Cryptocurrency; What is it?

Cryptocurrency & Blockchain: What Are They & How Are They Related?

Last month, we talked about the factors that were driving the current bull market in the cryptocurrency space; namely the increased attention and capital from institutional investors and the improvements in technology that are empowering and driving innovations in the “DeFi”, or Decentralized Finance, sector of cryptocurrency.

But what ‘is it” exactly? What is blockchain? What is the relationship between blockchain and cryptocurrency? What does “decentralization” even mean? Why do professionals need to know about these terms and concepts? We will unpack each of these four concepts in the article below. We help financial professionals understand complex topics and demystify the jargon. So, let’s start from the foundation with the “what” and “why”.

What is Blockchain?

Blockchain is the underlying technology that underpins all cryptocurrency. The function of blockchain technology is “distributed ledger technology”. Those might be words that all make sense, but the concept is revolutionary. Consider the number of steps required in traditional financial transactions; we can use something like writing a check for $100 to give as a gift for graduation as our example. The process generally flows like this.

1. You write a $100 check to the young graduate
2. You create an entry in your checkbook deducting the amount of the check ( the entry is your personal ledger)
3. Mail the check
4. Once received and processed, the graduate marks an entry on their ledger of funds received
5. Those funds are then deposited in their bank and their account/ ledger is marked and credited
6. The graduate’s bank sends a remit for actual settlement and funds from your bank (they mark their ledger; your bank deducts from their ledger)
7. Your bank registers the transaction in your account and the amount of the check is debited- marking the final entry in the ledger

In this model, “you” have to mark your ledger, but in truth, your bank and the graduate hold their own “centralized” ledgers where the money is being credited and debited. Without using the instruments of our financial institutions, their transactions would not be executed or recorded. So how is that any different on a blockchain?

A blockchain is a cloud-based, distributed ledger technology. There are several blockchains like there are several different types of databases and networks and software applications.”Blockchains enable peer-to-peer transactions and entries into permanent ledgers that are indelible. Peer-to-peer, in this regard, means individuals sending monies and conducting transactions without intermediaries. In some sense, people are gaining the ability to become their own bank. So how does it work? Using our example, I can send that $100 (or equivalent) electronically to the graduate eagerly waiting to receive it directly. Once I know the address of their “virtual wallet”, read that as their personal account, I can send funds directly to them. This is where the “distributed ledger tech” comes into play. Once the payment is initiated and we send those funds to the recipient, various computers are recording and “validating” the transaction along the way. This validation process of various computers between the sender and receiver is done by the computers recording the transaction into this cloud-based virtual ledger. This validation process is either done through a process called “mining” or a different process called “staking”. In each method, computers solve various cryptographic problems and in doing so, embed the transaction details in the fabric of the internet. Once validated, the receiver gets a notification. The entire settlement process can take from 10-30 minutes.

The process is fairly straightforward to create the ledger, but two big questions remain. 1) Why would people let their computers validate these transactions and use their energy and processing speed? And 2) What kind of funds were sent in that transaction? The answer to both is cryptocurrency.

What is the relationship between Blockchain and Cryptocurrency?

To make this transaction happen, the senders convert their native currency (or whichever currency they choose)  into a digital currency. The most notable of these virtual currencies is Bitcoin, which was created to facilitate peer-to-peer transactions. This conversion happens on cryptocurrency exchanges. The largest cryptocurrency in the US is called Coinbase, and they have recently begun the process of filing for an IPO that will rival the size of the Facebook IPO. On exchanges, users can exchange USD, Canadian dollars, Euros for a virtual currency like Bitcoin, Ethereum, Cardano, Polkadot, or others to send to other parties nearly instantly. The transactions will always be available and settlement occurs instantly via the blockchain. The receiver then can take that virtual currency and use it for payments or convert it into the currency of their choice for use as cash.

Banks who leverage services like Zelle will recognize this general pattern and flow, except note that the payments are still done between financial institutions, not people directly.

The other question asked was “why would people let their computers be used for validating transactions? Essentially, “what’s in it for me?” Users who agree to participate in the validation process are rewarded in the cryptocurrency associated with the Blockchain they are using. The largest again is Bitcoin. So, Bitcoin validators, called “miners” are given fractional slivers of Bitcoin to compensate for the use of their machine and the energy. That Bitcoin or Ethereum, whichever Blockchain is being used, can either be converted to currency or traded with others on exchanges in a way similar to speculative investments. Due to the limited supply of cryptocurrencies, speculators establish the price and value on trading exchanges. So, miners or people receiving crypto can convert it back to USD, hold it and hope the value increases, or sell it to another speculator with the same intentions.

What is Decentralization?

In the example used earlier with sending a $100 check to the graduate; you, the banks, and the receiver each had ledgers. But in reality, the ones that really mattered were the ledgers held by the bank. Banks or credit unions hold the ledgers and exchange cash and currencies and facilitate payments. In the crypto example where it is peer-to-peer, the blockchain software and the validations are happening in the cloud. Using peers to validate the transaction on open-source software embedded into the fabric of the internet, means the process is “decentralized” compared to the “centralized” ledgers held by banks.

While the technology exists for facilitating payments, it is already slowly changing the way the internet works and our experience. Consider what happens when you watch a YouTube video. You watch the video and if there are enough views, the content creator gets a sliver of the ad revenue from YouTube. We, the consumer, get to watch ads and YouTube/Alphabet generates ad revenue. What would that look like decentralized? We do not have to think about it. If you have used the “Brave” web browser, you will see it is decentralized running on blockchain tech. Once you start watching those YouTube videos, the content creator can participate as normal, but now you the viewer are rewarded with cryptocurrency for watching ads play. Blockchain tech creates peer-to-peer experiences and we are only at the very beginning.

Why do Financial Professionals Need to Know About This?

In a way, decentralization like this is facilitating the rise of Web 3.0. When the internet became available for public use (Gen 1), we could look at static web pages. Web 2.0 and the internet of things brought live chat, social networking, video sharing, live video sharing all on centralized services by large tech companies. Web 3.0 is driven by peer-to-peer blockchain applications where we will not have to rely on YouTube, Google (for example) as central hubs where giants control the space. In a decentralized web environment, the power is in the hands of the people.

So why is it important? Part of the Web 3.0 is Decentralized Finance or “DeFi”. What innovations may be developed is hard to tell, but early use cases are already showing crypto banks, peer-to-peer lending, earning interest, profit sharing, microloans, and more. Financial institutions are looking at using blockchain tech for identity management, titles, ownership verification, and ultimately their own “coins” to remain relevant to their clients.

Financial professionals may hear these terms, interact with clients with significant holdings of various cryptocurrencies, and be asked how those assets can be held in trust or passed to future generations? What will the role of financial advice be in the future with new digital assets and forms of currency? Now there are “nonfungible tokens” in crypto which allow art and collectibles to be transferred and verified with blockchain.

The future is decentralized, and you need to be prepared when these terms, concepts, and digital assets come up with clients and their families.

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