The Introductory Parent’s Guide to Understanding Cryptocurrency

Over the last several weeks, there have been increasing amounts of attention paid to cryptocurrencies.  It’s hard to turn on the television or go onto social media without seeing some story or cute meme about cryptocurrency. This emerging technology has generated a ton of interest among techies, investors, and the general public. In fact, the two most popular cryptocurrencies – Bitcoin (BTC) and Ethereum (ETH) have seen rises of 800% & 2,856% respectively. However, it’s important to note that the blockchain and associated digital currencies have been around for less than 10 years. At Digital Adventures, we believe that in order for us to accomplish our mission that it is important for parents to understand as much as they can about new technologies so they can help educate their kids. In this introductory parent’s guide, we will attempt to explain in plain English what cryptocurrency is all about.

In the established banking system, we depend on financial institutions that have been around for hundreds of years to verify and validate transactions. For example, when you pay your phone bill, you submit your credit card information to your cell phone provider. Your cell phone provider uses that information to request the money from your credit card company for the phone bill. If your credit card company verifies that the money is in your account, then your cell phone company receives the transfer and your phone bill is paid. However, it is not as though someone physically moved $100 from your bank account to your cell phone company’s account. Instead, a debit was made from your account and a credit was made to your cell phone provider’s; literally just a string of text in both accounts.

Existing financial institutions are able to provide this service and reap the associated financial rewards because they have built up trust over several years and your cell phone company knows that if Citibank, Bank of America or Chase says that you have the money in your account that they can believe that. This is known as a centralized financial transaction system and is the basis for the modern day financial system.

At this point, you might be thinking, “I like the current banking system, what’s the big deal?” Well, if we think back to prior financial crises (Great Depression – 1920’s, Savings & Loan Crisis – 1980’s, Subprime Mortgage – 2000’s), there can be issues with such centralized systems. Once customers lose confidence, they can make a bank run (withdrawing all their assets) and create a snowball effect that destroys a great deal of wealth. Alternatively, one could argue that it’s nice to have an alternative to manage financial transactions. Still others say that the blockchain is not simply limited to financial transactions. Instead, they believe that any transaction (contracts) that currently utilizes 3rd party verification can be managed using this technology.

Now imagine that you and your friends believe that you don’t need Citibank or Bank of America to tell your cell phone company that you have money in your account. Instead, your group believes that you can keep track of what is in each account by anonymously recording and tracking transactions by recording them in a redundant, verifiable ledger that would work in a similar manner to the existing system.

Assume there are 5 anonymous friends who agree to do the tracking of each other’s transactions. On the 1st day, friend #1 announces, “I’m sending $100 to friend #3”. Friends #1-#5 record this on a piece of paper.  This continues on until a set number of transactions are recorded onto the transaction log. It is important to realize that we now have 5 separate, independent logs of these 10 transactions. 

In order to provide the validity of the entire page, we need to make sure that this page never changes – not today, not tomorrow, not 5 years from now. So, each friend has to lock their page containing the same 10 transactions with an individual key (note: this key is the same for all 5 pages). Once their individual page is locked, they can begin a new page and begin recording the next 10 transactions. A series of these pages put into folders forms a chain of transactions – a blockchain.

And now imagine that instead of it being 5 anonymous friends, it’s thousands or hundreds of thousands of friends that are verifying and validating these individual transactions and sealing individual pages into folders.

In any system with financial incentives, there is always the opportunity to game the system to reap benefits for you and your friends. For this new blockchain technology to work there has to be a way to prevent cheating for individual or group gain. The inventors of digital currency considered this and developed a novel solution.

Remember the key that goes onto each page before it goes into the folder of transactions. It turns out that the development of this key is very difficult. In fact, it requires the use of a special machine called a hashing machine. This special machine takes in an input and spits out the same alphanumeric output each and every time. The process of developing these alphanumeric keys for individual pages and subsequently groups of pages is called mining. However, the key difference is that we don’t know how the hashing machine calculates the output based on the input. Instead, we only know that given a certain input, the output will always be the same. This input based on the output must be verified by the other 5 friends in order to become the sealing number for a given page of transactions to be entered into the registry. 

In addition for an individual page to be validated, we must verify the sealing number for all previous pages by entering them into the special machine to develop a given output. As we’ve already learned, our hashing machine can easily verify that a given input results in an output. So, in this way, once we have all the prior sealing numbers we can compare to the expected output using the hashing machine. If it matches, we can confirm that there has been no tampering of the prior pages. If it doesn’t match, we know there has been an issue. However, this is where the de-centralized nature of the system comes into play. The input and output would not have to match for our 5 friends or in reality the thousands of friends who are the custodians and records of the records. 

Essentially, blockchain technology depends on the honesty of the individual and overall group of participants. Remember, this is why the initial group of 5 friends joined up because they wanted to try a de-centralized distributed method of validating that we could pay our cell phone bill without the use of a 3rd party.

Beyond the honesty incentive, there is also a financial incentive to expending resources (time + computing power) to calculate the sealing number for individual pages + the blocks of pages. Whoever comes up with the accurate number first and having it verified by the other members in the group receives cryptocurrency as a reward.

If we are at the forefront of an alternative trust system with applications in financial transactions and beyond, then your kids need to be aware of: 1) how does the blockchain work?,  2) what opportunities should they consider can be built using this new technology?, and 3) how might this technology evolve over their lifetime?

By understanding the current state of the world, your kid will be best prepared for what could be a massive shift to a de-centralized, trusted peer-to-peer system that is facilitated by technology.