Cryptocurrency Investment: What's The Appeal For Big Money?

Cryptocurrencies are digital assets that are secured by cryptography. They are traded between consenting parties with no broker and tracked on digital ledgers. They are usually based on blockchain technology, which is a distributed database that is shared and verified via a computer network.

The first cryptocurrency was Bitcoin, which was founded in 2009 and remains the best known today. Much of the interest in cryptocurrencies is to trade for profit, with speculators at times driving prices skyward.

There are several ways to invest in cryptocurrencies. These include buying them directly from crypto exchanges, investing in crypto funds and companies, and investing in a cryptocurrency Roth IRA.

Cryptocurrencies are considered highly speculative and are subject to far less regulatory protection than traditional financial products. They are also associated with high energy usage and evolving government regulations. However, they offer the potential for high returns and have lower transaction fees compared to traditional online payment methods.

The advantages of cryptocurrencies

Decentralized systems

Cryptocurrencies are decentralized, meaning they are not issued or regulated by a central authority like a government or bank. This makes them immune to government interference or manipulation and theoretically, less susceptible to collapse.

Secure and transparent

The use of blockchain technology in most cryptocurrencies ensures transactions are verified and secured by a distributed ledger enforced by a network of computers. This makes it nearly impossible to forge transaction histories.

Faster and cheaper transactions

Cryptocurrency transfers are faster than standard money transfers as they do not require third-party intermediaries like banks. They are also cheaper, with lower transaction fees.

Accessibility

Anyone with an internet connection can access and use cryptocurrencies, making them a more inclusive form of currency.

Passive income opportunities

Some cryptocurrencies offer staking, which allows owners to earn passive income by helping to verify transactions on a blockchain protocol.

Disruptor to traditional finance

Cryptocurrencies and blockchain technology have the potential to disrupt multiple industries, including finance and law, by removing the need for third parties such as banks. This could lead to lower costs and increased speed of services.

The disadvantages of cryptocurrencies

Despite their popularity, cryptocurrencies have several drawbacks that have led some to refer to them as a "bubble". Here are some of the main disadvantages:

• Scalability: Cryptocurrencies face problems with scaling. The number of transactions processed by major payment companies like VISA dwarfs that of cryptocurrencies, and the speed of transactions is also slower. However, solutions such as lightning networks, sharding, and staking have been proposed to address this issue.
• Cybersecurity issues: Cryptocurrencies are vulnerable to cybersecurity breaches and hacking attempts. While enhanced security measures are being implemented, breaches have resulted in significant financial losses for investors.
• Price volatility and lack of inherent value: The value of cryptocurrencies is highly volatile and subject to rapid changes. This is partly due to the lack of inherent value in cryptocurrencies, which are not tied to any tangible or intangible assets.
• Regulations: Cryptocurrencies operate outside the control of governments and central authorities, which raises regulatory concerns. The lack of clear regulations and the potential for sudden regulatory crackdowns increase the risk for investors.
• Data loss and user risk: If a user loses access to their private key or wallet, there is no way to recover their cryptocurrency, resulting in financial loss. Additionally, there is no way to reverse or cancel a cryptocurrency transaction once it has been sent.
• Centralization and wealth concentration: While cryptocurrencies are meant to be decentralized, wealth distribution is becoming more concentrated. Large companies and investment fund managers are purchasing and holding significant amounts of cryptocurrencies, which goes against the decentralized nature of these digital assets.
• High energy consumption: Cryptocurrency mining, particularly for popular cryptocurrencies like Bitcoin, requires significant computational power and energy input. This has led to increased energy consumption and carbon emissions, especially in countries like China that rely on coal for electricity production.
• Susceptibility to hacks: Cryptocurrency exchanges and wallets have been vulnerable to hacks, resulting in the theft of millions of dollars worth of coins.
• No refund or cancellation policy: Cryptocurrency transactions cannot be reversed or cancelled, which creates a business problem and increases the risk of fraud.
• Limited acceptance and legal status: Cryptocurrencies are not widely accepted as a form of payment, and their legal status varies across different countries and jurisdictions. The lack of acceptance and legal uncertainty make it impractical for everyday use.

The legality of cryptocurrencies

In the majority of countries, the use of cryptocurrency is not in itself illegal, but its status as a means of payment or a commodity varies, resulting in different regulatory implications. For example, in the US, cryptocurrencies are not considered legal tender, but exchanges are legal and subject to regulation by the Bank Secrecy Act. In the UK, cryptocurrencies are not legal tender, but exchanges must register with the Financial Conduct Authority (FCA) and comply with anti-money laundering and counter-terrorist financing reporting obligations.

Some countries have taken a more progressive approach to cryptocurrency regulation. For instance, El Salvador and the Central African Republic have adopted Bitcoin as legal tender, while Australia, Canada, and Japan have implemented comprehensive frameworks for the use and taxation of cryptocurrencies.

On the other hand, some countries have imposed strict restrictions or outright bans on cryptocurrencies. China, for instance, has banned cryptocurrency exchanges, transactions, and mining, while Bolivia has issued a comprehensive ban on the use of any currency not issued or regulated by the government, including cryptocurrencies.

The regulatory landscape for cryptocurrencies is constantly evolving, and it is important for individuals and businesses operating in this space to stay informed about the legal status and applicable regulations in their respective jurisdictions.

