Answers to Your Questions About Cryptocurrency
Everyone’s heard of cryptocurrency. More and more brokers are offering crypto portfolios. It feels a little embarrassing to not know what the heck it is. This post is for you…and you’re not alone. Cryptocurrency has a value, but it’s determined by the people who use it. Compared to other investments, it can be volatile.
Cryptocurrency is most frequently associated with Bitcoin. But crypto isn’t an actual coin – it’s a digital method of payment exchange between individuals or groups. The industry is unregulated by any government. The transactions are highly encrypted, hiding the users’ identities. Crypto is considered an alternative currency as a result. As of this writing, there are 1000s of virtual currencies available to investors.
1. What is Bitcoin?
Bitcoin defines itself as a consensus network that provides cash for the internet. The concept of cryptocurrency is a peer-to-peer payment system. It requires no middleman (bank, card, payment processor) and encrypts the identities of transaction users. Bitcoin was the first digital currency, publicly available since 2009.
Bitcoin is open-source technology. It has standards and protocols to protect the transactions and users. A blockchain documents all transactions and users’ computers verify their authenticity. The system is secured with private keys that serve as digital signatures. Encryption keys are not new technology or limited to Bitcoin.
To have value, currency has 6 criteria to meet. Bitcoin meets them. Their money supply is transparently managed via the blockchain. The value of the currency is determined by the coins in circulation and the numbers of exchanges. The current volatility of the currency is because the circulation numbers are small. Large exchanges in the network impact the overall value.
2. What’s a Blockchain?
A blockchain is a database. Its design is unique, using individual blocks to store information. The blocks connect to each other. When new data is entered in the system, a new block is created to store it. Each block can hold a set amount of data. When it is filled, the block is chained to the previous block. The chronology of the blockchain cannot be altered.
The most common use for a blockchain is a ledger for transactions – like Bitcoin. Bitcoin’s ledger is decentralized – no one owner. The users retain control. Once data entry fills a block, it is irreversible, no changes, no deletions. In the Bitcoin example, the ledger is visible to the users and the public using blockchain explorers.
Blockchain technology is not limited to cryptocurrency. It can be used to track most any supply chain to identify a point of error or contamination. There is discussion of deploying block chain to track votes to further election integrity. It’s also a very viable solution for electronic medical records and drug development.
3. What’s the difference between coins and tokens?
Cryptocurrencies with their own standalone blockchain use the term coin. The coin is virtual – commodity – and only exists in the blockchain. Bitcoin is the standard. Companies that came after Bitcoin – DogeCoin, Tether or LiteCoin are alt-coins. Crypto coins are all coded differently, so they can only be used on the exchanges.
Tokens do not have a standalone blockchain. They live on someone else’s blockchain, typically on a smart contract network like Ethereum. Ethereum set the standard for their ERC-20 tokens in 2017.
Because a token is built to standards, it doesn’t need a currency exchange. The tokens can be exchanged among the users on the blockchain. They are often created to support crowdfunding or develop interest in new projects. Tokens are not crypto coins or alt-coins, but represent the terms of a deal that both parties agree to.
4. What’s a smart contract platform?
A smart contract has computer code embedded in a token. A token documents the terms of the deal, creating a self-enforcing agreement. Ethereum, Tron and RSK are all smart contract platforms. They may be a better long term investment because of market volatility in coin exchanges.
Smart contracts are virtual but similar to any other contracts you’d sign. The formula is: If you do this, we do that. These terms are coded into a token. If you were buying a car on the blockchain, for example, the token would include the amount owed to take possession of the car. If you pay 200 Ether, we provide the car and title.
Smart contract platforms are going mainstream with applications for specific transactions. The security and accuracy of blockchain technology is applicable to almost every industry. A smart contract platform called EcryptGen is designed to help patients control the ownership of their DNA.
5. Is Cryptocurrency legal?
The legality of cryptocurrency is growing but there are variances on how or if it is regulated. It’s legal in the United States, European Union and Mexico. It’s legal in Canada as well, but with strict regulations and banning by some banks. See a complete list of countries here.
Ecuador has banned digital currencies but is planning to create its own national blockchain. Russia has declared the ruble their official currency. Russia’s Finance Ministry is supporting a bill to fine individuals involved with digital currencies. Officials and legal entities will face significant fines.
As cryptocurrency becomes more mainstream, we can expect to see more regulation. New York State and California are already developing legislation.
6. What about the IRS?
In the U.S., the IRS considers cryptocurrency property – as opposed to actual money. That means an investor’s profits can be taxed as capital gains. The other issue sits with foreign investments. There is no clear tax guidance for investors making their purchases on platforms in foreign countries. But there are laws on the books for reporting income from outside the U.S.
Taxpayers who make $10,000+ are required to submit to the Report of Foreign Bank and Financial Accounts (FBAR) at the Treasury. Some taxpayers may need to fill out Form 8938 based on the Foreign Account Tax Compliance Act (FATCA.)
