Bitcoin and other cryptocurrencies are cryptic to say the least. Some people consider bitcoin a currency, others an investment and still others a store of value. Even government agencies can’t agree on what bitcoin truly is. The IRS treats it as property, the Securities and Exchange Commission considers it a security, while the Financial Crimes Enforcement Network says it’s a currency.
All that confusion makes bitcoin a volatile and uncertain investment. It doesn’t help that cryptocurrencies are the Wild West for investments because they’re virtually unregulated. No central authority, such as a government or central bank, regulates or controls bitcoin, and like all revolutionary new ideas, it could evolve once the world discovers what it is and what it might mean for the future of financial transactions.
What Is Bitcoin?
Bitcoin is a digital currency that has attracted considerable attention because of its investment potential. Investors hold bitcoin in the hope that the price will rise.
There is no physical coin linked to bitcoin. It exists only in the internet where bitcoin uses its own network to enable global transfers directly between individuals so no intermediary like a bank or PayPal serves as gatekeeper between users and their funds. “You are fully in control of your money,” says Spencer Bogart, a partner at San Francisco-based Blockchain Capital, a venture capital firm investing in blockchain-enabled technology. You may hear bitcoin likened to digital cash because you can store it and send it without a bank as you would cash.
This marks the first time in history that people across the globe are able to transact with each other in a peer-to-peer network without relying on an intermediary, says Christian Catalini, professor at MIT Sloan School of Management and founder of the MIT Cryptoeconomics Lab. But if no one is overseeing it, how can we verify the sender has the funds available and the recipient actually receives them? The answer is blockchain technology.
[Read: 3 Important Things to Know About Bitcoin.]
What Is Blockchain?
Blockchain is the method behind the bitcoin madness. It’s a global accounting ledger that records all bitcoin transactions. Anyone can view it with the appropriate software, called the bitcoin protocol, which is open-source, meaning free to use.
Think of the bitcoin protocol as the language spoken by the bitcoin network. Any computer that speaks the language can join the network, and any computer can be taught the language for free. The computers speaking bitcoin protocol make up the bitcoin network. When Alice sends Bob 10 bitcoin, the network updates the blockchain ledger with the details of the exchange so all network computers can see it.
This transparency secures the network, says San Diego-based Eric Ervin, chief executive officer of Reality Shares. “Picture blockchain as a giant Google Sheet that everyone has a copy of on their own computer,” he says. “If there’s one duplicated or incorrect cell, everyone would see it.”
The blockchain records the details of every transaction without people’s real names. It refers to Alice and Bob by their digital addresses, which are long sequences of letters and numbers not tied to their real-world identities. So bitcoin transactions are considered pseudonymous, not anonymous.
How Bitcoin Transactions Work
When you buy bitcoin, you are effectively buying a password to a unique coin, Bogart says. Each bitcoin is a combination of a public and private key, similar to a username and password.
The public key is like your address, telling people where they can send you bitcoins. The private key is a 64-character password to a particular bitcoin. No one but you will ever see your private key. It’s like the key to a locked mailbox. As long as people know your public key, they can send you letters, but only the person with your private key can access those letters.
These two keys are mathematically linked, much like a person is linked to his DNA. “We could have a DNA sample without knowing who the person is, but presumably he is the only person who could produce such DNA,” Bogart says. “Similarly, we could have a public key and not know what the private key is, but if someone signed a message with the private key, we could definitely confirm that it’s the counterpart to the public key.”
Your private key acts as your digital signature. When you send bitcoin, you’re essentially writing a digital contract that you sign with your private key to verify you are the owner of the funds and you want to send them, Catalini says.
What Is Bitcoin Mining?
Bitcoin miners are individuals with computers on the bitcoin network, known as mining nodes, that run specialized, open-source software. Anyone with this sofware can set up a mining computer, but as mining becomes increasingly competitive, these computers need faster and faster hardware to keep up.
Miners play a key role in clearing bitcoin transactions and reconciling them across the globe, Catalini says. They verify the sender has the funds available to send and isn’t trying to “double-spend,” or send the same bitcoin, to two users at once.
Miners compile new transactions into bundles called “blocks,” which are like pages in the bitcoin ledger. Each new block contains information from the previous block, linking them into a “blockchain.” To complete a block, miners must solve a complex mathematical puzzle. This prevents blocks from being produced easily and ensures there is only one valid blockchain. Once the solution has been found, all other mining computers can easily verify that it’s correct.
