What is Blockchain & Cryptocurrency?
A Guide to Blockchain & Cryptocurrency
Introduction
If you’re like most people, the terms “blockchain”, “bitcoin”, and “cryptocurrency” bring back the same sensation you may have felt when taking a high school vocabulary test – you probably heard the words once or twice before, and you may have even heard someone use them in a sentence, but you cannot exactly place what they mean. Like us, these words may be intimidating and seem far too confusing for anyone who does not fall into the classes of Silicon Valley “tech”, Ivy League-dropout-billionaires, or government regulators. By now, you probably know someone who claims to invest in cryptocurrency (Bitcoin, Ethereum, and Litecoin to name a few), and may have begun to speculate yourself.
Experts talk about the blockchain or cryptocurrency “revolutions” and how they are going to change the world; but, besides the snippets you may find on your morning commute Facebook feed, you have little idea on where to start learning about this new technology. Is the blockchain a part of Bitcoin or is Bitcoin a part of the blockchain? How is a “crypto” currency any different than the dollar bills in my wallet or my credit card? Why does my 4th grader know more about the blockchain than I do? If you have these questions, no worries! – you are not alone. Before you give up hope and decide to become a technology dinosaur, falling prey to technological extinction, take a look at what we have pulled together in this white paper, which will hopefully serve as a simple guide to help you become more familiar with the fundamentals of blockchain and cryptocurrency.
We hope that this guide will provide a reader-friendly overview of the most important aspects of blockchain and cryptocurrency and will provide real value with regard to the beginning steps of making educated decisions for your businesses and personal investments. You may not become a blockchain or cryptocurrency expert after reading this white paper, but we can promise you will not become a dinosaur.
What is Blockchain?
Simply put, a blockchain is a series of links, attached to each other in chronological order, each of which contains details regarding a transaction between parties. Each link in the chain is comprised of digital information detailing the specifics of a particular transaction and is unique from every other link in the chain. Together, these links form a ledger containing all of the transactions throughout this history of the blockchain. In many cases, this ledger is decentralized so that all parties with access to it can view all past transactions.
However, transactions on the blockchain can be made between anonymous parties. For example, if Alan, Betty and Carl all have access to the blockchain and Alan and Betty made a transaction on August 31, 2018, Carl would be able to see that the transaction occurred but may not know that the transaction was between Alan and Betty. This anonymity provides a benefit for certain users, which is critical in certain industries (e.g. healthcare and certain financial services markets). Since each block is attached in chronological order, it cannot be altered individually or rearranged with new blocks on the blockchain in between transactions. Blocks in the blockchain cannot be retroactively rearranged because, other than the first block in a blockchain, every block in the chain contains a mathematical link (“cryptographic hash”) to the block before it.
Therefore, if the blocks were rearranged, the information they contain would not match up and users would be able to tell that someone had sought to manipulate the chain. For a comprehensive list of terms associated with blockchain, please click here.
While this chart is meant to provide a simple overview of blockchain technology, it is not comprehensive with regard to how different blockchains are used in different circumstances. For example, here we include both the ability to enter into smart contracts which relates to Ethereum and the mathematical proof of work method which is used in Bitcoin.
There are other nuances that relate to specific blockchains as a way to maximize their applicability to specific cryptocurrencies. Despite this, we hope that this visual provides a useful tool in conceptualizing how blockchain technology is used in relation to cryptocurrencies.
Each “block” or “link” in the blockchain is a single transaction and is timestamped so that everyone knows exactly when it took place and so that it cannot be retroactively altered. Therefore, blockchain technology seeks to prevent a “double-spending” problem that is unique to digital currencies. Double-spending is a situation in which a user of digital currencies duplicates his digital “coin” and then tries to spend the coin multiple times. By timestamping every transaction, requiring a proof of work and connecting it to blocks of transactions that have occurred before it, as well as allowing subsequent transactions to attach behind it in the chain, blockchain technology seeks to prevent double spending.
