Bitcoin: Decrypting the infamous Cryptocurrency

Imagine a time before money, when trade ruled. You grew some crops and traded them to the blacksmith to gild your sword. But what if the blacksmith had all the crops he needed? Well, then you had a dilemma on your hands; you had to figure out what the blacksmith wanted and find someone with that item who needed your crops. You would then trade your crops for the item the blacksmith wanted and then trade that item to the blacksmith, who would gild your sword. Matching wants and needs could be a problem—a problem solved with the emergence of currency thousands of years ago.

Fast-forward several thousand years. The system of currency is still in place, but some argue there’s too much friction in the current system given our level of technological sophistication. Currency in the U.S. is different from currency in England or China, so you still have to find someone to trade currencies with if you wish to buy something from another country. You’ll probably have to pay a fee for that service as well. Or if you want to buy something in your local currency, and you pay with any other method besides cash or check, there’s probably going to be a fee; you may not see it directly since the seller typically foots this bill, but undoubtedly the price of the item will be set high enough to recoup that charge. In addition, that transaction may take a day or two to go through, and in some cases the transaction can be reversed, creating uncertainty for the recipient of those funds.

Some argue these friction points are significantly lubricated—or completely eliminated—by Bitcoin. Whereas traditional currency is rooted in an individual nation or other centralized authority—making transfers to people in other parts of the world difficult, costly and slow—bitcoin can be transferred as easily as sending an email at virtually no expense, and the transaction cannot be reversed. Better yet, this can be done any time of any day, rather than just between regular business hours.

But what’s the on-ramp? How do you get bitcoin? If you have traditional currency and want to buy bitcoin, you have to find someone with bitcoin and buy from them. The simplest way to do this is through a service, such as Coinbase in the U.S., where you sign up, link your bank account and buy bitcoins or fractions of bitcoins with funds from that bank account. The process is virtually identical to the process of setting up an online brokerage account, but instead of buying stock, you’re buying bitcoin.

Once you’ve bought your bitcoins, they show up in the account of whatever service you choose, but can be transferred to any bitcoin address. A bitcoin address can be thought of as a house with a mail slot; anybody can walk up to the front door of that address and slide bitcoin into the mail slot—and even look inside the mail slot to see how many bitcoins are inside the door—but only the key holder can get into the house and access the bitcoins to send them back out. This is one of the fundamental concepts of bitcoin:  bitcoins are stored in “addresses” and only can be transferred out if you know the “private key.” This is similar to a user name and password, but the address and private keys are extremely long—31uEbMgunupShBVTewXjtqbBv5MndwfXhb is an example, (case sensitive)which means there are an unfathomably large number of possible addresses to store your bitcoin; in fact, there are 2160, or 1.4615 x 1048 (that’s 48 zeroes), possible addresses. Furthermore, you can have fractions of bitcoin as small as 0.00000001 bitcoin, commonly referred to as 1 Satoshi in a nod to the pseudonym of the creator of Bitcoin, Satoshi Nakamoto. (Said another way, 1 bitcoin equals 100,000,000 Satoshis.) Of course, you can just leave your bitcoin in your Coinbase account—or the account of whatever service you chose to use—which means Coinbase is managing your address(es) and private keys, but that’s a significant decision that requires careful consideration of the pros and cons.

Say you want to buy something from an online retailer. You select your items like usual, but when it comes time to check out, you select the option to pay with bitcoin. Enter your public key (which identifies your address) and your private key, and you’re done. The transaction will be submitted to the bitcoin ledger, known as the Blockchain, to be verified by a number of computers, most of which exist solely to verify that address A does in fact have the number of bitcoins it purports to have and log the transfer to address B. Your address will automatically reflect the new, lower balance.

So who’s verifying these transactions? People invest in computers specifically built to verify these transactions, because in return for their processing power they are awarded bitcoin. Not only can these computers see and verify each transaction; anyone with a computer has the ability to contribute their processing power to the cause, and anyone has the ability to look at any transaction. This transparency makes the Blockchain ripe with opportunities for data analytics, such as tracing Bitcoins between addresses, identifying the addresses with the most bitcoins and tracking the change in daily activity over time.

As fascinating as all of this is, it’s easy to get caught up in the excitement and want to jump on the bandwagon. However, there are bad people out there who will want to take advantage of this unbridled enthusiasm and offer to help you invest in bitcoin. I’m not implying that there’s anything inherently fraudulent about Bitcoin. But as the SEC explains in its “Investor Alert:  Bitcoin and Other Virtual Currency-Related Investments,” fraudsters make promises that if you invest with them they will, in turn, invest in bitcoin and provide huge returns to you. Be skeptical of these potential schemes. Also, there are reports of Bitcoin being used in money laundering activities and by organized crime and terrorist organizations.

So now we have a basic understanding of what bitcoins are, how you obtain them, how you spend them, how all of this is tracked and what to watch out for. To bring this full circle, I’ll leave you with one last piece of information. To use the old “a square is a rectangle, but a rectangle is not necessarily a square” analogy, bitcoin is a cryptocurrency, but cryptocurrency does not necessarily have to be bitcoin. Cryptocurrency is the generic term for any digital medium of exchange, but bitcoin is by far the most popular to date.

 

To learn more, check out the following websites:

Bitcoin – A good all-around source of Bitcoin-related information aimed at Bitcoin beginners.

Bitcoin Pulse – Tracks key metrics related to Bitcoin, focusing on adoption rates.

Bitcoin Charts – Tracks key metrics related to Bitcoin, including in-depth price information.

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Tom is a senior managing consultant with BKD’s Forensics & Valuation Services team. He has provided fraud investigation, litigation support, computer forensics, data mining and business valuation services. His experience includes managing large forensic accounting, fraud investigation and data mining projects.

Tom Haldiman – who has written posts on BKD Forensics.


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