Last Updated: August 25, 2020
Table of contents
- How Does Cryptocurrency Work?
- Benefits of Cryptocurrency
- Types of Cryptocurrency
- Is Cryptocurrency Legal?
- How Do You Store Cryptocurrency?
- Can Cryptocurrency Be Stolen?
- Do You Have to Pay Taxes on Cryptocurrency?
Cryptocurrency is an emerging digital capital that is tradeable and exchangeable, and it is changing the way we think about money. Having a currency that is free from governments or banks, is widely accessible, yet is secure enough to store, is a promising way to provide a superior alternative to how we manage our monetary systems. Cryptocurrency is still in its infancy, so it may help to fully understand it before it becomes the new monetary standard.
How Does Cryptocurrency Work?
Cryptocurrency transactions take place on a ledger. This is a peer-to-peer exchange that takes place on a blockchain network, with the ledger acting as a mediator — making sure everyone is playing fair and eliminating the risk of double-spending. The ledger is a public, self-run, and self-governed record-keeping system, which means that cryptocurrency is decentralized and free of any intervention by outside parties such as banks. It is for this reason that digital currency is revolutionizing monetary systems and the way transactions take place.
History Of Cryptocurrency
The idea of anonymous, electronic money was first conceived in 1983 by David Chaum. Since his idea of ecash, cryptocurrency has been refined through the years, such as B-money and Bit Gold and transformed with the technological innovation of the blockchain. In 2009, an individual who goes by the pseudonym “Satoshi Nakamoto” created Bitcoin — the first decentralized digital currency with a solid, secure, feasible framework. Since 2009, a number of cryptocurrencies have taken off, each expanding off of this framework to make an increasingly secure, decentralized digital currency.
How Is Cryptocurrency Different From Traditional Money?
One major distinction between cryptocurrency and traditional money is that cryptocurrency is digital and decentralized. Generally, cryptocurrencies operate using blockchain technology, making digital cryptography an intrinsic feature. When you purchase something on a credit or debit card, your information is sent to businesses, banks, and third party affiliates. Digital currency transactions only include personal information if you choose to include it. In fact, many cryptocurrency users choose to go by a pseudonym (since tracking transactions only require a digital wallet address).
Additionally, cryptocurrency is decentralized, and can be used entirely without traditional financial institutions that control traditional currency systems. Each cryptocurrency has its own monetary policy. Bitcoin for example has a maximum supply of 21 million units that are issued on a regular schedule and there is no government or central authority that can issue extra bitcoin or increase circulation to cause inflation (the way a government or central bank can with traditional money).
Cryptocurrency are global protocols (they operate the same from one country to the next), though making a purchase with cryptocurrency is only possible by the merchants who accept this form of money. As cryptocurrency further develops, it is gaining more ground as a legitimate form of legal tender.
Benefits of Cryptocurrency
Cryptocurrency is becoming more and more popular, and being used more frequently because of the unique properties it can bring into a transaction. Cryptocurrencies have several advantages, including:
- Preventing Fraud and Identity Theft: cryptocurrencies cannot be counterfeited, and the ledger prevents double-spending. For merchanges, this eliminates the problem of a costly chargeback (as in the case with credit cards). Additionally, personal information is given out during a credit card transaction. Cryptocurrency allows a user to restrict this information to a certain extent. Credit cards operate by pulling money out of your account, while cryptocurrency adopts a method in which you push money to a recipient — sending the exact amount you want and no further data, and settling the transaction then and there (more similar to an electronic version of cash)
- Lower Fees: third parties and other authorities involved in traditional money generally include expensive transaction fees (often ~3% for credit/debit cards), foreign transaction fees, and other service charge fees. Cryptocurrency — as a global-digital native currency — eliminates these fees
- Accessibility: the cryptocurrency market can be accessed by anyone with access to the internet (even with just a simple mobile phone). This is a vastly larger number of individuals than those with access to traditional banking infrastructure and makes it easier for anyone, and especially those in developing countries, to obtain, trade, and make transactions with virtual money as cryptocurrency is not bound by geography. For instance, many countries in Africa are turning to bitcoin to deal with the inflation issues of traditional money
Types of Cryptocurrency
As mentioned above, there have been a variety of cryptocurrencies created in attempts to expand and innovate the concept. In considering one cryptocurrency over another, it's important to take into account what each one offers.