The tax consequences of cryptocurrencies

Cryptocurrencies are considered property for federal tax purposes in the US, and so general tax principles that apply to property transactions must also be applied to exchanges of cryptocurrencies. This means that taxpayers must recognise the gain or loss on the exchange of cryptocurrency for cash or for other property. As such, a capital gains tax will be applied to any profits made from cryptocurrency investments.

The US Internal Revenue Service (IRS) treats cryptocurrencies as financial assets or property for tax purposes. If you make a profit by selling or trading cryptocurrencies, you will be taxed on the resulting capital gains. The exact tax you will pay depends on how long you held the cryptocurrency and how you used it.

If you sell a coin position for cash, you must report a capital gain on Form 8949. A coin position held for one year or less is considered a short-term capital gain, taxed at your ordinary tax rate. If you hold the coin for more than a year, it is considered a long-term capital gain. Capital losses can be used to offset capital gains, and net capital losses can be deducted from other types of income, up to a certain amount.

Cryptocurrency gains from trading coins held as capital assets are treated as investment income by the IRS. As with stock trades, capital losses can offset capital gains, and net capital losses can be deducted from other types of income, up to a certain amount.

If you are paid in cryptocurrency by your employer, this will be taxed as ordinary income and must be reported on Form W-2. If you are an independent contractor and receive payment in cryptocurrency, this will be subject to income tax and self-employment tax, and must be reported on Form 1099.

If you receive cryptocurrency as a gift, you will not immediately be taxed on it. You will only be taxed when you sell, exchange, or otherwise dispose of the virtual currency. For tax purposes, your basis will be equal to the donor's basis, plus any gift tax they paid. If you cannot substantiate the donor's basis, your basis will be zero.

If you donate cryptocurrency to a charitable organisation, you will not be taxed on any gains. You will be entitled to a charitable contribution deduction equal to the fair market value of the cryptocurrency at the time of the donation, provided you have held the cryptocurrency for at least a year. If you held it for less than a year, your deduction is the lesser of your basis or the cryptocurrency's fair market value at the time of the donation.

The IRS requires taxpayers to maintain excellent records to establish positions taken on tax returns. You should keep records documenting receipts, sales, exchanges, or other dispositions of virtual currency, as well as the fair market value of the virtual currency.

The risks of cryptocurrencies

Cryptocurrencies are a risky investment, and it is important to understand the associated dangers before investing. Here are some of the key risks to consider:

User Risk

Unlike traditional finance, cryptocurrency transactions cannot be reversed or cancelled once they have been sent. It is estimated that about one-fifth of all bitcoins are now inaccessible due to lost passwords or incorrect sending addresses. This risk is heightened by the intangible nature of cryptocurrencies, where human error or password amnesia can result in the total loss of a crypto fortune.

Regulatory Risk

The regulatory status of cryptocurrencies is still evolving and remains unclear in many jurisdictions. A sudden regulatory crackdown or change in policy could make it challenging to sell cryptocurrencies, potentially causing a market-wide price drop. The legal status of cryptocurrencies also creates implications for their use in daily transactions and trading.

Counterparty Risk

Many investors and merchants rely on exchanges or custodians, such as crypto wallets, to store their cryptocurrency. In such cases, theft or loss by these third parties could result in the loss of the entire investment.

Management Risk

Due to the lack of coherent regulations, there are limited protections against deceptive or unethical management practices in the cryptocurrency space. Many investors have lost large sums due to management teams failing to deliver promised products or services.

Programming Risk

Many investment and lending platforms in the crypto space use automated smart contracts to control the movement of user deposits. Investors using these platforms assume the risk of bugs or exploits in these programs, which could result in the loss of their investment.

Market Manipulation

Market manipulation remains a substantial problem in the cryptocurrency market, with influential people, organizations, and exchanges acting unethically. The naïve can easily become prey to cyber extortion, market manipulation, fraud, and other investor risks.

Cyber Risk

The cyber threats posed to cryptocurrencies are ever-evolving. While the Bitcoin blockchain has proven to be among the most cyber-resilient innovations, the firms that plug into it are often new entrants with lax cybersecurity standards. This makes the cryptocurrency space vulnerable to risks ranging from the "mysterious disappearance" of assets to complex ransomware attacks and AI-powered bots.

Technological Risk

The computational complexity of cryptocurrency mining, as seen with Bitcoin, poses potential risks to the asset class. Complex systems can fail in complex ways, and not all cryptocurrencies are created equal in terms of their traceability, transaction ledgering, and levels of trust or fiduciary responsibility.

Price Volatility

Cryptocurrencies traded in public markets suffer from extreme price volatility, and investments require accurate price monitoring. For example, Bitcoin has experienced rapid surges and crashes, climbing to nearly $65,000 in November 2021 before dropping to just over $20,000 a year and a half later. This volatility has led many people to consider cryptocurrencies a speculative bubble.

Criminal Activity

The pseudonymous nature of cryptocurrency transactions allows for criminal uses, such as money laundering and illicit purchases. Cryptocurrencies have become a popular tool for criminals, with cases such as the Dread Pirate Roberts, who ran a marketplace to sell drugs on the dark web, highlighting this risk.

Environmental Impact

The energy consumption and environmental impact of cryptocurrency mining, particularly with Bitcoin, is significant. Bitcoin mining consumes more energy than all U.S. residential lighting, according to a comparison by the University of Cambridge.

Frequently asked questions