An Introduction to Cryptocurrencies

Cryptocurrencies, also known as Bitcoin, have captured the imagination of investors and are making headlines. In a recent executive order President Donald Trump announced the intent to start a Crypto Strategic Reserve. The initial plan is for the government to stop selling bitcoins it currently holds and to not use taxpayer dollars to purchase additional crypto assets. Instead, new digital reserve assets will be acquired by keeping future seizures from criminal operations or civil asset forfeiture. Potential future regulation or deregulation only adds to the asset class uncertainty as the government involvement grows.

Although cryptocurrency has become all the rage, many might not understand what this space is all about. Let’s explore a few of the basics.

Origin of Cryptocurrency

In 2009, an anonymous person/group known as Satoshi Nakamoto created the first decentralized digital currency known as Bitcoin, which became the most commonly known and used cryptocurrency in the world.¹ Your balance is kept on a public ledger that everyone can access, although each specific record is encrypted.² Bitcoin isn't traded on any stock exchange, which also means it isn't regulated or secured like other investments. At the time of this writing there are more than 1,900 other cryptocurrencies and many more entering and exiting the space every year.

What Is Cryptocurrency?

According to the Federal Trade Commission (FTC), cryptocurrency is "a type of digital currency that generally only exists electronically."³ In simple terms, cryptocurrency is electronic money (no paper bills or coins) created and verified using technology, while hiding the identities of those involved in the transactions. Accounts and transactions cannot be connected to real-world entities. Identities of all parties involved are anonymous.

The term cryptocurrency is made up of two parts: crypto and currency. Crypto, short for ‘cryptography,' is the computer technology used for encryption to help hide information and identities, as well as provide security for this digital cash. Currency, on the other hand, is simply a monetary token (something that carries some monetary value and can be used for the exchange of goods and services).

No central bank issues the currency (yet), and no regulator or nation state stands behind it while several have banned the asset. Cryptocurrencies are designed to be more reliable, cheaper, and faster to use as compared to government-issued currencies. With cryptocurrencies, you don’t have to rely on the government to create and distribute your money or banks to store, send, and receive it. All these duties are transferred into your hands, provided you have a secure wallet for the storage of your cryptocurrencies. You can easily use your cryptocurrencies to quickly transact with others both online and offline, and you are also able to store your money by yourself (using hot or cold wallets). Sending money directly without involving a middleman (mostly banks) makes transactions fast and very affordable. The public key cryptography system used in protecting your funds is military-grade encryption and ultimately secure. Addresses used to send and receive cryptos are more secure than most other systems. However, there's always the risk of cybersecurity breaches, hacking, fraud/market manipulations, and other technological risks.

To make the process efficient and help thwart fraud or manipulations, all cryptocurrency users can simultaneously record, view, and verify their own transactions, as well as those of other users. The digital transaction recordings are made in a “ledger” that is publicly available for anyone to view. In fact, the ledger is not located in one place. Its copies are with all the participants engaged in the distributed network. The public ledger helps transactions become transparent, secure, efficient, and permanent, hence there is little chance of manipulation. You also don’t need to trust the person you are transacting with online because you can actually see the money being transferred, received, verified, and recorded by hundreds, if not thousands of people.

Cryptocurrency transactions are irreversible once you hit the confirmation button. No one can help you recover your funds if you send them to the wrong address and you won't be able to dispute the purchase with your credit card company like you can with traditional exchanges. So, be extra careful!

As discussed, one important thing to remember is that cryptocurrencies aren't protected by banks or financial institutions and don't come with the same legal protections as credit and debit cards. If something happens to your currency, for example, you get locked out of your digital wallet or someone steals your computer it will be difficult to find a solution. Cryptocurrency and digital wallets give a new meaning and horror to the prompt "Forgot your password?"

The FTC warns that if you store your crypto with a third-party company and that company goes out of business or is hacked, the government has no obligation to step in and help as it would with FDIC-insured assets.³

Expected Returns

The reason you invest is you expect to grow your wealth and maintain or increase your standard of living tomorrow. By investing in stocks and bonds today investors exchange cash today for an uncertain but greater amount of expected cash in the future. In comparison, the price of crypto is tied to supply and demand. We should not expect to receive more bitcoins in the future just by holding one bitcoin today. Additionally, there is no reliable way to earn a positive return just by holding crypto and no reliable way to predict by how much and if appreciation will occur. Unlike stocks or bonds, it is not clear that bitcoins offer investors positive expected returns nor hedge against equity risk. Before adding cryptocurrency to your portfolio, investors should ask themselves: “Why would I expect a positive return?”⁴

It’s important to remember that cryptocurrency is not a currency at all. It’s a speculative asset class with unpredictable extreme volatility that is not appropriate for everyone. Bitcoin and other cryptocurrencies come with significant, well-documented risks.⁵ One of the biggest concerns surrounding Bitcoin may be its history of volatility. It has been known to rise and fall quickly, with drops as extreme as 80 percent.⁶

Currently, Bitcoin is taxed like most other assets.⁷ If paid in bitcoin, it must be reported on a W-2 and standard employment taxes apply. Upon sale you will need to report capital gain/loss.

With all the media attention about the currency's performance these assets might sound like magic. But, as with any asset, it's important to remember that we can't see into the future, and we have no idea how it will perform in the coming years. Approach these claims as hesitantly as you would those regarding any other asset.

Cryptocurrency Mining

Another common jargon term is mining, which refers to the process of registering transactions on the blockchain. This requires computer algorithms that solve a series of calculations and get rewarded with some new cryptocurrency. Mining is how many new cryptocurrencies are made but considering that it’s a time-consuming and complicated process, many people choose to buy preexisting currencies. Only 21 million Bitcoins can be mined, and they become more time-consuming to create as the supply grows.⁸

Blockchain Technology

Blockchain technology is one common term you will hear in the cryptocurrency world. A blockchain is the technology used to create permanent and secure digital recordings that are not managed by a single person or group. It can be used to store any type of information, including medical records and computer information, but the first blockchain was used to record Bitcoin transactions. Imagine the blockchain as a book of records, where each page in that book is a block that can record anything. The blocks are created simultaneously, hence creating a chain of blocks known as the blockchain. This is where the real value lies. None of this is to deny the exciting potential of the underlying blockchain technology that enables the trading of bitcoins. It is an open, distributed ledger that can record transactions efficiently and in a verifiable and permanent way, which has significant implications for banking and other industries, although these effects may take some years to emerge.

Environmental Impacts

Even though cryptocurrency is digital, mining for crypto has real-world impacts. Mining requires huge amounts of electricity. According to the Cambridge Bitcoin Electricity Consumption Index, mining for Bitcoin uses more power globally than entire countries, including the Netherlands, the Czech Republic, and Pakistan.⁹ And that's just for Bitcoin, which is a single form of crypto. Mining for Ethereum generates more than 62.9 million tons of carbon dioxide emissions, the same amount as Serbia and Montenegro combined.¹⁰ According to Digiconomist, a single Bitcoin transaction uses as much power as it takes to run the average US household for over 78 days.¹¹

The world of cryptocurrencies continues to evolve away from the previous administration’s aggressive stance in regulatory enforcement. There are many emerging cryptocurrencies that have the potential to disrupt the future, while others seem doomed to fail. Right now, crypto is seen as a speculative investment, attention grabbing, interesting, volatile, and risky. Some investors have become extremely wealthy by investing early while others have lost all their money, so it's important to tread carefully in this space. Caveat emptor!