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What Is Cryptocurrency, and How Does It Work?

September 21, 2017 / by Mark Wald

some change over black.jpegIf your business isn't already conducting transactions in Bitcoin or other cryptocurrency, it probably will be eventually. Here's what you need to know.

The biggest differences between cryptocurrency and conventional currency are that cryptocurrency isn't issued by a specific government, and there are no banks serving as middlemen when cryptocurrency "tokens" are traded from one party to another.

In the traditional banking system:

    • First, a government's central bank issues money in the form of their national currency.
    • Then people invest in that government's currency by trading it for other foreign currencies or by accepting it as a form of payment for goods and services.
    • When one party wants to pay money to another party using a check, a credit card, automated clearing house (ACH) or wire transfer, the payer's bank records the transaction in its own ledger, and the recipient's bank records the same transaction in its own separate ledger.
    • Each day, all the banks around the world spend a substantial amount of time and resources comparing their respective ledgers with each other to agree on how much money each bank has to transfer between the other banks to settle their customers' trade debts.
 

With cryptocurrency, by contrast:

  • Certain technology companies have created a growing number of more efficient digital platforms for managing the exchange of value between parties across a large network of privately owned computers. Those companies issue digital "tokens" on their platform and establish an initial value for each token.
    • A token is much like a dollar, euro or peso, only it doesn't generally take the form of paper bills or metal coins. Rather, it is merely a digital record of a unit of value on the cryptocurrency platform, just as an Amazon or iTunes gift card is a digital record of a unit of value that you can use to buy stuff from Amazon or iTunes online.
  • Then people like you and me decide to invest in those tokens by trading traditional currency, like U.S. dollars or euros, or other assets with the technology company in exchange for ownership of cryptocurrency tokens — or by accepting those tokens as payment for goods and services.
    • Bitcoin is one popular example of such a token.
  • When one party wants to give cryptocurrency tokens to another party, the transaction gets recorded on a "distributed public ledger" rather than on a pair of private ledgers managed by banks.
    • The "public ledger" is managed using technology called a "blockchain," which is simply an endless, chronologically sorted chain of consecutive transactions that are each related to the next using complex math equations. Each computer on the network has an identical full copy of the public ledger (i.e. blockchain) to keep track of who has what number of tokens at any given moment across the entire system.
  • All computers involved in the network participate in the process that records every individual transaction between each party onto the blockchain. The underlying architecture of blockchain technology automatically reconciles each individual copy of the public ledger against the others, ensuring they're all identical and avoiding the problem that banks have with retrospectively settling their customers' debts through a resource-intensive antiquated process.

For Example …
That's all pretty abstract, so let's say I want to sell someone US$100 worth of widgets and allow them to pay me using Bitcoin. First, I have to open an account with a digital "wallet" application to identify myself and keep track of my transactions on the public ledger. Next, I have to determine how many Bitcoins to charge for my widgets.

Although Bitcoin has no intrinsic value on its own, it has a market value determined by the laws of supply and demand and a relative value by way of an exchange rate like any other form of currency. Basically, the more people want to invest in Bitcoin, the higher the price will be, and vice versa. The relative value to traditional currencies fluctuates not just day to day, but minute by minute, just like publicly traded stocks and foreign currencies. (You can track these values just as you can real-time stock prices.) As I type this, one Bitcoin is valued at US$2,803.30. So if you want to buy US$100 worth of my widgets right now using Bitcoin, I'll charge you roughly 1/28th of a Bitcoin.

Before our transaction is permanently recorded, the several hundred thousand computers on the Bitcoin network all do a ton of complex calculations to mathematically attach our transaction to the end of the blockchain. Once the calculations are successfully completed by enough computers, the transaction is validated and made permanent on the Bitcoin blockchain. (In addition, all prior transactions that had been recorded on the blockchain are further locked into the ledger through the cryptographic structure — which, by the way, is not unique to Bitcoin.)

So What's the Point?
What advantages do cryptocurrencies like Bitcoin offer? Well, because all the heavy lifting in facilitating the transactions is done by private computers rather than for-profit financial institutions, there doesn't have to be a 3% merchant card processing fee like there is with credit card transactions. Nor can government entities arbitrarily increase or decrease the supply of available cryptocurrency to manipulate its value in the market.

Also, cryptocurrency transactions offer a higher level of precision and trust. With traditional banking, customers each rely on their own bank to keep track of the transactions in their respective accounts. However, banks sometimes make mistakes, and it isn't very difficult to forge something like a check or credit card number. With cryptocurrency, even if a group of ill-intentioned users tried to fraudulently change the historical blockchain record book, the rest of the hundreds of thousands of computers would reject that change because it doesn't agree with their own copy of the blockchain, thereby protecting the integrity of the data for everyone involved.

In addition, cryptocurrency transactions are perceived to be anonymous. That anonymity was a strong initial draw for a certain criminal element, although their identities turned out not to be as anonymous as some thought

What Are the Tax Implications?
Like most everyone else, the IRS itself is still sorting out how cryptocurrency transactions fit into the existing economy. But the short answer is that cryptocurrency transactions are (or will likely soon be) subject to the same tax regulations as conventional currency transactions.

A growing number of software tools can assist businesses with the infrastructure required to manage and trade their cryptocurrency assets. Still, properly accounting for those transactions and the gains or losses on the relatively volatile value of most cryptocurrencies can be tricky. If you decide to enter the cryptocurrency economy, team up with an experienced bookkeeping service provider first.

Topics: Santa Monica, Los Angeles, Ventura County, Business Advice

Mark Wald

Written by Mark Wald

Mark is managing director of Supporting Strategies | Santa Monica, CA.

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