What is Cryptocurrency?

How Does it Work?

Everyone seems to be talking about cryptocurrency these days, but many are unsure how to define it and fewer still, know exactly how it works. Cryptocurrency is a digital construct without physical substance; the only evidence of its existence is the digital record or ledger indicating balances held (like a balance sheet) and transactions that have occurred (like an income statement). What follows is a basic primer on how cryptocurrency works and how it differs from physical currencies.

Everyone seems to be talking about cryptocurrency these days, but many are unsure how to define it and fewer still, know exactly how it works. Cryptocurrency is a digital construct without physical substance; the only evidence of its existence is the digital record or ledger indicating balances held (like a balance sheet) and transactions that have occurred (similar to an income statement). What follows is a basic primer on how cryptocurrency works and how it differs from physical currencies.

Why Does it Have Value?

Like many physical currencies across the world, it has value because people agree it has value, are willing to use it as a measure of the value of goods and services, and most importantly, willing to accept it in exchange for those goods and services. The U.S. dollar used to be backed by gold; each Federal Reserve Bank was required to hold a gold certificate for at least 25 percent of its Federal Reserve note liability. The gold certificates represented gold held by the U.S. Treasury. In March 1968, President Johnson removed that requirement, which was sometimes referred to as the “gold cover,” and in August 1971, President Nixon suspended the ability to convert U.S. dollars into gold in international transactions, thus completely ending the gold standard that had been the backbone of global monetary systems for centuries. Nevertheless, the dollar retains value because it is still accepted in exchange for goods and services. Currently, the U.S. dollar is the world’s de facto reserve or global currency despite a lack of backing by gold reserves.

Today, the major physical currencies trade on global currency exchanges and their value relative to each other is determined by supply and demand and by the stability of the issuing government. The government-issued currencies not backed by a commodity like gold are sometimes referred to as fiat currencies. Most modern paper currencies like the U.S. dollar and the euro are fiat currencies.

These physical currencies, issued and regulated by governments, handle transactions through a banking system that includes private online payment platforms like PayPal. Digital currencies are not issued or regulated by any government; they are privately issued and tracked on a public digital ledger via an algorithm.

How is Cryptocurrency Used to Pay for Purchases?

Using cryptocurrency for purchases is very much like using your debit card, making an electronic payment from your bank account, or using a payment platform like PayPal or Venmo. The money is tracked digitally without a physical exchange of currency, and it is transferred between user accounts. The key difference lies in how the transaction is handled and tracked. Debit cards, electronic payments, and payment platforms all maintain a private record of transactions and account balances through an intervening entity like a bank or payment platform. Cryptocurrency is exchanged directly between users (so-called “peer-to-peer”), without the typical intermediary, using a public transactional ledger that is not controlled by any one entity or person. That public ledger and the technology behind the tracking are both referred to as blockchain.

Cryptocurrency Transactions and the Blockchain Ledger

The digital public ledger containing all the transaction data and balances is secured by cryptography, meaning all transactions are securely encrypted. It is both a decentralized and distributed process. Decentralized because it is controlled by the users and the algorithm; distributed because the blockchain ledger is hosted on many computers across the world. Besides being used for purchases, cryptocurrency is also traded on exchanges just like physical currencies.

Transactions are sent using cryptocurrency wallets, which is actually software used to send the transaction between peers. The person initiating the transaction uses the software to transfer the specified balance from one account to another. To actually make the transfer to another account, it is sent to a public address using a private key associated with the account. These transactions are encrypted and broadcast to the cryptocurrency network where they remain until they are added to the public ledger through a process known as “mining,” which I will explain in the next section. Many transactions are added at once in sequential blocks, which is where the term blockchain originated—the ledger is literally composed of a chain of blocks of transactions. (Please note that some altcoins, which are alternatives to Bitcoin, feature totally private transactions and some do not use blockchain technology to secure transactions.)

All users of a specific cryptocurrency can gain access to the ledger by downloading software referred to as a full node wallet, or they can choose to use a third-party like Coinbase to track their cryptocurrency. While the cryptocurrency transaction amounts are public, the parties involved are not. Each transaction has a unique set of keys and whoever has the keys owns the associated amount of cryptocurrency, which is why it is vitally important to store multiple copies of the keys in safe places. There is no other way to retrieve your cryptocurrency unless you are using a custodial service like Coinbase that tracks your cryptocurrency for you.

