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The market capitalisation of virtual currencies surged over a thousandfold since Bitcoin’s inception in 2009, but despite its popularity, not many understand what it’s all about. Here’s a basic guide to digital monies to better understand how they work.

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Virtual currencies, also known as cryptocurrency or digital currency, are types of electronic money. They are decentralised and can be used all over the world regardless of local currency.

Some investors see cryptocurrencies as good investments because of the incredible surge in the value of its market capitalisation. However, these digital monies is more complicated than what most people think.

Here we discuss the basics of virtual currencies and why investors need to exercise caution when considering these as an asset for their portfolio.

Is virtual currency similar to physical money?

Virtual currencies and physical money are similar in a sense that they are both used to pay for goods and services. They can also be held as a form of investment and may be taxable depending on how it is acquired and used.

Unlike physical money, virtual currencies are not recognised as legal tenders in most countries. This means merchants are not legally required to accept them as a valid form of payment.

Virtual currencies and taxation

Regulatory bodies have also started cracking down on virtual currencies and, depending on how they are used, the investor may be liable for tax.

For instance, the Australian Taxation Office (ATO) exempts cryptocurrencies worth up to $10,000 if the owner only uses it to pay for transactions. However, it is considered as property if acquired as an investment, which means capital gains tax (CGT) will be charged once the owner disposes of it.

If it is used in a business, the amount received will be subject to goods and services tax (GST). If the ‘business’ is mining bitcoins or other cryptocurrencies, their earnings will form part of their assessable income.

How do virtual currencies work?

Anyone can offer virtual currencies, so there can be hundreds or thousands of different digital currencies in circulation at any given time. However, each currency is usually designed to only hold a fixed number of ‘tokens’ in its lifetime.

These currencies are not regulated by central banks, rather, they exist in decentralised databases called blockchains that all users have access to, including the data stored into it. However, that doesn’t mean that the data is easy to acquire and reuse. The blockchain’s main use is to ensure that a user cannot cheat by using the same tokens for different transactions—similar to counterfeiting—because it acts as a public ledger of legitimate transactions.

Virtual currency owners have public and private keys to verify their transactions. The public key is recorded with every transaction while the private key is used by the sender to sign off or ‘legitimise’ the transaction.

Storing virtual currencies also require wallets. These wallets may be digital, such as wallets offered by exchanges, or in physical form, such as one’s hard drive or a secure hardware wallet. Most wallets simply secure private keys since this is the most important part of virtual currencies, but some can also store tokens.

Where to buy and trade virtual currencies

Virtual currencies may be purchased in cryptocurrency exchanges which require users to open an account and fund it with their local currency. The local currency injected to the account will then be used to buy the cryptocurrency. However, there are some exchanges which allow users to trade directly with other users.

In the case of Bitcoin—currently the most popular cryptocurrency—there are also special automated teller machines (ATMs) in 58 countries that allow people to purchase them.

Risks of investing in virtual currencies

Cryptocurrencies gained popularity in the past decade, especially after Bitcoin’s surge in value that some people have begun to purchase them as viable investments. However, these digital currencies can be complicated and potential investors must understand the risks before actually adding it to their portfolio.

These are the risks of investing in virtual currencies:

• No legal recourse
• No protection
• Hacker bait
• Extreme volatility

No legal recourse
Cryptocurrencies are not legitimate currencies issued by central banks and the exchanges. They are also traded in exchanges that are not regulated by the appropriate authorities, such as the Australian Securities and Investments Commission (ASIC).

This means that there is currently no legal support available for a virtual currency owner in case their cryptocurrency platform is compromised, their tokens are stolen or any dubious transactions take place.

No protection
Since cryptocurrency is not considered money and it is doesn’t come from authorised deposit-taking institutions (ADIs), owners do not have any insurance to fall back on if the exchange fails.

Hacker bait
Several instances of hacking in cryptocurrency exchanges in the past years have already cost virtual currency owners hundreds of thousands of dollars which they can never get back.

