Blockchain Basics: What You Need to Know to Invest in Cryptocurrency

Image via BTC Keychain/Flickr CC

Cryptocurrencies are the sometimes mysterious and highly volatile investment of recent years. For those who are willing to take the risks, the potential is promising. What makes cryptocurrencies so mysterious is what scares away many investors: they’re hard to understand. Once you’ve really got a grasp on how cryptocurrencies work, it’s easier to see why they are so appealing to many investors.

Cryptocurrencies, and the blockchain technology that makes them possible, have the potential to transform the way we do business. Referred to as a foundational technology — one that fundamentally changes our economic and social systems — blockchain is something you can expect to hear a lot more about in coming years, as we discover how to practically integrate it into our day-to-day lives.

That’s why as of August 2016, $1.55 billion in venture funding had gone into blockchain ventures, with industry focuses in finance, insurance, information, communication, and professional services.

The blockchain is an essential piece of the puzzle when it comes to understanding cryptocurrencies. This technology has the capacity to transform the way we make transactions, and it’s not as complicated as it might seem.

What is Blockchain?

Let’s think about the blockchain in a way that’s easy to understand.

We know how we trade money in real life. If I have a dollar, I can hand it to you, and now it’s yours. You can keep it, or give it to someone else, but there’s nothing I can do with that dollar after it leaves my hands. I don’t need anyone (like a bank) to help me give you a dollar: I can just put it in your hand.

It’s hard to cheat and make more dollars by making a copy of a dollar in real life. If I make a counterfeit dollar, and then keep the real dollar for myself and try to give you the fake, someone will eventually realize I cheated.

If I want to trade money digitally with you, it’s a little trickier. It’s hard to always tell if something is a copy in the digital world. I could make a copy of my dollar, and save the first dollar my computer then send you the copy. I could just keep making copies of my first dollar indefinitely, which means that dollar isn’t really worth anything anymore.

If we want to trade digitally, we need a way to make sure that our dollars are real, not copies. I can ask a third party (like a bank) to make sure the dollar I try to give you isn’t fake, but both of us have to trust that third party. And that person might want a dollar too, from both of us, for doing the work of helping us trade our dollar. Isn’t it better for both of us if I could just give you the dollar like I could in real life?

The blockchain is a ledger, and it accounts for all the digital dollars so that we can trade them just like we trade regular dollars. The first digital dollars to use blockchain are called bitcoins.

Imagine the blockchain like a shared collaborative document, where we can add information, but we can’t edit it. The document doesn’t belong to one person, it’s shared with everyone who wants to trade, so that no one can tamper with the ledger. Everyone records every trade ever made with digital dollars in this ledger.

But someone has to record all of that information and keep track of all of those digital dollars. That’s a lot of work and takes tons of (computing) energy, especially if there are a lot of dollars being traded. So we all decide that if anyone wants to maintain the ledger and do the accounting work for the digital dollars, they can make some digital dollars, since the energy it takes to record our transactions is worth something (digital dollars).

Recording our transactions in the ledger is actually the only way to make more of the digital dollars. If I want to turn my real dollars into digital dollars, I can buy some of the digital dollars that already exist from someone who has them, but there’s no way to create more digital dollars, unless I contribute to the work that needs to be done maintaining our shared ledger.

This recording work is referred to as bitcoin mining.

The blockchain makes it possible to trade directly with other people, without the need for a third party, digitally. Prior to blockchain, this technology didn’t exist.

The Implications

What does this mean for us? The blockchain represents the next evolution in trade and business. Like the printing press before it, this foundational technology has wide reaching implications. We can’t fully understand all of the ways that blockchain will change our world until we can use it more, but looking back on prior foundational technologies gives us a good idea of what to expect — big changes.

Trade

We can use blockchain technology to trade anything of value: information, art, votes, titles, deeds, dollars. From music to cotton, blockchain makes trade easier and more efficient.

Blockchain helps to alleviate the barriers to trade, meaning it’s integration could boost trade and economies globally. Cash flow issues that would have crippled small business in the past could disappear with blockchain payment. Up to 80 percent of global trade is currently backed by financing or credit insurance; blockchain could make that a thing of the past.

Efficiency

The blockchain means lower costs and more transparency and regulation for financial transactions. The blockchain removes the need for third parties in trade, and eliminates many overhead costs for exchanging assets. Data security is expensive and requires investments in time, equipment, and staff. According to a report by Accenture and operations benchmarking company McLagan, integrating blockchain into operations could save investment banks $12 billion per year in back office costs.

Trust

With the use of blockchain, trust is built in. Using the blockchain, we can enforce and use contracts better than ever before through the application of smart contracts. ProofofExistence.com (PoE) uses the blockchain as an alternative to publically-known patents. The blockchain removes the need for trust in trade. We can make tamper-proof public databases that are cheap and easy to maintain, no notary needed.

When we look at the bigger picture, beyond Bitcoin, it becomes clear that blockchain technology aims to change world at large. Businesses, both large and small, are working to integrate the blockchain. Supply chain transparency is improved with the use of the blockchain, financial services are made more accessible, data records are more reliable and trustworthy, and identities can be easily verified through public ledgers. The blockchain is more than money, and that’s why it’s worth your investment.