If you do a lot of reading in the financial arena, you probably have questions about cryptocurrency. We have chosen 21 of the questions we hear most often and provided answers for you below.
1. What are cryptocurrencies?
This is a seemingly simple question, but since most people answer about what they think, hope, or want cryptocurrencies to be, it is a confusing one. Cryptocurrencies are a digital asset that started as a medium of exchange for people to buy goods and services. Over time, their functionality has expanded.
2. Beyond a method for payment, what are other functions of cryptocurrencies?
Cryptocurrency value can be pegged to underlying asset such as U.S. dollar, central bank digital currencies, privacy coins (senders and receivers are anonymous), governance tokens (gives owners the right to vote in decisions regarding blockchain’s future development), utility tokens, and non-fungible tokens (distinct characteristics from all others). This is from a developer/development side. Of course, there are also investors and speculators who are hoping for appreciation. It is very important you know the intent and functionality of cryptocurrency you own or are considering owning.
3. How are cryptocurrency transactions recorded?
Cryptocurrency transactions are recorded on a shared, digital ledger called a blockchain. This is decentralized technology, spread across many computers, that records every transaction.
4. Are blockchain and cryptocurrencies the same?
No. Blockchain is the technology that allows for cryptocurrencies to work. It is a decentralized and digital ledger of transactions used for cryptocurrencies and other assets/functions. It is important to separate the technology behind cryptocurrencies from the actual cryptocurrencies.
5. Help me with the lingo — crypto, coins, tokens, ICOs.
Here’s a brief glossary:
- Crypto — umbrella term for all digital and/or virtual currencies
- Coins — Generally, any cryptocurrency that has its own separate blockchain
- Tokens — Generally, any cryptocurrency that is built on top of existing blockchain, e.g., some companies issue their own cryptocurrencies, called tokens, which can be used to purchase goods or services specifically from issuing company
- ICO — Short for Initial Coin Offering, this is analogous to a privately held company going public via an initial public offering (IPO)—a way to raise funds for a new cryptocurrency or expand services for existing coins
6. What are the top cryptocurrencies?
The most popular and widely heard of cryptocurrency is Bitcoin. As of early January 2021, the total cryptocurrency market is over $1 trillion, and Bitcoin is around $700 billion. Believe it or not, there are over 7,800 cryptocurrencies in existence and growing. The top five, with over 80 percent of the market value, are Bitcoin, Ethereum, XRP, Tether, and Litecoin. (footnote 2)
7. Why are there so many cryptocurrencies?
People saw the success of Bitcoin and tried to improve existing functionality and provide new functionality with new cryptocurrencies. Additionally, investors and developers were certainly trying to make money.
8. Can cryptocurrencies fail?
Yes. It is estimated that close to 2,000 cryptocurrencies have failed. This is for a variety of reasons: lack of funding at start and after launch, failure to evolve, and a few were outright frauds. Many of the failures happened during the initial coin offering boom of 2017–2018.
9. I hear cryptocurrencies are used for illicit/illegal activities; is this true?
Since cryptocurrency operates on a decentralized network that lacks a central authority, it is possible to exchange cryptocurrency without registering an identity. Yes, since the start there have been criminal activities with cryptocurrencies. However, the blockchain publicly records every transaction, and while names are not assigned to addresses, you can trace activity back to a crypto exchange, which knows the end user. The estimates vary for how many transactions are for illegal activities and proponents of cryptocurrency point to illegal activity with traditional currencies. (Source: NY Times article Jan 2020)
10. Is it legal for me to purchase cryptocurrency in the U.S.?
Yes. In 2013, the U.S. Treasury Department’s Financial Crimes Enforcement Network (FINCEN) stated that it is legal to invest in Bitcoin and use it as a form of payment as long as the seller is willing to accept it. The Securities and Exchange Commission has designated cryptocurrency as digital currency, the Commodity Future Trading Commission as commodities, and the IRS as property. You can purchase in any state, but certain states have imposed regulations. As an example, New York has a policy where any business must apply for a BitLicense if it is dealing with cryptocurrency. As adoption increases, look for regulatory and legal updates at the federal and state level.
11. Okay, okay, I have U.S. dollars — how do I purchase cryptocurrency?
There are a couple of methods, but the simplest and least expensive is via an online cryptocurrency exchange. You establish an account and from there, you transfer in cash and purchase the cryptocurrency of your choice. The exchange will allow you to buy, sell, and hold cryptocurrency. The user experience, fees, and identification requirements all vary based on the exchange, so it is important to conduct research before you do anything. Some of the most popular are Coinbase, Gemini, and Kraken. Additionally, traditional online brokers are starting to offer services such as eToro and Robinhood. Further, fintech and technology companies are starting to offer these services (Square and PayPal as two examples).
