets are another popular payment option. Here the users
can add money to their virtual wallet using debit or credit cards and use the money
added in the wallet to perform digital transactions.

Some of the most popular mobile wallets are Paytm, Mobi Kwik, PhonePe, etc.

6. Point of Sale Terminals: PoS terminals are installed in shops or stores where
payments for purchases can be done through debit and credit cards. There are variations
of PoS, one which can be Physical PoS and the other one is mobile Pos. The mobile
PoS does away with the need of maintaining a physical device.

7. Mobile Banking: Mobile banking is a service provided by the banks through their
mobile apps in a smartphone for performing transactions digitally. The scope of mobile
banking has expanded extensively after the introduction of UPI and mobile wallets.
Mobile banking is a term used to describe a variety of services that are availed using
mobile/smartphones.

8. Internet Banking: Internet banking is the process of performing banking transactions

from the comfort of your home using a mobile phone/laptop/ desktop and an active
internet connection. The major type of transactions can all be done using internet
banking. Internet banking services can be availed round the clock and all 365 days in a
year, which makes it a popular choice for performing digital transactions.
The innovations and future of Digital payments are mentioned below:
1. AEPS (Aadhaar enabled payment system): AEPS can be used for all the following
banking transactions such as balance enquiries, cash withdrawal, cash deposit, Aadhaar to
Aadhaar fund transfers. All such transactions are carried out through a banking correspondent
which is based on Aadhaar verification. This service can be availed if the Aadhaar is registered
with the bank where an individual has a bank account.
2. UPI (Unified Payment Interface): UPI is the latest digital payment standard where the user
having a bank account can transfer money to any other bank account using UPI based app. UPI
enabled payments occur throughout the day and all 365 days in a year. Payment can be done
using a Virtual Payment Address (VPA). To use UPI services, one must have a bank account
and a mobile number registered with that bank account.

3. Mobile Wallets: Mobile wallets are another popular payment option. Here the users can add
money to their virtual wallet using debit or credit cards and use the money added in the wallet
to perform digital transactions. Some of the most popular mobile wallets are Paytm, Mobi
Kwik, PhonePe, etc.
CONCLUSION
The payment sector is at a tipping point, regulatory mandate coupled with the Fintech
revolution has ushered in a new era in the way the world pays. At a time when the fintech’s are
making immense inroads into the payments market through their solutions, bank and the card
networks are finding it increasingly difficult to stay relevant and risk being relegated to just
being a utility player for third parties, if they are reluctant to adapt. To remain relevant, the
banks and the card networks must redefine the payment experience through digital payments
experience through digital payment offerings, build personalized connections with customers
with the best-in-class customer experience and collaborate pragmatically with other banks and
fintech to open up hitherto untapped revenue streams. Presently, the solutions are primarily
focused on real time low high-volume peer to peer payments, ecommerce and m-commerce
payments and financial inclusion drives in case of developing economies. But with digital
payments getting ingrained in a most economies. But with the digital payments getting
ingrained in a most economies globally, newer prospects like real-time B2B payments and
cross border digital payments are fast emerging. By positioning strategically – and building on
their core strengths the incumbents can offer a competitive and compelling payment solutions
and thrive in this new payment landscape.
Q.3.
INTRODUCTION
Blockchain is a shared, immutable ledger that facilitates the process of recording transactions
and tracking assets in a business network. An asset can be tangible (a house, car, cash, land) or
intangible (intellectual property, patents, copyrights, branding). Virtually anything of value can
be tracked and traded on a blockchain network, reducing risk and cutting costs for all involved.
Business runs on information. The faster it’s received and the more accurate it is, the better.
Blockchain is ideal for delivering that information because it provides immediate, shared and
completely transparent information stored on an immutable ledger that can be accessed only
by permissioned network members. A blockchain network can track orders, payments,
accounts, production and much more. And because members share a single view of the truth,
you can see all details of a transaction end to end, giving you greater confidence, as well as
new efficiencies and opportunities. All network participants have access to the distributed
ledger and its immutable record of transactions. With this shared ledger, transactions are
recorded only once, eliminating the duplication of effort that’s typical of traditional business
networks. No participant can change or tamper with a transaction after it’s been recorded to the
shared ledger. If a transaction record includes an error, a new transaction must be added to
reverse the error, and both transactions are then visible.
CONCEPTS AND APPLICATION
a.)
A blockchain is a chain of blocks that contains information. Most people think that Blockchain
is Bitcoin and vice-versa. But it’s not the case. In fact, Bitcoin is a digital currency or
cryptocurrency that works on Blockchain Technology. Blockchain was invented by Satoshi
Nakamoto. As the name suggests, each block consists of a number of transactions, and each
transaction is recorded in the form of a Hash. Hash is a unique address assigned to each block
during its creation and any further modification in the block will lead to a change in its hash.
The features of blockchain which makes the complete management of cryptocurrencies
transparent are as follows:
1. Immutable
Immutability means that the blockchain is a permanent and unalterable network. Blockchain
technology functions through a collection of nodes.

