Although they’ve been around since 2008, cryptocurrencies continue to draw fascination from every corner of the globe, making their way into TV news reports, investor meetings and even cocktail party conversations. But what are they? How do they work? And do they represent the future of a digital, cashless society?
This innovative asset class presents many opportunities and, along with it, significant risks. One thing is for certain: some embrace cryptocurrencies, some do not and some still don’t understand the idea enough to choose a side. Below are a few basic questions and answers to help remove some of the mystery surrounding these “new” currencies.
Traditional currencies, such as the U.S. dollar, are regulated by a government/central authority and take a physical form that can be handed to someone to complete a transaction. Cryptocurrencies are solely electronic. Instead of being backed by a centralized system, they operate via a decentralized peer-to-peer network, which uses specialized encryption techniques as a secure way to record transaction activity. While there are more than 1,500 cryptocurrencies, each with varying degrees of risk, liquidity, value, etc., Bitcoin is the original and probably most commonly known cryptocurrency today.
Anyone can, theoretically, create a private currency. What matters is that each person in the transaction has faith in the currency as a legitimate and authentic exchange of value. The value of most currencies is largely driven by two primary beliefs. First, the issuing government has the ability to back the currency. Obviously, this belief works best in developed and stable countries. A lack of faith in government-issued currency can be crippling to unstable countries. In some cases where using a decentralized currency is viewed as a positive, the use of cryptocurrencies has helped spur economic growth.
The second driver of value for traditional currencies is authenticity — the fact that the currency is “real” and extremely difficult to replicate. If everyone could create U.S. dollars in their own home, the value of the dollar would decrease significantly. Similarly, people trust the authenticity of a cryptocurrency, largely in part because of the blockchain technology that protects it.
The electronic nature of cryptocurrencies is also driving their value. Much of our wealth today is recorded via accounts for which we have electronic access but we do not physically hold those assets.Cryptocurrencies are built to easily transact in a digital environment. Imagine a world where you travel across borders without exchanging currencies because cryptocurrencies have no geographic boundaries.
Generally speaking, as societal acceptance of cryptocurrencies has risen over the past several years, there has been a dramatic rise in their value. And, as with any asset, an increase in demand means an increase in value and price. Still, there is a lot of speculation in this asset class, which can drive significant volatility.
In its simplest form, blockchain is a digital ledger that validates and records thousands of transactions. Each transaction is recorded on a block and one transaction builds on the next, hence the name blockchain. Blockchain is built on the concept of a decentralized network, which works on a peer-to-peer basis. So when someone enters into a transaction using a cryptocurrency, that transaction must be approved by the decentralized network, which verifies the transaction by performing sophisticated math called cryptography.
There are websites known as crypto exchanges, such as Coinbase, through which anyone can use traditional currencies to purchase cryptocurrencies, like Bitcoin, Ethereum and Litecoin. Some crypto exchanges do not accept traditional currencies, but do accept cryptocurrency as payment for other cryptocurrencies offered on their sites.
Crypto exchanges are currently not regulated like banks or stock exchanges. After a cryptocurrency is purchased, most people move their holdings off of these platforms to other storage options, such as electronic wallets stored online or offline. If stored online, good cybersecurity controls are important to have in place to mitigate the risk of hacking. Regardless, it is critical to protect the private keys that provide access to these assets. If the keys are lost, there is no other way to access the purchased cryptocurrencies. Custody of cryptocurrencies is a top priority, so a strong information technology security environment is critical.
Cryptocurrencies can be very secure if those who hold custody of the assets have the appropriate IT security controls in place. The blockchain depends not on people to secure transactions but on sophisticated cryptography. Cryptography was difficult to create and adds a very secure way to validate the transactions that occur.
Also, the protocol of the blockchain is built so that the block cannot be modified once it is recorded.
The public nature of the blockchain also creates a much more secure environment than a centralized network. In a centralized network there is a single point of data collection and storage, which means a hacker only needs to gain access to that one single point to manipulate or modify transactions. In a decentralized network, there are multiple points within the network that are critical to a transaction, making entry by an unauthorized individual into that network much more difficult.
This asset class is still in its infancy, which means there’s still a lot of speculation about its future. There has been discussion that some central banks are considering their own cryptocurrencies, including China, Japan, Sweden and even the United States, although that may be years away. But users like cryptocurrencies specifically because they are not regulated by a central bank, and are thereby free from government influence. So even if that happens, users may continue using existing cryptocurrencies on decentralized networks.
The biggest area I am excited to watch is how blockchain technology may be adapted in many ways to help businesses run more efficiently and help society have better transparency and confidence in transactions. It could really change the way we do business.
Please contact contact Corey McLaughlin at corey.mclaughlin@cohencpa.com for further discussion.
Cohen & Company is not rendering legal, accounting or other professional advice. Information contained in this post is considered accurate as of the date of publishing. Any action taken based on information in this blog should be taken only after a detailed review of the specific facts, circumstances and current law.