The Technology Behind Blockchain

Cryptocurrency transactions are sent out to all users hosting a copy of the blockchain ledger. Users who are referred to as “miners” use software to solve a cryptographic puzzle in order to unlock the transactions and add a block of transactions to the ledger. Whoever figures out the puzzle and unlocks the transactions first, earns a few “mined” coins for his or her efforts and also gets the transaction fees paid by the originators of the transactions, hence the term cryptocurrency mining. Alternately, miners can combine their computing power to solve the puzzle collectively and share the newly mined coins. The algorithm guarding these transactions requires consensus. If the majority of those trying to solve the cryptographic puzzle all submit the same transaction data, the consensus provides confirmation that the transactions are correct, and they can then be added to the ledger.

Another level of security is added using encrypted connection data. Each block of transactions shares a connection to the previous block via one-directional encrypted codes called hashes. The distributed nature of the ledger, the consensus required, and the difficulty of solving the various cryptographic puzzles all contribute to making tampering with the ledger extremely difficult. The awarding of new coins and transaction fees incentivize the miners to do the important work of ensuring both the continuity and integrity of the ledger. Because of the monumental effort and consensus required to manipulate the ledger, blockchain is among the most secure transactional data capture methods available.

The keys themselves also use public-key cryptography; a type of one-way cryptography similar to that used by the hashes. The transaction data is tokenized, another form of one-way encryption that points to the data but does not contain all the original data. Thus, cryptocurrency uses cryptography that is easy to decipher one way, but difficult to decipher the other direction without keys. The idea is it is easy to create a strong encryption from the originator’s end, but exceedingly difficult to break that encryption without the assistance of the keys. Think of the keys as the Rosetta Stone for the encrypted data.

Custodial vs. Non-Custodial Wallet Services

There are two different types of wallet services available: custodial and non-custodial. Most of the cryptocurrency exchanges, brokerages, and trading platforms are custodial. They are third-party systems that protect customer assets within their system, which is very similar to the function of a bank. Coinbase is a popular service that is both an exchange and a brokerage and allows its customers to store cryptocurrencies within their own wallets. The advantage of a custodial service is it will track your cryptocurrency for you and you will not have to worry about losing a private key, and thus, all access to your cryptocurrency. The disadvantage is they have control of your funds and can halt transactions so you can neither send nor receive cryptocurrencies. Granted, there is usually a good reason for them to suspend transactions but still, they are in control, not you.

Non-custodial wallet services, by contrast, are the exact opposite. The customer is fully in charge of his or her wallet and is issued a private key, which the customer must secure. If the private key is lost, all access to the cryptocurrency is lost. The customer also is responsible for ensuring the overall safety of the funds.

The History and Volatility of Bitcoin

Bitcoin, the original cryptocurrency, can be traced back to a whitepaper entitled “Bitcoin: A Peer-to-Peer Electronic Cash System” that was published under the pseudonym “Satoshi Nakamoto” and posted to a cryptography mailing list on October 31, 2008. Previous to that, in August of 2008, an unknown person or entity registered the Bitcoin.org domain. The first block, called the genesis block, was mined on January 3, 2009. The first test transaction took place about one week later. Then on January 8, 2009, the first version of Bitcoin was publicized, and Bitcoin mining began soon after that.

The first transaction with actual economic consequences would not take place until October 12, 2009, when a Finnish developer, who helped the Bitcoin founder work on Bitcoin, sold 5,050 Bitcoins for $5.02, establishing a value of $0.0009. These initial transactions had somewhat arbitrary values; it was not until Bitcoin started to be traded on exchanges (symbol: BTC) and businesses started to accept Bitcoin as a form of payment that Bitcoin gained serious credibility. So much so that in mid-December 2017, Bitcoin reached a then-high of nearly $20,000 per Bitcoin before retreating, but in 2020, prices reached an all-time high of over $60,000! Recent Bitcoin prices have hovered around $35,000 to $40,000. 

Bitcoins are divisible into smaller units known as satoshis—each satoshi is worth 0.00000001 Bitcoin. These fractional Bitcoins make cryptocurrency investing more affordable and thus, stimulate demand—similar to the bump in trading that usually occurs after a stock-split and which typically serves to drive stock prices up. While Bitcoin tends to be more resilient than gold and fiat currencies, it can still be volatile and carry significant market risk as shown in the chart below:

Bitcoin Historical Prices—2010 to Present

Chart obtained from https://99bitcoins.com/bitcoin/historical-price/

The total available supply of Bitcoin is finite, limited to 21 million total. New coins are being released daily but at some point, the cap will be reached. Bitcoin is projected to hit that limit around 2140, but the actual amount in circulation will be much lower due to the amount of Bitcoin “lost” every year by people who have lost their keys and thus, access to their Bitcoin. (Studies indicate that up to twenty percent of the issued supply may be inaccessible to its owners.) At that point, demand could very well exceed supply or perhaps channel the demand into other cryptocurrencies.