Likewise, if the owner keeps their private key in an online wallet or any device that is connected to the internet and is, therefore, hackable, they may not be able to track who stole their virtual money.

Extreme volatility
Depending on an investor’s risk tolerance, volatility can be a good or bad thing. However, virtual currencies can increase the risk of loss from volatility to the extremes because it is not backed by physical assets which could determine supply and demand—only the public’s speculation.

Consider Bitcoin’s performance from the fourth quarter of 2017 to the first quarter of 2018 as an example of how volatile virtual currencies can be.

On October 1, Bitcoin was trading for $5,569.26 and it continued to increase in value to $8,660.70 by November 1. It surged up to $25,410.04 by December 17. However, Bitcoin’s value fell to $17,823.22 on the last day of the year and the price continued to fluctuate until reaching its lowest value of $8,702.51 by February 5, 2018. By March 31, the popular cryptocurrency is trading at $9,055.05.

Are virtual currencies a good investment?

Virtual currencies can be a good investment depending on how high the investor’s risk tolerance is and how well they can safeguard their private key.

Many experts discourage investing in cryptocurrencies because it is not secured against physical assets, but that doesn’t mean a knowledgeable investor cannot earn big from them.

Like all investments, it’s best to understand how it works and what risks are involved first. If the investor cannot decide, speaking with a licensed financial expert is highly recommended.

This information has been sourced from the Australian Taxation Office, Crowe Horwath Australasia and XE.

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Learn the best strategies in investing and options like cryptocurrency, bonds, mutual funds, property and stock market." ["secure"]=> int(0) ["page_description"]=> string(7) "nestegg" ["page_rights"]=> NULL ["robots"]=> NULL ["access-view"]=> bool(true) } ["initialized":protected]=> bool(true) ["separator"]=> string(1) "." } ["displayDate"]=> string(19) "2018-05-04 07:52:55" ["slug"]=> string(36) "11928:basic-guide-virtual-currencies" ["parent_slug"]=> string(16) "284:invest-money" ["catslug"]=> string(11) "294:bitcoin" ["event"]=> object(stdClass)#2691 (3) { ["afterDisplayTitle"]=> string(0) "" ["beforeDisplayContent"]=> string(417) "" ["afterDisplayContent"]=> string(0) "" } ["text"]=> string(268) "

The market capitalisation of virtual currencies surged over a thousandfold since Bitcoin’s inception in 2009, but despite its popularity, not many understand what it’s all about. Here’s a basic guide to digital monies to better understand how they work.

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Central banks need to prepare for action in the face of the “combination of a bubble, a Ponzi scheme and an environmental disaster” that is bitcoin.

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That’s the indictment given by the Bank for International Settlements (BIS) general manager, Agustín Carstens. Speaking at the Goethe University House of Finance in Frankfurt, he added that bitcoin’s volatility means it’s a “poor means of payment and a crazy way to store value”.

In a lecture made this week, he said: “To the extent they are used, bitcoins and their cousins seem more attractive to those who want to make transactions in the black or illegal economy, rather than everyday transactions.

“In a way, this should not be surprising, since individuals who massively evade taxes or launder money are the ones who are willing to live with cryptocurrencies’ extreme price volatility.”

Echoing the Reserve Bank of Australia’s governor Philip Lowe, he said the current “fascination” with the cryptocurrency reflects a “speculative mania” more than any interest in its uses as a means of exchange.

Mr Carstens’ criticisms are nothing particularly new in the sector, although it is one of the stronger slams. In the last few months, Australian researchers have argued that between 43 and 49 per cent of all bitcoin transactions can be linked to the buying and selling of illegal goods, while others have warned of the amount of energy bitcoin mining consumes.  

Multiple analysts, economist and researchers have called bitcoin a bubble.

However, Mr Carstens’ criticisms have added weight as BIS’ capital is held by central banks only.

Noting that authorities are already moving towards cracking down on cryptocurrencies, he said: “There is a strong case for policy intervention.