Where Do Bitcoins Come From?
When a miner solves the math problem, the protocol allows the person behind the computer to get a predetermined number of new bitcoins on the ledger. One way to think of mining is as a collection of volunteers contributing to the knowledge base of the bitcoin network and then being rewarded bitcoins for their work, says Robert Hockett, the Edward Cornell Professor of Law at Cornell Law School and a former adviser to the Federal Reserve Bank of New York and the International Monetary Fund.
The system is designed so that a new block will be completed — and new bitcoins issued — roughly every 10 minutes, no matter how many miners are trying to solve the problem. If blocks are created faster than this, the network will make the math problem harder to solve and vice-versa.
The network also reduces the number of coins miners are rewarded over time. About every four years, or the length of time it takes to generate 210,000 blocks, the reward is cut in half. At that rate, we’ll reach the 21 million bitcoin limit (the maximum number of bitcoins that can ever be created) by approximately the year 2140.
How to Determine Bitcoin’s Value
“The thought was that this limited supply would render bitcoins like gold,” but this is inaccurate, Hockett says. Gold is not inherently valuable because of its finite supply; rather, gold is valuable because we endowed it with value. “There’s a tendency for people to think gold became a monetary metal because the metal itself was precious, but if you look back in history, the causal relationship runs the other way,” Hockett says.
Gold became precious when humans began using it as currency because it was malleable enough to stamp the sovereign’s image while not degrading the way clay and other soft materials did. To believe gold has inherent value is like “saying gold would be valuable even if there were no humans,” Hockett says.
The same is true of bitcoin. Bitcoin will always have a floor value of zero, Catalini says. It only has value “because people believe it has value and want to accept it as a medium of exchange or recognize it as a store of value.”
The price of bitcoin is “essentially a collective wisdom around the expectations about this network becoming valuable and useful to society,” he says. Every change in those expectations — for example, if people fear regulatory action against it or a new technology arises that makes the system more efficient — is reflected in its price. That’s why bitcoin’s price is so volatile.
What Can You Buy With Bitcoins?
This volatility makes bitcoin a “terrible medium of exchange today,” Catalini says. But that hasn’t stopped people from using it. In addition to peer-to-peer exchanges, a number of websites such as Expedia, Overstock.com, Newegg and Mint.com and various brick-and-mortar stores accept bitcoin. Sites like Airbitz.co and 99Bitcoins.com maintain a directory of businesses accepting bitcoin.
Bitcoin transactions are irreversible, meaning there’s no way to get bitcoins back after they’ve been sent. This is good for retailers, who don’t have to worry about credit card charge backs, but less beneficial to senders who have no recourse if their merchandise is never delivered.
Also, bitcoin transactions aren’t free. The computers verifying transactions on the network will prioritize those that include some compensation for themselves. Like tipping, it’s up to the sender to decide how much of a transaction fee to pay.
Transaction fees can be as volatile as the price of bitcoin itself. The average fee in January 2017 was 0.3 bitcoins, but in January 2018, it was more than 40 bitcoins, according to CoinMetrics. Transaction fees may begin to play an even more important role once the 21 million bitcoin limit is reached and miners aren’t rewarded new coins for their work.
How Are Bitcoin Transactions Taxed?
The IRS treats virtual currencies as property for U.S. federal tax purposes. This means, among other things, that:
— Virtual currency transactions are taxable.
— The applicable tax rate will depend on whether the transaction was short or long-term.
— Selling virtual currency will result in capital gains or losses.
— Taxpayers are responsible for determining the fair market value of their virtual currency in U.S. dollars as of the date of payment or receipt to calculate their gain or loss.
— If the virtual currency is listed on an exchange where the exchange rate is determined by supply and demand, that exchange rate can be used to determine the fair market value of the virtual currency.
— Business transactions are subject to sales tax.
Keep detailed records of your bitcoin transactions as you must be able to report them just like any other property transactions, including the fair market price and transaction date.
How to Buy Bitcoins
You can buy fractional bitcoins out to eight decimal places. The smallest possible unit, 0.00000001, is called a satoshi after Satoshi Nakamoto, the pseudonym of bitcoin’s inventor. Other common units are one-one thousandth, called a milli, and one-one millionth, called a bit.
