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Cryptocurrency Basics

Bitcoin Blockchain Software 2.4a

Editor’s Note
The following transcript was taken from one of Kelly’s live classes for tax professionals.

SLIDE 48

Let’s get into the technology and explore the following questions. How does the technology do what it does? How does a bitcoin get created? How does a person track their bitcoins? How do you track your transactions?

The bitcoin software is a digital innovation. It combines three technologies to decentralize trust. Those three technologies are 1: public-key cryptography, this is your passwords and keys, 2: proof of work, this is the consensus algorithm that avoids the double spend problem, and 3: the distributed public ledger, which is the Blockchain that keeps track of all the transactions. What’s the benefit of this new technology? It allows two people to safely exchange confidential information, like bitcoin, over a public network, the Internet, that is being monitored by a potential hacker.

SLIDE 49

Let’s go over the three technologies. Public key cryptography. This is what you’ll probably pay the most attention to if you ever buy and sell bitcoin. Public-key cryptography means that a pair of digital keys defines ownership and allows spending of bitcoins. The public key is an address that is shared publicly. The public key address is like giving someone the address to your house so they can find you if they want to come to your house. If you want them to come into your house when you’re not there, you have to give them the key. This is why the private key is secret. The private key is what allows a transaction to get signed. For example: if I want to send Bob 50 bitcoins, in order for me to do that, I have to know his public address, his wallet address, which is a string of numbers and letters. There’s no identifying information in that address. You can’t tell whom it belongs to. If I gave you my address to my house, you wouldn’t know that I live there unless you look up a document with the county. Let’s say he’s given me his address and I am sending him some bitcoin right now as a gift. I go into my wallet and I say I want to send some bitcoin. It will ask me for the address. I copy and paste the address. Addresses are too long to actually type in. When I go to hit send, I have to put in my private key address in order for the software to actually send it. I have to sign it, like a digital signature.

SLIDE 50

Let’s talk about wallets. The bitcoin wallet is important because it stores those public-key addresses and private signature keys. They are stored in the wallet which is usually on a computer, your smart phone or website. Remember, bitcoins only exist on the Blockchain ledger and are identified by their public key. Bitcoins do not live in the wallet. This is a trick question: I bought a bitcoin from Amazon, it’s that big around, it’s in a little plastic case and I usually carry it with me so I can show it to people and say hey, this is a bitcoin! Their eyes get big. It looks like gold and it cost me $19. That’s not a bitcoin, folks! I like to use it as a representation of a bitcoin, but that is not a bitcoin! It’s just a play coin. Everybody wants to be able hold something. They’re just ones and zeros on a ledger. The ledger lives in the Blockchain.

How do we buy and sell bitcoins? Where are the bitcoins? You must have an address to send and receive bitcoins. Let’s say I decide to send 50 bitcoins to a particular address, which belongs to Bob. I sign that transaction and it goes to a miner. The miner will then validate that I actually have 50 bitcoins to give him. The wallet will validate his address to make sure that it’s valid. It’ll process the transaction and it’ll take 50 bitcoins from me and give it to him. What actually just happened? Does my wallet have 100 bitcoins in it that I can give away? No. What did I say was in the wallet? The addresses and the signature keys.

So where are the bitcoins? They are in the ledger on the chain. The ledger started out with a balance, think of it like a literal spreadsheet ledger, and over here is the balance column. The balance started at zero. The first block was mined, block number one. There were probably two transactions in it. When it got mined it created 50 bitcoins, so the balance in the ledger is now 50. However, that $50 belongs to somebody. There’s an address associated with it. At the time there was probably no more than one full node with one guy mining. So he put 50 bitcoins in there. They’re associated with his account, with his address. I try not to use the word account anymore because that confuses people. It is an address associated with him. He’s all excited and he wants to send 20 of those to a friend. The 50 bitcoins haven’t changed. It’s still 50 bitcoins on the ledger. He goes and gets his buddy’s address and says I’m going to send 20 bitcoins to that address. The ledger now says okay, 20 belong to him. The total is still 50 but 30 belongs to the first guy. Every time you do a transaction all it does is rearrange who’s got what in this ledger. I think of the address as a pointer.