“As now noted by many securities markets and regulatory and supervisory agencies, these assets can raise concerns related to consumer and investor protection. Appropriate authorities have a duty to educate and protect investors and consumers, and need to be prepared to act.”

He said central banks have a duty to safeguard money’s real value and as such need to protect payment systems.

Bitcoin is not yet autonomous as a means of payment, he continued, highlighting that it “relies on the oxygen” that trading apps which link users to conventional bank accounts provide.

“If the only “business case” is use for illicit or illegal transactions, central banks cannot allow such tokens to rely on much of the same institutional infrastructure that serves the overall financial system and freeload on the trust that it provides.”

Mr Carstens said that while cryptocurrencies “may pretend to be currencies”, they don’t align with basic definitions – a sentiment expressed by the deputy governor of the Swedish Central Bank, Cecilia Skingsley at the World Economic Forum’s Davos meeting in January.

Blasting them as also defying “lessons from theory and experiences” and unlikely to be trusted as sustainable forms of money, he said central banks need to be ready to step in if necessary.

“Cryptocurrencies piggyback on the 10/10 institutional infrastructure that serves the wider financial system, gaining a semblance of legitimacy from their links to it. This clearly falls under central banks’ area of responsibility.

“The buck stops here. But the buck also starts here. Credible money will continue to arise from central bank decisions, taken in the light of day and in the public interest,” he concluded.

Investors should embrace regulation

According to Melbourne law firm KHQ Lawyers' Darren Sommers, impending regulation should be welcomed by cryptoinvestors. 

Speaking today, he said that a lack of regulation had enticed the more gung-ho investors to put money into crypto, in spite of the risk involved and that regulation would work to reduce risk with diminishing potential returns. 

He said: "Cryptocurrency has become something akin to new Wild West of investment markets – it’s practically lawless and everyone is risking it all trying to cash in.

“It’s scary how many people I’ve heard of who see a lack of regulation as an incentive, whereas it should be the opposite. The massive ups and downs bitcoin has experienced recently is surely enough to warrant legal certainty.

“Make no mistake, regulation is coming and the authorities won’t hesitate in making an example out of someone when that time comes."

Investors should prepare for upcoming regulation by doing their homework and working out how and what they are willing to invest in, he said. 

Apollo Capital's chief investment officer, Henrik Andersson repeated the sentiments, saying that his firm welcomed regulation as it would make the cryptosphere more appetising to institutional investors. 

“At the moment digital is the domain of risk takers and day traders. But institutional investors like super funds and trusts have a cascade effect so if they enter the digital market the benefit is shared and more people win,” Mr Andersson said.

“Certainly, that would indicate greater regulation is a good thing."

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Learn the best strategies in investing and options like cryptocurrency, bonds, mutual funds, property and stock market." ["secure"]=> int(0) ["page_description"]=> string(7) "nestegg" ["page_rights"]=> NULL ["robots"]=> NULL ["access-view"]=> bool(true) } ["initialized":protected]=> bool(true) ["separator"]=> string(1) "." } ["displayDate"]=> string(19) "2018-02-08 00:00:56" ["slug"]=> string(48) "11466:bubble-ponzi-scheme-environmental-disaster" ["parent_slug"]=> string(16) "284:invest-money" ["catslug"]=> string(11) "294:bitcoin" ["event"]=> object(stdClass)#2693 (3) { ["afterDisplayTitle"]=> string(0) "" ["beforeDisplayContent"]=> string(417) "" ["afterDisplayContent"]=> string(0) "" } ["text"]=> string(161) "

Central banks need to prepare for action in the face of the “combination of a bubble, a Ponzi scheme and an environmental disaster” that is bitcoin.

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Like the first pancake in a batch, bitcoin got the crypto ball rolling, but will probably end up in the bin.  

