You may have heard much about cryptocurrencies and their potential effects on the financial system and economy. Reports on regulation, ransomware, and volatility with up to $10,000 swings may have been read or heard by you.
The value of Bitcoin more than quadrupled in 2021 and sharply declined in the first few weeks of 2022, but it’s not the only cryptocurrency to see dramatic changes. To stay abreast of the expanding industry, venture capital firms have invested in crypto fintech companies like Coinbase.
What happens to established financial institutions, then? This blog overviews cryptocurrencies, their banking implications, and crypto banking solutions in general.
Watch this on-demand webinar to learn more about the rules and risks associated with virtual assets.
What do Cryptocurrencies Stand For?
A writer (or authors) using Satoshi Nakamoto’s alias published the first cryptocurrency, Bitcoin, in a 2009 academic paper. Fast-forward to the present: Among the more than a thousand cryptocurrencies today, bitcoin has gained some investors millions.
The basics of cryptocurrencies are straightforward, even if the details might become complicated:
- Cryptocurrencies are worth something.
- Cryptocurrency only exists digitally.
- There often needs to be a centralized issuer or authority.
To authenticate transactions and provide additional money to the system, computers solve challenging algorithms using a cryptographic proof of work.
This cryptographic proof of work is evaluated by a decentralized peer-to-peer network, which determines whether a new coin has been “mined.”
A finite amount of “coins” may be mined due to managed scarcity, which prevents inflation.
To put it simply, cryptocurrencies use complex mathematical formulae to produce digital assets. Similar to conventional currencies or equities, the value of these digital assets fluctuates. Complex cryptography prevents forgeries and fraudulent transactions.
How Are Cryptocurrencies Operated?
A network of decentralized computers that oversee and keep track of transactions is how cryptocurrencies operate. As network users transact, those transactions are added to a global ledger, often known as a blockchain.
Using certain cryptographic keys, transactions must be signed and validated to show that they took place. This measure eliminates the possibility of duplicate spending.
New transactions are examined and verified by nodes, which are strong computers in the network. Essentially:
- Recent transactions are broadcast to all nodes by the system.
- Each node gathers new transactions into blocks.
- Each node looks for a challenging proof of work to validate its block.
- Every node receives a broadcast when a node discovers proof of work for a possible block.
- Only blocks with valid transactions that have yet to be spent are accepted by nodes.
Working on the subsequent block in the chain demonstrates node acceptance of the block.
The source code determines the number of Bitcoins that may be in circulation. Only 21 million Bitcoins may ever be mined to force scarcity and avoid inflation.
How are Cryptocurrencies Made?
Because operating these nodes is analogous to mining valuable resources, those who do so are referred to as miners. Both involve a significant amount of work and provide the miner with a source of revenue.
To demonstrate that a bitcoin has only been transmitted once, miners serve as auditors by resolving math problems specific to each transaction. These transactions are then assembled into a block. A miner is paid in fresh bitcoins after finishing a new block.
These block incentives compensate people who give up computer power to participate in the system. In the end, this method rewards individuals who honestly produce blocks more significantly since fake ones are quickly exposed.
How Does Blockchain Work?
Blockchain, also known as distributed ledger technology, is a network of independent computers that keeps track of transactions in a public digital ledger without an intermediary like a bank or government.
The blockchain protocols used by various cryptocurrencies vary. They do, however, generally follow this process.
A copy of the ledger is available to thousands of nodes, who may also approve transactions. These nodes compete to confirm the transactions as the chain’s blocks are being added one after the other. The overall amount of ledger dollars rises once a player produces a block and earns a “block reward.”
Say a user exchanges one Bitcoin for a specified sum of USD. Peer-to-peer computer networks independently verify the transaction, which is time-stamped, added to a growing data chain and verified again. That trade will be approved by network nodes, who will then apply the transaction to the ledger and finally advance it. The transaction is deemed genuine if at least 50% of the participants agree. New Bitcoin blocks are created on average every 10 minutes.
