Is investing in cryptocurrency safe? Legal? Financially sound?
As the financial world becomes more and more dependent on digitization and data analysis, information sharing has developed as a way to not only relay communications but to quantify value and transfer currency. Decentralized currencies provide a new way of looking at money and controlling your financial future, without interference from traditional banks or financial institutions.
Decentralized Currencies vs. Fiat Currencies
Decentralized currency, also known as “peer-to-peer money,” is a bank-free method of transferring commodities (such as wealth) without dependence on a third party for transaction validation. By cutting traditional banks out of the picture, decentralized currencies have led to a reimagining of how money is viewed and treated and offers the potential for wide-reaching effects on other important, data-driven processes.
Most nations use the fiat currency model: all monies held by a central bank which is then backed by the bank’s ability to honor the currency. This money can be represented physically in bills, coins, bank transfers, as well as certificates of deposit. Since the bank determines the value of the money, the bank can raise or lower its value without consent or input from consumers. With fiat currency, the value of your money is always held by a banking institution of some kind, even if you have real paper, or plastic, bills in your wallet.
Unlike the fiat model, decentralized currency’s value is represented by an encrypted piece of computer code, known colloquially as a coin. The code is straightforward to verify but exceptionally hard to replicate or hack. The coin has two keys: one identifying its currency (i.e., Bitcoin, Ethereum, Litecoin, etc.) and connecting it to that currency’s system, and one identifying the owner of the coin. The second key is transferable from person to person and is held in the owner’s choice of wallet (either virtual or paper).
Benefits of Decentralizing Currency
A decentralized currency, or “cryptocurrency,” has a consumer demand-driven value instead of a value determined by governing banks. Cryptocurrencies have many benefits, including:
- Protection from bank failures or collapses, high banking fees, and other bank policies designed to charge you for handling your own money;
- Borderless payments that work around limits set on international transfers by traditional banks operating on fiat currencies and allow large transfers to be made at a meager cost;
- Stabilization in countries with a faltering fiat currency and a struggling economy, and equitable value unaffected by tariffs or varying exchange rates;
- ‘Wallet Only’ requirement, allowing unbanked or underbanked populations to achieve security and the ability to perform financial transactions;
- Blockchain technology, which is more secure than most financial institutions when it comes to transactional data.
With more than 1,000 different cryptocurrencies in existence, and new ones being created almost daily, it can be challenging to know all the players.
Bitcoin (BTC) was created in 2008 by Satoshi Nakamoto, a pseudonym for a person or persons whose real identity remains unknown to this day. Based on blockchain (distributed ledger) technology, Bitcoin is in widespread use, including acceptance by Bloomberg, Microsoft, Overstock.com, Expedia.com, and even Dish Network. Bitcoin is currently the most expensive type of cryptocurrency.
Created in 2015 by Vitalik Buterin, Ethereum (ETH) is not just a cryptocurrency but also a blockchain platform upon which other people can build apps, create “smart contracts,” and even launch other blockchain-based cryptocurrencies. Transaction speed takes just seconds compared with Bitcoin, which can take up to 10 minutes.
Ripple (XRP) was designed to be a cryptocurrency used explicitly for rapid international money transfers. Unlike other cryptocurrencies that are entirely decentralized, Ripple Labs holds half of all coins as an owner. The company achieved its primary objective; international transfers with Ripple take only a few seconds compared with the one-week or longer timeframes experienced with traditional banks. Ripple has the added benefit of being accepted by American Express and Santander Bank.
Cryptocurrencies currently gaining in strength include Bitcoin Cash (BCH), EOS, Cardano (ADA), Litecoin (LTC), Stellar (XLM), IOTA, and NEO.
Forked Cryptocurrencies and ICOs
A ‘forked’ cryptocurrency occurs when a parent currency, such as Bitcoin, splits off creating a ‘child.’ In 2016 Bitcoin launched Bitcoin Cash in 2016 to improve scalability and resolve transaction fee issues. By December of 2017 BCH reached an approximate value of $4,000. Bitcoin Cash is faster than parent Bitcoin, with transaction fees that are much lower.
