Almost overnight Bitcoin took the financial market by storm as it became the first successful cryptocurrency exchange in the United States in 2009. The success of Bitcoin has spawned new cryptocurrencies, such as Ethereum, Tether, and Binance Coin, to name a few. While cryptocurrency was once touted as being a vehicle for illicit activities, digital currency has, for some time now, been recognized as a legitimate form of payment, and many countries are considering recognizing cryptocurrency as legal tender.
As more businesses begin to accept cryptocurrency as a form of payment and its impact across industries and markets increases, so does the need for a basic understanding of the currency. The following Q&A addresses some of the questions that everyone is asking.
What is Cryptocurrency?
Cryptocurrency is a peer-to-peer version of electronic currency that allows online payments to be sent from one party to another without going through a financial institution. From a user perspective, cryptocurrency is similar to cash for the internet; it is a decentralized currency that gives no one user central authority or special privileges to regulate and police transactions.
How is Cryptocurrency Valued?
Unlike physical currency, cryptocurrency derives its value from the community of users who collectively believe it holds value. Each cryptocurrency’s particular transfer method, scarcity, and divisibility are traits that users believe create a valuable cryptocurrency.
Who Controls Cryptocurrency Networks?
Cryptocurrency is managed by a decentralized network rather than by any single authority. This means there isn’t one controlling authority deciding when to issue more, determining how much to “print,” or investigating fraudulent use of the cryptocurrency.
Are Cryptocurrency Transactions Anonymous?
Despite public perception that cryptocurrency is wholly anonymous, cryptocurrency networks rely on modern cryptography to replace legal names and signatures with alphanumeric public addresses and digital signatures. This method allows users to share highly sensitive and private information through public platforms while maintaining anonymity. Mathematical algorithms scramble the original message into a random set of numbers and letters which can only be accessed by the intended recipient.
How do you Access and Exchange Cryptocurrency?
In order to access and exchange cryptocurrency, users need to have a digital “wallet” to store their cryptocurrency, and there are generally two wallets to choose from: One is to use a peer-to-peer (“P2P”), or “decentralized” exchange and the other is to use an online “centralized” exchange platform. When using a peer-to-peer exchange, users access and exchange cryptocurrency through P2P websites without the reliance on central financial intermediaries such as brokerages or exchanges, and store their cryptocurrency in “hard wallets,” which are physical devices such as a flash drive, or can store it on a “mobile wallet,” where users can create a wallet and instantly transfer money to other wallets by scanning a QR-Code. This decentralized exchange gives owners full control over their cryptocurrency, passwords and keys, and allows for full anonymity.
Cryptocurrency owners who use an online exchange platform to hold and manage their cryptocurrency are using a “hosted” wallet. A hosted wallet is where a third party, such as Coinbase, Robinhood, Gemini, Voyager, or Crypto.com holds custody of a user’s private key but does not consummate cryptocurrency transactions. This is similar to how a bank holds your money in your checking account. This option alleviates users’ worries of losing their private keys or flash drive but increases the risk of their cryptocurrency being vulnerable to thefts and hackers.
Storage Methods for Cryptocurrency
Cryptocurrency wallets can be maintained using either “hot storage” or “cold storage.” Hot storage is the storage of cryptocurrency on the internet or on a device connected to the internet. Cold storage refers to the storage of cryptocurrency on a device not connected to the internet and without the use of an online exchange platform. An individual using cold storage may place their cryptocurrency information on a specialized flash drive or a physical sheet of paper. You could compare this storage method to banks moving customer funds into a vault rather than keeping funds in circulation at the bank teller desk.
What is the “Blockchain”?
A cryptocurrency’s blockchain establishes ownership by recording all transactions on the network. To understand how the blockchain works, imagine you are playing poker with a group of strangers, and no one has any chips. Instead, the group decides each player will individually record every player’s bets, wins, and losses to accurately reflect the game. After a couple of hands, you fill up a page with all the bets, wins and losses – a record of each transaction of the game. By the end of the game, you compare your records; any mistakes or attempts to cheat can be corrected by comparing records.
The blockchain works similarly to recording the best in the poker game. No one person is in charge of verifying each cryptocurrency transfer. Instead, all users work to determine and settle any dispute about ownership. Each “block” on the blockchain represents a set of verified transactions that selected users have time-stamped for every user to view and confirm.
What is “Mining”?
Mining is the process where users time-stamp a set of new cryptocurrency transactions and then place those new “blocks” of transactions on the blockchain for every user to view and verify.
Although seemingly simple, the process of verifying transactions is arguably the most important and innovative creation used to successfully maintain a decentralized cryptocurrency network. To create the Bitcoin network, developers invented a way to give people the ability to time-stamp transactions while simultaneously maintaining a decentralized network through “mining.”
Who “Mines” the Blockchain?
Not all users who have an interest in mining the blockchain are allowed to do so; only users who successfully complete a complex mathematical problem created by the network are allowed to mine it. Once a miner solves the problem, the miner can verify and record a new block of transactions not previously recorded on the blockchain. Typically, miners are rewarded by the network with cryptocurrency and receive additional compensation from transaction fees.
This article is the first in an ongoing series that will address cryptocurrency trends, considerations, and issues that impact estate planning, tax, real estate, corporate, and governmental matters.
This article provides information for educational purposes. Jones Foster does not offer advisory or brokerage services, nor does it recommend specific investments, including stocks, securities, or cryptocurrencies.