Several cryptocurrencies for payment have stood out above the other in recent years, each with their own advantages. These cryptocurrencies include:
- Bitcoin (BTC): Bitcoin was created in 2009 and the first widely used cryptocurrency which paved the way for the others on this list. Bitcoin has the highest market value, the greatest traction, the most users, and the widest adoption of any cryptocurrency
- Litecoin (LTC): Litecoin is a peer-to-peer, open-source software project that takes credit for fast transactions and uses Scrypt for a secure cryptography algorithm. Some see it as a testing grounds for new features that could eventually be merged into the Bitcoin protocol
- Ethereum (ETH): Ethereum uses smart contracts that users can write and control called a Turing-complete smart contract
- Ripple (XRP): Ripple is a centralized digital payment protocol, and is used for currency exchange and debt settlement
- Bitcoin Cash (BCH): Bitcoin Cash is a fork of Bitcoin — meaning that developers took a copy of Bitcoin’s source code and made it a separate entity
- Ethereum Classic (ETC): following an attack on The DAO, a decentralized autonomous organization for investing, Ethereum underwent a fork that gave rise to Ethereum Classic. This caused controversy within the crypto community about immutability and whether cryptocurrencies should fork to save user funds in the event of a hack.
In looking toward a lasting future with cryptocurrency, the blockchain economy has been proposed as a potential replacement for traditional monetary systems. The blockchain economy has the power to significantly change the future of banking, credit card systems, and more. Since the blockchain economy operates on a secure, decentralized ledger, businesses and individuals can use a growing variety of exchanges to trade cryptocurrencies, potentially saving money on the exchanges without service fees and making it easy to manage their digital wallets or portfolios.
Many cryptocurrencies include a public virtual wallet. One concern is that these wallets are publically viewable. Privacy coins such as Monero (XMR) and Zcash (ZEC) are being introduced as a way to address safety concerns for individuals and businesses to protect them from hackers and anyone who will view someone’s transaction history and use it for their own personal gain.
A utility token is a digital cryptocurrency that can be used to purchase a good or service offered by the issuer of the cryptocurrency. Utility tokens have historically been used as a way to fund specific cryptocurrencies and companies in the form of an ICO (initial coin offering) that can then be later used on the platform itself to redeem some value. A simple analogy would be investing in a kickstarter campaign for a new loyalty program and the loyalty points you got would be akin to the utility tokens that you could use with the company once the loyalty program launched.
Stablecoins often have their value tied up with another asset — whether that be traditional currencies, cryptocurrencies, precious metals, or a basket of other assets. In an effort to combat the volatile market of cryptocurrency, stablecoin adoption ties their value to an asset to do just that — stabilize the value of its currency. For instance, the popular stablecoin Tether is backed by the US Dollar to anchor the value of several different types of cryptocurrency.
Is Cryptocurrency Legal?
Cryptocurrency has no specific regulating/governing entity. That being said, countries have taken it upon themselves to figure out how to oversee it within their existing regulatory frameworks. Buying, selling, sending and receiving cryptocurrency is legal in most parts of the world, but there is still work to be done to clarify the exact regulations which apply. It is important to understand the regulations of cryptocurrency around the world.
How Do You Store Cryptocurrency?
Cryptocurrency is stored in a digital wallet, similar to a password manager. This wallet may be a device, physical instrument, or more commonly a software program that will secure your cryptocurrency by securely storing your private keys (password) to your wallet.
What is a Cryptocurrency Wallet?
