By Meir Ilia, CPA LL.M.,CIA, partner Rosenblum-Holtzman & Co.
Virtual currency, with Bitcoin as concept king, is dominating headlines across the globe and making a lot of noise. Thousands of digital currencies have flooded the online financial arena, and have raised many complex questions and disputes regarding the risks on the one hand, and the trend’s immense but questionable potential on the other.
The last couple of months have witnessed very volatile rates on the digital currency market. There is talk of Bitcoin and its contemporaries exchanging hands in both business and criminal circles, and reports of digital currency fraud and larceny.
International banks, regulators around the world (including in Israel) and tax authorities are examining the possibility of security loopholes in digital currencies and whether these currencies are susceptible to manipulation. Some are seeking to limit the use of digital currencies and others hope to prohibit their use altogether.
CHANGING THE WORLD,BITCOIN BY BITCOIN
Bitcoin was created as a digital means for transferring payment between two parties via the Internet, without the need for a third party (such as a bank, credit card company or other entity) to serve as intermediary for transfer of payment.
The coin was first described in an article published at the end of 2008 by an anonymous writer with the pen-name Satoshi Nakamoto, whose identity remains elusive. Bitcoin pioneered the virtual currency revolution and has been adopted as the generic name for all digital coin currencies. The nickname for all other digital currencies that piggybacked on Bitcoin’s open source project are called Alternative Coins (Alt.Coins) and an increasing number of people are using, promoting and investing time in the development and promotion of these currencies. Neither produced nor issued by any government or central bank, Bitcoin is based on the tenets of cryptography and peer-to-peer networks.Digital coins have no physical manifestation, and their worth is determined only by users who believe in the value of the coins and their validity as real currency for the exchange of goods or services. This is also why the Bitcoin market is so volatile.
The process of issuing new currencies into public circulation requires investment of considerable computing power and, borrowing terminology from the gold industry, is called “mining.” Bitcoin operates as a digital ledger system, which records how many “coins” are in each digital account. Anyone who is connected to the Bitcoin network has access to a copy of the ledger so that each transaction is collectively transparent and secured by a consensus verification model.
Since digital currency is essentially an information file, it can be duplicated. This means that anyone can copy a file and repeatedly reuse the coins. The ability to duplicate and recycle coins, known in industry terms as “The Double Spending Problem,” is the biggest challenge faced by digital currencies.
Since the entire concept is based on code and technology, the only way to track activity and maintain transaction security is to fight technology with technology and harness the power of peer-to-peer networks. Online transactions generally involve a third party—such as a credit card company or PayPal—trusted by both buyer and seller. The role of the third party (the broker) is to verify payment transfer between the parties. For example, when we use a credit card, the transaction is submitted for approval by the credit card company or bank, who makes sure there are su¡cient funds in the account and then authorizes the seller to make the transfer. This can take time and the broker service usually entails a commission fee.
Digital currencies like Bitcoin eliminate the need for a middle man using complex mathematical coding whose inherent security capabilities supersede standard intermediaries. Instead, a user consensus confirms registration of a transaction and all transactions are bundled together in a ledger called a blockchain.
The way the model works is by decentralizing the confirmation of transactions. This process is coined “mining” and uses cumulative public confirmation to register each exchange of currency between a seller and buyer. The more nodes (users) that confirm a transaction, the more di¡cult it becomes to manipulate the transaction fraudulently, ensuring that buyers cannot use the same coin twice, i.e. make two purchases using the same coin. Miners—users on the network who verify the transactions and determine their chronological order—invest vast amounts of energy and electricity in the process of transaction verification. Compensation for the investment of these resources is issued to miners in the form of new coins.
BLOCKS, STACKS AND CHAINS
The transactions themselves are filed in groups called blocks. Each new block file contains about 2,000 transactions and is linked to the preceding block, starting from the first Bitcoin transaction. This forms a chronological chain called a blockchain, which is designed to verify the authenticity of the data and transactions in the ledger, using technology called “stacking.”
Alteration of existing documentation or production of a fictitious transaction is blocked through a system that processes transactions using a one-way stacking function. This is a code that serves as a black box, which converts regular text into short, static text, called stacked text. The stack function is designed so that any small change in input text will result in entirely new output, so that reproducing the original stacked text from new input is extremely difficult.
During the mining operation, network users verify and bundle transactions into blocks. In principal, each stacked output is coded so that it begins with a number of zeroes in a row, for example a row of thirty zeroes. But no block can genuinely yield a stacked output that begins with a row of thirty zeros! The miners add a single line at the end of each block with a random value to test if the contents of a block produce the correct stacked output.
Each new block in the blockchain contains the stacked contents of the preceding block which determines chronological documentation in the transaction ledger, and establishes a running history for all preceding blocks. If a user attempts to alter information in one block, it will alter the stack in the next block. Since all the blocks are linked, this will alter the entire blockchain. Through timeline documentation and connectivity, this enables retroactive identification of any attempt to falsify a transaction.
FLIP A COIN
Digital currencies have yet to be recognized as a widely-accepted means of payment, and there is much skepticism regarding their integrity and fate. But if you think about it, who would have believed ten or twenty years ago that we would be paying bills and doing our grocery shopping online? That all our photos and documents would be stored in a cloud? That every man’s pocket and every woman’s pocketbook would carry a mobile phone that gives us instant access through various applications to everyone we know (and don’t know!) and that renders map books obsolete!
The great accomplishment of Bitcoin is the introduction of successful transfer of payment between two parties, through verification of the transaction by consensus of a peer-to-peer network model. Both the unique structure of Blockchain code and the concept of transaction validation on masse by users themselves—is revolutionary. But it’s still a revolution in its infancy, and the market isn’t yet equipped to handle the sheer scope of currencies out there.
MONEY COME MONEY GO
Most digital currencies in circulation today will probably eventually burn themselves out. But their legacy will live on in their contribution to the advancement of the original source code, a stepping stone to further technological development. It’s tempting to invest in digital currencies but it’s risky and requires examination with a very cautious and critical eye. The million bitcoin question is whether digital currency will become a universally endorsed means of payment and change the world of finance as we know it (like the epic change brought by the printing revolution in the 15th century). Perhaps we’ve just been momentarily blinded by fairy dust in the wind. But time will tell, and it’s too early to be prophets of doom.
The information presented in this article should not be construed as professional advice regarding investment activities or proposals, nor an offer to purchase any product or service, and is not a substitute for a comprehensive consultation that takes into account specific data and personal needs. Use of information in this article is the sole responsibility of the reader and at his own risk.
Rosenblum Holtzman, CPA was founded in 1981. The firm provides a wide range of services to corporations, kibbutzim, non-profit organizations and private clients. These services include auditing annual financial statements, representing clients before the tax authorities, tax planning, internal auditing, information systems, risk management, information security, financial consulting, Sarbanes Oxley implementation, and evaluating corporate governance. The firm has special expertise in forensic auditing and assisting in legal proceedings involving accounting and financial evaluations. With over 100 employees, Rosenblum Holtzman provides a top tier professional service, while simultaneously allowing clients to receive personal attention from the partners.
Rosenblum Holtzman CPAs can be reached at 03-609-20-20 or through their website www.rhcpa.co.il.
Meir Ilia, CPA, LL.M., CIA and licensed investment manager is a partner at Rosenblum-Holtzman & Co.
He holds a BA and MBA in business management with specialization in management, accounting and finance.