With over 1500 different cryptocurrencies available over the Internet, and with Facebook recently announcing its version, Libra, more investors want to know what cryptocurrency is, how it works, and if it's a viable investment.
Even after more than five years in the financial limelight, the public still views cryptocurrencies with skepticism today.
They first garnered attention in the world of finance when Bitcoin, one of the first of its kind, started skyrocketing in value in early 2017.
Most people have heard of this new virtual currency, but very few understand what it is and the craze. And many conservative investors tend to view it with great caution, as they do any type of new investment vehicle.
It's rare to see successful investors willing to throw caution into the wind.
But, just the same, there's a large number of wealthy people who gained their riches by taking enormous risks, seizing unique opportunities.
Therein lies the crypto debate.
Does investing in cryptocurrencies offer a unique opportunity to gain riches and build great wealth?
Or is it nothing more than a bubble investment opportunity ready to burst?
Individuals need to answer that question for themselves. With that said, the only way you're able to arrive at an educated answer is to understand precisely what's on the table before you invest.
The following information, will hopefully, provide you with the ability to decide if cryptocurrency investing is a fad. Or perhaps a viable trend and an opportunity to cash in on the cryptocurrency craze.
What are Cryptocurrencies?
Merriam-Webster defines cryptocurrency as follows:
any form of currency that only exists digitally, that usually has no central issuing or regulating authority but instead uses a decentralized system to record transactions and manage the issuance of new units, and that relies on cryptography to prevent counterfeiting and fraudulent transactions.
That's a slightly convoluted way of saying cryptocurrency is a digital monetary instrument used for peer-to-peer payments and investment exchange.
The imaginary coin is created through a process called mining. Not through a standard minting process at some government agency.
Calling the coin imaginary is simply a way of saying there's no physical coin someone can physically possess and place in their purse or pocket. Instead, a cryptocurrency is a “virtual” coin you hold in a digital wallet for digital exchange between parties.
Cryptocurrency transactions between two or more entities are not recorded in a bank account sitting on the server of a centralized bank.
They are not subject to regulation by anyone other than the decentralized millions of people who are transacting business through a public registry. The public registry is a by-product of something they call “blockchain technology” (more on blockchain technology to follow).
Today, close to 2,000 different cryptocurrency coins exist. Many of these coins are available for investment purchase through crypto exchanges operating all over the globe. Most can be used as a method of payment.
Some coins, such as Bitcoin, are general use coins while other currencies were developed for specific uses.
Starting at the beginning is the best way to understand why cryptocurrencies have become so popular. For example, Bitcoin was created in 2009 as a way to make a transaction between two parties without needing a middle-man.
So, in theory, you could take a pile of US dollars and buy a Bitcoin to send to someone for some product or service. And then they could take that Bitcoin and either save it or exchange it for a pile of their currency.
Typically, you would have to take your US dollars to a bank and exchange it for another currency (or vice-versa) to make the payment for the product or service. This would involve transaction fees, exchange rate fluctuations, and a paper trail.
Growing In Popularity
For the reasons stated above, currencies like Bitcoin became popular among black market transactions. Primarily because of the ability for both parties to remain anonymous.
The transactions of Bitcoin are known as a ‘block'. These blocks need to be added to some sort of general ledger. Called the ‘blockchain’, it keeps track of how many Bitcoins are in fluctuation. They call this process ‘mining’.
When a coin is offered for sale or exchange, a unique transaction code is created. A majority of all participants must theoretically approve the transaction.
Once the transaction has been approved, the transaction is officially attached to a linear chain of transactions called a blockchain. Each deal is permanent and completely protected from manipulation.
Names are not included. Meaning that the transaction is only identifiable by the transaction code, given only to the transacting parties.
A decentralized blockchain offers three distinct advantages over traditional transactions maintained on centralized bank servers:
- The transaction data is safer from manipulation and hacking – better security
- Transactions carry low to no transaction fees
- Transactions can be completed within seconds
But What About Their Value?
Unlike paper money, there's a maximum number of Bitcoins. So the supply and demand will cause significant fluctuations in the price.
If demand exceeds supply, the price is driven upwards. If supply exceeds demand, the price drops. This could have an enormous impact on the value of any coin in the future
Technically, anyone can mine these transactions and receive rewards with a small amount of Bitcoin. Though it's technical and very energy-intensive.
Using Bitcoin as an example, a supply limitation of 21,000,000 coins that can be mined exists. In other words, there will never be more than 21,000,000 coins in existence for eternity.
The mining limitation is a function of an algorithm controlling the speed and number of coins able to be mined. Currently, the number of Bitcoins mined to date is near 18,000,000.
If Bitcoin increases in popularity as a viable form of payment for goods and services, the chances of a severe shortage of Bitcoin becomes very high. In all likelihood, that would drive the value up. According to some enthusiastic experts, the value could reach a high of $500,000.
While the algorithms and mining processes might differ from one coin to the next, almost all of them will eventually reach their supply limitation.
In each case, the ultimate value of the coin will be determined by the viability and popularity of the currency in the eyes of the public.
As more women understand the importance of investing these numbers may continue to rise.
What Risk Is Involved?
Using a currency like Bitcoin as a medium of exchange is relatively low-risk, as you would not be holding any substantial amount of it at one time. But the problem for investors and institutions is trusting the value over a more extended period.
