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Marcus by Goldman Sachs is excited to share this insight in collaboration with our friends at Goldman Sachs Digital Assets.
It seems like these days you can’t throw a rock without hitting five headlines related to cryptocurrency.
The cryptocurrency market has grown in the last few years, and people are becoming more interested in learning about how these digital assets work, why they have become so top of mind, and their potential risks. Let’s cover some basics.
Cryptocurrency is a digital asset that is created, managed, and transferred in a decentralized manner.
Cryptocurrency can be used to buy goods and services in a peer-to-peer fashion over the internet without necessarily requiring an intermediary to send funds from one person to another. That basically means with cryptocurrencies, you can transfer value directly between any two people on the network.
Although cryptocurrency has the word “currency” in its name, it’s different from the traditional currencies we know today. While most currencies - like the US dollar - are backed by the faith in their respective governments, most cryptocurrencies are not managed or maintained by a central authority.
Instead, the value of a cryptocurrency depends on its underlying utility, as well as supply and investor demand. Given how nascent the cryptocurrency market is, many cryptocurrencies have had high price volatility.
The first modern cryptocurrency to gain significant adoption was bitcoin (BTC), and it was first introduced in 2008 when the Bitcoin white paper was published under the pseudonym Satoshi Nakamoto.
Today, bitcoin remains the most dominant cryptocurrency by market capitalization, followed by ether (ETH) on the Ethereum blockchain, which launched in 2015.
Outside of bitcoin and ether, there are over 8,000 different cryptocurrencies in circulation that can have specific features and mechanisms that enable new types of functionality outside of basic transactions.
Without a central authority managing and verifying cryptocurrency creation and transactions, you might be wondering how the cryptocurrency network can be secure.
The security comes from the use of blockchain technology, which is essentially a type of database that is shared and authenticated by a distributed network of computers, or “nodes."
The blockchain itself is comprised of groups of transactions and data - known as “blocks” - that are linked, or “chained”, together in chronological order (hence the name).
No single node controls the database, and the network of nodes continuously maintains and reinforces the security of the blockchain.
The blockchain is where cryptocurrency transactions are submitted, validated, and subsequently executed and stored in their respective blocks, so that the database stores the entire history of transactions.
Each node on the network stores a copy of the database, and every time the blockchain is updated, every node’s copy of the blockchain is simultaneously updated with the new information. This process ensures all records are identical and accurate.
To prevent attacks on the network, such as “double spending” of cryptocurrency, a distributed validation process is used. Depending on the blockchain, a different consensus algorithm may be used.
Using the Bitcoin blockchain as an example, to append a new block of transactions to the blockchain, the majority of nodes on the network must verify it.
Once that block has been verified and appended, it’s very difficult to hack the network and overwrite that block.
A “bad actor” on the network would have to reverse engineer that block and alter the transaction data within it, as well as simultaneously make that change to at least 51% of the copies of the blockchain stored by nodes on the network.
As a result, the probability of the Bitcoin blockchain getting hacked is very low.
The use of public and private key cryptography is also an integral part of blockchain and allows network participants to send and receive digital assets like cryptocurrency in a secure manner.
When someone purchases cryptocurrency, they receive a public key - which functions similarly to a mailing address and allows them to receive cryptocurrency - and a private key - which gives them the ability to transact with the cryptocurrency linked to that public key.
In other words, your private key allows you to send cryptocurrency and lets the recipient verify that the transaction is being sent from you (this is called “signing”).
Your public key allows the recipient to verify that you are the actual owner of the cryptocurrency, and the recipient can receive that cryptocurrency to their respective public key.
Storing digital assets like cryptocurrency is different from how we hold assets today. For example, today we might store value as dollar bills that we keep in our wallets.
Like we mentioned in the previous section, when you purchase cryptocurrency, you receive a public and a private key. The private key allows you to access the cryptocurrency linked to that public key and transact with it.
Because of this, it’s important that users keep their private key safe since anyone who knows the private key has access to that cryptocurrency. Additionally, if you lose your private keys, you lose access to your cryptocurrency holdings.
Users can choose to store their private key independently of any third party in a digital wallet, which will store and keep your private keys safe and accessible. These wallets can be hardware wallets like Ledger, which can resemble a USB stick.
Others may opt to use an online digital wallet application or digital asset custodian, who will store their private keys on their behalf and users then execute cryptocurrency transactions through the application or the custodian.
This article is for informational purposes only and is not a substitute for individualized professional advice. Articles on this site were commissioned and approved by Marcus by Goldman Sachs®, but may not reflect the institutional opinions of The Goldman Sachs Group, Inc., Goldman Sachs Bank USA or any of their affiliates, subsidiaries or divisions.