The beauty is in the math: Top 5 crypto questions answered

By Abigail Olson

Cryptocurrency is gaining momentum and becoming more mainstream. As founder of Afloat, a blockchain-based tax credit marketplace, VSCPA member Louise Reed, CPA, answers a lot of questions about crypto and other innovations.

“You can’t truly appreciate the value of bitcoin until you understand the underpinnings of the math that make blockchain technology profoundly disruptive,” Louise says.

Mathematically speaking, Louise says, what can be done can mostly be undone: addition can be undone with subtraction; sine with arcsine; derivatives with integrals; and Fourier series with Fourier transforms. In accounting, there are journal entries and reversing journal entries.

However, in the late 1900s, computer programmers developed a one-way function, which, by definition, cannot be undone. They called it a hash function.

Louise employs an example of someone’s dog to further explain hash functions. “Let’s say you have a picture of your dog made up of pixels, and you hash it. You’ll get a long string of numbers and letters. If you give a copy of that digital image to your friend, who changes the sparkle in your dog’s eye from white to a light brown, and you hash that slightly modified image, you get a completely different set of numbers and letters.”

The new set of characters indicates a change but does not specify what changed, how much or why.

Each pixel in Louise’s example represents a person’s wallet with the amount of Bitcoin they have at any moment in time. If that information is hashed, a string of letters and numbers result. This truth of the amount in everyone’s wallet is copied on thousands of computers around the world, which means that if one bad actor changes the amount of bitcoin in anyone’s wallet, all the other computers will instantaneously know that the bad actor’s computer doesn’t hold the truth.

“Imagine that Sally pays Harry a 10th of a bitcoin, which is a legitimate transaction in real time. The bitcoin algorithm, for example, takes a hash from the past and the new legitimate transactions of the past 10 minutes and hashes that combination. So, every 10 minutes, you have a hash of new information plus the most recent previous hash. That is the chain of blockchain.”

Here are the top five questions Louise receives when giving presentations on the blockchain and cryptocurrency.

1. No government or company backs bitcoin, so why does it have any value apart from speculation?

Louise says to compare the time, resources, energy and property that banks use to keep track of everyone’s bank accounts, and how much effort it takes to keep those accounts secure from robbers, hackers, internal fraud and other bad actors. Having existed for more than 10 years in a hostile global environment, the bitcoin blockchain has never been hacked. Its security, efficiencies and liquidity alone give the cryptocurrency its intrinsic value.

“The U.S. dollar is no longer backed by gold. Our governments, the federal reserve and financial institutions consistently use the monetary multiplier effect to stimulate our economy. The bitcoin algorithm has a programmed and set decreasing inflationary rate with an eventual maximum supply and circulation. That is not true with the U.S. dollar or other government-controlled currencies.”

While many people trust that the U.S. government has good command over monetary policy in the domestic and global economies, bitcoin and blockchain technology remove the need for that faith.

2. What accounts for the extreme price volatility if a cryptocurrency has intrinsic value?

In traditional markets, such as the stock market, the money and intelligence at large financial institutions dampen the price volatility. However, the U.S. government has not encouraged cryptocurrency, leading to the absence of those large financial institutions.

“For the original programmers and creators of blockchain technology, the demand holds strong throughout crypto winters. Since the cryptocurrency markets are available 24 hours a day, 365 days a year with no barrier to entry, early investors can become addicted to trigger-happy highs and lows — a little bit like gambling.”

Because of its availability with no barrier to entry, the market tends to attract risk takers and social media followers, both banked and unbanked. The nuances of the bitcoin algorithm are hard to understand, and the concepts are new to our traditional financial markets, giving disproportional weight to an Elon Musk tweet.

Louise has spent many hours with a Virginia Commonwealth University cryptography professor to learn more about the bitcoin algorithm.

“Even still, it is hard for me to trust the algorithm when an element of it has not been tested yet, and here’s an example. The bitcoin algorithm uses a ‘lottery’ type system to determine which of the bitcoin miners will determine the next block of new transactions. If a bitcoin miner knew ahead of time which block they would determine, they could manipulate the data. But because of the way the algorithm was created, the miners do not know if they have won the lottery until the very last second, which adds to the security of the chain.”

Before China’s government outlawed bitcoin mining in June 2021, two-thirds of miners were located there. The bitcoin markets reacted with a substantially lower price in bitcoin.

