Modern Money: A Primer on Cryptocurrency and Bitcoin

Throughout history, humans have developed new ways to exchange resources and pay for goods and services—from the bartering system to various forms of physical currency to the first credit card in 1950.

More recently, the evolution of money continues with advances in digital currency. You may have noticed that cryptocurrencies—particularly Bitcoin—have been making headlines through our economy and investing landscape. In this article, we’ll cover the basics of cryptocurrency and what role they may have in your portfolio moving forward.

How cryptocurrency works.

When introduced to the idea of digital currency, a common (and often knee-jerk) reaction is, “How can it be worth anything if it’s not real?” However, when you consider that the vast majority of modern currencies are no longer backed by commodities (as in the gold standard), conventional money only offers the value we assign it. Several characteristics are typically required of any currency, including scarcity, widespread use, divisibility, transportability, durability, ease of storage, and difficulty counterfeiting. Like the U.S. dollar, cryptocurrency can meet these criteria.

The most significant differences are that cryptocurrencies are decentralized and built on a technology called blockchain. Blockchain is a type of database that collects information in blocks. When one block is full and more information is added, another block is created and digitally linked to the previous one. As these blocks accumulate, they form a timeline or ledger of data. Blockchains can be used for many purposes, including supply chain management, healthcare records, property records, and, yes, digital currencies.

When it comes to most cryptocurrencies, the blockchain is hosted across a broad network—not controlled by a single entity, as in the case with government currency. The data of transactions can then be publicly viewed and audited. However, the technology is incredibly secure because old blocks are essentially locked, making it nearly impossible to edit, manipulate, or counterfeit cryptocurrency.

Buying and using cryptocurrency.

Cryptocurrency can be acquired in several ways and requires a digital wallet, which is software or an app that holds the assets.

1. Purchasing or trading cryptocurrency through exchanges such as Binance and Coinbase. Unlike other markets, crypto can be traded 24/7.
2. Payments made between individuals.
3. Mining, a system where individuals run complex computer programs to audit crypto transactions (therefore securing the currency) and are rewarded for their contributions.

Once you have cryptocurrency, what can you do with it? As mentioned earlier, it’s a popular avenue for person-to-personal transactions with minimal banking or international transaction fees. As cryptocurrency becomes more mainstream, large retailers are starting to accept it for payment, including Microsoft, Starbucks, Home Depot, and Whole Foods, just to name a few. Finally, you can hold your cryptocurrency as an investment, which we’ll dive into shortly.

The rise of Bitcoin.

Even if you’re new to cryptocurrency, you’ve likely heard of the largest version of it— Bitcoin. Introduced in 2009 by an individual (or possibly a group) going by the pseudonym Satoshi Nakamoto, Bitcoin was created in response to the financial crisis of 2008. Utilizing blockchain technology, the new virtual currency was designed to enable payment transactions without relying on government fiat currency or the established banking system.

Since its humble beginnings within a small online community, the value of Bitcoin has experienced extraordinary growth. In a humorous piece of crypto lore, the original commercial transaction occurred on May 22, 2010, when a Bitcoin developer named Laszlo Hanyecz bought two pizzas for 10,000 bitcoins, which at the time was valued at around $41. Today, it would be worth over $587 million.  

One reason for Bitcoin’s skyrocketing value is that there is a finite supply—and increasing demand. The way the currency was programmed, there will only be 21 million bitcoins. Currently, around 18.6 million are in circulation, and the rest are still being mined. The limited supply is one reason why some consider Bitcoin a good hedge against inflation.

While the overall gains are eye-popping, crypto investors must also be prepared for constant and sometimes staggering volatility. Bitcoin has experienced multiple bubbles in the past decade, and double-digit price fluctuations can be daily occurrences. Why is Bitcoin so volatile? There’s no single explanation; rather, it is influenced by several factors, including swings in public perception, inflation, security breaches, regulation, and tax treatments, among others.

Other cryptocurrencies in play.

While Bitcoin is the original and largest cryptocurrency, it’s certainly not the only one. In fact, there are currently around 4,000 cryptocurrencies available globally. Many, but not all, are modeled after Bitcoin—but each cryptocurrency can have unique features and characteristics. For example, stablecoins are a type of cryptocurrency backed by a reserve asset to achieve improved price stability.