For example, a car dealer accepts one Bitcoin in exchange for a new car. They expect to hold that Bitcoin for a few months. Then they'll exchange it for two new vehicles to add to their inventory. However, the dealer cannot be sure the one Bitcoin they receive months earlier will still be worth enough to purchase two new cars later.
The large fluctuations in value are purely based on supply and demand, coupled with speculations about the usefulness of the currency in the future.
Since a lending institution like a bank does not back it, it could technically be worth nothing in a matter of minutes.
The Future of Cryptocurrencies
Large companies have been paying close attention to the public opinion of cryptocurrency. Understanding an increasing focus of individual privacy and lower fees has led many companies to invest in this blockchain technology.
Most recently, Facebook announced its product, Libra, as a more stable form of cryptocurrency. In partnership with other large corporations, like Visa and Uber, Facebook has aimed this currency to the risk-averse consumers and investors with the hope it will be a more trusted form of exchange.
To do this, they have backed Libra with diverse physical assets, like government bonds and other forms of low-risk securities, so there's less fluctuation of value.
This way, businesses, and investors will know their invested money can appreciate through increasing demand. While also earning interest on assets purchased with the funds they invested in Libra.
This new form of crypto is set to release in early 2020. Although the government has recently asked them to put the brakes on. It could have the potential to be the payment method of the future, should the cryptocurrency craze continue on.
Taxes and Cryptocurrency
Taxes themselves are complex, add in cryptocurrency, and it sounds like a potential nightmare.
As we are not experts in either, we refer you to this article – The Taxation of Cryptocurrency – Virtual Transactions Bring Real-Life Tax Implications from The CPA Journal.
The IRS addressed the taxation of cryptocurrency transactions in Notice 2014-21, which provides that cryptocurrency is treated as property for federal tax purposes. Therefore, general tax principles that apply to property transactions must be applied to exchanges of cryptocurrencies as well. Notice 2014-21 holds that taxpayers must recognize gain or loss on the exchange of cryptocurrency for cash or for other property. Accordingly, gain or loss is recognized every time that cryptocurrency is sold or used to purchase goods or services. How the gain or loss is recognized depends largely on the type of transaction conducted and the length of time the position was held. -Mordecai Lerer, CPA, The CPA Journal
What is clear is that there's much to still be investigated and decided.
How to Buy Cryptocurrency
You can buy, manage, and sell cryptocurrency via a “Digital Wallet” on sites such as:
- Coinbase.com – Bitcoin, Ethereum, XRP, Litecoin, EOS, plus 10 more
- Bitfinex.com – Bitcoin, Ethereum, EOS, Litecoin, Ripple, NEO, & many more
After opening an account and verifying your identity on one of these or other platforms, you'll connect your bank account or credit card, and can then begin exchanging.
You can start investing with minimal dollars, as cryptocurrency is available in various amounts. For example, you can buy one entire bitcoin, or you can purchase a fraction of one bitcoin. Each coin or fraction of a coin is placed in your digital wallet when the transaction is complete.
Should You Invest in Cryptocurrency?
Now with a general understanding of cryptocurrencies and how they work, you are in a better position to decide to invest in them or not.
Every investment opportunity comes with an inherent risk/reward consideration. If you were to speak to 10 cryptocurrency experts, you would likely get ten different recommendations. There's nothing wrong with that.
It's incumbent on you to decide how much risk you're willing to take for a possible big return. We use the term possible big return because most of these coins sit in uncharted realms.
We simply have little information to determine how high the highs can be; knowing full-well the downside is a total loss of value.
As a rule of thumb, you must first decide how viable you think digital currencies will be in the future.
Those investors who are pro-crypto are betting on the increasing use of the currency.
All indications are a fast-growing number of entities (people/merchants) are moving towards the exclusive use of digital payments, trending away from conventional fiat currencies.
They want businesses and consumers to start using Bitcoin as a popular medium of exchange to increase the demand while supply stays constant; thus increasing the value of each Bitcoin.
This is why many investors will push the importance of privacy and anonymity amongst small and large transactions, alike.
If this is true, limits on the potential value of every coin are only what the last person is willing to pay for it.
If you ultimately sense digital currencies are here to stay, it would make sense that the downside potential for top coins like Ethereum, Verge, and Bitcoin is pretty small.
With a small downside and the currently unlimited potential upside, a risk/reward calculation would point out investment in cryptocurrency could make some economic sense.
As a word of caution, not all coins are equal in quality and viability, though. It will take time for the marketplace to weed out the pretending coins from the contending coins.
Most coins will likely fall by the waste-side while a few coins will become market leaders. It's a good bet Bitcoin will always be one of the leading cryptocurrencies. But exercise a great deal of caution before making any investment in a coin with little history.
This is where your personal opinions and willingness to take risks come in.
Final Thoughts on the Cryptocurrency Craze
If you think banks and credit card companies charging fees and requiring accounts is a thing of the past, you may be more inclined to invest in some amount of cryptocurrency.
If you think consumers and businesses will continue to enjoy the safety of the value of a physical dollar, then you may want to stay away.
Taking everything into consideration and falling short of us making any recommendation, the potential for you to make a significant amount of money investing in cryptocurrency is out there. It just comes with enormous risk.
Vicki and Amy are authors of Estate Planning 101 – a Crash Course in Planning for the Unexpected -coming soon from Adams Media.