Crypto inspires passions among investors, some believing it’s a transformative technology and others worrying it’s a bubble. Regardless of your view, it’s important to understand the basics.
Basically, cryptocurrencies are digital assets that allow people to send and receive value without the need for an intermediary like a bank or payment processor. Crypto uses a decentralized system to verify transactions that are recorded on a public ledger called a blockchain. Transactions are verified by computers around the world that constantly compare encoded documents. The computer that finds a matching set of numbers and letters (referred to as a hash) gets to add the new transaction to the blockchain, which is a continuously growing record of all previous transactions. Each hash references the previous one, creating a chain of validated encoded documents that is difficult to reverse engineer.
The blockchain enables a wide range of applications, including peer-to-peer payments, smart contracts, and trading on exchanges. The underlying technology also creates the potential for decentralized banking and global financial markets that could operate independently of traditional government and central bank regulation.
Because of these innovations, some believe that cryptocurrency is a form of money that could eventually supplant or facilitate financial transactions and other traditional functions. However, it is still too early to know how this will play out, and if it does prove successful, it may face significant resistance from those who derive power from the status quo.
Crypto’s ability to cut out the middleman may be particularly useful in developing economies, where there are limited or no traditional financial services. But it’s also important to remember that cryptocurrencies are not insured by the FDIC or SIPC, and that they’re subject to intense price volatility.
The most famous example of a cryptocurrency is bitcoin, which rose from virtually worthless in 2008 to thousands of dollars a coin today. Its value is driven by supply and demand, as well as expectations about what the coins can do in the future. Some coins are backed by a real-world asset, such as gold or fiat currency, and some try to stabilize their value by pegging them to a particular country’s or company’s dollar valuation.
The IRS treats cryptocurrency as property and taxes it based on how long you hold it, whether you use it to make a purchase or sell it. Platforms that buy and sell crypto can be hacked or go out of business, and there’s a risk that you could lose some or all of your holdings. For these reasons, we advise you to consider only investing in crypto with an amount that you’re willing to lose. Your advisor can help you evaluate the risk-reward tradeoffs.