“It wasn’t until a month later that you could witness the algorithm working as it was designed. When the pool of miners is very big, the threshold of correct answers to win the lottery is very narrow. When the number of miners substantially decreases, the algorithm automatically adjusts the window of right answers to win the lottery to ensure a new block is mined every 10 minutes. Therefore, the incentives to be a miner outside of China became that much more lucrative.”

The technology is designed to be bigger than any country or government.

3. Because it’s easy to create a coin, thousands exist, so why should any particular cryptocurrency have value over other existing or soon-to-be-created ones?

“Knowing who created the coin and for what purpose is a strong determinant of value and future adoption. The newer coins have been less tested simply because they’re newer and therefore carry more risk and are usually less valuable. Amazon stock trades at a higher price per share than a stock spun up just yesterday by an individual.”

Not unlike spinning up a corporation or partnership, most coins have different attributes and long-term potential. One of the distinguishing attributes of these coins is the consensus mechanism for determining who secures the next block of information: proof of work, proof of stake, proof of authority, and new ones being tested every year. Another differentiation is the ability of additional programming to be attached to the main blockchain. Other factors include speed, security and innovation. Along with brand and name recognition, the maximum number of coins that are in circulation and will ever be in circulation are taken into consideration when determining the value of a cryptocurrency.

Although bitcoin has held up for more than a decade, there are a number of coins with vulnerabilities, which hackers have exploited to control the coin and make a lot of money. The most common and well-known example is the 51% attack. If the coin doesn’t have a substantially large capitalization, a person or entity with a lot of access to capital can quickly buy 51% of the coins to ensure they control the transactions to their benefit.

“It’s not breaking the code, it’s taking advantage of how it was written in a way that the original creators didn’t intend for it to be used. This is why time in a public domain is the best test of security and resiliency.”

4. How should a small CPA firm treat a client with cryptocurrency assets?

Most people in cryptocurrency and the blockchain industry enjoy a certain amount of adrenaline rush on the novelty and risk.

“The CPA profession in general tends to be particularly conservative and risk averse. Anything an accountant can do to empathize, accept and validate the client’s risk tolerance — even though it may not be their own — goes a long way. It’s important to remember that this industry is evolving and innovating so much faster than our tax code and government know how to understand, let alone respond.”

Louise finds it helpful to remember that the accounting industry has historically been wrought with estimations and judgment calls. She compares the unclear IRS treatment of staking awards to how the “expense versus capitalize” threshold has morphed with new IRS guidelines and tax court cases through time.

“I tell my blockchain and cryptocurrency clients that it is extremely important for them to have a very good, clean set of books outside of the cryptocurrency transactions, so that if they are taking risks in unclear areas of the tax code, they can demonstrate to third parties that where the tax code is very clear, they are in compliance.”

Louise does tend to give her cryptocurrency and blockchain clients choices within the tax treatment reasonableness spectrum.

“Right now, there are circumstances where the tax code regarding crypto and blockchain is clear, but the accounting and technology required to get a perfect answer is unreasonable given the income and scale of the entity’s situation.”

There are tax software solutions coming out to address this challenge, but it’s important to remember that, by definition, that industry trails the innovation and will never be fully up to date.

5. Isn’t cryptocurrency environmentally unfriendly?

“When I get this question, the first point I want to make or that I want people to account for is the energy required right now in our world to maintain our banking systems. Think of the staff, think of the bank clerks, the security officers, the programmers. Think of the real estate, the buildings to maintain, the lights to keep on, and all the people traveling from their homes to support a trusted, secure banking system.”

The additional value of bitcoin having a global audience and increased liquidity is that no real estate, governance board or cars are needed to move money.

“From the programmers and cryptographers that I respect the most, there appear to be trade-offs between energy use and security right now and for the foreseeable future — the more energy efficient a blockchain, the less secure. Bitcoin is particularly secure because of its need for power.”

Louise believes that the energy required for securing bitcoin could incentivize discovering more efficient sources of energy. Within days or weeks following social media attention to the negative environmental impact of cryptocurrency and blockchain, the president of El Salvador announced an intention to harvest energy from a dormant volcano for geothermal power.

“Is it possible that the desire to mine bitcoin will help someone figure out how to capture energy from hurricanes, tornadoes, tidal waves and other forms of severe weather?”

Abigail Olson is a freelance writer based in Richmond.