For example, here in this Ledger I own this many bitcoins, here in this Ledger, I own a few more. You can have more than one address, which is a good idea. My wallet keeps track of all the addresses and it’s also a place where it can look at the ledger and it can add up all the bitcoins with addresses on the Blockchain. I think of the wallet as a place that aggregates all the coins that are associated to me on that block chain. It makes it easy to figure out which ones are mine. It puts it all in the wallet so I can see what is the total of my bitcoins that live on the Blockchain.

Audience question: if there are other companies creating cryptocurrencies, where they put their cryptocurrencies? Do they have a blockchain of their own? Answer: it is not on the bitcoin Blockchain if it’s not a bitcoin. The bitcoin Blockchain can only manage bitcoins. Each cryptocurrency has to first have its own Blockchain and it has to have its own wallet to keep track of it. I’ll complicate it a little bit. Can you read those cryptocurrencies in that wallet on the slide? It says bitcoin, ethereum, ethereum classic and USD coin. This is a single wallet that’s keeping track of multiple crypto currencies. You can have wallets that will track more than one crypto currency in that wallet.

Audience member asked a question on whether the wallet is where you view basis fees and transaction fees. Answer: All the wallets are slightly different. If it’s a good wallet, you’ll actually have the transaction ID. If you click on the transaction ID, it should take you to what’s called a Block Explorer, which will show you all the details about that particular transaction, which should hopefully include fees. This is not generally how you get basis information. We will get to how you get basis in just a little bit.

Audience member question: looking at this digital wallet that’s on an iPhone, it’s more like a purse that has four different wallets, and each wallet has a particular kind of crypto currency in it. Answer: that’s a great analogy. All it is, is there’s some computer code on the back end that tells this wallet to go talk to a particular Blockchain and get the data off of it. The code is written into the wallet. If you got the address, and it’s bitcoin, it’ll go to the bitcoin Blockchain, get the data, and it’ll tell me which bitcoins are mine. For the ethereum cryptocurrency there is some code in this wallet that will go to the Block Explorer of the ethereum Blockchain and grab the information about all the transactions associated with me, and then consolidate it into this wallet. It’s all computer code. They use these API keys for just about everything. You can tell it to go out and grab the information and consolidate it in one place.

Audience member question: how did you get the bitcoin in your wallet? How do I get bitcoin in the first place, unless there’s some really nice person here that wants to give me bitcoin? How do you get bitcoin? Answer: You can mine them, you can work for it, receive it as a gift, you can exchange it for services rendered, you can buy from an ATM and buy from an exchange, which is how most people get it these days. You’re not tied to the digital currency unless you sell it. Then it sells back into digital currency, legal digital currency.

Audience member question: does anything identify each particular piece of bitcoin? Answer: this is we’re getting into the idea of tax lots. That question was just answered by the IRS three weeks ago and luckily you guys get this version of the training where I was able to incorporate their new guidance where we will talk a bit about tax lots and what that means. Each individual transaction has an ID associated with it. It is called a transaction ID, but does every little piece of bitcoin have an identifier? I think only in the transaction. I do know the transaction itself has an ID associated with it. Does each little piece of bitcoin that in the Blockchain ledger have an ID? It’s part of a block, there’s hashes and all kinds of technology and language and I don’t want to bring up now.

SLIDE 51

Audience member question: if you see your wallet on the phone, can it be displayed anywhere else? Answer: If your wallet is on the phone, that’s where you’re going to see that wallet. There are other kinds of wallets. I have multiple kinds of wallets. I have a wallet on my phone, I have wallets on my computer, and I have a hardware wallet. In this slide I’m showing you a picture of the desktop wallet that I use called Exodus and I’m showing you a picture of the hardware wallet that I like. It’s made by Ledger. The prior slide was a picture of a digital wallet on a phone. I have wallets in all three places. If I have bitcoins in my wallet on my phone, they don’t automatically show in other wallets. If I want my bitcoin to go from the wallet that’s on my phone to this hardware wallet that is disconnected from the Internet, hence more safe and secure, it’s called a cold wallet, I have to send it from my phone wallet to an address on my hardware wallet. Does it cost me lots of money to send it? No, just a few pennies for the transaction fee, because every time you send bitcoin, that generates a transaction. This means a miner has to validate the transaction and he gets paid a little bit in fees.

