An Introduction to Cryptocurrency

Introduction

Ethereum, Ripple, Litecoin, Neo, and Dash. Are these Marvel superheroes or 1980s dance moves? Unfortunately, neither. They’re cryptocurrencies, of which bitcoin (BTC) is probably the most well publicized. A cryptocurrency is a digital asset, meaning it only exists in digital form (i.e. on the Internet) and can be exchanged for other assets, both digital and physical as a form of alternative currency. Cryptocurrencies are designed to limit the number of units produced, creating a finite amount of “currency.” This is in contrast to central governments like the United States Federal Reserve System that can effectively “print money” to affect monetary policy.

Investing.com currently lists more than 2,500 cryptocurrencies. There are potentially numerous uses for these currencies. Some can be used to store wealth and some can be used to transfer money and pay for goods and services, while others are used as an alternative currency in areas of the world where the current fiat currency doesn’t appear to be stable. Some people mine their own cryptocurrency and others look at cryptocurrencies as speculative investments.

Cryptocurrencies are highly complicated. This article is designed to give an overview to help you understand what cryptocurrencies are, where they came from, and what they can do.

Okay, but what IS a Cryptocurrency?

Cryptocurrencies have been around since the early 1980s but gained notoriety and media exposure when the market price of a single bitcoin went from ≈ $2,500 in June 2017 to nearly $19,000 just six months later in December 2017. That’s an increase of over 700%! At the time of this publication, the price has dropped to about $3,700, which is approximately an 80% drop in value as compared to the December 2017 prices. Huge fluctuations in value, regulatory, and taxation issues—as well as theft and loss—have made people more cautious when looking to start participating in cryptocurrencies.

It is widely believed that in 2009 bitcoin was the first decentralized cryptocurrency to be created. Cryptocurrencies are digital forms of currency that use blockchain technology to create and record a ledger of all transactions. These records use complicated mathematical equations and algorithms to prove the integrity of the blockchain and protect it against manipulation. Cryptocurrencies were designed to be used over the Internet and mostly outside of the traditional banking systems.

Bitcoin, as mentioned, is far and away the most recognized cryptocurrency and is routinely mentioned on television stations like CNBC and Bloomberg. There are many others available. Some are designed for peer-to-peer exchanges, while others have more specific uses. For example, Ripple was designed to make it quicker and more cost effective for banks and other large institutions to move money globally for transactions that may be low in value but high in volume. An example would be paying app and online advertising companies frequent but small amounts each time a user clicks on a site or link. In yet another variation of a cryptocurrency, Ripple is trying to be a bridge between fiat currencies during transactions and create nearly immediate liquidity.

Engaging with Cryptocurrencies

Since cryptocurrencies are digital, you can’t simply go to your local coffee shop and pick one up. You will need to buy them off exchanges—similar to how stocks can be found on the New York Stock Exchange or NASDAQ—but without added government regulation and protections. Two of the more popular exchanges are Coinbase and Kraken. These sites allow you to transfer cash from your bank account to their site and then buy the cryptocurrency. Similar to opening an account with any company or website, due diligence is crucial. There are a small number of bitcoin ATMs that allow you to exchange bitcoin and cash.

Another way to obtain cryptocurrencies is to “mine” for them. This doesn’t mean you need to get a bulldozer and go down to your local quarry and start digging. It refers to a computer program solving equations to complete a “block”, like in blockchain. As more bitcoins are mined, the less there are that remain and the harder and costlier it is to mine them. Bitcoin mining was designed to be halved roughly every four years. In 2009, each block mined would generate 50 bitcoins. Today that number is 12.5 and will be cut in half around 2020. In February 2018, Elitefixtures.com estimated it cost $4,758 to mine one bitcoin. The value of a bitcoin as of the time of this writing is just under $3,600.

Let’s say you’ve made the decision to exchange your hard-earned money for some cryptocurrency. What can you do with it? Well, you can buy and do things. Virgin Galactic is accepting bitcoin to travel into space at a cost of $250,000 per person. If your travel needs are slightly less ambitious, some travel agents will allow you to book air travel and car rentals with cryptocurrencies. Instead of renting a car, you can even buy a Lamborghini from the de Louvois Bitcoin Elite Marketplace.

Besides buying goods and services, cryptocurrencies can be used to invest in new cryptocurrencies, similar to venture capital or private equity financing. Some people have also viewed cryptocurrencies as commodities that can be traded or exchanged. A bitcoin obtained in December 2015 cost around $400. If sold 2 years later at about $19,500, a profit of $19,100 (4,775%) would have been recorded.

Cryptocurrencies can also been viewed as a store of value. Throughout history, another “vehicle”, gold, has been used as both a currency and store of value. While most stores won’t accept gold as a form of payment, it has a quantifiable value and a belief that it will continue to hold its value and be a means of exchange for the foreseeable future. In situations where current banking systems are unstable or there is concern about the value of a country’s currency, some believe cryptocurrencies can be the tools and vehicles to continue the economic cycle without having to rely on traditional forms of payment.

Caveat Emptor: Cryptocurrencies can be Unpredictable

Not all cryptocurrencies are created equal. Algorithms and processes of cryptocurrencies can change in addition to any changes to the intended use of the currency itself. For this reason, it’s critical that you continue to do your research on the design and inner workings of the specific cryptocurrency to understand where it came from and what potential vulnerabilities exist.

The price of bitcoin has skyrocketed since being introduced in 2009. So, what could go wrong? In 2014, one of the largest bitcoin exchanges, Mt. Gox, closed its doors. At that time, the exchange claimed that 650,000 bitcoins—a value of $377,000,000—had been lost or stolen. As of 2018, the increase in the value of bitcoin has allowed Mt. Gox to repay their creditors, but there is still the potential for loss and lack of recovery when operating without oversight or regulation. Newsweek had reported that in 2013, a Wales man threw away a hard drive that contained 7,500 bitcoins valued at $4 million at the time. These are digital currencies with digital wallets that need secure backups and extra vigilance to be kept safe from loss, theft and hacking.

The price swings of cryptocurrencies have been extraordinary. Remember, whenever you see someone selling a cryptocurrency, another person is buying it. If you sold bitcoin at $19,500, that means someone bought it for $19,500 and now that same bitcoin is worth about $3,600. Before jumping into the cryptocurrency conversation, remember to focus on regulation, uses, and expectations.

What if you did buy bitcoin in 2015 for $400 and sold it in 2017 for $19,500? That’s a $19,100 gain. If that happened with a stock like Microsoft, the government would say that’s a long-term capital gain and you could be taxed at 20%, depending on your tax bracket. In 2014, the IRS made a ruling that cryptocurrencies should be treated like property and subject to capital gains taxes. As the digitization of our world changes, so can the way governments treat transactions that only occur over the internet. While these are the laws today, they can always change and evolve.

Next Steps

This has been only a light discussion. Before investing your hard-earned money in cryptocurrencies, I encourage you to do your research and seek professional advice from your financial advisor and accountant to help determine how cryptocurrencies may affect you and your financial situation.

Remember: safety first. Fraud, theft, and deception can be lurking in these unregulated markets.