Meet David Yerger
Redwood Digital Group Founder
There’s a lot of confusion about what a blockchain is and the different types of networks. People think every cryptocurrency business is involved in shady, illegal activity. But, when you look at the data, that’s simply not true. In fact, less than 1% of the network transactions are illicit or illegal, and compared to cash, it’s much better. It is a digital way to send and receive value that can’t be replicated.
If you’re interested in learning more, there are great resources out there. Lopp.net is a fantastic resource and for those in the Triangle, Jamison Lopp runs a local Bitcoin Meet-up.
After you’ve learned a bit, set up a few different wallets and send transactions to yourself. Buy a small amount of cryptocurrency from an exchange and send some value to yourself to see how to it works.
One of the toted benefits of blockchain technology is the transparency it affords to certain transactions. By allowing anyone on the ledger to see and verify the transaction, blockchain technology eliminates the need for a trusted third-party intermediary. Throughout history, individuals have sought to use independent third-parties in order to facilitate transactions (e.g. escrow agents).
Through a blockchain, the need for a third-party intermediary is effectively eliminated, thereby reducing transaction costs. Instead of a centralized network that vests the power to validate and overrule transactions in a central authority filled with human and operational input, blockchain technology can create a decentralized network in which the transactions are verified by random disinterested parties through complex alogrithms. This concept is so revolutionary in part because it has the potential to disrupt a multi-trillion dollar industry of back and middle office support in facilitating transactions as well as reducing the need for central clearinghouses.
Furthermore, persons who wish to make transactions on a blockchain network do not necessarily have to provide identifiable personal information to anyone else on the ledger and likely do not even need to be able to identify the person with whom they are making the transaction. This ability creates high levels of privacy that many users of blockchain cherish; however, it does not come without the risks of obviating certain money laundering, tax, and regulatory laws that societies have put in place in order to protect the public.
What are Blockchains’ Applications?
Many proponents believe that blockchain has an almost unlimited potential in its application. Since blockchain represents a combination of cryptography and computer science, blockchain technology is useful to a myriad of different industries and situations. Although it is best known for its association with cryptocurrencies, blockchain also has great potential in the realms of secure voting, smart contracts, identity protection, healthcare and national defense, amongst others. Governments have already begun considering the use of blockchain to streamline voting and citizenship issues, for financing opportunities and to protect sensitive data and reduce administrative costs. Many companies have started looking into the use of blockchain technology to track their inventory and manage their manufacturing processes. For example, a company may desire to keep track of when packages and goods arrive at its warehouses, how long they are sitting in the warehouses and which manufacturers are most efficient, by means of an automated function that is considered error free, compared to traditional methods. Many blockchain advocated believe this technology well help companies streamline their processes and ultimately eliminate unnecessary procedures and inefficiencies in manufacturing.
Where do the risks lie?
While blockchain has the potential to revolutionize many industries, there are potential risks that should be highlighted. First, although the parties to the transactions can often remain anonymous, the transaction details are available for all to see on the public ledger.
Therefore, depending on the details of your transaction and your willingness to allow the general public to see the transaction, you may not want to use the blockchain, or you may try to develop methods to “privatize” the blockchain. Also, government agencies across the world are increasingly looking at means and methods of controlling blockchain and the technologies that rely on blockchain. In certain jurisdictions, governments have already enacted legislation around blockchain and will likely continue to scrutinize transactions more closely as blockchain transactions become more common. Money laundering, tax evasion and funding terrorist organizations are important concerns that governments use to justify legislation requiring disclosure of more personal or financial information when using blockchain technology.
The mechanics of dispute resolution are also an issue that merit some attention with regard to blockchain risks. Since blockchain is an inherently non-jurisdictional technology, and indeed you likely will not even know where the party with whom you are making the transaction is physically located in the world, you are unlikely to have strong legal remedies to disputes that arise, unless they are accounted for at the outset. Not only do American courts likely lack jurisdiction over many blockchain transactions, they also little precedent and sophisticated decisions that make the law more predictable for parties with regard to blockchain. Finally, no technology is totally perfect all of the time.
