Daniels expert shares more on cryptocurrency and blockchain’s place in U.S. banking.
President Joe Biden recently signed an executive order directing the U.S. Department of the Treasury and other federal agencies to develop policy recommendations focused on the risks and opportunities of cryptocurrency.
The President’s call for a cryptocurrency strategy is based on the technology’s explosive growth. According to White House statistics, the size of the cryptocurrency market exceeds $3 trillion and 40 million adult Americans have engaged with cryptocurrency.
Despite the rising numbers, crypto remains very cryptic to the many Americans still accustomed to standard currency, whether as cash, debit, credit or other forms. The Daniels Newsroom recently sat down with Joshua Ross, director of Entrepreneurship@DU and teaching assistant professor of entrepreneurship at the Daniels College of Business, for an updated primer on cryptocurrency. Ross also consults with corporations to help them understand their technology assets, create a technology roadmap and mitigate cybersecurity risks.
Give us a basic definition of cryptocurrency.
When many people think of cryptocurrency, they go straight to Bitcoin. But the term cryptocurrency really refers to a broad group of digital currencies that exist virtually. They have no physical form—no coins or notes. And they use cryptography, which is the sophisticated encoding of data, to secure every transaction.
Another key characteristic of cryptocurrency is the lack of an essential authority—a central bank like the Federal Reserve System—that validates each transaction. Instead, they use a decentralized network of computers to prove and record transactions, and even issue new units of the currency, new Bitcoins or ETH, in the case of Ethereum.
How does cryptocurrency differ from blockchain?
Blockchain is not a cryptocurrency. It’s the underlying technology that powers, stores and authenticates cryptocurrency transactions. Blockchain provides a means for people to exchange value in a way that doesn’t require a third party to validate the transaction. Most important, it allows for complete strangers to transact in a trustless environment with each transaction validated by nodes on the network.
How does blockchain operate?
The blockchain is a digitally distributed, decentralized ledger that exists across a cryptocurrency’s network. Rather than a central authority, a decentralized network of computers—each one called a node—is required to validate every transaction before it is added to the blockchain. They do this through something called consensus, which is generally either majority consensus—51 percent—or unanimous consensus among the network nodes. Once the nodes validate the transaction, which is a transparent process, the transaction is added to the blockchain.
How does transaction validation occur?
If I were to send two Bitcoin to someone, the nodes on the network would validate that the public address for my Bitcoin wallet is associated with the two Bitcoin I’m sending, this eliminates any opportunity to spend the Bitcoin twice. With consensus—the 51 percent—the transaction would be validated and added to the open block on the blockchain. Once the transaction is added to the block and the block is added to the Blockchain, the transaction can’t be changed. The process is automatic; it doesn’t require human intervention.
What is a good analogy for the difference between cryptocurrency and blockchain?
A good analogy would be a Las Vegas casino, which isn’t meant to suggest that cryptocurrency and blockchain are akin to gambling. The analogy is about operating in a closed system, which is what cryptocurrencies do.
Every casino has its own chips that can only be used to gamble at that casino. They’re worthless in any other casino. What gives those chips value is that one casino, which substitutes for the blockchain in this analogy. The casino is the underlying technology that provides access to all the different kinds of gambling, all the different types of games, using your chips as a type of currency in that casino.
Where is the ledger housed?
An up-to-date copy of the ledger exists on every one of the thousands of computer nodes that is part of the blockchain network. Every time a transaction takes place, each node updates its ledger with the most recent transaction. They are all in sync in terms of the transactions that have taken place.
Anyone can look at a public ledger and see every transaction, going back to the first transaction on that blockchain. They’re immutable, meaning that once a transaction is validated, it can’t be changed—it is secured using cryptography. If any data in that block were to be changed, it would break the link with the other blocks—hence, blockchain—alerting the other nodes that a ledger had been compromised. This is the aspect of blockchain that makes it so secure.
Blockchain also provides anonymity. Aren’t there some dangers with anonymity when it comes to financial transactions, especially with movement of illicit funds and money laundering?
One of the fundamental misunderstandings of cryptocurrency and blockchain is the notion of complete anonymity. The best way to move money around anonymously is still through cold, hard cash. I could meet someone on a street corner and give them a $10,000 in cash, which, according to federal law, is a transaction that must be reported to the government. But nobody, except those two people, knows about that transaction. With movement of cryptocurrency, there is still a trail and documentation that people leave behind.
How are people identified with their cryptocurrency?
If someone wants to move money via cryptocurrency, they have to go through a cryptocurrency exchange, which takes cash, converts it into cryptocurrency and holds it in a virtual wallet. These exchanges are identified under federal law—the Bank Secrecy Act, which controls money laundering—as types of financial institutions that must be licensed in each state where they do business and file reports on large cash transactions and suspicious activity.
They operate under what are called Know Your Customer rules, which require them to identify who they are doing business with by obtaining personally identifiable information.
Are there similar laws and rules outside of the U.S.?
Laws and regulations outside of the United States—which itself doesn’t yet have a fully developed regulatory framework—are best described as patchwork.
For example, cryptocurrency is broadly legal across the EU, but regulation of exchanges is up to each country. China generally has an anti-cryptocurrency stance, prohibiting cryptocurrency exchanges and outlawing cryptocurrency trading. Instead, China is piloting a digital version of its own currency, the yuan. In yet another approach, El Salvador identifies Bitcoin as legal tender.
Why have banks become interested in blockchain?
Banks are understanding that blockchain is the future of financial technology. They know they must become more efficient and more transparent, and blockchain is the answer.
The issue is that many financial institutions are rooted in antiquated processes. Their applications sit on old code bases, their communications are siloed, and they require a third party to settle their transactions. Sending money from one institution to another takes a day or two. Cross-border transfers take three to five days.
Cryptocurrency is pretty much immediate. Blockchain also brings greater efficiencies and is more transparent.
Maybe most important, blockchain has the potential to disrupt banks’ stream of fee income, which totals billions of dollars. They fear blockchain from that perspective. But they also see it as an opportunity. It’s a matter of getting on board or losing the fee income.
We’re seeing an increasing number of cryptocurrency thefts. How does that happen considering blockchain’s security features?
The blockchain isn’t being hacked, the exchanges are. The exchanges are like banks, which hold their customers’ holdings in accounts. Just like banks, the exchanges are subject to network hacking where hackers try to penetrate their servers.
Hackers are also trying to obtain private key information—which is a type of password using encrypted combinations of letters and numbers that give wallet owners access to their holdings—using the same social engineering tools they use in other types of fraud. If a fraudster gets access to the private key, they can access funds held at an exchange.