Bitcoin and other cryptocurrencies
A lot of cryptocurrencies, such as Bitcoin, Ethereum, Litecoin and Ripple, have emerged over the last 10 years and have become popular investments, but how safe are they?
Here we explain what cryptocurrencies are and the risks involved with trading or investing in them.
Cryptocurrencies, also known as virtual currencies or digital currencies, are a form of electronic money. They do not physically exist as coins or notes. A cryptocurrency unit, such as a bitcoin or ether, is a digital token created from code using an encrypted string of data blocks, known as a blockchain. There are usually only a fixed number of digital currency tokens available.
Cryptocurrencies are not only used as payment systems but can also be used to execute contracts and run programs. Anyone can create a digital currency, so at any given time there can be hundreds, or even thousands, of cryptocurrencies in circulation.
Virtual currencies can be bought or sold on an exchange platform using conventional money. Some popular digital currencies, like Bitcoin can be bought or sold for cash through special ATMs.
Digital currencies use blockchain technology. A blockchain is simply a decentralised database that all users share. There is no central server and nobody owns the data but everyone in the blockchain has access to all the data in the blockchain.
Users earn or create blocks (units) in a digital currency by solving complex cryptographic puzzles and verifying transactions, also known as mining. This is a difficult process that requires significant computing power. Blocks are then added to a blockchain where they can be used for electronic peer-to-peer payments. The blockchain tracks ownership of each currency unit and holds a history of every transaction ever made on the blockchain.
Cryptocurrencies are kept in a digital wallet and can be used to pay for actual goods and services from any person willing to accept them as payment. However, they are not legal tender and may not be accepted in many places. Digital currency payments are made online, but some merchants can accept payments in store using mobile devices. Cryptocurrency networks generally have no or low transaction fees.
Popular with criminals
The relatively anonymous nature of digital currencies has made them very attractive to criminals, who may use them for money laundering and other illegal activities. Digital currencies are a popular choice of payment for transactions conducted on the dark web.
Each cryptocurrency has different capabilities depending on the purpose for which it was developed. Although digital currencies have been traded for profit, most were not created as investment vehicles.
Bitcoin is primarily a digital currency. Users in the Bitcoin network, known as bitcoin miners, use computer-intensive software to validate transactions that pass through the network, earning new bitcoins in the process. Bitcoin was developed as a decentralised global payment system; however, it has also been bought and sold in large volumes as a speculative investment.
Ethereum uses blockchain technology to run an open software platform. It can process transactions, contracts and run other programs, which allow developers to create and run any program, in any programming language, on a single decentralised platform.
In the Ethereum blockchain, miners work to earn ether, which is the crypto token that drives the network. Ether can also be used to pay for fees and services within the network.
Litecoin, like Bitcoin, was created as an electronic payment system; however, transactions on the Litecoin network are processed faster and there are more litecoins in circulation than there are bitcoins. Some users see Litecoin as a ‘lighter’ version of, or backup for, Bitcoin.
Ripple is a transaction protocol designed to complement Bitcoin by allowing real-time transfers between users in any currency. It is a database in which users can store and transfer value in any currency, including other cryptocurrencies, on a protected network.
Ripple uses tokens that were created by the developers, rather than mined or earned like other digital currencies. Some users don’t see Ripple as a true cryptocurrency, but the technology has been popular with financial institutions.
The exchange platforms on which you buy and sell digital currencies are not regulated, so if the platform fails or is hacked, you will not be protected and will have no legal recourse. Cryptocurrency failures in the past have lost investors significant amounts of real money. In most countries cryptocurrencies are not recognised as legal tender and are only regulated to the extent that they fit within existing laws, such as tax laws.
A cryptocurrency is not guaranteed by any bank or government. Its value is based on its popularity at a given time, which is influenced by factors such as the number of people using it, the ease with which it can be traded or used and the perceived value of the currency and its underlying blockchain technology. Investing in virtual currencies is considered highly speculative, as values can fluctuate significantly over short periods of time.
Your money could be stolen
Just as your real wallet can be stolen by a thief, the contents of your digital wallet can be stolen by a computer hacker.
Your digital wallet has a public key and a private key, like a password or a PIN. However, digital currency systems allow users to remain relatively anonymous and there is no central data bank. If hackers steal your digital currency you have little hope of getting it back.
You also have no protection against unauthorised or incorrect debits from your digital wallet.
If the cost of your digital currency is less than $10,000 and you are only using it to pay for personal goods or services, it is not taxed. However, according to the Australian Taxation Office (ATO), if you are using virtual currencies, such as bitcoins, for other purposes, you will be taxed. Here is an outline of the ATO’s proposed tax treatment of crypto-currencies:
- Investment – If you hold digital currencies as an investment you will pay capital gains tax on any profits when you sell them.
- Trading – If you trade virtual currencies for profit, the profits will form part of your assessable income.
- Carrying on a business – If you use cryptocurrencies to pay for (or accept them as payment for) goods or services, the transactions will be subject to goods and services tax (GST).
- Mining bitcoin – If you are mining bitcoins or other digital currencies, any profits you make will be included in your assessable income.
- Conducting an exchange – If you are buying and selling cryptocurrencies as an exchange service you will pay income tax on the profits and transactions will be subject to GST.
For more information see the ATO’s webpage on the tax treatment of cryptocurrencies in Australia.
If you decide to trade or use virtual currencies you are taking on a lot of risk with no recourse if things go wrong.