Although blockchain is considered a very secure and anonymous technology, there are always hackers who will try to develop a system to defeat the blockchain security. While blockchain technology is very innovative and secure, blockchain (like everything else) simply cannot guarantee absolutely perfect security.
IV. Why are Cryptocurrencies Developed?
In the general sense, cryptocurrencies can act just like currency that is in your wallet (or, maybe, more like your checking account). Cryptocurrencies are relatively new and innovative forms of currency that, although similar, are very different from historic forms of currency used in the past. Whereas ancient forms of currency, including shells, animals, paper currencies, and precious metals, required a person to have ownership of a physical object, cryptocurrencies require digital ownership, which is theoretically traceable from its origin. For those of you who ever wrote (or saw) a name or address physically written on the back of a dollar bill, cryptocurrency, through use of a blockchain, creates a digital “address” for each transaction.
While credit cards also allow people to make transactions instantaneously, they do not provide the anonymity, freedom from third-party intermediaries, ability to enter into “smart contracts,” or the investability that are fundamental components of cryptocurrencies. However, like older forms of currency, cryptocurrencies still depend on a party’s faith of the “currency” in order to assign an intrinsic value, which can fluctuate in price- much like the dollar, gold and other forms of currency. Many governments, however, have raised some concern due to the fact that (most) cryptocurrencies are not backed by the full faith and credit of a government, which may have complex fiscal policies and a centralized bank to manage the output of currency, control inflation, and stimulate economies.
Bitcoin
Bitcoin is the most well-known cryptocurrency, and was created in 2009 by a mysterious person or group of people who went by the name Satoshi Nakamoto. It was created after one of the worst financial crises in American history when faith in the traditional banking sector and government was at a record low. Many believe that the initial intent was to create a digital currency with the capacity to circumvent third-party intermediaries (banks), government oversight and the inherently-public nature of using traditional forms of money. This new form of currency could also be borderless – transactions could take place between people from any place in the world using the same currency. In that respect it is meant to represent a universal currency, much like the U.S. dollar, British Pound, and more recently the Euro have been treated over the past several decades.
The flexibility and privacy of Bitcoin was bolstered by the fact that it was not subject to government fiscal and monetary policies. There is no “Bitcoin Reserve” that can print more Bitcoins whenever it wants in the way that the “Federal” Reserve can. Bitcoin is “free to float” in price so that its price is determined by the market as opposed to policy considerations and “expert” opinions.
As a result, whereas some countries may seek to artificially manipulate their currencies through a policy of depreciation in order to increase the amount of goods they sell to foreign countries, no individual country can enact such policies with regard to many cryptocurrencies. Likewise, having a fixed number of coins (often also referred to as “tokens”) helps to reduce the chances that a cryptocurrency experiences inflation. Bitcoin and many other cryptocurrencies that have followed it, are capped to a certain number of “coins” to be issued in order to prevent inflation of the currency due to overprinting by central banks. However, because some of these cryptocurrencies (including Bitcoin) are infinitely divisible, inflation can actually occur despite the fact that the number of Bitcoins will never surpass 21 million and the number of Litecoins will never surpass 84 million (for example). One could argue that inflation may be controlled naturally as people lose their cryptocurrencies over time and the supply decreases. Therefore, while cryptocurrencies are not actually immune to inflation, they are less likely than paper currency to fall victim to so called disastrous policy decisions that end up in catastrophic devaluation of currency.
Other cryptocurrencies were developed for many of the same purposes but incorporated other features such as the ability to enter into smart contracts, faster transactions, automatic mining, and in the case of the Venezuelan government’s cryptocurrency, to switch from a failing bolivar to a (hopefully) more stable and trusted currency.
What is mining?
Mining is the method used to verify and attach transactions to the blockchain. For Bitcoin and Ethereum, mining is the process of creating new Bitcoins and Ether. Mining involves solving tough mathematical equations and earning Bitcoins/Ether based on the miner’s success in solving those equations. Once a person has solved the equation, he or she is issued a certain number of Bitcoins/Ether for the work performed and the transaction with which the equation was associated is confirmed and linked to the blockchain.