There are many different kinds of cryptocurrency wallets which have pros and cons based on a users’ needs. For instance, “hot wallets” are connected to the Internet and allow a user to access them from anywhere in the world as long as they have an internet connection. On the other hand a “cold wallet” allows a user to store their cryptocurrency offline, and is not connected to the Internet, which offers additional security benefits. Cold wallets can still receive funds at any time from anywhere, but to spend the funds, the user needs to be physically colocated with the wallet.
In addition to hot and cold wallets, there are several different forms of wallets, including:
- Paper Wallets: these are cold wallets that include a paper or physical copy of your public and private cryptography keys. Paper wallets are considered secure, although you do not want to lose the paper or else you will lose access to your funds
- Cloud Wallets: these are inherently hot wallets. Cloud wallets let you access your funds from any computer or device at any location. Private keys here are stored online and may be controlled by third parties — leaving you vulnerable to potential attacks. Examples include exchange wallets on services such as Coinbase and Binance
- Software Wallets: these wallets are susceptible to malware, but considered generally highly secure. Exodus.io is an example of a secure and free to use software wallet. Software wallets can be downloaded and installed on a computer or mobile phone and can generally be accessed by the internet (unless they are an an air-gapped computer)
- Hardware Wallets: these are cold wallets designed to store your private keys on an external device, such as a USB stick. Hardware wallets are considered one of the more secure types of wallets, however they require physical collocation with the device in order to send funds from the wallet
Can Cryptocurrency Be Stolen?
Unfortunately crypto-theft does occur. It is vital for a crypto user to understand what channels they are using to carry out cryptocurrency transactions, and how to secure their cryptocurrency. In 2018, cryptocurrency theft and scams cost users $1.7 billion. These crimes have been carried out by users accepting fraudulent coin offerings, exchange hacks, and Ponzi scheme type scams. Common techniques to steal cryptocurrency include:
- Malware: in which attackers exploit weak spots in software. This is most common if someone downloads an app on a public Wi-Fi network, and then receives a malicious code such as a Trojan
- Social Engineering: where phishing emails, website clones, and more crimes are committed through attacker manipulation and user error
Cybertheft is carried out on a large scale by hacking crypto companies, however individuals who do not understand how to secure their cryptocurrency can be targeted as well. It is vital that individuals understand what networks they are checking their crypto wallet on, what type of wallet they choose to store their cryptocurrency on, and how social engineering tactics may be used against them. In the event that a user is subject to crypto-theft, there may be remedies on how to claim tax losses.
How To Secure Cryptocurrency
Understanding your crypto wallet is essential in securing your cryptocurrency. For instance, a hot wallet may be more vulnerable, since it is connected to the Internet. Crypto-theft can happen in a variety of ways, so there are several measures you can take to make sure you minimize your risk of being hacked.
- Only use wallets from a known, trusted source
- Don’t leave all your money in one place
- Use (and back up) private keys to store your cryptocurrency
- Create strong passwords with a password manager like LastPass or 1Password
- Make sure you are using secure networks
Do You Have to Pay Taxes on Cryptocurrency?
In most jurisdictions, cryptocurrencies are subject to taxes. Tax rules vary from country to country, so it is vital you understand how cryptocurrency is taxed in your area of residence. Generally, there are taxable and nontaxable events that will determine whether or not you have to report capital gains or losses on your tax return.
Taxable events include:
- Selling cryptocurrency for fiat currency
- Trading cryptocurrency for another cryptocurrency
- Using cryptocurrency to buy a good or service
- Receiving cryptocurrency as a result of a fork or from mining
Non-taxable events include:
- Buying cryptocurrency with fiat currency
- Donating cryptocurrency to a tax-exempt organization
- Gifting cryptocurrency (subject to some limits)
- Transferring cryptocurrency between wallets that you control
Cryptocurrency is a comprehensive concept that is still in the early stages of development. Regulation, security, and tax issues are still being ironed out. However, being relatively new doesn’t mean that cryptocurrency won’t potentially transform our entire monetary system one day.
Disclaimer: this post is informational only and is not intended as tax advice. For tax advice, please consult a tax professional.