Every node in the network has a copy of the digital ledger. To add a transaction every node
checks the validity of the transaction and if the majority of the nodes think that it is a valid
transaction then it is added to the network. This means that without the approval of a majority
of nodes no one can add any transaction blocks to the ledger.
Any validated records are irreversible and cannot be changed. This means that any user on the
network won’t be able to edit, change or delete it.
2. Distributed
All network participants have a copy of the ledger for complete transparency. A public ledger
will provide complete information about all the participants on the network and transactions.
The distributed computational power across the computers ensures a better outcome.
Distributed ledger is one of the important features of blockchains due to many reasons like:

In distributed ledger tracking what’s happening in the ledger is easy as changes propagate really
fast in a distributed ledger.
Every node on the blockchain network must maintain the ledger and participate in the
validation.
Any change in the ledger will be updated in seconds or minutes and due to no involvement of
intermediaries in the blockchain, the validation for the change will be done quickly.
If a user wants to add a new block, then other participating nodes have to verify the transaction.
For a new block to be added to the blockchain network it must be approved by a majority of
the nodes on the network.
In a blockchain network, no node will get any sort of special treatment or favors from the
network. Everyone will have to follow the standard procedure to add a new block to the
network.
3. Decentralized
The blockchain network is decentralized which means that there is no central governing
authority that will responsible for all the decisions. Rather a group of nodes makes and maintain
the network. Each and every node in the blockchain network has the same copy of the ledger.
Decentralization property offers many advantages in the blockchain network:

As a blockchain network does not depend on human calculations it is fully organized and fault-
tolerant.
The blockchain network is less prone to failure due to the decentralized nature of the network.
Attacking the system is more expensive for the hackers hence it is less likely to fail.
There is no third-party involved hence no added risk in the system.
The decentralized nature of blockchain facilitates creating a transparent profile for every
participant on the network. Thus, every change is traceable, and more concreate.
Users now have control over their properties and they don’t have to rely on third-party to
maintain and manage their assets.
4. Secure
All the records in the blockchain are individually encrypted. Using encryption adds another
layer of security to the entire process on the blockchain network. Since there is no central
authority, it does not mean that one can simply add, update or delete data on the network.
Every information on the blockchain is hashed cryptographically which means that every piece
of data has a unique identity on the network. All the blocks contain a unique hash of their own
and the hash of the previous block. Due to this property, the blocks are cryptographically linked
with each other. Any attempt to modify the data means to change all the hash IDs which is
quite impossible.