After creating an account and linking it to your bank or credit or debit card, you can place an order and Coinbase will fill it for you. This convenience comes at a fee, however, which varies depending on the size of your transaction.
Another way to buy it is through GDAX, which enables investors to trade directly on the Coinbase exchange. It “requires a little more work than using a basic brokerage service but usually comes with slightly lower fees,” Bogart says.
A less common method is to buy bitcoins off of LocalBitcoins, essentially the Craigslist for bitcoin, he says. Users who create advertisements on the site pay a 1 percent fee for every completed trade. Additional network fees are associated with different transaction types.
Lastly, bitcoin ATMs exist in many major cities, although they “usually charge a considerable convenience fee,” Bogart says.
Where do You Store Bitcoins?
Your bitcoin is only as secure as your private key. Anyone who can steal your private key can take control of your funds, so the question of where to store virtual currency is essentially a question of where to keep your private key.
You could store your private key in your own wallet or on your computer hard drive. This gives you full custody of your assets, but it means you must keep track of your 64-character private key. If you lose your private key, there’s no one who can recover it for you “because you’re essentially running your own bank,” Catalini says. The bitcoins associated with that private key will be lost forever.
If you store it on your computer, there’s the risk of your hard drive crashing or getting hacked. You could print your private key out, but then you have to safeguard that paper.
An alternative to self-storage is a bitcoin wallet, software programs that operate like a digital wallet by storing users’ private keys for them. Instead of having to remember your private and public keys, these wallets allow you to create a traditional username and password to access your account. If you forget your wallet password, the service can reset it for you.
The primary types of wallets are local, online and hardware. Local wallets are kept on your computer or smart device. Often free to download, they give you complete control over the wallet but can only be accessed from your device, making them only as secure as your computer or phone.
Online wallets like Coinbase or Blockchain.info can be accessed from anywhere. But these sites are susceptible to hacking, like the one that hit the now-defunct bitcoin exchange Mt. Gox in 2014, resulting in 850,000 bitcoins disappearing overnight. Since online wallets often hold large pools of cryptocurrency, hackers are more likely to target them as opposed to your personal computer. Using online wallets also means putting an intermediary between you and your funds.
Hardware wallets for storing your private key aim to provide self-sovereignty, security and mobility. Similar to USB sticks, hardware wallets are easily carried and secured with their own password. There’s still the risk of losing the device or forgetting the password. Also, they’re not free: A quality hardware wallet typically costs $100 to more than $200.
How to Invest in Digital Currency?
Buying bitcoin with the idea that its price will appreciate is like investing in only one company. There’s no guarantee bitcoin won’t be replaced by another currency. In fact, no one can say which — if any — cryptocurrency will be adopted in the future.
You could invest in a cryptocurrency index fund like the Bitwise HOLD 10 Private Index Fund, which holds the top 10 cryptocurrencies weighted by market capitalization, Bogart says. The fund is private, however, so it doesn’t trade on national exchanges and is available only to accredited, U.S.-based investors via Bitwise.com. It also has a minimum investment of $25,000 and a management fee of 2.5 percent.
“The problem with this strategy is that digital currencies are very volatile at the moment, and their value could potentially be short-lived,” Ervin says. He says blockchain is a more promising long-term investment vehicle. “Unlike bitcoin, the uses and applications of blockchain technology are wide-reaching,” he says. “Think of blockchain as the internet and bitcoin as email; it’s just one way to use the power of the internet.”
Blockchain has the potential to transform a variety of industries, he says, including health care, financials, consumer products and supply chain management. Just look at Walmart, which hopes to use blockchain technology to instantaneously track food through the supply chain to improve safety.
You can invest in blockchain through companies that stand to benefit from the technology. The exchange-traded fund Reality Shares Nasdaq NexGen Economy ( BLCN) uses its proprietary Blockchain Score methodology to “rank companies according to their potential to leverage and benefit from blockchain technology,” he says. The ETF currently holds 59 companies across sectors and continents, and trades daily on the Nasdaq exchange with an expense ratio of 0.68 percent.
[Read: IBM May Get a Big Boost From Blockchain.]