Summary

To summarize the key features of cryptocurrencies:

• They are digital rather than physical. In that respect, they are like using a debit card, making an electronic payment, or using a payment platform like PayPal or Venmo.
• Digital currencies are not issued or regulated by any government; they are privately issued and tracked on a public digital ledger via an algorithm.
• Cryptocurrency is exchanged directly between users using a public transactional ledger that is not controlled by any one entity or person. The public ledger and the technology behind the tracking are both referred to as blockchain.
• The blockchain ledger is both decentralized and distributed. Decentralized because it is controlled by the users and the algorithm; distributed because the blockchain ledger is hosted on many computers across the world.
• Transactions are sent using cryptocurrency wallets, which is software used to send the transaction between peers. The person initiating the transaction uses the software to transfer the specified balance from one account to another.
• Transactions are added to the blockchain in sequential blocks—the ledger is literally composed of a chain of blocks of transactions, hence the name.
• Cryptocurrency miners use software to solve a cryptographic puzzle to unlock the transactions and add a block of transactions to the ledger. Whoever figures out the puzzle and unlocks the transactions first, earns a few “mined” coins for his or her efforts and also gets the transaction fees paid by the originators of the transactions, a process known as cryptocurrency mining.
• The use of cryptography is vital to the functioning of the blockchain. Each transaction has a unique set of keys and whoever has the keys owns the associated amount of cryptocurrency.
• Blockchain is among the most secure transactional data capture methods available. The distributed nature of the ledger, the consensus required, and the difficulty of solving the various cryptographic puzzles all contribute to making tampering with the ledger extremely difficult.
• Custodial wallets use third-party systems to manage the cryptocurrency. Risk is reduced but control is sacrificed. Non-custodial wallets mean the customer has total control but also bears all the risks.
• Besides being used for purchases, cryptocurrency is also traded on cryptocurrency exchanges just like physical currency exchanges.
• Bitcoin is the original cryptocurrency, and its prices can be very volatile. It can be traded in fractional units called satoshis, which helps to stimulate demand when Bitcoin’s price is high.
• The supply of Bitcoin is finite, limited to 21 million units. Studies indicate that up to twenty percent of issued Bitcoin may be “lost” or inaccessible to its owners.

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Cathy Roper, CPA, ABV, CVA, CFE, CGMA, is an adjunct professor of accounting at Webster University, a long-time financial professional, and has the rare distinction of being an Elijah Watt Sells medalist when she sat for the CPA exam. Her firm, Roper Consulting Group, is based in St. Louis and specializes in business valuations, lost profits, economic damages and other types of forensic accounting services. She also partners with ARA Fraud and Forensics in the prevention and detection of business fraud and the quantification of resulting damages.

Ms. Roper can be contacted at (314) 835-7876 or by e-mail to cathy.roper.cpa@roperconsultinggroup.com.

Sources

Zawatsky, Jay. (March 18, 2015) “Who Really Killed the Gold Standard?” The National Interest https://nationalinterest.org/feature/who-really-killed-the-gold-standard-12435

“How Does Cryptocurrency Work? (For Beginners)” https://cryptocurrencyfacts.com/how-does-cryptocurrency-work-for-beginners/

Bitcoin Exchange Guide News Team. (December 1, 2018) “Custodial Vs Non-Custodial Crypto Services: What is The Difference?”  https://bitcoinexchangeguide.com/custodial-vs-non-custodial-crypto-services/

“The History of Bitcoin” https://www.genesis-mining.com/the-history-of-bitcoin

Hicks, Coryanne. (September 1, 2020) “The History of Bitcoin: A look at Bitcoin’s beginnings and price history,” U.S. News  https://money.usnews.com/investing/articles/the-history-of-bitcoin

Coinbase website, https://www.coinbase.com/price/bitcoin

99 Bitcoins website, https://99bitcoins.com/bitcoin/historical-price/

Team Luno. (January 9, 2019) “Where Do ‘Lost’ Bitcoin Go?” https://medium.com/luno/where-do-lost-bitcoins-go-7e8dd24abd0f

Reiff, Nathan. (June 25, 2019) “20% of All BTC Is Lost, Unrecoverable, Study Shows” https://www.investopedia.com/news/20-all-btc-lost-unrecoverable-study-shows/