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That’s according to CMC Markets’ Australian chief market strategist, Michael McCarthy. Speaking to Nest Egg, Mr McCarthy explained that the crypto-sphere is experiencing something similar to the dotcom bubble.

That is, it’s uncertain which technologies or cryptocurrencies will survive, so investors are “buying everything”.

However: “It's almost certain that if a cryptocurrency becomes one of the biggest currencies' in the world, it will not be bitcoin.

“One of them [the cryptocurrencies] could do. If it does, it's going to be worth a lot more than it is even at its peak, worth a lot more than it is today.”

Alternatively, should someone discover how to “crack the cryptography” all currencies would be worth nothing.

“We don't know which of those two scenarios is more likely even, so it's a difficult call,” Mr McCarthy said.

“And that's why I say it's very much high risk, potentially high reward, but because of that uncertainty about the future, it's just like the dotcom bubble. Nobody knew, but everybody wanted to get involved.”

Regardless, he says the one thing that is certain is that if a cryptocurrency does take off; “It can’t be bitcoin. We know that much.”

He says bitcoin’s algorithm is now too slow and its payment processing lag is also too slow. That means that the current and future innovations in the crypto-sphere will leave it behind.

He referenced ivyKoin, which hopes to aid in the transparency of transactions of more than $10,000. As Nest Egg reported yesterday, ivyKoin said it will challenge whether the anonymity behind cryptocurrencies and the blockchain is the best thing for businesses and consumers.

The currency’s chief technology officer, Michael Beck said the anonymity of transactions was the biggest hurdle for crypto’s mainstream adoption.

“This issue is limiting businesses to realise the potential of using cryptocurrencies in cost savings, speed and convenience,” Mr Beck continued.

“With ivyKoin, we’re giving business owners and financial institutions that rely on bank-based transactions a level of certainty and trust for moving, storing and transacting with cryptocurrencies.”

Noting this particular currency, Mr McCarthy said: “There's a lot of room for innovation in digital currencies.

“There's a lot of potential in digital currencies that might mean that one day they will replace conventional currencies, but we're a long way from that, and my view would be that none of the existing coins could do that at this stage.”

He argued that the current “explosion” of cryptocurrencies mirrors the way most industries start – a preponderance of offerings followed by a sharp reduction.

According to coin ranking service, CoinMarketCap, there are 1,508 different cryptocurrencies.

Mr McCarthy commented: “In June last year, it was estimated there were just over 900. By September that had grown to 1,000. We're now at more than 1,300, so although we hear a lot about bitcoin, ethereum, and ripple or bitcoin cash, or whatever, there are literally hundreds of them out there.

“So… it’s exploding. And that is the way most existing industries started. I think it was in 1950, there were 62 car manufacturers in the US. Now, there are four.”

“I think we're at the enormous expansions phase, and that suggests there is something here that will last. But the majority of the current won't.”

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Like the first pancake in a batch, bitcoin got the crypto ball rolling, but will probably end up in the bin.  

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Fast food giant KFC's Canadian operations have joined the growing list of businesses to begin accepting online payments using bitcoin.

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“KFC Canada presents the Bitcoin Bucket. Sure, we don’t know exactly what bitcoins are, or how they work, but that shouldn’t come between you and some finger lickin’ good chicken,” the company announced on its social media pages recently.

 The fried chicken giant has created a dedicated web page to track the volatile currency’s price and allow for the online purchase of the special meal deal, which includes 10 original recipe tenders, waffle fries, a medium side, medium gravy and two dips.

Despite reportedly generating considerable interest (the offer was sold out when My Business visited the site), the company insists the move is a promotional one only and is being offered only within Canada.

“The Bitcoin Bucket is a limited-time offer,” the website states, adding: “We can only accept purchases within Canada. Apologies, rest of the world.”

My Business has sought comment from KFC Australia about whether it plans to follow suit. It’s demonstrating growing business interest in joining the bitcoin bandwagon and allowing cryptocurrencies to be used to make online purchases.