12. What is a crypto wallet?
Simply put, crypto wallets are places to store digital assets more securely than just on an exchange. You hold your wallet via an exchange account, custody wallet, or outside of the exchange. You can establish an online or “hot” wallet that is internet connected—to your desktop, table or mobile phone. There is also the option to store on a device that is not connected to the internet (“cold” wallet). Cold wallets are the most secure way to store your cryptocurrency, but they are meant for longer-term holdings as they are not connected to the internet. With cold storage, you must remember your private keys (identifier number for your cryptocurrency).
13. Are there ways to purchase outside an exchange?
Believe it or not, there are Bitcoin ATMs. You insert cash and bitcoins are transferred to your secure, digital wallet. There are also peer-to-peer (PTP) exchanges. Users post what they are hoping to buy or sell and then choose their trading partner(s).
14. If I want exposure, isn’t there just a security (like an exchange-traded fund) that I could purchase?
These products are just starting to come to the marketplace. The design of these products is to gain exposure to cryptocurrencies like Bitcoin and Ethereum without having to directly purchase. Beyond the fees for doing this, these products currently trade at a very high premium to the underlying cryptocurrency prices. The premium could continue to persist in the future, but investors need to consider the price they are pricing for the exposure.
15. Why would I purchase a security?
Depending on who you ask, you would most likely get a different answer. Some investors believe it will be a store of value over time and a hedge against traditional fiat money. Some people just want to speculate and make a quick buck (coin). Some do want to be part of the ecosystem and use it as an alternative to traditional currency—not as an investment per se but a means of transacting.
16. Is it true you can trade 24/7?
Yes, on many exchanges you can place an order at 11 a.m. Sunday or any other day and time. Many cryptocurrencies trade 24 hours a day, seven days a week.
17. How volatile is it really?
Very! The charts below show the previous five-year price history Bitcoin and Ethereum. Each currency has experienced over a 50 percent drop in the past five years.
18. As a U.S. citizen, how do taxes work?
In 2014, the IRS issued a notice that virtual and digital currency is treated as property for federal income tax purposes. When you sell cryptocurrency for capital gain or capital loss, this will be recognized. Starting in 2019, the IRS specifically asks about cryptocurrency on the first page of Schedule 1. The expectation is for this to continue going forward and for CPAs to ask this question in their annual tax binder. Even if the exchange you purchased does not provide tax reporting forms, you need to record your transactions. Additionally, the IRS does provide a handy FAQ.
19. Can I be hacked? What if I am hacked?
Unfortunately, there is a history of exchanges and online wallets being hacked. This is one of key reasons to thoroughly research where you trade cryptocurrency and securely store your digital assets. If you are hacked, there is not FDIC insurance or anything similar. If you have a large position, you can purchase individual crypto insurance. Additionally, many exchanges finance their own insurance plans in the event of a hack. The insurance coverage is generally capped and not guaranteed, so there is still a risk of loss.
20. Is institutional adoption increasing?
There was an increased institutional adoption in 2020 from traditional banks, newer technology companies, endowments, and pensions. As examples, Square and PayPal are now allowing users to buy, hold, and sell cryptocurrencies via their apps and use them for payments in certain instances. Asset custodians are also working on products and services, such as Fidelity with its Digital Assets Group.
21. What are other considerations/will prices keep going up?
This is a rapidly evolving space on all fronts: development, investment, regulatory, and trading. All the areas surrounding cryptocurrency—trading, execution, custody—will continue to become more efficient, less expensive, and safer as the market matures and more institutional players get involved. Governments are considering additional rules, regulations, and disclosures for consistent identity collection, reducing illegal activity, and tax collection. There is still not consensus about the best use case and even what that is (viable alternative currency, store of value, investment, speculative, etc.) and that is okay. Ultimately, the stakeholders and marketplace will determine the next decade of cryptocurrency.
Still have questions about cryptocurrencies? Contact us to speak with one of our advisors.
1. Data from CoinMarketCap, Cryptovantage, NerdWallet, NY Times (Jan 2020)
2. Charts by YCharts
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Different types of investments involve varying degrees of risk, including the risk of loss of your entire investment. Past performance is not indicative of future results. CPWM and its employees can give no assurance that the performance of any specific investment recommendation or investment strategy discussed herein, whether directly or indirectly, will be profitable, or that it will be equal to any historical performance level discussed herein. The discussion or information contained herein is not intended to be, and should not be deemed as, personalized investment advice. The recommendations made may not be suitable for your specific individual situation and we encourage you to discuss with your financial professional before undertaking any investment strategy or recommendation contained herein. The discussions contained in this blog is current only as of the date hereof and may change due to a number of factors, including varying market conditions.