5. Consensus
Every blockchain has a consensus to help the network to make quick and unbiased decisions.
Consensus is a decision-making algorithm for the group of nodes active on the network to reach
an agreement quickly and faster and for the smooth functioning of the system. Nodes might
not trust each other but they can trust the algorithm that runs at the core of the network to make
decisions. There are many consensus algorithms available each with its pros and cons. Every
blockchain must have a consensus algorithm otherwise it will lose its value.
6. Unanimous
All the network participants agree to the validity of the records before they can be added to the
network. When a node wants to add a block to the network then it must get majority voting
otherwise the block cannot be added to the network. A node cannot simply add, update, or
delete information from the network. Every record is updated simultaneously and the updations
propagate quickly in the network. So it is not possible to make any change without consent
from the majority of nodes in the network.

7. Faster Settlement
Traditional banking systems are prone to many reasons for fallout like taking days to process
a transaction after finalizing all settlements, which can be corrupted easily. On the other hand,
blockchain offers a faster settlement compared to traditional banking systems. This blockchain
feature helps make life easier.

Blockchain technology is increasing and improving day by day and has a really bright future
in the upcoming years. The transparency, trust, and temper proof characteristics have led to
many applications of it like bitcoin, Ethereum, etc. It is a pillar in making the business and
governmental procedures more secure, efficient, and effective.
b)
Blockchain technology is an amalgamation of various technologies coming together under one
roof to help the system run smoothly. Mathematical computation, cryptography, game theory,
peer-to-peer systems, and validation protocols essentially join forces to power blockchain
operations. However, since blockchains eliminate the presence of a central governing authority,
all transactions must be robustly protected, and data must be stored securely on a distributed
ledger. The distributed ledger technology (DLT) works on a pre-set protocol with various
computers across the network (or nodes) arriving at a ‘consensuses to validate transactional
data. Each node adds, scrutinizes, and updates entries as they come. Blockchains have a layered
architecture to facilitate this unique way of authenticating transactions. There are five layers
involved, each with its distinct functionality.
Blockchains have a layered architecture to facilitate this unique way of authenticating
transactions. There are five layers involved, each with its distinct functionality. Let us dive
right in and understand the architecture and what each layer does.
1. The Hardware Infrastructure Layer:
Blockchain data lies securely stored in a data server. When we browse the web or use any
blockchain apps, our machines request access to this data from the server. The framework that
facilitates this data exchange is known as the client-server architecture. Blockchains are peer-
to-peer (P2P) networks that allow clients to connect with ‘peer-clients’ to make data sharing
faster and easier. It is nothing but a vast network of devices communicating with each other
and requesting data from one another. This is how a distributed ledger gets created. Each device
communicating with another device on the network is a node. Each node randomly verifies
transactional data.
2. The Data Layer:
Blockchains are nothing but a long chain of ‘blocks’ containing transaction data. When the
nodes validate a certain number of transactions, the data is bundled into a ‘block,’ added to the
blockchain, and linked with the previous block of data. The ‘Genesis Block’ is the first block
in the chain and therefore does not need to be linked with any previous block. Instead, the
subsequent block is linked with the Genesis block, and the process is repeated every time a
new block is added. This is how a blockchain forms and continuously grows.
Every transaction is ‘digitally signed’ with the private key of the sender’s wallet. Only the
sender has access to this key, thus ensuring that the data can neither be accessed nor be
tampered with by anybody else. This is called ‘finality’ in blockchain terminology. The digital
signature also protects the owner’s identity, which is itself encrypted, thus ensuring maximum
security.
3. The Network Layer:
The P2P framework enables various nodes to exchange transaction data to arrive at a consensus
about the validity of a transaction. This means that every node must be able to discover other
nodes on the network for fast communication. It is the network layer that facilitates this ‘inter-
node communication’. As node discovery, block creation, and block addition are also managed
by this layer, it is also referred to as the ‘Propagation Layer.’
4. The Consensus Layer:
This is the most critical layer in blockchain operations. This layer is responsible for validating