 
While bitcoin is just one of many cryptocurrencies (or digital currencies) on the open market, it is arguably the most well known. In late 2017, its value soared well over $20,000; however, at the time of writing, one bitcoin was trading at just under $17,335.

As previously reported, bitcoin has even been accepted for residential property sales in Australia.

It comes despite tech entrepreneur and Shark Tank judge Steve Baxter telling Nest Egg's sister site, My Business last year that blockchain — the technology behind bitcoin — is the “most overhyped” technology he has come across in his career as an investor.

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Fast food giant KFC's Canadian operations have joined the growing list of businesses to begin accepting online payments using bitcoin.

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Human error has meant that while bitcoin is secure, it's not "perfectly secure", a cybersecurity expert has said, warning that with every development comes a unique set of challenges.

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As such, it's crucial that users remember that bitcoin is an "experimental currency", the managing director at Kamino and Midwinter, Julian Plummer told Nest Egg. 

Speaking in a recent Q and A with Nest Egg, he said new entrants to the bitcoin market should consider encrypting and backing up their wallets, making copies of the backup and placing the copies in different places.

"It is also a good idea to not put all your eggs in the one basket and keep your bitcoins [spread] across different wallets," he advised.

Here's what else Mr Plummer had to say:

Nest Egg: What are the most important things bitcoin novices should know about bitcoin security?

Julian Plummer: The main thing to keep in mind is that bitcoin is secure, but it is not perfectly secure.

The building blocks of bitcoin are made up using encryption, and it is the encryption itself that helps make bitcoin a secure currency. The recent events of the #intelbug has shown us that even the smartest people in the room create bugs and nothing (not even computer chips!) is immune to bugs. With bugs come vulnerabilities and new opportunities for hackers to take advantage of.

It is important to remember that bitcoin is an experimental currency which is in constant active development by software engineers. While each new development in bitcoin makes it more appealing, each release comes with its own set of challenges. This may result in increased bitcoin fees over time, slower transaction confirmations, or any number of new security issues.

Ensuring that your wallet is secure is key – this is your responsibility and you should adopt best practices if you want to hold on to your bitcoin. If you are storing your bitcoin online, undertake due diligence on the exchange or online wallet service. Keep in mind that there have been a number of high profile cases of security breached of bitcoin exchanges and online wallets. If your bitcoins have been hacked, there is no getting them back, and certainly no 1300 support number to talk to a friendly customer representative for assistance.

NE: How have these concerns changed over time? What do you see as emerging areas to be aware of?

JP: The history of bitcoin has been plagued with human error, poorly implemented software and bugs that would make even the most hardened software developer throw away his diet coke in disgust.

Known bitcoin issues are categorised as ”might be a problem”, “probably not a problem” and “definitely not a problem” and this speaks volumes for the nature of concerns with bitcoin.

Bitcoin is a man-made, open-source software – and so as software issues come and go, so do security concerns.

Some high profile concerns include the “51 per cent attack”, where if a hacker (or country) controls more than 50 per cent of the bitcoin network's computing power which allows them to modify the ordering of transactions slowing them to double-spend transactions. It is interesting to note that the world’s biggest bitcoin miner is Beijing-based and controls nearly 30 per cent of all the processing power devoted to bitcoin mining. So that’s going to be an impending problem.

Another looming threat is the rise of quantum computing. Traditional computers must solve complex mathematical problems in order to “mine” bitcoins. The massive calculating power of quantum computers will soon be able to break bitcoin security.

Bitcoins have two security features that guard them from being copied or stolen or copied. This is done using cryptographic protocols that are hard to crack for an ordinary classical computer. The problem is that those quantum computers find those same cryptographic protocols easy to crack – blowing holes in the bedrock of bitcoin’s security. This is a clear and present danger for bitcoin with researchers investing possible workarounds to this.

NE: How does bitcoin security and hacker scrutiny compare to that of other cryptocurrencies?

