Those of you who know me, know that I view cryptocurrency like a parent talking to their kid about sex for the first time: “I might not approve of this, but I know you’re going to have questions, and I’d rather get information from me than from some strange person on the internet.”
Admittedly, I know jack squat about the subject, so I turned to my friend Shannon Adair, who is the Director of Project Management at BitOlympus, an up-and-coming blockchain asset and cryptocurrency exchange. Not sure what that means? It’s cool, hopefully you will by the end of this article!
And one big, fat DISCLAIMER here: I do not advocate cryptocurrency as a part of a well-balanced portfolio, and this article is not to be taken as investment advice or a recommendation to buy or sell cryptocurrency or blockchain assets. So good luck, and be careful out there!
Michelle: Shannon, thank you so much for joining me today. You know that this topic isn’t my cup of tea, so I’m grateful you’ve taken the time to chat. Let’s start with the basics: what do cryptocurrency and blockchain mean?
Shannon: Everyone is familiar with paper money and physical, metal-based money, but nowadays we’re familiar with digital money too. Take your bank account for example. If you deposit money into the bank, that information about your account is stored in a digital database, which is controlled by your bank. The bank is responsible for maintaining the database and keeping your money safe and secure, an activity that is highly regulated and insured by the federal government.
But what happens when a bank or other entity decides to abuse their power? For example, when Wells Fargo decides to open fraudulent accounts, they got away with it for a long time because the bank was solely responsible for keeping track of people’s financial information. As a consumer, you couldn’t have any idea that someone has opened an account in your name. The database is ‘centralized,’ meaning the bank is solely in control of the information. Cryptocurrency—and the technology behind it—is meant to solve the problem of centralization: how can we maintain something as important as a financial record in such a way that is not centralized with one entity?
That’s where the concept of blockchain comes in. Rather than relying on one government, corporation, or entity to control the database, cryptocurrency is built on a database called blockchain, which is largely considered to be the most secure type of database in the world. Blockchain is secure because it functions as a “decentralized consensus-based database.”
Michelle: What does that even mean? Decentralized, consensus-based database?
Shannon: Think about the way that we label dollar bills, which can’t share the same serial number. Cryptocurrency is the same way; each coin starts as a “block” of information similar to a serial number, called the Genesis block. Then, as you conduct transactions with that coin, the data about those transactions are “chained” onto the previous blocks—hence the name “blockchain.” As time goes on, the block not only represents the coin itself, it also gives us a complete digital record of that coin’s transaction history. A coin is a single entity. You can sell a fraction of a coin, because it’s all just data, but you can’t duplicate the database to make more bitcoin out of thin air.
When we say this is a “decentralized” database, that means that the complete digital record of all the coins out there is not held by a private entity; the record is public information. The ledger is essentially held in thousands of computers across the globe. The database is consensus-based, because if someone goes in and tries to change the ledger or commit a fraudulent transaction, they can’t simply do so to one of those computers. When a ledger change occurs, the computers hash it and compare your copy of the database to the other copies all over the world. If the new version on one computer doesn’t match the rest, the change is rejected. So what’s why we say it’s consensus based.
If you wanted to change the ledger maliciously, you’d have to hack thousands of computers simultaneously. Every few minutes, the computers come into consensus. It’s not technically impossible to do that, but it’s financially prohibitive in most cases. This is called a 51% attack and it is something people should consider when asking whether blockchain is a good idea for the product they’re investing in. For example, people want to use blockchain for more secure voting. But it’s not hard to imagine a foreign power like Russia deciding that it is worth their money to control 51% of the miners and insert whoever they want.
Michelle: I understand that you can’t hack one computer to change the ledger, but if this is all public information, what keeps it secure? How is this not one big free-for-all?
Shannon: I think it helps to realize that what’s public is just the info about the coin itself and all the relevant transactions. The system is secure, because none of the coin information is directly tied to the people involved. There’s no name, address, or traditional bank account number directly tied to the currency.
Instead, people who own cryptocurrency use a “public key” and a “private key.” The public key is how someone sends you coin, much like a digital P.O. box. Then, your private key is like the metal key that opens your P.O. box. Since your name isn’t on the mailbox, if you lose that private key, you lose the ability to access what’s inside.