Federal tax laws on cryptocurrency are evolving. State revenue departments are becoming more engaged. The best way to manage your tax liability is by talking with a tax professional. Do not mistake the information here – or any other internet blog – for guidance on how to file your taxes.
7. How do I buy Cryptocurrency?
Most people buy cryptocurrency online at one of the exchanges or from another person. Some locations have BitcoinATMs where you can load up your Bitcoin Wallet. They’re not yet the norm in the U.S. But there are hundreds of online exchanges.
Get a Wallet
The way to start is to create a wallet on one of the exchanges. Your wallet isn’t for storing digital currency, it’s for holding your private and public encryption keys. Those keys are how you manage your transactions.
The most popular crypto wallet is an app on your desktop or mobile device. Mycelium offers a mobile only wallet. There are online wallets stored on a server. Hardware wallets stored on an external device, like a hard drive or USB. Investors can even generate their own keys for a “paper wallet.”
The one thing they all have in common. You should back up your wallet immediately. If you lose those keys (or the server storing them is breached) you lose your account. It’s locked forever and all the money in it.
Find Your Exchange
Coinbase is the most popular in the U.S. and the EU. The platform also provides insurance on the funds in the exchange. Not the norm by any means. There are other coin exchanges, CEX or a peer-to-peer exchange called LocalBitcoins. Another exchange, Shapeshift, is focused on building crypto portfolios. A simple google search will bring up lists of results.
Exchanges don’t perform smart contracts – they trade coins. But smart contract networks have their own coins as well. It can get confusing.
To use a smart contract network to make transactions, set up an account on a specific platform. Ethereum is the most well-known, focused on helping to build next-generation decentralized applications. TRON is focused on decentralizing the internet. There are any number of industry-specific smart contract platforms leveraging blockchain technology.
How to Pay
The majority of exchanges and networks allow you to pay with credit cards, debit cards, PayPal or bank transfer. Bank transfers take longer to process, but some exchanges require them. Before you commit to an exchange, make sure you’re comfortable with the payment providers.
8. What’s the Risk?
We’ll start with the standard disclaimer: All investments have risk. With that out of the way, digital currencies have unique risk factors.
If you get ripped off, you are out of luck. There is no governance in cryptocurrency. There’s no resource that can reverse a transaction – it’s not like a credit card that can dispute a transaction.
The majority of exchanges and platforms do not insure your funds. Coinbase and Gemini are two that do. But for the most part, if the exchange goes under – you lose all your money. If an exchange goes bankrupt, you have no standing as a creditor.
The value of cryptocurrencies is very volatile. Prices can drop substantially in a day. The exchanges operate 24/7, which means you could lose your shirt at 3:00 am. Because digital currencies are virtual – their price can drop to zero.
If you lose your wallet and don’t have a backup – you lose access to your account and everything in it. Lastly, the location of the exchange can have an impact on transfers and security. Different countries have different laws and regulations are changing every day.
9. Investing Pros & Cons of Cryptocurrency?
- No third-party transaction fees. If you were buying a house, for example – no closing costs, no realtor commissions.
- No “business hours.” 24/7 access to fast fund transfers.
- Blockchain technology keeps a resolute, verifiable ledger of transactions.
- Decentralized technology limits outside manipulation of value.
- High risk but high reward.
- Completely anonymous transactions
- No computer necessary. Do your transactions on your phone or mobile device.
- Industry specific smart contract networks.
- Little or no government oversight.
- Not impacted by inflation.
- Cryptocurrency is hard to understand. The concept is intimidating.
- Market value can fluctuate wildly.
- Cryptocurrency isn’t legal in some countries. Even when it is, countries apply different rules or requirements.
- The supply of currency is limited. Large trades can affect the entire exchange.
- No resource or protection in the event of a fraudulent transaction.
- Most exchanges store user keys, making accounts vulnerable to hackers.
- Anonymous transactions allow criminals, terrorists or money launderers to avoid law enforcement.
- No recourse if you lose your private key. There’s no “reset” – your account is locked for good.
- No standing in the event an exchange is shut down or goes bankrupt.
- S. tax law is still unclear about how to report earnings. Capital gains taxes may apply.
- States are beginning to try and regulate or govern cryptocurrency investment.
Should I invest in Cryptocurrency?
Before you do, make sure you understand what you’re getting into. There’s some significant opportunities, but not with a high level of risk. If that doesn’t line up with your investment strategy, it’s not a good fit.
But more and more businesses are accepting crypto payments for merchandise. The use of blockchain in healthcare, pharma, energy and even government is growing. Investing sooner than later will increase your opportunities.
Find an exchange that’s located in the U.S. That eliminates any the tax liability from foreign companies. Invest a little bit. If you already have an investment portfolio, ask your broker about cryptocurrency. Chances are good they may already some networks for you to consider.
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