With concerns about cyber security at an all time high, it’s natural for investors and consumers to worry about money that exists solely as digital code. Regardless of what you think of cryptocurrencies, they are probably here to stay, so everyone should understand how they work and know the security risks involved.
What are Cryptocurrencies?
Cryptocurrency is a new form of money that exists only in the digital world. Bitcoin, Litecoin and Ethereum are all examples of cryptocurrencies. They are based on the principles of cryptographic security, which makes them hard to counterfeit. These virtual currencies are not issued nor backed by any central authority, which means they aren’t subject to any government regulations or international tax laws. While banks tack on processing fees for financial transfers, cryptocurrency users don’t have to deal with such inconveniences. Cryptocurrency transactions are also difficult to trace, which has made them popular among tax evaders and people doing business on the black market.
The real world values of some cryptocurrencies have soared exponentially in recent years, which is why large financial institutions like JP Morgan Chase have started handling bitcoin-related trades. Other people, however, are switching to cryptocurrencies because they no longer trust banks. Consequently, more and more legitimate businesses are accepting them as a form of payment.
Although cryptocurrencies have only taken off in the past few years, the concept has been around for at least two decades. In 1998, a developer named Wei Dai proposed a distributed electronic cash system he called “b-money.” A decade later, bitcoin became the first widely used decentralized cryptocurrency in 2009. Others such as Namecoin, Litecoin and Peercoin soon followed.
Cryptocurrency is stored in digital “wallets,” which are like online bank accounts. Most cryptocurrencies are supported by a shared public ledger called a “blockchain” that coordinates transactions through a system of public and private security keys. The blockchain may be thought of as a spreadsheet that is constantly being updated, but it cannot be changed by anyone. This system ensures that virtual currency cannot simply be copied and reused; they can only be transferred from one wallet to another.
As of late 2017, there are few laws regarding cryptocurrency, but that could soon change since the UK government has commissioned a study of cryptocurrencies to determine the best way to regulate them. Research into cryptocurrency may have other real-world implications. For instance, blockchain technology could be useful for other purposes like online voting and crowdsourcing.
Since cryptocurrency isn’t issued by banks, where does it come from? Digital money is created through a process called mining. For example, bitcoin mining software produces bitcoins by solving a set of increasingly complex computational problems. Mining software is typically open source, so anyone can mine for cryptocurrency. Once a problem is solved, a new block is added to the blockchain, and the newly generated “coin” is added to the miner’s virtual wallet.
The mining process, also known as a proof-of-work system, gives cryptocurrencies their value. It may be helpful to think of cryptocurrency units as password-protected answers to complex math problems. The unalterable nature of the blockchain theoretically ensures that no individual can make changes to blocks, so coins can’t be forged or duplicated. Bitcoin uses the SHA-256 hash function for its proof-of-work scheme, but newer cryptocurrencies use different methods to achieve the same goal.
Potential Threats to Cryptocurrency
Cryptocurrencies have come under criticism for being extremely volatile, but wild price swings are attractive to some investors, especially considering that the value of bitcoin has risen by about 4000 percent in the past five years. The advent of cryptocurrency has thrown many economists for a loop since everyone assumed the currency would crash by now. What goes up must eventually come down, but until that day comes, cryptocurrency trading will continue.
Due to their natural volatility, cryptocurrencies are also prone to flash crashes, or sudden drastic drops in value. Federally regulated stock exchanges have circuit breakers to prevent trading during these vacillations, but most digital coin exchanges do not, which can further destabilize the currency during a crash.
Traditional banks have been skeptical of cryptocurrencies, but that hasn’t stopped dozens of cryptocurrency trading platforms from popping up. Most of these exchanges lack standard security and investor protections; however, the world’s largest cryptocurrency exchange, the San Francisco-based Coinbase, is backed by the Intercontinental Exchange. The company currently stores about $9 billion worth of virtual money including some large hedge funds. Some banks have dabbled in cryptocurrency and then backed out, which has created problems for customers. For example, Wells Fargo suddenly stopped processing wire transfers for the Bitfinex exchange leaving some customers temporarily unable to trade their digital currency for real cash.
Aside from their volatility, cryptocurrencies come with other risks. Since cryptocurrencies only exist as virtual files, they can be lost in computer crashes if backup copies aren’t available. They can also be hacked. Dozens of bitcoin thefts have been recorded so far with losses totaling in the billions of US dollar. Despite these drawbacks, the allure of trading is worth the risks for many people, so the relative values of cryptocurrencies keep climbing.
Cryptocurrency Cyber Security
In addition to individual bitcoin thefts, heists on cryptocurrency exchanges have been committed, but most hacked exchanges have been shut down. Individuals who lose bitcoins due to hacking usually have no recourse. When a Japanese bitcoin exchange called Mt. Gox went under due to hacking a few years ago, about 25,000 customers collectively lost $400 million worth of the currency. Another cryptocurrency exchange based in Florida called Kraken lost $5 million worth of funds in a cyber attack. In another case, some users of a popular digital wallet called Parity were locked out of their accounts when someone accidently deleted the code library.
Some victims of exchange hacks have gotten compensation. When a U.S. exchange called Cryptsy collapsed earlier this year, a federal judge in Florida forced the owners to pay out $8.2 million to customers who filed a class-action lawsuit. Coinbase is introducing a new security platform called Coinbase Custody to deal with potential threats. The new protections include insurance and multi-user accounts with separate permissions. This all comes with a $100,000 startup fee, so it’s clearly aimed at larger customers.
Mining malware is yet another cryptocurrency security concern. Such programs allow hackers to hijack a computer’s’ resources to mine for bitcoins and other currencies, which diminishes processing power while fraudsters make a profit. Google is in the process of introducing defenses against such malware to Chrome.
In spite of these concerns, several cryptocurrencies have persisted for several years now despite financial experts continually calling for a bust. Instead of waiting for a crash that may or may not come, business leaders should focus on preparing for the challenges that come with this new type of tender.