What Is Blockchain Technology and Could Cryptocurrency Disrupt Finance?

FT Contributor  | 

What is cryptocurrency? What is blockchain technology? Any discussion of cryptocurrency and blockchain must include the b-word — that is, bitcoin. Bitcoin began in 2009 and was preceded by a white paper published by a mysterious entity known as Satoshi Nakomoto.

The white paper detailed a new kind of peer-to-peer electronic currency that would bypass the middleman.

Through bitcoin, Nakomoto proclaimed, you could pay for goods and services without involving a bank and a government that regulates the bank. You wouldn’t have to trust anybody, because cryptocurrency on the blockchain is supposed to guarantee credibility by virtue of structure.

Blockchain and Cryptocurrency

This is possible because of a technology called “blockchain.” Ever since bitcoin was born, a new market emerged — the cryptocurrency market, which is very speculative and volatile. Based on blockchain, other cryptocurrencies have emerged, blossomed, or died, all within a relatively short period of time in the world of finance.

Anyone interested in personal finance wants to know whether cryptocurrency is worth considering. To understand cryptocurrency, and to speculate as to whether it could disrupt the financial system, you must first understand blockchain.

What Is Blockchain Technology?

A blockchain is a means of recording transactions digitally — it’s an electronic ledger that employs cryptography. Basically, cryptography is a way of encoding a message so that only the people who have the cryptographic keys can decode the message.

A cryptographic key is a line of code that is encrypted so that only the owner of the key has access to it. In the case of blockchain, each computer user — each member of a network — is a link in the chain, and each member has a unique, private cryptographic key. Each member has a public key, too.

When a user requests a new entry on the ledger — which is like using their own private key to put a new item in a vault — a certain number of network members must use a public cryptographic key to verify the entry.

The user who requests an entry on the ledger provides the public cryptographic key, which the other members of the network use to to verify the entry. Once the minimum number of users verifies the entry, it’s visible to everyone on the network, and no one can reverse the transaction.

Blockchain and Data Security

At its core, blockchain is a way to store and transfer data. Because a minimum number of people on a blockchain have to approve of the storage and transfer of data, and because each transaction is visible to all while simultaneously being irreversible, blockchain advocates consider it a secure system. Security and transparency are the primary reasons why bitcoin and other cryptocurrencies are on the blockchain.

What Is Cryptocurrency?

Cryptocurrency is a digital token (a crypto token or cryptocoin) — a unique, encrypted line of code — that you receive once the blockchain network verifies the transaction. If you decide to buy cryptocurrency, the network must be able to verify your identity in the sense that your request is tied to real funds.

In other words, when people buy cryptocurrency, they use credit, debit, Paypal, or even real cash to make the purchase. Then they keep the token in a wallet, which is a storage center online. The storage center, or wallet, has blockchain as its basis.

The Cryptocurrency Advantage

One purported advantage to cryptocurrency is that, once you buy in, your tokens are not tied to the centralized system. When Equifax, the gigantic credit reporting agency, suffered a cyber attack that led to the breach of 145.5 million Americans’ personal data, you may have been one of the many people concerned with identity theft protection. With cryptocurrency, identity theft isn’t possible because you are anonymous on the blockchain.

If you own bitcoins, or whichever cryptocurrency you own, your crypto token is not linked to your personal information. The unit of cryptocurrency is simply a line of code out there on the blockchain. It’s attached to you in the sense that you have a private cryptographic key corresponding to the unit of cryptocurrency; you also have a public key. When you initiate a transaction with your private key, you provide your public key so that the network can verify your transaction.

The Volatile Cryptocurrency Market

Paradoxically, the status of cryptocurrency as independent from the centralized market is both its strength and weakness.

Let’s take bitcoin for an example. In 2017, bitcoin made a huge rally, skyrocketing from around $900 to $20,000 per bitcoin. That means to buy a single bitcoin at the end of 2017 you had to shell out $20K. As of this writing, a single bitcoin is worth $6,384. What happened?

In January of 2018, bitcoin dropped below $10,000, an incredibly quick, vicious decline from its high of $20K. When bitcoin hit that high, investors began cashing in their bitcoins for real currency. This created many millionaires and billionaires, but it lowered the price of bitcoin because cryptocurrency needs people to keep trading it to maintain its value.

