I discussed credit score in my previous note and mentioned that it is a measure of how trustworthy a person is when paying a loan. Trust is the main foundation of investment and financial system of the world. People put their trust in systems and procedures that are in place to ensure that their money and transactions are recorded properly. It used to be manual in the old days but since the advent of computers, these records are now stored digitally and can be accessed online. These digital records of financial transactions are traditionally managed by banks or, in the case of stock market, brokers.
These systems are centralized, maintained, audited and secured by these financial institution and theoretically impossible to hack. It will cause chaos if these systems became unsecured and unreliable since it will erode the trust that people have on them. In essence, these digital records are ledgers of every person that have banking transactions and if people can access them and change the entries freely then they can just add money to their account by entering fraudulent deposits or transfers. In this case the trust will be broken and people and business will stop using it.
Cryptocurrency are digital currencies that were created to allow people to transact with each other without the involvement of the banks. As I mentioned above, the banks are the record keepers of financial transactions happening between people or businesses. When you go to a store and buy an item and use your debit/credit card, the payment device will contact the banking system and ask for you card’s current balance. If there is sufficient fund in your account then the transaction succeeds and an entry for that transaction is put in your and the merchant’s account. As you can see, the record of transaction (i.e. ledger) is managed by the bank. Cryptocurrency removes the banks from the picture. In this case, the ledger is managed by millions of computers that share the ledger using a technology called blockchain. This note will be so much longer if I discuss how blockchain works so I am not going to discuss it. Just think of it as something that allows for transactions to be recorded and shared by millions of computers and it’s fully secured that no one can enter a fraudulent transaction in the ledger. Since this ledger is impossible to hack or change fraudulently then it is reliable and trustworthy. So it goes back to the word “trust”, it is a decentralized (not managed by an entity such as a bank) system than can record people’s financial transactions and therefore can be used to do their purchases or fund transfers.