JP: Even with some of the hiccups that bitcoin has experienced over the years, it is still a very strong currency candidate against the other “alt coins”. bitcoin has been growing without major security failures for eight years now and has undergone far more “road testing” than its significantly younger competitor coins.

In regards to the many of the other “alt coins”, it could be argued that some of their creators act like benevolent dictators over the alt coin community and can bend its rules as they see fit. This introduces further uncertainty and risk into the alt-coin value proposition.

NE: Is there anything you'd like to add, or anything you think is important to note?

JP: It seems to me that the success of bitcoin has been a pyrrhic victory. The increased interest in bitcoin has led to wild fluctuations in its value – which is far from ideal for a budding currency disruptor. These wild fluctuations have led to Microsoft and Steam dropping bitcoin as a payment method.

Steam wrote in its December statement that they “will no longer support bitcoin as a payment method on our platform due to high fees and volatility in the value. These fees result in unreasonably high costs for purchasing games when paying with bitcoin.

The high transaction fees cause even greater problems when the value of bitcoin itself drops dramatically.”

The core purpose of bitcoin is for it to be a “store of value”, and according to Microsoft it is no longer fit for purpose.

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Human error has meant that while bitcoin is secure, it's not "perfectly secure", a cybersecurity expert has said, warning that with every development comes a unique set of challenges.

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At the height of the Brexit debate, politician Michael Gove said Britain had “had enough of experts”. According to an economist, bitcoin has been fuelled by the same sentiment.

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Chief economist at ABC Bullion, Jordan Eliseo told Nest Egg that while the story of bitcoin’s rise can be largely explained by the appeal of blockchain and bitcoin’s exponential increase in value, bitcoin’s rise can also be told as a story of trust or lack of it.

“I think one of the reasons that people are so willing to ignore the warnings of financial market commentators, including myself, who have said, ‘Look, people need to be cautious about chasing bitcoin and putting all their money in cryptocurrency,’ is that it's just a fact that all across the western world, people’s trust in institutions, in government, in financial markets, commentators, mainstream economists, you name it, has declined substantially.

“And that's more or less a 10-year story that goes back to the start of the global financial crisis and has continued ever since.”

He said this mistrust is also playing out in politics, as populist policies like Brexit and politicians like Donald Trump gain favour.

Continuing, the economist argued that there’s “no conceivable way” those political developments would have happened 10 years ago.

Additionally: “With the onset of the GFC, [and] with everything that's happened since, there is no surprise that there is a greater element of distrust.

“If you look at wealth and equality now, it is back to the levels that we last saw prior to the onset of the great depression.”

Bearing in mind the argument that bitcoin was fuelled by mistrust for mainstream institutions, Mr Eliseo warned that chasing Bitcoin is “incredibly risky”. The same goes for any other cryptocurrency, he added.

However, he conceded that bitcoin is an attractive proposition.

“If you look all around the world, half of them [interest rates around the world] are near zero in real terms; money has been printed religiously in the last 10 years.

“So more and more people every day are saying, "Well, look, I don't trust the RBA or the Federal Reserve,” or, “I'm not comfortable leaving my money in a regular bank account,” or, “I'm not comfortable leaving all of my money in a regular bank account," so bitcoin looks like it could be an answer.”

Then, once the price reaches the heights it has, “it ends up becoming self-reinforcing” and even more attractive as potential buyers hear stories of someone making hundreds of thousands of dollars.

Whether the activity constitutes a bubble is another question. Mr Eliseo contends that even if it is a bubble, bitcoin is “in very good company”.

Noting that less than 1 per cent of Australians own bitcoin, and as such the impacts of a crash would be localised, Mr Eliseo warned that the impact of a housing or stock market crash – both possibilities, in his opinion – would have much wider ramifications.

“These things are going to cause much bigger damage and it should be of far greater concern to actual market commentators, to everyday investors, you name it.”

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At the height of the Brexit debate, politician Michael Gove said Britain had “had enough of experts”. According to an economist, bitcoin has been fuelled by the same sentiment.

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