November 13, 2017
Part 1 Blockchain and Cryptocurrencies: What You Need to Know
Posted by Andries Verschelden
Blockchain and cryptocurrencies are mainstream news, especially as Bitcoin continues to hit record prices. But while most people have heard of this exciting new technology, it’s still not widely understood. To help you get up to speed and better anticipate the potential impacts on your business, here are the basics.
What is cryptocurrency?
Cryptocurrency is currency that exists only online and doesn’t have a physical form. Bitcoin is the most well-known example, but there are hundreds of others, such as Ethereum, Litecoin and Dash.
These digital assets use cryptography, the solving of codes, to secure transactions, keep the identity of coin owners private and produce new coins. When you own a cryptocurrency, you’re given a private key that only you know. You need to input this key to get past the encryption and access your coins.
To create new coins, a computer needs to solve a series of mathematical equations―a process known as mining. After enough equations have been solved, the miner receives a new coin, which they can keep or sell.
Are cryptocurrencies legitimate?
Throughout history, all kinds of things have been used as money. Tulip bulbs were pushed to the value of a house in the 1600s. Gold sells for a high price today, even though it has no particularly valuable characteristics, except for being rare. Currency is only valuable because we believe in it, and cryptocurrency may be the next step forward.
Cryptocurrencies can seem like a strange substitute for traditional money. After all, they exist digitally and have no physical form. But, they fit the three characteristics of a currency:
- Must be accepted as a unit of exchange, meaning people accept them for transactions
- Must be able to store value
- Should be measurable as a unit of accounting
Cryptocurrencies meet all of these requirements. People accept them for payment, and they are also rare, which allows them to be a store of value. The maximum number of Bitcoins that can ever be released is capped at 21 million, for example. Cryptocurrencies also can be easily measured in units for accounting.
This is only part of the story, however. Another reason cryptocurrencies could reshape the financial system is their underlying technology, known as blockchain.
What is blockchain?
Blockchain is a public ledger for tracking all transactions that occur within a particular ecosystem. For example, if you send one Bitcoin to your friend, this transfer will be recorded on the Bitcoin blockchain, similar to how your bank would record a wire transfer between you and your friend on their ledger, and it would be recorded on the receiving bank’s ledger. The big difference with blockchains is that there is only one ledger, and everyone in the ecosystem is on it. The key part of this system is that the database is stored on potentially hundreds or thousands of nodes (computers), which all keep a copy of the ledger and validate with one another that they are recording the same information.
The ledger can be open to the entire public or just to a limited group. But since the information is stored on multiple nodes, it’s much more secure. It becomes very, very difficult to reverse a transaction or illicitly change the record, short of hacking into hundreds of nodes and changing the information on every single one.
This decentralized ledger system also makes it incredibly easy to share information. With current financial systems, if a transaction happens, separate databases need to be updated. Going back to the banking example: If you transfer money to someone else’s bank account, both banks need to update their records, which takes time. With blockchain you’re on the same distributed ledger, which updates immediately.
Advantages of cryptocurrencies/blockchain
Cryptocurrencies speed up the transfer of funds. When you want to transfer coins, you submit a request to the distributed ledger, using your private key. There’s no long delay, like with escrow or a bank-to-bank transfer, where the two financial institutions compare records to prove you actually have the money in your account.
Cryptocurrencies are also simple to split up. You can divide a coin into as many small pieces as you want for a currency, and you can make infinite splits, since it’s just data on a screen. There’s no need to print new bills or physically divide up a piece of gold.
The blockchain system also is secure and extremely difficult to hack. If information is stored with only one network, hackers just need to break into one database to steal money. With blockchain, every transaction is encrypted in a way that makes it virtually impossible to reverse, which prevents anyone from going back into the ledger and changing information.
Finally, there is no central bank or single government authority behind cryptocurrencies. Supporters like the fact that there is no one government setting the value of coins—instead, it’s set by the free market.
There are some negatives. Blockchain and cryptocurrencies are still new and unfamiliar, and it will take time for people to feel comfortable with the technology and adopt it in their daily lives. As a popular new trend, cryptocurrencies are also prone to speculative swings in value. (Many financial industry observers point to the current high valuations of cryptocurrencies as evidence of a bubble.) The influx of money is encouraging technology development, but it can also be stressful for people buying in.
The lack of central authority can also be viewed as a negative. There’s no way for a central bank to change the value of coins to adjust to economic cycles, like how the Federal Reserve adjusts interest rates to control the money supply. A decentralized currency could make it harder for the government to respond to recessions.
Despite these challenges, cryptocurrencies and blockchain should only become more popular as we get better at using the technology. This could mean big changes in the way your company operates. In my next post, we’ll look at four possible business applications that could be just around the corner.
Find more helpful insights from Armanino’s Outsourced Finance & Accounting team.
Andries leads the Blockchain practice and brings a passion for growth to his clients. He works with a variety of crypto and blockchain projects and exchanges, helping them navigate accounting, audit, tax and risk best practices as they grow. He also helps non-crypto industry clients transform their business through blockchain technology enablement.
Prior to joining Armanino, Andries was CEO at The Brenner Group, a boutique Silicon Valley financial services firm. Before that, he was a partner at Moore Stephens Belgium. He started his career at PricewaterhouseCoopers. He grew up in Belgium, and lived and worked in New York and Shanghai before moving to California.