Cryptocurrency: What is it and How Can it Affect Me?

Cryptocurrency:  What is it and How Can it Affect Me?

By Nathaniel Torrey

Alright, BRC, it seems whenever I log on to my preferred financial source of news, all I hear about is cryptocurrency this and cryptocurrency that.  What the heck is this?  Antiques from a pharaoh’s tomb?  I’m lost.

Pharaoh’s gold it is not, but it has been in the news cycle a lot lately.  Cryptocurrency is a digital currency-like asset not backed by any centralized authority.

Digital? Currency-like?  What do you mean?

It’s currency-like in that it functions in many ways like the U.S. dollar or British pound or Euro. People will accept cryptocurrencies in exchange for goods and services.

This sounds a bit far-fetched.  I see some cryptocurrencies going for thousands or tens of thousands of dollars.  How can it be worth anything?

Well, let me answer your question with a question: why is the U.S. dollar worth anything at all?

*uncomfortable silence pregnant with existential woe*

…because the U.S. government says so?

Correct!  The U.S. dollar is only worth anything because the apparatus of the U.S. legislative system will back up transactions conducted with dollars.

I’m trying to ignore all the potential implications this has for our monetary policy. I feel like I need to sit down.

It’s OK; it’s all a little confusing but let’s stick to the basics.  Currencies like the U.S. dollar are what are commonly called fiat currencies.  This comes from a Latin word fiat which means “let it be done.”

Hey, I thought we were keeping it basic here! I don’t need a dead language lesson; I want to figure out what this all means for me and if I should be paying attention to this or not!

OK, I understand your fear of missing out. But, we’re going to have to do a little work to understand this because cryptocurrencies, as you’ve probably noticed, aren’t without their risks.  Per Yahoo Finance, Bitcoin, the original cryptocurrency, was going for $63,503 per coin in April and was going for as low as $29,807 per coin in July.  As of mid-August, it was trending upward again to $47,507 per coin.  It is a highly volatile asset.

OK OK, let’s start from the top.  I get that a cryptocurrency is like our own U.S. dollars in that the value of it comes from agreeing to make it so.  But it is different because no government backs it.  So how does it work?

The short version is that cryptocurrencies run on what is called a block chain.  Think of it like a giant digital ledger book spread across all the users of it.  For Bitcoin, certain users, colloquially called miners, record the transactions.  These miners are rewarded in cryptocurrencies.  Most cryptocurrencies function this way.

What?  There are miners now?!  I thought this stuff was digital!

It’s just a metaphor.  Due to the complexity of the transactions, entire buildings are filled with computing equipment.  These are called mines.  The President of El Salvador, Nayid Bukele, who has made Bitcoin legal tender in his country, has built a Bitcoin mine that runs on geothermal energy.  Since all the records have to be updated after each transaction, cryptocurrencies use a staggering amount of energy which has drawn a lot of criticism.

OK, so how do I get some?

There are many exchanges for cryptocurrencies.  Coinbase, Binance, Kraken and Gemini are popular applications for doing so.

So, this seems like the stock market.  But I have a feeling you’re about to tell me it is different.

You’re catching on!  Stocks are obviously based on the valuation of the assets, revenue, and the like of each company.  The value of the stock is tied to our perception of the company in question continuing to succeed in the future. Cryptocurrency obviously differs because there is no underlying asset that it represents.

So, what makes cryptocurrency valuable? The U.S. dollar at least has the advantage of support from our government.  What is anyone getting out of it?

Have you ever heard of the theory of the greater fool?

No, but I don’t have a good feeling about this.

It’s the idea that people will invest in overvalued assets since they believe a yet “greater fool” will buy it for even more. The risk of course is that one could end up being the greatest fool and stuck holding the bag.

But if it isn’t tied to any government or entity, wouldn’t it still be worth something should the sky start falling?  While I was trying to look like I was paying attention to my financial advisor, he said something about diversifying my portfolio one time.  Should I be investing in this in case my nest egg goes south to balance it out?

Depends who you ask.  It seems like in its history, Bitcoin at least has been correlated to the S&P 500 and gold.  But others disagree.  Whether one would want to invest in cryptocurrencies in order to diversify one’s portfolio is speculative as well.

OK.  Let’s say I take a chance on this.  Do I have to report this on my taxes?  Didn’t you say no one could see who made the transactions?

I’m sure those holding the Colonial Pipeline for ransom felt very confident about the anonymity of cryptocurrency right up until the FBI knocked on their door.  It would seem that blockchain is not as impenetrable as people thought.

Regardless, let’s be model citizens.  According to the IRS, cryptocurrencies are treated like property. In this case, one would need to know the fair value at the date of purchase of the cryptocurrency and then any gain or loss when it is subsequently part of a transaction.  Given the volatility, this can be a bit complicated.

Anything else I need to think about it?

Oh, many things, my friend.  But as for cryptocurrency, that about covers the basics.  Cryptocurrencies aren’t going away anytime soon but proceed with caution!

Nathaniel Torrey

Nathaniel Torrey Staff Accountant