What Advisors Need to Know About Cryptocurrencies

You may have heard about bitcoin, the cryptocurrency whose mysterious creator, the pseudonymous Satoshi Nakamoto, has been nominated for a Nobel Prize – even though his, her or their true identity remains stubbornly unknown. Spurred on by breathtaking price runups, some clients may even have asked you if they should invest in them, or if it’s safe to buy them and use them to make payments.

Most likely you dismissed the whole thing as some sort of a tulip bubble, or a creature of illicit economies like drug trade, money laundering, and cyberhacking.

But it’s not as simple as that. This bubble could be the start of something big.

The basic facts about cryptocurrencies

Virtually all other transactions systems – whether their purpose is to transact in currencies, land titles, medical records or something else – are conducted through the medium of centralized databases, owned and maintained by large trusted institutions such as banks, insurance companies, hospitals or governments. The names and personal details of the transacting parties are fiercely defended against theft by those trusted institutions. Yet there have been well-publicized hacks that have caused data leaks and serious losses. Those systems are called centralized ledger systems.

Cryptocurrency transactions, by contrast, rely on what is called a decentralized ledger system (DLS). Instead of sensitive private information being kept on a single very tightly-guarded central system (with a few tightly-guarded backups), a decentralized ledger allows the information to be public, stored by everyone who wants to, on their computers and their local or cloud-based storage devices.

How then can the information be protected against theft? The answer lies in cryptography, in particular the “digital signature.” No cryptocurrency transaction can take place unless the owner of the currency (who is identified only by constantly-changing encrypted “addresses”) digitally signs it. No private information resides on the public database (known as the blockchain), so your private information, which consists only of your “private key,” cannot be stolen unless you reveal it yourself.

How does a digital signature work?

The answer is by mathematics. But I’ll explain it by analogy, using an event from my childhood. When I was a pre-teenager, I liked to play with a chemistry set that my parents gave me, and any additional interesting chemicals that I could get hold of. I would visit a Merck wholesaler in a warehouse in Boston, where a nice man would sell me my chemicals in bulk. This sounds amazing now, but it’s true.

I noticed once a recipe for invisible ink. You could create two chemical solutions, one I’ll call the ink (labeled K) and the other I’ll call the “revealer” (labeled R). If you wrote on a piece of paper with the ink you would see nothing, as if you had written with water. But if you wiped it with a cloth that was dipped in the revealer, R, what you wrote would become visible, as if you had written with real ink.

I was so excited about this that I bought a number of small brown glass bottles and mixed large quantities of the two formulas, K and R, then sold them to my classmates for 25 cents for a pair of bottles – a substantial amount at the time.

Before anybody besides me had the invisible ink (I’ll now call it my “private key”), I could have used it to securely sign documents. If I gave the revealer solution, R, to everyone else (my “public key”), then they would know when they revealed the signature that I was truly the one who signed, and not a forger, because only I had the invisible ink.

If you go on to assume that there are many, many secret formulas for invisible ink (Kj, j=1,…,n), each one uniquely paired with its own revealer (Rj, j=1,…,n), you can begin to understand how it is possible that many private-key-holding individuals can each sign transactions and be secure in the knowledge that their signature can’t be forged (as long as each one’s ink formula is kept private). Furthermore, they can do this without anyone ever knowing their real-world identity or personal information.