I’ll also add that regular people can’t just open a ledger and look at it. To get in requires hashing. You need to hash the algorithm to find the transaction, validate it, and append to it. While this in itself is a form of security, it’s also a criticism about bitcoin—because it’s the first cryptocurrency, it’s slow. It can take 5-10 minutes for the transaction to go through, because there are thousands of computers across the world hashing at the same time to clear the transaction.
All that to say, when cryptocurrency gets “stolen,” it’s usually because someone stole the private key that open someone’s “mailbox”. Hackers don’t go after the database itself, they’re interested in your private key, so it’s vitally important that you protect that information.
Michelle: Is there a general best practice for protecting your private key?
Shannon: There are a handful of ways people protect their wallets, or collections of private keys. Some people literally just have all their information stored on pieces of paper, known as a paper wallet. The upside is that no one can hack your info, but if that paper gets misplaced or stolen, or your house burns down, that information is gone forever. Some people also rely on their memories, but again, if you’re incapacitated, no one can access your coin. Finally, some people store their information on a USB drive or other device—this is called a cold wallet—but that has some of the same limitations as paper in that the drive could also get lost or destroyed.
For that reason, a lot of people rely on digital wallets, which are services that store your keys online. There are a lot of those offered both by cryptocurrency exchanges, as well as other services, so make sure to do your research there.
Michelle: Okay, so now that we know the basics behind the technology itself, let’s talk about use cases. Can you talk about what kinds of cryptocurrencies are out there? How do they hold value?
Shannon: Sure. Cryptocurrency is only 10 years old or so but there are already over 1,500 different types. Some are specifically meant to be used as payment—so they hold value because you can use them to buy things. If enough people use them as a medium of exchange, then that’s valuable. Bitcoin is the one that most people are familiar with, just because it was the first. At this point, you can buy all kinds of things with bitcoin. PayPal and Expedia both accept bitcoin as a form of payment, for example. Bitcoin also has value because of its scarcity. The math that creates bitcoin has a mathematical limit embedded in it, such that it’s impossible to create more than 21 million coins.
Then, there are all types of other cryptocurrencies out there, such as commodity-backed cryptocurrencies. The UK royal mint has a cryptocurrency that’s backed by gold. Some are backed by the US dollar; for example, a cryptocurrency called Tether supposedly keeps physical paper dollars to correspond to the value of the Tether. That one may or may not be true, though, since there were some recent attempts to audit Tether, and they prevented the audit. But all that to say, it is possible to have a cryptocurrency backed by fiat money.
Governments can also make cryptocurrency legal tender, which means the currency must be accepted as payment within that government’s jurisdiction. The Marshall Islands wanted to have the first cryptocurrency legal tender, called the Sovereign. Japan also passed a law last year saying cryptocurrency was “allowable”. This act didn’t make it a legal tender in that merchants are required to accept it, but even legally acknowledging it as a payment system did a lot to increase the integration of cryptocurrency into point of sale options among Japanese retailers.
Finally, you’ve got commodity-backed currency where the commodity is virtual. There’s a game called Decentraland, a virtual reality game, where you can buy things within the game with cryptocurrency. There are actually people who will pay $300,000 for a piece of real estate that only exists in cyberspace, but since it’s built on a blockchain, you’ve got the rights to the code. Players are paying lots of money for luxury goods that only exist in the game, though it’s not like buying a weapon or avatar; it’s a discrete piece of property. The game founders actually released their own cryptocurrency in an ICO (initial coin offering). In this case, there are rumors that well-connected game players bought up all the coins so that casual game players couldn’t buy any left. It just goes to show you the power of what people are willing to spend and what they think is important.
What’s interesting, though, is since cryptocurrency takes so many different forms—people invest in it and trade it like a stock, people use it to pay for things, etc.—people in the investment world are having a really hard time classifying it. Is it money, or is it an asset? As an industry, we still don’t have a great answer to that question. The Securities and Exchange Commission (SEC) says it’s a security, but the IRS considers it to be property. Then, the Commodity Futures Trading Commission (CTFC) says it’s a commodity. Lots of CPAs are unclear about how to report it and treat it, and lots of people trying to regulate it. Even the SEC’s own blog posting official statements aren’t always internally consistent. Everything in this article could be outdated next month!
Michelle: If there are so many cryptocurrencies, how do you know what to invest in?