What Makes Secure Cryptocurrency?
One of the key draws of cryptocurrencies is their enhanced security. Various encryption algorithms and cryptographic approaches protect transactions inside the Bitcoin market.
The blockchain system is incomplete without cryptographic hash functions, which operate as randomly generated IDs for transactions and identities that are very difficult to predict without much computational power. Computers carry out these operations to validate transactions and extend the chain.
Any effort to rig the system is proven impossible after a few blocks since continuing addition to the blockchain requires continual computing input. The phony chain a fraudster attempts to establish will be quickly outpaced by all other computers working together on different concurrent chains.
The chain would also need to be hacked, which would demand unheard-of computing power and expose at least 50% of the supercomputers in the system. Therefore, there is a lot more motivation to follow the regulations.
How are Cryptocurrency Accounts Secured?
Similar to previous methods of exchange, the bigger dangers come from the people using the economy rather than the system as a whole.
Each active member of the Bitcoin ecosystem also holds public and private keys to the cryptographic sequence. These keys use cryptography and a random string of letters and numbers to identify the person. Participants typically possess the following:
- Access to their Bitcoin wallet via a private key
- A shared public key for online transactions
If both keys are not securely protected, these elements of the Bitcoin ecosystem are just like conventional transactional methods, vulnerable to hacking or other hazards. Consequently, smart industry participants implement extra security measures to prevent malicious actors from manipulating the Bitcoin wallet.
Why Are Banks Important to Cryptocurrencies?
The pros and cons of cryptocurrencies have been hotly debated, with opponents citing anything from volatility to environmental effects. However, as the market becomes more competitive, banks should consider the possibilities that cryptocurrencies inherently provide.
Venture capital companies have started pouring money into the financial technology sector to take advantage of the boom and beat out financial institutions.
For instance, the cryptocurrency startup Coinbase facilitates the acquisition, exchange, and storage of various cryptocurrencies. Seventy-three million people now use Coinbase, up from 12 million in 2012. Similar to Square Cash, Q1 2021 sales were over $3.5 billion.
Following suit, money service companies like PayPal that profit from conversion fees have begun to provide the service and search the market for crypto expertise. Understanding the risks and obligations associated with maintaining digital assets, PayPal purchased Curv, a fintech company, to give PayPal customers the ability to buy, trade, and retain cryptocurrencies.
Banks must be concerned about cryptocurrencies since many clients are interested in them, and rivals are moving ahead. Profiting from the trend might ensure patrons interact securely and strengthen their bond with the establishment.
What Affects Banks from the Crypto Boom?
Despite the rise in interest in cryptocurrencies, some worries and uncertainties remain. Many customers rely on industry professionals for custodial management so they may properly manage risks, send money reliably, and get tax assistance.
Financial institutions have the chance to continue serving as financial advisers in the cryptocurrency space. Many customers want to take part, but they want the help of a reliable partner, like their institution, to grasp better how. Allowing clients to dangle their toes in crypto might earn cash and provide instruction.
The public and the federal government have paid the greatest attention to Bitcoin since it is the first and most well-known cryptocurrency. The IRS defines it as an asset, much like a stock, rather than advising its use as money. This regulatory clarity lowers the market participation risk and provides banks with access. As a result, the convergence between cryptocurrency and banking has been focused on Bitcoin.
Banks have a significant edge in ensuring clients because they are institutional, regulated, audited, and market-proven. They can easily access cryptocurrency without going into the uncertain realm of using it as money. Some people have already hired fintech firms to provide custodial management solutions.
The world of cryptocurrencies is continuously changing and is under more public scrutiny than ever. Additionally, there have been rumors that the Federal Reserve may introduce Fedcoin, a digital money that uses blockchain technology development (distributed ledger technology.
Banks can assist their clients in participating securely in the cryptocurrency market while continuing to serve as a resource and financial adviser due to custodial management solutions.
It seems sensible to watch future regulatory changes and the Federal Reserve going forward.