This block is followed when other transactions are entered into and another miner solves an equation to verify the transaction. Therefore, mining serves the dual purposes of both offering a proof of work that allows current transactions to take place and releases more Bitcoins or Ether into the market.
Different Types of Cryptocurrencies
Currently, Ripple, Litecoin and Ethereum are three of the most popular cryptocurrencies that, along with Bitcoin, have become the most serious contenders for a viable alternative to the U.S. dollar and other government-backed currencies. We have briefly compared these three cryptocurrencies to Bitcoin in an effort to help you understand their differences.
Ethereum:
Ethereum has expanded on Bitcoin’s elimination of third-party intermediaries to also allow users to create “smart contracts” that are maintained on a decentralized network and automatically come into effect upon the occurrence of a preset condition. For example, if a salesperson and his employer agree that if the salesman improves his sales by 10% over the previous year he will get a 5% raise, they could construct a contract using Ethereum that would automatically send the extra 5% to the salesperson at the exact second his sales account registered the 10% increase. Ethereum has a much faster transaction time and a significantly lower transaction fee than Bitcoin. However, critics express concern about inflationary repercussions due to the fact that there is no limit of the number of Ethereum coins (known as Ether) that can be put into the marketplace. Bitcoin has a cap at 21,000,000 coins that will ever be put into the marketplace, although, as discussed above, a Bitcoin is infinitely divisible.
Litecoin:
Litecoin is capped to only ever allow 84,000,000 coins into the marketplace. This means that for as long as Litecoin exists, there will only ever be 84,000,000 Litecoins. The goal behind this limit is to prevent a situation in which the coins are continually mined and their value is thus diminished due to an ever-increasing supply. The number 84,000,000 was originally selected because Bitcoin was limited to 21,000,000 and Litecoin was intended to be four times as fast as Bitcoin. However, like Bitcoin, Litecoin is also infinitely divisible. That means that it can theoretically be divided into as many smaller fractions as are necessary. Whereas a dollar can only be divided into 100 pennies as the smallest denomination, in theory Bitcoin and Litecoin could be divided into even smaller sizes so that instead of being limited to one one hundredth of a Bitcoin, you could continue to divide it into one one-thousandth, one ten-thousandth and so on. Essentially, Litecoin can be seen as a revised version of Bitcoin that has faster transaction times and lower transaction costs.
Ripple:
Ripple is the odd coin out in this comparison. Unlike the other coins compared here, Ripple does not use a public blockchain technology to facilitate transactions. Instead, it utilizes its own, centralized, internal crypto-processing method. Ripple also allows users to hold, send and receive other currencies through its internal blockchain network, and even allows traditional financial institutions, such as banks, to utilize its payment system. Ripple transactions take place much faster than those of Bitcoin. Ripple has a maximum 100 Billion coins (not all currently in circulation). Ripple, unlike many other cryptocurrencies, also complies with many prominent banking regulations and may therefore have an edge in achieving an accepted mainstream status.
How do Individuals Use Cryptocurrencies?
Individuals can use cryptocurrencies to make purchases, accept payment, and invest in much the same way they can with traditional, paper currencies. While there is no central authority backing cryptocurrencies, and the FDIC does not currently insure them, two willing parties are free to enter into voluntary transactions using any cryptocurrency they want. Because the majority of brick and mortar and online businesses do not yet accept cryptocurrency payments, most individuals simply invest in cryptocurrencies through online platforms such as Coinbase or Kraken. These platforms allow users to buy and sell various cryptocurrencies whenever they like in much the same way as investors invest in the stock market. The biggest difference is that instead of investing in companies in the way that stock investors do, crypto investors are investing in the cryptocurrencies themselves, in much they same way as is done by people who speculate on traditional currencies.
How do Companies Use Cryptocurrencies?