Shannon: For buy and hold investors, treat it like any other investment, where you want to buy low and sell high. The value of cryptocurrency fluctuates like the stock market, responding to similar market forces of supply and demand. You can look up the prices at coinbase.com.
With a stock you own part of a company, so you want to ask: would I want to own this company? It’s not quite the same with cryptocurrency, but you can still ask similar questions about the investment: What problem is this cryptocurrency is solving? What new innovation has the company created? With ICOs, who is the company and what are their credentials? Why should you trust them?
There are definitely some extra risks associated with cryptocurrency though, so be careful.
Not necessarily the algorithm, but the point of failure is the human being. Watch out for people who take the money and run, and be careful about “pump and dumps.” Unlike the highly regulated stock market, market manipulation is not always illegal in the cryptocurrency market. That’s one of the reasons you need to be careful; there’s flagrant market manipulation, where people try and generate interest in a certain coin or offering to drive up the price, then sell their own holdings. That’s only part of what makes it so risky. It’s a dangerous market to only know a little bit about.
Michelle: Wow, that’s crazy. So let’s say you push past all that, you decide to buy cryptocurrency, and you’ve got one picked out. How do you actually go about completing that transaction?
Shannon: Well, if you wanted one currency specifically, you could just go directly to that provider and buy it. Go to Bitcoin and buy Bitcoin. If you want to get into trading between cryptocurrencies, it can get tricky, because there’s not yet a single exchange where you can buy every kind of coin, the way there is with the stock market. As a result, it’s hard to give clear guidance on how to complete the transaction, because it will all depend on what cryptocurrencies you’re trying to exchange.
But you start by buying some kind of coin, essentially converting fiat money into cryptocurrency. Bitcoin, Ethereum, and Litecoin are the most popular, though like I said, there are over 1,500 different cryptocurrencies. Those popular ones are the “gateway cryptocurrencies.” Then, you go to a site that lets you exchange those into the more obscure currencies. Right now, there are a handful of exchanges competing to onboard as many types of cryptocurrency as possible, such that the landscape is constantly changing.
Be sure to do your research though, since the user interfaces on those exchanges don’t always make it easy on the casual trader. It’s not impossible if you’re not technically inclined, but the process will be easier for you if you are. That’s actually one of the problems that we at BitOlympus are trying to solve: we’re trying to build a more intuitive user interface, as well as offering a wide variety of cryptocurrencies on one exchange.
I should also add: you do not have to go to an exchange to buy coin. You can still do all this stuff anonymously. You just have to know a little more about it.
Michelle: Damn! I feel proud that now I know enough about cryptocurrency to actually understand what your company does! One last question for you, though: I’ve also heard about blockchain itself being “disruptive technology” even beyond its role in cryptocurrency. Can you talk about some of the other ways this might get used?
Shannon: Sure. Some blockchains aren’t based on currency, but rather exist just so you can buy certain services, for example, legal documents. Essentially, you’re automating processes that used to be manual. When you put money on a public ledger and encrypt it, and you have it validated in a decentralized way, you’re essentially automating the process of validating money. The way you pay for that service is through small mining fees that go to the miners, the people who are crunching the numbers to get that math.
So think about setting up a simple contract, like a check. You’re marking who the money is going to, how much it’s for, and then you sign to authorize the transaction. You could essentially do the same with blockchain, automating the generation of this contract.
Or let’s say for example that a lawyer has a bunch of separate pieces of a divorce contract, they could create a service where they put out the parts of a contract, then the user can get on and say which parts apply and don’t apply to them, fill in with relevant detail, sign and send to the spouse, they sign and send back, and then you’ve automated divorce contracts for a small fee. The lawyer can get paid for the intellectual property of the contract textover and over without having to draw it up separately for each new couple seeking divorce, no longer a manual process on their part. Think of it as a vending machine for code.
Finally, some companies are applying blockchain technology to other internal databases that have previously been hard to manage. Think about tracking and redeeming frequent flyer miles or consumer reward points, for example, how cumbersome it is to track all that data. If those types of systems moved to a public ledger system such that the customer was in charge of keeping up with their own keys, it could save those companies time and money.
And bam, just like that, your humble financial advisor friend went from knowing near-zero about cryptocurrency, to actually understanding the basics behind it. I hope you did too. If you have additional questions for Shannon, you can find her contact information—and more information about BitOlympus—on the BitOlympus website:.