Written by Annie Zhang
This post was originally published on FinLitMe.
Cryptocurrencies have been making headlines frequently in recent times. This includes a whole series of digital currencies such as Bitcoin and Ethereum to name two of the most well-known out of a list of over 40 known cryptocurrencies.
Bitcoin was the first cryptocurrency to emerge on the market in 2009. It was created by Satoshi Nakamoto and was initially priced at nearly nothing. By March 2010, it was priced at only US$0.003/Bitcoin. At the end of 2017, it was priced at a whopping US$13,000/Bitcoin and subsequently fell to under US$10,000/Bitcoin a few days into January 2018. The exponential growth is what made Bitcoin a staple name in the financial headlines in the last year. There have been reports of people selling all of their possessions to invest in Bitcoin. Many millennials are trying to buy in now to earn some quick cash and capitalize on the gains. The market frenzy is reaching levels of insanity, but what many don’t realize is that there is also the possibility of major losses.
The interesting thing is; most people don’t really know what a cryptocurrency is. There are a couple of key features that make cryptocurrencies unique.
- It is decentralized
- It is digital
- It is built using blockchain
Normally, in an economy, the amount and the regulation of currency is controlled by the central bank. This is known as centralized currency. The central bank is a government institution with the ability to print money and adjust interest rates. They control the total supply of money in that economy. The government monitors money fraud. Financial institutions such as retail banks and credit unions act as intermediaries to facilitate transactions to prevent fraud. When performing their role properly, they ensure that your money comes from a valid source that isn’t illegal or fraudulent. Cryptocurrencies are not regulated by a central bank and therefore making them decentralized which means they need another means of controlling supply and validity.
What makes cryptocurrencies even more challenging to monitor is that they only exist digitally and there is no central entity overseeing the supply. This exposes each unit of a cryptocurrency to the risk of being counterfeit. Why not copy one Bitcoin 100 times, 1000 times?
The measure used to control supply and prevent counterfeiting lies in blockchain.
At a very basic level, a blockchain is a sequence of data and each cryptocurrency’s blockchain is slightly different but the basic premise is the same. This blockchain is a record of where a particular cryptocurrency has been spent since its inception, also known as a “ledger” and it is universal.
For ease of discussion, let’s use Bitcoin as an example. The Bitcoins that appear to be in your account are really a set of queries from the universal ledger and the ledger has indicated your account as their current “address”. This is a major control that prevents counterfeiting. The universal ledger is publicly available and cannot be altered by an individual. Because the Bitcoins aren’t actually in your account per se, you can’t make a copy of it.
The blockchain is released in small “blocks” of data. For Bitcoin, each block is 1MB in size. To ensure the legitimacy of the new block, the block’s information is encrypted using cryptography with a hash ( or reference code) that links it to the last block. In order to read the information in these block, it needs to be decrypted.
This is where cryptocurrency miners come in. Miners could be anyone in that invested in the computer hardware and software equipped to break the code. Once a new block is released, miners from all over the globe race to decrypt the block of data. The first miner to decrypt the block is compensated with units of the cryptocurrency associated with the data that was just decrypted. So, these people are paid to maintain the universal ledger.
However, the amount of compensation released with each block may decrease as the supply of the cryptocurrency increases. Bitcoin will eventually cap at around 21 million units in circulation. This essentially controls the supply without a central bank.
Opinions over the viability of cryptocurrencies in the future as a staple and mainstream currency are highly debated. Supporters revere them and believe that they will eventually replace physical currencies. Skeptics have demonized them as the very thing that will corrupt economies. Both sides have valid arguments.
Blockchain technology is an interesting concept that many believe can be applied in the financial markets today; possibly integrated into the banking system. Some believe it will do away with or revolutionize the modern banking system entirely.
Conversely, some are concerned with the viability of the blockchain once the supply is capped. Once the supply of Bitcoin reaches 21 million units, miners will no longer be compensated for their efforts. The main incentive that drove them to mine and to maintain the universal ledger is gone, which could spell problems for the market as a whole.
The market will continue to watch cryptocurrencies; opinions will continue to clash. But like everything else that we have come across in history, we’ll figure it out eventually; whether it’s good or bad or neither. But to the everyday investor, it’s important to understand what you invest in before jumping on a bandwagon.
Annie Zhang will be the guest speaker for the Networking 101 seminar on Thursday, February 8th. Register for the seminar here.
Written by Annie Zhang, CPA, CA
Annie is the founder of FinLitMe. She has worked in public accounting for 5 years in both audit and consulting. Her client base mainly consisted of large mutual funds and pooled funds, and large banks in Canada in their adoption of new accounting standards. She currently works for one of the biggest banks in the world supporting the finance function in reporting underwriting deals, trade activity and operations. You can find her on LinkedIn here.