Companies can utilize crypto currencies in many of the same ways that individuals can. They can accept them as forms of payment, offer them as forms of payment, invest in them and develop them. One important thing to remember is that many cryptocurrencies have historically experienced severe volatility. During the fall of 2017 Bitcoin rose to record levels, only to drop again and settle much lower several months later. While companies may do well to accept cryptocurrencies, executives have to keep this volatility in mind.
Where to Securely Store your Cryptocurrency
One of the most important decisions all holders of cryptocurrencies should carefully consider is where to hold their cryptocurrencies. Similar to dollars, gold or anything else of value, cryptocurrencies must be kept in a secure location. Unlike the aforementioned forms of value however, cryptocurrency is digital; so, it does not require much physical storage space. One of the easiest methods for storing your cryptocurrency is to simply keep it in one of many “wallets” that are available online. Cryptocurrency wallets are online ledgers that are both protected by the wallet’s security system and through the use of your own private password. They act much like the vaults of your grandparents’ generation. You can hold all of your cryptocurrency on various wallets. However, if the wallet is hacked or someone discovers your password, you could lose all of your cryptocurrency and would have a very slim chance of recovering it. Likewise, if you keep your cryptocurrency in one of these wallets, you could lose access to it if the server simply went down. Overall, while wallets are a very common and convenient means for storing cryptocurrency, they are not the most secure.
Another option for holding your cryptocurrency is to keep it on a “mobile” wallet. A mobile wallet is a wallet that you can download onto your phone. While more secure than wallets controlled by third party entities online, mobile wallets do pose risks associated with losing your phone. Mobile wallets allow you to check your cryptocurrency anytime you are with your phone, but also require that you make sure that your phone is secure and that you do not ever lose it. Another option is to download an “offline wallet” onto your computer. This allows you to keep your cryptocurrency very secure since it is not stored with a third party, you are unlikely to lose your computer and because you can also still protect it with a password. Finally, a very secure option for storing your cryptocurrency is to maintain it on a “hardware wallet”. A hardware wallet is a wallet that is downloaded to a usb drive, or other removable device, that you can store in a secure location and then plug into your computer when you need to access your cryptocurrency. This allows you to keep the wallet in a safe or even a bank’s security box if you prefer and then simply plug it in to your computer when you need access to your cryptocurrency.
Meet JohnPaul Baric
MiningStore Founder
It’s important that entrepreneurs and business owners understand that cryptocurrency is here to stay. It’s not something you can just dismiss because you feel like it’s too complicated. In reality, it’s a fairy simple technology to get your head around. And we’re still in the very early stages.
People think we only use cryptocurrencies to buy things, but there are much bigger use cases than small transactions. We’re seeing a lot of institutional money coming into the space. As that money keeps coming in, we’ll see a price increase, which will drive an overall increase in interest.
I think we’re a few years away from day-to-day usability, but I think the first use cases will happen where we’re putting assets on the blockchain.
Laws Affecting Cryptocurrency
While the laws below are certainly not exhaustive, we hope that they will provide a general understanding of the types of ways that the legal system attempts to regulate cryptocurrencies. If you have any questions or concerns, please feel free to contact the attorneys at Fourscore.
Salaries and Wages Paid in Cryptocurrency are Taxed:
The IRS has mandated that any wages paid in cryptocurrency are subject to income taxes. Therefore, employees and contractors paid in cryptocurrency should account for that payment when filing their W-2 or 1099 forms. It is important, however, to make sure that your employees are fully informed about, and properly consent to, being paid in cryptocurrency before you simply begin paying them with these new form of currency that cannot be used in many locations.
Cryptocurrency is Considered Property:
From the IRS’ perspective, cryptocurrency is also considered property. Therefore, it is subject to either short-term or long-term capital gains taxes, if its value appreciates. While beside the point for cryptocurrency tax considerations, it is interesting to note that although the value of U.S. dollars also fluctuates, the physical dollars you possess are not technically your property and therefore are not subject to capital gains taxes when their value increases due to market fluctuations. This is one advantage of dollars over cryptocurrencies. However, if you lose money in one type of cryptocurrency, such as Bitcoin, but make money on another type, such as Ethereum, you may be able to offset that loss in Bitcoin through tax-loss harvesting. Please make sure to check with a qualified accountant before using this technique. We have yet to see how cryptocurrency is treated for death tax purposes. Although it is likely that it will be taxed in much the same was as other inheritance gifts, please consult with your tax and legal advisor about this specific issue.