Initial Coin Offerings, or ICOs, can be built on blockchain technology for practically any company, providing them with an opportunity to seek investors and raise capital while simultaneously creating a new cryptocurrency. The ICO is supported by investors who provide funds in the form of other cryptocurrencies.
Investing in ICOs can carry a higher risk than investing in a standard cryptocurrency, but brings with it the potential for higher return payoff in a shorter period. Most successful cryptocurrencies achieve their most substantial value explosion value within the first year or two of hitting the market.
In contrast to an Initial Public Offering (IPO), ICOs are less regulated by rules governing raising of capital, thanks mainly to the fact that legislation has not fully caught up with the reality of decentralized currency and blockchain technology.
So, should I invest?
And now we come to the key point. And the answer is an individual one — it comes down to your risk appetite. While there are still potentially compelling reasons to invest, there are also reasons thoughtful investors may want to wait and see how the market plays out.
Reasons you may want to take the risk
Speed and Ease of Use
Cryptocurrency payments generally occur within seconds or minutes, even for substantial or international transactions. Transfers can be made from any location and any device with an internet connection using a virtual wallet.
Cryptocurrencies are notoriously hard to hack, and the top cryptocurrencies maintain teams of experts whose job it is to keep it that way. Additionally, counterfeiting is impossible since there is no paper or coin currency.
Cryptocurrency transactions can remain utterly private since the username is unseen and only the unique wallet identifier is required to complete each transfer. While not entirely anonymous, this is attractive to many people who prefer more privacy than afforded by traditional banking institutions. ‘Privacy Coins’ go one step further, helping to mask a user’s identity on the blockchain.
Unlike fiat currency which requires a centralized institution to maintain stewardship of monies, cryptocurrency provides full autonomy within a peer-to-peer system, instead of the need to be overseen by a third party (that can potentially interfere with financial transactions).
Cost Effective and Tax-Friendly
Fees and commissions associated with cryptocurrency are small, and most digital currencies avoid high tax rates, tariffs, and international fees for global transfers. These currencies are borderless, without the constraints of geographical or political barriers.
With digital currencies, third parties cannot reverse a transaction once it is made. There can be no chargebacks, returned funds, or other forms of transaction reversal by a third-party.
Unlike traditional banks which are subject to off hours, statutory holidays, and location closures, cryptocurrencies transactions can be performed at any time, day or night, every single day of the year.
Increase in Value – So Far
Most major cryptocurrencies have shown a constant growth rate over time. While spikes and dips have been radical, cryptocurrency is believed by many financiers as a viable long-term investment. Though the technology remains unproven at scale, the advantages of blockchain could eventually mean an impressive market capitalization for cryptocurrency — but we’re not there yet.
Reasons you may want to wait
Bitcoin has a theoretical limit allowing it to process no more than a few transactions per second. Due to the way it’s structured, it will never exceed that (while entities like Visa process hundreds). While this isn’t a fundamental limit of Blockchain, Bitcoin is still the biggest cryptocurrency by market cap, and its failures may be reflected in the ecosystem as a whole.
The currency has value because it’s commonly accepted — it’s an upgrade from a barter system because its holders don’t need to find someone that has the exact good they want who also wants the exact goods they produce. Because there’s a common value exchange, transactions can happen easily.
In the world of cryptocurrency, it’s yet to be determined which (if any) currency will be the most commonly adopted. This means that while there may be big winners, there will also very likely be big losers, so investing in a non-diversified portfolio of cryptocurrencies carries a high amount of risk. My own industry (accounting software) has seen this same fragmentation happen: the backers of Xero or Quickbooks, for example, are very happy — while many other players have fallen by the wayside.
