Understanding Cryptocurrency

I've already confessed that I'm not a major techie. Because of that, I tend to delay learning "new things" - maybe even longer than I should. And cryptocurrency is one of those "new" things, even though the technical foundations of cryptocurrency date back to the 1980's and concepts of digital currency were discussed back in the late 1990's. But I didn't hear about it for the first time until my first Scaling New Heights in 2016, and I've put off learning about it until 2021!

What exactly is cryptocurrency? 

Ignoring history from the development of money way back when until current times when many of us don't even use cash (which is covered in this great video on How Cryptocurrency ACTUALLY Works), you need to understand that at its most base nature cryptocurrency is simply the transfer of digital assets.

In banking with traditional money, each bank maintains a ledger where they debit and credit accounts. If both accounts in a transaction are within the same bank, then that bank makes both the debit and credit entries. If the accounts are located in different banks, then both banks have to make entries. Each bank has their own ledger which is connected through a centralized ledger at a clearing house. This system has been working fairly well for quite a few years, but centralized ledgers are vulnerable to fraud and cyber attack.

With cryptocurrency, there is only one ledger where all entries are made; however, it is a de-centralized ledger that does not require a central authority to process entries. Instead, the cryptocurrency ledger is a distributed ledger, meaning there are multiple copies of it located at nodes (computer servers) that are all updated simultaneously each time a transaction is entered. Because of these multiple copies of the single ledger, distributed ledgers are far safer than centralized ledgers for two reasons. First, they are transparent - what happens is recorded in millions of copies accessible by millions of people. Second, fraud is all but impossible as every transaction is checked across all copies of the ledger before it is made. Transactions are by their nature open, verifiable and trackable.

The existence of distributed ledgers has led to cryptocurrency mining. Although each person who is a member of a cryptocurrency network has a copy of the ledger, there are individuals who set up computers specifically dedicated to processing transactions on their copy of the ledger in exchange for compensation in that cryptocurrency. In fact, a recent story I ran across was two kids who are making $30,000 each month in mining bitcoin! 

What does blockchain have to do with cryptocurrency?

Blockchain is used to protect cryptocurrency. It is a secure way of organizing the single ledger that records transactions. Each transaction is recorded as a block, and the block contains information about the transaction including the parties, amount and time stamp of the transaction as well as the unique identifier of the transaction which is called a hash. Most importantly, the block also contains the previous unique identifier of the last transaction that was made - the previous hash. Because each block contains the current AND the previous hash, each transaction is able to be compared to previous blocks to verify the accuracy of the transaction.

This is the magic behind blockchain. To steal from the system, someone would have to not only create a fraudulent transaction, but would also have alter the hashes of every transaction that comes after it. And that person would have to do that across all of the copies of the ledger at the same time. 

You may have heard people using blockchain and distributed ledger technology almost interchangeably, which is understandable considering their relationship. 

A distributed ledger is a single ledger that stores transactional data in multiple copies of the ledger which are all simultaneously and identically updated as transactions occur.

A blockchain is the chain built of each individual transaction block that contains information about that individual transaction. The hashes (the unique identifier of the current transaction and the unique identifier of the previous transaction) are what holds the chain together.

So the blockchain protects the integrity of the transactions that exist inside the distributed ledger.

Is that it?  

No. Sorry. There is more to understand, but I know that when I got to this point in understanding cryptocurrency, I needed to take some time to chew on it mentally. After all, I've never really gotten past the fact that somehow at the beginning of time we all decided that gold was worth something. 

So, I will have more questions and more answers for you in the coming weeks, such as - How are my transactions private if everyone can see them? What is proof of work and how is that part of all of this? What is the future of cryptocurrency? And...

What do you as an accountant, bookkeeper or tax preparer need to know about cryptocurrency?