Cryptocurrency Security Offerings likely need to be Registered with the SEC:
Like other securities offerings, cryptocurrency offerings must be registered with the SEC or be subject to an exemption. This registration, pursuant to the Securities Act of 1933, is meant to protect potential purchasers from predatory schemes that were rampant prior to the stock market crash of 1929. It is also important to note that each state may also regulate securities offered within their borders. These state laws are referred to as “blue sky laws”. This means that you will need to make sure that any cryptocurrency you offer as a security complies with both federal and individual state laws. Some of the states that are particularly stringent include New York, Georgia and Hawaii while others, such as Montana, Texas and New Hampshire, are much more lenient with regard to cryptocurrency regulations.
How to Invest in Cryptocurrency
Individuals can invest in cryptocurrencies through exchanges such as Kraken, Coinbase and Gemini. After making a profile, these exchanges allow users buy and sell various cryptocurrencies. On many of the cryptocurrency exchanges you can simply link your crypto account with your bank account and fund your crypto purchases through your checking account. It is important to do your own research before deciding not only on a cryptocurrency in which to invest, but also with regard to which exchange to use. Some exchanges offer cryptocurrencies not offered by other exchanges, the fees are much higher in some exchanges than others and some have even been successfully hacked.
Investor strategies also differ greatly. Some investors choose to buy and hold in the hopes that over time the value of their chosen currency will increase. Others like to frequently sell their crypto in order to lock in short term gains. As with other forms of currency, it is important to remember your initial strategy so that you do not get caught up in the excitement of a sudden market swing and make a decision you will later regret. For example, if you have a long term buy and hold strategy, do not become overwhelmed if the market, which has historically been very volatile, drops significantly. It may be a serious mistake to simply start selling off your crypto holdings at the first market drop in an effort to mitigate further losses in value if you employ a long-term buy and hold strategy. Obviously, investing in cryptocurrency involves understanding your own risk tolerance. If you make other investments in much more stable assets such as U.S. government-issued bonds, you may want to invest in cryptocurrencies to add more risk (and therefore more reward potential) to your portfolio. Although these are all important considerations, you should always consult a financial professional before relying on anything you read online when making financial decisions. Fourscore does not provide investment advice and you should not make personal financial decisions without consulting your financial professional.
Future Opportunities for Cryptocurrency Investors
As cryptocurrencies become ever more prevalent in our daily lives the future possibilities they represent are endless. While governments are increasingly involved in banning, restricting or even creating their own cryptocurrencies, the idea of a decentralized, anonymous digital currency is here to stay. Innovative tech gurus are leading the way to a cashless future with their almost-daily creations of new cryptocurrencies. While investment and speculation are currently the largest uses of cryptocurrency, in the future you can expect to pay for anything from lunch to your bills in crypto. This also means that government policies related to economic sanctions and maintaining the dollar as the world reserve currency will have to change in major ways. Even if U.S. legislators tried to ban crypto trading in the United States, they have no authority to ban the use of cryptocurrency in other countries. Therefore, such a policy would only freeze Americans out of the crypto trade, but would not actually prevent from people in other countries from using cryptocurrencies instead of U.S. dollars.
We hope that this broad overview of some of the critical aspects of cryptocurrency will serve as a useful resource as your business and everyday life becomes increasingly affected by this new currency revolution. While it is still anyone’s guess as to how governments and markets react to the increasing prevalence of cryptocurrencies in our lives, by staying informed and not putting all of your eggs in one basket you will stand a better chance of benefitting from the crypto revolution. Here at Fourscore, we are enthusiastic about representing clients involved in cryptocurrency and would be happy to
speak with you more about your business and legal needs!
