Cryptocurrency FAQs
By: Financial Hotline
Fall 2021 (Vol. 39, No. 3)
This article is intended for educational purposes only and should not be construed as investment advice.
Q: What is the difference between fiat money and cryptocurrency?
A: fiat currency is money that is not backed by a physical commodity like gold, but instead backed by the government that issued it. Examples include the U.S. dollar, the British pound, the Indian rupee, and the euro.
Cryptocurrency, also known as virtual currency, is defined as a digital representation of value that functions as a medium of exchange. For some, that definition seems more confusing. But, in general, we are familiar with many forms of exchange. Our ancestors used a variety of different commodities - from salt and animal skins to gold nuggets - as a form of payment. Cryptocurrency is an alternative form of payment that can be exchanged online for goods and services. You still need legal currency to buy the coins but then you can use them in different areas where they are accepted.
Q: How does cryptocurrency work?
A: Most cryptocurrencies operate using a technology called blockchain. Blockchain is a decentralized technology spread across many computers that manages and records transactions. Digital assets are distributed instead of copied or transferred, creating an irreversible record of an asset. That means everyone can see what’s happening, all the time. The main difference is you can’t just login to your local bank and get an overview of every transaction that has transpired there since they opened but you can access this information with most cryptocurrencies. Investors value this transparency as it creates trust in the asset.
Q: What is an “Altcoin”?
A: Any cryptocurrency that isn’t Bitcoin, is referred to as an altcoin. Altcoins currently account for nearly 60% of the total cryptocurrency market, with more than 12,000 cryptocurrencies and counting. The basic principles are similar to Bitcoin but there are also variations that distinguish them.
Altcoins have created a market for themselves. Investors are attracted to the hope that their choice is the next best alternative. Some altcoins fall into several categories but here’s a few possibilities:
Mining based coins are mined into existence. Most use Proof-of-Work (PoW), whereby systems generate new coins by solving difficult problems, to create blocks. Examples include Litecoin (LTCUSD), Monero (XMRUSD), and Zcash (ZECUSD). There are also pre-mined coins such as Ripple’s XRP (XRPUSD). These coins are not produced through an algorithm but are distributed before they are listed in cryptocurrency markets.
Stablecoins peg their value to a basket of goods, such as fiat currencies, precious metals, or other cryptocurrencies. In other words, they are backed by collateral. True to their name, these coins don’t usually see big price fluctuations. Examples include USDC and MakerDAO.
Security tokens are digital, liquid contracts for fractions of any asset that already has value, like real estate, a car, or corporate stock. The tokens give you part of an ownership stake and some pay dividends. They are generally offered to investors through initial coin offerings (ICOs).
Meme coins are inspired heavily by social media and are usually a spoof of well-known cryptocurrencies. They typically gain popularity in a short period of time, often hyped online by prominent crypto influencers and retail investors attempting to exploit short-term gains.
Utility tokens are used to provide services within a specific network. In the brick-and-mortar world, it would be similar to buying a Starbucks gift card or a public transportation pass. You can use the token the same as cash but only when buying products or services from the issuer.
Q: I read that cryptocurrency transactions are anonymous so how can that be transparent?
A: The blockchain is public list of every cryptocurrency transaction — both the payment and receipt sides. Depending on the cryptocurrency, the information added to the blockchain can include details like the transaction amount and the sender’s and recipient’s wallet addresses. A wallet address is a long string of numbers and letters linked to your digital wallet. Even though you can use a fake name to register your digital wallet, it’s possible to use transaction and wallet information to identify the people involved in a specific transaction. And when you buy something from a seller who collects other information about you, like a shipping address, that information can be used to identify you later on.
Q: What does ‘decentralized’ mean?
A: Simply put, it means that no single person or group has control—rather, all users collectively retain control. The big difference is delegation of duties. In a centralized environment, the top tier makes the decisions. Examples include the U.S. Military where orders come from the top. A big corporation like Apple or a mom-and-pop shop would normally have an owner or small group shouldering the brunt of the responsibilities. By comparison, decentralized management allows more flexibility for decisions to be made at lower levels. A franchise like Subway, for instance delegates more responsibilities to individual owners or managers.
Q: How does cryptocurrency get value?
A: Not all cryptocurrency is the same so it’s hard to give a catch all answer. For instance, Bitcoin and Ether (ETH; the digital coin of a leading blockchain called Ethereum) increases or decreases in value as a result of supply and demand. The value of any currency form is largely propelled by its scarcity or rarity. For example, if gold was as plentiful as sand, it would hold about the same value. Another component of value is security and whether it can be easily counterfeited. In terms of the stablecoins or security coins, the value also depends on the collateral or the asset it’s tied to. The more ways the cryptocurrency can be can also increase value. More retailers are normalizing cryptocurrency payments, and El Salvador recently became the first country in the world to make the cryptocurrency Bitcoin legal tender for all payments.
Q: Are cryptocurrency accounts protected by FDIC like other financial institutions?
A: No. Cryptocurrency accounts are not backed by any government therefore, cryptocurrency accounts are not insured like U.S. dollars deposited into a bank account. If you store cryptocurrency with a third- party company, and the company goes out of business or is hacked, the government has no obligation to step in and help get your money back. You may see some companies that claim they are FDIC insured but read those guarantees closely. The FDIC assurance is only for the US dollars you have deposited with them, not for the cryptocurrency.
Q: How does the IRS treat cryptocurrency?
A: Virtual currency is treated as property and general tax principles applicable to property transactions apply to transactions using virtual currency. If you held the virtual currency for one year or less before selling or exchanging the virtual currency, then you will have a short-term capital gain or loss. If you held the virtual currency for more than one year before selling or exchanging it, then you will have a long-term capital gain or loss. The period during which you held the virtual currency (known as the “holding period”) begins on the day after you acquired the virtual currency and ends on the day you sell or exchange the virtual currency. For more information on short-term and long-term capital gains and losses, see Publication 544, Sales and Other Dispositions of Assets.
Q: The IRS Form 1040 asks whether at any time during the year, I received, sold, sent, exchanged, or otherwise acquired any financial interest in any virtual currency. During 2020, I purchased virtual currency with real currency and had no other virtual currency transactions during the year. Must I answer yes to the Form 1040 question?
A: No. If your only transactions involving virtual currency were purchases of virtual currency with real currency, you are not required to answer yes to the Form 1040 question.