Here a few of the top cryptocurrencies, along with their values as of March 30, 2021.

• Bitcoin (BTC): $58,832.40
• Ethereum (ETH): $1,839.42
• Bitcoin Cash (BCH): $529.13
• Binance Coin (BNB): $301.96
• Litecoin (LTC): $197.98
• Polkadot (DOT): $34.13
• Tether (USDT): $1.00
• Cardano (ADA): $1.22
• Ripple (XRP): $0.57 (note: Ripple Labs, Inc. is currently fighting a lawsuit against the SEC)

Bitcoin in the news.

While the long-term outlook of Bitcoin is still unclear, there’s no question that cryptocurrencies are creeping into mainstream investing and our everyday lives. Here are just a few recent headlines.

• On Sunday, April 18, 2021, Bitcoin plunged 15% to $56,000 less than a week after hitting a record high of more than $64,000. 
• In February 2021, Tesla bought $1.5 billion in Bitcoin and announced that it would begin accepting the cryptocurrency as a payment method. The value of Bitcoin surged nearly 20% immediately have Elon Musk added the hashtag #bitcoin to his Twitter profile.
• Also in February 2021, Visa announced it will enable banks to offer Bitcoin-based services.
• In January 2021, JPMorgan called a long-term Bitcoin price target of over $146,000
• During the most recent NFL season, Russel Okung received half of his salary in Bitcoin.
• In August 2020, Fidelity launched a Bitcoin mutual fund.
• Finally, to illustrate that cryptocurrency isn’t infallible, there’s the cautionary tale of Stefan Thomas, who lost his password to access $200 million in Bitcoin.
  
  

A word on cryptocurrency and taxes.

While Bitcoin and other cryptos live purely in the digital realm, they have real-world implications, including taxes. In January 2020, the IRS released guidance regarding the taxation of digital currencies. In short, the IRS considers virtual currencies as property, not currency. Taxpayers must maintain records of transactions and report gains or losses on Schedule D. For those involved in crypto mining, income is reported on Schedule C and subject to self-employment tax.

For more on how cryptocurrency is taxed, read Karen Nicpon’s key takeaways article.

The environmental cost of Bitcoin.

In addition to the investment opportunities of cryptocurrency, it’s important to consider the technology’s environmental ramifications. Earlier, we introduced the concept of crypto mining. Not only is mining critical to maintaining the security of Bitcoin, but it can also be a very lucrative endeavor. Unfortunately, the mining software takes heavy-duty computer power and therefore consumes a significant amount of energy.

As the popularity of Bitcoin (and thus, mining) has surged over the past decade, so has the network’s total energy consumption. According to testimony presented to the U.S. Senate Committee on Energy and Natural Resources in August 2018, Bitcoin mining is responsible for nearly 1% of the world’s energy consumption (a figure that has likely increased since then). Another way of illustrating the point, as reported by the BBC, is that if Bitcoin were a country, it would be a top-30 global energy user—consuming more electricity than Argentina.

This is a complicated issue to solve. As Bitcoin’s value rises, more individuals and companies will be enticed to enter the mining market, further increasing energy consumption and CO2 production. There are also questions regarding how to measure Bitcoin’s carbon footprint without accurate data on where mining is taking place.

Final thoughts.

Cryptocurrency is another step in our evolution of money and will have a place in our economy and personal finances moving forward. The million-dollar question is, how much of our traditional money can and will be replaced by cryptocurrencies?

Within an investment portfolio, the role of Bitcoin (or other currencies) in an investment portfolio is entirely speculative. Like other speculative investments, cryptocurrency should be viewed as an opportunity somewhere between a lottery ticket and a home run swing. At Sanderson, we know this risk/return profile intrigues a select group of investors, including some of our clients. With that in mind, we are researching solutions that will allow our interested clients to invest in crypto assets through institutional-quality registered investment vehicles. Our tax team is also well-versed in the requirements and challenges of crypto, and has already implemented these strategies into tax planning for our clients.

If you’re interested in learning more about Bitcoin or other cryptocurrencies, reach out to your Sanderson adviser or contact us for a consultation.