This strategy leaves the proverbial $64,000 question unanswered, Hockett says: How certain are we that blockchain will become as successful as people believe? He tells investors to not just diversify with cryptocurrency and blockchain investments, but across all of fintech. And make your fintech holdings only one portion of your overall portfolio.
Should I Invest in Digital Currency?
Bogart says cryptocurrency investments should be less than 5 percent of most investors’ portfolios and certainly not more than 10 percent.
Investing in cryptocurrency today is like investing in an early-stage startup, Catalini says. “Most of the projects in this space won’t exist five years from now; that’s just the nature of innovation when it’s an early-stage industry.”
Before investing, do your homework — lots of homework. Catalini suggests reading everything you can find about the various cryptocurrencies, their trade-offs, and the challenges they and the market for them face. “Many people may be tempted to jump in because they’re afraid of missing out on some great investment opportunity, but like any other investment, if there’s a big upside, there’s also a lot of risk,” he says. “Cryptocurrencies are extremely speculative assets, and only investors who can tolerate the risk should expose themselves to it.”
Investing in Digital Currency Is Risky
The Securities and Exchange Commission put bitcoin on its 2018 list of examination priorities, meaning the SEC is keeping a close eye on it.
Bitcoin investors are engaging in some of the same behavior that we saw from real estate investors before the 2008 financial crisis, Hockett says. Namely, people are borrowing heavily to buy bitcoin. “As soon as people start taking on debt to make speculative purchases, regulators take notice because it’s a telltale sign of a bubble,” Hockett says. “The worst crises and crashes and ensuing depressions are the ones that result from a credit-fueled bubble.”
Investors who borrow at a fixed rate to speculate on an asset take on a huge risk if the price of that asset falls. “You end up being in debt without any corresponding assets, which means you owe more than you own,” Hockett says. This is what happened in 2008 when home values tanked. “As if to shine a spotlight on the irony, some people have taken out mortgage loans to buy bitcoin,” he says.
The SEC issued warnings highlighting bitcoin’s investment risks. For instance, bitcoin is not insured by the Securities Investor Protection Corp. or the Federal Deposit Insurance Corp. Some wallet services are beginning to offer insurance, but the level of protection they provide remains to be seen.
The SEC also cautions investors about bitcoin’s extreme volatility. Price swings have caused its value to drop 50 percent in a day. Swings of this magnitude would have prompted the New York Stock Exchange to shut down trading, something that could happen to bitcoin exchanges as well. The SEC has suspended trading in securities of cryptocurrency-related companies for disseminating potentially inaccurate or inadequate public information.
Other regulatory agencies are also keeping watch. The Commodity Futures Trading Commission has declared cryptocurrency a commodity, bringing it under its regulatory umbrella. Likewise, the Financial Crimes Enforcement Network requires digital currency exchanges to comply with its anti-money laundering and “know your customer” laws.
The Future of Cryptocurrency
Hockett says it’s only a matter of time before governments — specifically, central banks and monetary authorities — take control of cryptocurrency networks, but it won’t be the tragic end some believe. “There are certain key phenomena within any decentralized economy that require centralized management in order for everything to work right,” he says, and two of them are the payments system and the money supply.
Without the Federal Reserve, there would be no one to stave off inflation, counteract deflation or pull us out of recession. “You have to be able to change the money supply depending on what’s going on” in the economy, Hockett says. Otherwise, we end up with a loaf of bread costing $5 today and $10 tomorrow or the value of your bank account being cut in half overnight.
A decentralized money supply is really a faux freedom, he says. If your money is worth $50 today, $60 tomorrow and $15 the next day, how free are you?
But the electronic payment system we have currently is outdated. Ultimately, “the Fed will commandeer one or another distributed ledger technology and make it the basis for the new payment system,” Hockett says. This is happening in other jurisdictions already. The Bank of England is looking to adopt a ledger technology, while the Monetary Authority of Singapore already has. Even the Bank for International Settlements, the Financial Stability Board and the International Monetary Fund are looking into it.
[Read: The Fed’s Critical Role in Your Portfolio.]
“There’s no doubt that the market and technology are here to stay, but in five to 10 years it may look very different from today,” Catalini says. It’s important for potential investors to keep this in mind so they don’t fall for the hype.
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Everything You Need to Know About Bitcoin and Cryptocurrency originally appeared on usnews.com