transactions, and without it, the entire system will fail. This layer runs the protocol that requires
a certain number of nodes to verify one transaction. Therefore, every transaction is processed
by multiple nodes that must then arrive at the same result and agree on its validity. This
framework maintains the blockchain’s decentralized nature as no node has sole control over
any transactional data, and the role is distributed. This is called the consensus mechanism.
With so many nodes processing transactions, bundling them up, and adding them to the
blockchain, multiple blocks may get created simultaneously, resulting in a branch in the
blockchain. However, there must always be a single chain block addition, and the consensus
layer also ensures that this conflict is resolved.
5. The Application Layer:
This is the layer on which smart contracts and decentralized applications (dApps) run. Smart
contracts make decisions based on certain triggers such as contract expiration dates,
achievement of spot prices, etc. The actions that follow these decisions are executed by dApps.
And all of this happens on the application layer.
dApps also facilitate the communication between user devices and the blockchain. Therefore,
the application is like the user-facing front end, while the main blockchain is the backend,
where the data remains securely stored.
So, there you have it - the 5 layers of a blockchain that help it function smoothly. However, if
you have been reading about blockchains, you must have also come across terms like layer-0,
layer-1, layer-2, and so on. What are these layers, then? Let’s find out.
Layer 0:
This layer consists of the hardware and paraphernalia required to run the network and the
consensus mechanisms without any glitch. It also includes an internet connection.
Layer 1:
This layer governs the protocols that ensure security across the blockchain network. Layer 1
encompasses the consensus mechanism, coding language, and all the rules embedded in the
code for the operations of the blockchain. Therefore, sometimes this is also called the
‘Implementation Layer.’ When users mention the Bitcoin blockchain, they are referring to this
layer.
Layer 2:
To improve the throughput of blockchains, processing power must be added. But doing so
means the addition of more nodes, and this clogs the network. However, as mentioned earlier,
the addition of nodes is critical for maintaining the decentralized nature of a blockchain. This
means that if either scalability, decentralization, or throughput are tinkered with, they will
affect each other on layer 1. This is called the ‘classic blockchain trilemma.’
Hence, layer 1 cannot be scaled without moving all the processing to a separate layer built atop
the first layer, i.e., layer 2. This is made possible by enabling the integration of third-party
solutions with layer 1.
Layer 2 is a new network that handles all the transaction authentication and decongests layer
1. Layer 1 only handles the creation and addition of blocks to the blockchain. The new layer-2
network sits over the layer 1 network and continuously communicates with it.
The Lightning Network is an example of a layer 2 blockchain sitting on the Bitcoin blockchain.
Layer 3:
Smart contracts and dApps that only handle decision making and execution of follow-up
actions form layer 3. Since the maximum functionality of the blockchain is derived from the
innovation of dApps, this is the layer that interfaces between the real-world applications and
the underlying layers that facilitate everything.
CONCLUSION
A blockchain is a distributed database or ledger that is shared among the nodes of a computer
network. As a database, a blockchain stores information electronically in digital format.
Blockchains are best known for their crucial role in cryptocurrency systems, such as Bitcoin,
for maintaining a secure and decentralized record of transactions. The innovation with a
blockchain is that it guarantees the fidelity and security of a record of data and generates trust
without the need for a trusted third party. One key difference between a typical database and a
blockchain is how the data is structured. A blockchain collects information together in groups,
known as blocks, that hold sets of information. Blocks have certain storage capacities and,
when filled, are closed and linked to the previously filled block, forming a chain of data known
as the blockchain. All new information that follows that freshly added block is compiled into
a newly formed block that will then also be added to the chain once filled. A database usually
structures its data into tables, whereas a blockchain, as its name implies, structures its data into
chunks (blocks) that are strung together. This data structure inherently makes an irreversible
timeline of data when implemented in a decentralized nature. When a block is filled, it is set in
stone and becomes a part of this timeline. Each block in the chain is given an exact timestamp
when it is added to the chain.
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