Audience member question: what if I lose my phone? This is the crux of the whole industry. We are in the process of deregulating money. Usually deregulation is done with the help of the government. This is deregulation done by the people. Right now if I got my US bank account on my phone and I lose my phone, have I lost my money? No, because it’s on the computers at the bank. The bank is the one keeping track of my money and the bank is the one deciding when I can get my money, how much I can put in, how much I can take out whether it gets lost, whether a hacker can get to it. It’s the bank that’s gotta create that security and make sure it’s not stolen. With bitcoin, that is not the case. With bitcoin, each and every one of you that has a wallet, is your own bank. That means you are in charge of whether it’s hacked. You are in charge of whether your money is lost or stolen. I call it money. Many people in the industry call it money, IRS calls it virtual currency. You are 100% in charge of your addresses, so that you know what’s yours. You’re 100% in charge of your private keys so that you can do something with it. If you lose your private keys, you’re screwed. If you lose your address, you’re screwed too because you don’t know where it is. The address still exists and if you had a Block Explorer, you can see your crypto currencies in the Blockchain if you have the address. If you lost the address, it’s gonna be really hard to go find it again.

There are desktop wallets, online wallets, mobile wallets, hardware wallets and paper wallets. Those wallets can be put into categories. A cold wallet is the most secure because it’s not connected to the Internet. You connect it to the Internet briefly to transfer some cryptocurrency and once it’s in the hardware wallet, you disconnect it. It’s like having a USB drive. I can put cryptocurrency bitcoin onto a paper wallet. I can then put the paper wallet in a bank safe deposit box. That’s some irony there. There are lots of people who do that. That is another way of having a wallet that’s not on the network, so it’s safer, as long as you don’t lose the piece of paper, burn it up or have the bank lock you out of your safe deposit box.

If your wallet is online or is 100% connected to the Internet all the time, that’s called a hot wallet. That’s the most dangerous. I’m going to say something that you may not believe: the Bitcoin Blockchain has never been hacked! I don’t care what you read, it has never been hacked. What has been hacked? Wallets and exchanges have been hacked. What does an exchange use in order to keep track of transactions? A wallet. Wallets are the weak link, and exchanges are constantly doing transactions so they have hot wallets. A hot wallet is 100% connected to the Internet all the time, which means that it’s available to a hacker. If it’s on the Internet, the hacker can figure out how to get in there and muck with it. They spend a lot of money on trying to create security around their wallets. If you go to manage your own money, be diligent and responsible. If you have money that you don’t want to spend right away, keep it off-line. If you have money you need to be available to go buy coffee or groceries, keep it in a hot wallet. Don’t put thousands on it. Just keep a few hundred dollars on it.

Audience member question: so you can’t have redundancy by having multiple wallets accessing one account? Can you only have your addresses in one place? If you drop your phone, are you screwed? Answer: Pretty much, because it’s a hot wallet, unless you have that address stored somewhere else. If you don’t have the key somewhere else also, you’re screwed. There are wallets like this Exodus wallet, and one of the reasons I like it is because it shows me my addresses and my private keys. I have some redundancy built in. I’ve made a copy of those addresses and private keys and I put them in a safe place.

Regarding hardware wallet by Ledger: you can duplicate a hardware wallet on another hardware wallet of the same kind so that they’re showing exact same information. I haven’t done it yet because I haven’t had time to figure out how it works. But I know how to get into my Exodus wallet, copy the address and the private keys, and store them somewhere.

Audience member question: how do I get an address? The number one way that people get addresses in the US is to go to coinbase.com. You create an account and it already has multiple wallets. It defaults to having multiple wallets, eight or 10 for different kinds of cryptocurrencies that they work with now. When you go to send or receive, it will generate a wallet address.

SLIDE: Paper wallet

I am showing some addresses here at the bottom. I created a paper wallet similar to this one. There are cool tools out there that allow you to get an address. For example, there’s one where all I have to do is move my mouse around the screen and in that process it’s generating an address. It creates a different address from any other address on the planet.