Some creators of cryptocurrency have made a lot of money simply by issuing a new coin. And some of those have then walked away with the money and no support for the coin. Investors need to take extra care and diligence in finding dedicated and long-term teams behind a cryptocurrency.
While “immutability” is one of the key selling points of cryptocurrency, it can also be a drawback when hackers gain keys to coins they shouldn’t have access to. Once they process a transaction sending themselves the coin, there’s no way to reverse it. Meaning, there’s no fraud protection equivalent; when it’s gone, it’s gone, and we have yet to go a year without a major hack involving the equivalent of hundreds of millions of dollars.
The Future of Cryptocurrency Investing
Thanks to digital data transfer via the internet facilitating cryptocurrencies exchanges, decentralized money may be on its way to becoming a strong player in global commerce. With the worldwide expansion of high-speed internet access and the accessibility of online transactions becoming more readily available to individuals, cryptocurrency has room to thrive.
A staggering 2.2 billion individuals across the world do not have access to traditional systems of exchange or banking; they do, however, have access to an internet connection via a computer, tablet, or mobile device. Cryptocurrency offers a way for these unbanked populations to quickly, easily, and securely process transactions or facilitate asset transfers.
Cryptocurrency remains mostly unrecognized as legal tender by a majority of countries. But that’s not necessarily a negative. In countries where cryptocurrencies are considered digital products, as opposed to money, they are not subject to exchange rates, interest rates, transactions charges, or other levies imposed by specific nations. Additionally, the peer-to-peer mechanism of blockchain technology allows cross-border transfers and transactions to be conducted without concerns over currency fluctuations.
Getting Started in Cryptocurrency Investing
Initial cryptocurrency investments can be made via a traditional exchange, by funding an account with the currency of your choice, or by buying coins, such as Bitcoin or Ethereum, and using that to invest in other cryptocurrencies on an alt exchange like Coinbase.
Trading cryptocurrencies are not for the faint of heart, however, as the market can be much more volatile other types of stocks. Due to the high transacting speed, the market is highly volatile and can cause value change drastically in as little as an hour.
Talking with a financial advisor can help you make the best decision about whether investing in cryptocurrency is right for you.
Tips for Investing in Crypto Markets
Investing in cryptocurrency can be rewarding. But, as with all investment choices, decisions should only be undertaken with care and under the advisement of a trusted financial professional. Additional counsel from a tax specialist familiar with pending legislation that could affect how cryptocurrency is viewed.
Cryptocurrencies are customarily treated as high risk, with most experts recommending they occupy a maximum of 10-20% of a diversified portfolio, to mitigate extreme risks. Top rated cryptocurrencies such as Bitcoin and Ethereum are typically considered to be a preferred investment due to their history.
Conversely, ICOs are seen as the ‘penny stocks’ of crypto and can provide a variety of options for multiple, smaller investments. ICOs are currently under public and legislative scrutiny, and regulations concerning their use has the potential to change at any time with little forewarning.
Taxes on Cryptocurrency Investments
The Internal Revenue Service says virtual currency transactions are taxable by law. However, in the only guidance issued to date occurring in 2014, applies to transactions using cryptocurrency and states that for Federal tax purposes, “virtual currency is treated as property.”
It further defines cryptocurrencies as anything that is considered a “convertible virtual currency,” meaning it has an equivalent value in or acts as a substitute for, actual currency. This means it can apply to major cryptocurrencies such as Bitcoin but does not necessarily apply equally to all existing cryptocurrencies.
As things currently sit, purchase of cryptocurrencies does not result in a realized loss or gain until you sell.
While you’ll need to have a steady hand and a hefty appetite for risk (and a widely diversified portfolio outside of cryptocurrencies), smart investment in cryptocurrencies could still mean a substantial return on your investment.
This article was written by Jaren Nichols, Chief Operating Officer at ZipBooks Online Accounting Software. Jaren was previously a Product Manager at Google and holds an MBA from Harvard Business School.