Cryptocurrency Pump and Dump

Some people speculate that the bitcoin deflation was part of a cryptocurrency “pump and dump” scheme. In a pump and dump scheme, people inject a ton of cash into the cryptocurrency market, inflating its value, and then once the value of a bitcoin is a higher than what they paid for it, they dump it and take the cash.

Since the federal government backs the value of cash, it’s not subject to pump and dump schemes. This illuminates the weakness of cryptocurrency. Since it’s not a part of the centralized market, cryptocurrency can be manipulated by investors because investors determine its value.

Investors who realize that cash can buy them anything and is relatively stable in value may seek to manipulate unregulated cryptocurrency in order to make cash. That’s part of why a legendary investor like Warren Buffett says cryptocurrencies will come to a bad ending.

As mentioned earlier, the value of cryptocurrency has a lot to do with data privacy. While you may be concerned about protecting your data in the regular world of finance, cryptocurrency is a hedge against that world. You may seek to own cryptocurrency so that, in the event that a central bank gets hacked, or a recession occurs again, your money is relatively safe on the blockchain.

Bitcoin vs. Ethereum

Bitcoin and Ether — Ethereum’s cryptocoin — are the two biggest cryptocurrencies on the market. From a one-sided perspective, the primary difference between them is price; from a big-picture perspective, Ethereum has a completely different purpose.

As of this writing, ether is worth about $6,100 less than bitcoin. But, according to Investopedia, “The primary purpose of Ether is not to establish itself as a payment alternative (unlike Bitcoin) but to facilitate and monetize the working of Ethereum to enable developers to build and run distributed applications (?Apps).”

Around the world, there are more merchants who will accept bitcoin as payment, but unlike bitcoin, Ethereum provides blockchain as a service. You could use Ethereum’s blockchain for smart contracts and you could use it to develop a social media application. Ether cryptocurrency is a proof-of-work token that people trade in order to use Ethereum.

One example of Ethereum’s usefulness is Microsoft’s partnership with a software company called ConsenSys. Together, the companies are using Ethereum and the Microsoft Azure cloud to offer enterprise software developers a streamlined, decentralized environment for developing applications.

Investing in Cryptocurrency: Risk and Rewards

Say, for example, you’re planning for retirement. Before cryptocurrency came about, your investment options included an IRA or Roth IRA, a 401K through your employer, a certificate of deposit (CD), investing in gold, investing in individual stocks, bonds, securities, and futures (instead of mutual funds, which is what the IRA and 401K are), and investing in property.

Now cryptocurrency provides something of a hedge against traditional investment options. A hedge is a bet against a bet. If you were to look at traditional investment as a way of betting on the centralized financial system, you could look at cryptocurrency as a way of betting against centralization and betting on decentralization.

Risks

Cryptocurrency is far too risky to recommend as an investment. There’s the possibility that a cryptocurrency could never get off the ground, it could take a dive like bitcoin did in 2018, or a cryptocurrency exchange could get hacked, which is what happened to Zaif. Zaif is Japanese crypto exchange that lost $60 million to hackers. Once cryptocurrency is monetized on a centralized exchange like Zaif, it becomes just as vulnerable as any other data in cyberspace.

Again, the paradox: when cryptocurrency is decentralized, thus not monetizable, it’s safe; when it’s centralized so you can make money on it, it’s unsafe.

Rewards

The rewards for investing in cryptocurrency may be as follows:

  • It could increase in price the way bitcoin did; in March of 2010, bitcoin was worth $.003, but by the end of 2017 it was worth nearly $20K — if you had spent $1 on bitcoin in 2010, you could have made over $6 million in 7 years.
  • It could provide security against the unlikely event of a future economic depression or recession that weakens the value of the dollar.

Yet for cryptocurrency to ultimately become preferable to the dollar and the centralized stock exchange, our entire government and economic system would have to collapse. In other words, something akin to the apocalypse would have to occur. For now, you’re better off working on building good credit than you are investing in cryptocurrency.


Image SourceChris Liverani on Unsplash

This post was updated October 5, 2018. It was originally published October 5, 2018.