BITCOIN – Demystified (a bit)

Bitcoins have been around since 2008. But headlines were made when a single Bitcoin traded for more than $19,300 this past December. As recently as three years ago, the price was $130. The value of Bitcoins in circulation is now more than $250 billion though that number may have plunged or soared by the time you read this.

Though the stock market run-up in the first weeks of the New Year has briefly eclipsed Bitcoin mania, digital currency speculation isn’t going away any time soon. In the past six months, I’ve been approached three times in my practice with questions on digital currency: one concerning Bitcoin ATMs, another about mining Bitcoins, and the third involved participating in an ICO (initial coin offering – yup that’s the term). In 2017 alone, there were 235 ICO’s worth billions of dollars themselves. Many have not been used for anything other than speculative trading. Here are some fast facts and short explanations about digital currency to make you semi-literate.
Bitcoin is a digital currency. The point of digital currency is to allow any two strangers to transact business confidently and anonymously with each other using cryptography instead of relying on trust, governments, and financial systems. Bitcoin is just the most famous digital currency. Others, you may have heard of are Ethereum, ZCash, Litecoin, and the newest headliner, Ripple. Ripple’s co-founder, Chris Larsen, briefly passed Mark Zuckerberg as the fifth richest person in the world as his Ripple holdings soared to $59 billion on gains of more than 30,000% (not a typo) in the last year.

What makes a digital currency (also called “virtual currency”) secure is the recordkeeping associated with each unit (termed “coin” or “token”) or fractional unit detailing all the transactions in which the Bitcoin has been involved. Imagine a digital coin as an email that gets replied to and forwarded numerous times. In effect, the replies and forwards are transactions and the email thread (the Bitcoin) is the record of all the transactions from now to the beginning. Each thread will be unique because no two long email threads are identical. The long email thread in the world of digital transactions is known as a blockchain. It’s roughly equivalent to the history of a real estate deed, but in digital form and with many, many more buyers and sellers in the ownership chain. Think how many times a single paper dollar is handled. Like cash transactions, digital currency and its “To’s” and “From’s” are anonymous. What’s verified is the fact the transactions occurred not who participated.

Now imagine if the email thread (Bitcoin) was encrypted using highly complex mathematical formulas. In order to forward it (use it to pay for something) once you’ve received it, the email thread has to be decoded. Encrypting and decrypting a digital coin’s blockchain verifies the owner is paying with “real”, legitimately owned Bitcoins. Decrypting blockchains is known as mining. Miners use computers, sometimes many laptops networked via the internet in a process known as distributive computing, to decrypt blockchains. Miners are paid in Bitcoins. The more Bitcoins and fractions of Bitcoins in a transaction, the more effort. Depending on the cost and labor of the computing and the fluctuating price of the digital currency, mining can be quite profitable. Each Bitcoin has two keys (think long strings of numbers, letters, and symbols). The private key held by the Bitcoin owner verifies current ownership. The public key verifies the legitimacy of the transaction when the blockchain is unlocked via mining. Be careful with those private keys. Loose the private key, and you just vaporized $16,502.01 (current price as of 1/4/18) times however many Bitcoins you had. Leave it on the counter at Starbucks and you just gave a stranger that amount. No refunds, no recourse, no exceptions.

Why the wildly fluctuating prices? The number of Bitcoins in circulation is limited. Simple supply and demand pricing from there follows as with any commodity. What drives the mania and general goofiness is the fact that the amount of digital currency in circulation and the “creation” of Bitcoins are based on a mathematical formula and the calculated number of solutions to that formula – 21 million. Miners solve the encryption which verifies transactions, but they can also determine a new solution to the formula creating a new Bitcoin. Both activities are called mining, and miners are paid for both in Bitcoins. Currently, around 17 million Bitcoins have been created. The speed of Bitcoin creation is governed by the number of miners, the amount of computing capacity, the expense of running that capacity, and the Bitcoin payment to miners which decreases over time at a preset rate. Since we’re getting to the end of the number of Bitcoins that can be created, a bit of “goldrush fever” is occurring. This excitement is accelerating all of the variables that impact mining. What happens when all the Bitcoins are mined? Who knows? What we do know is the fear of missing out (now known as “FOMO”) is part of the phenomenon driving the wildly soaring and plunging prices.

Currently, each Bitcoin has 100 million subunits (compared to each dollar which has 100 subunits, or cents). There’s nothing to stop further subdivisions as there is no central authority. All that has to occur is for enough holders of enough Bitcoins to agree on what to honor. So just like any commodity, people can attempt to hoard or otherwise manipulate the prices. China and Russia are heavily involved in or sponsoring mining. Uncertainty in commodities drives price fluctuation, just like a “bomb cyclone” hitting Florida affects the price of orange juice. Just last week, South Korea which is the world’s largest trader of Bitcoin on a country basis, issue conflict reports as to whether it was planning to ban trading in cryptocurrencies. This sent Bitcoin plummeting 32% from its recent high. China

The financial world is going the way of blockchains. The concepts are here to stay. But when will Bitcoins make sense for you or your business? For your business, very hard to say. For you personally? That depends on your risk tolerance and your financial plan. If you need to speak with someone knowledgeable, let us know. We know a great many financial planners and wealth managers and can help you select one for your family’s specific situation.

Here are some things to think about when pondering whether to get involved in digital currency:

  • Practical. A safe deposit box for the physical copy of the private key is a must. And mention it in your will. Talk to your estate planning attorney. Don’t have one? Ask us. • Use. Bitcoins can be used to purchase goods or services. These businesses accept Bitcoins: PayPal, Expedia, Dell, Overstock.com, The United Way. Should you? You need to consider the regulatory environment. Those listed are not small enterprises. Will use become widespread in the future and will any of us live to see it? Don’t bet against either. But be very careful in placing bets on either as well.
  • Evolution. This stuff is changing fast. Some newer currencies don’t use mining and are controlled by a central authority, though the authority is a company instead of a government. This fast evolution lends itself to fads. Buying and selling fads was what “Tulip Mania”, the first great economic bubble (circa 1630’s) was all about. Fast forward to Pets.com’s collapse signaling the beginning of the internet stock bubble bursting. Hard to say some of these elements don’t exist with digital currencies.
  • Anonymity. First, carefully consider why you feel you need to be anonymous. Discuss that with your lawyer. Second, nothing including digital currency is truly anonymous. This is the real world. In November, Coinbase, the largest cryptocurrency exchange in the U.S. (#4 in the world), just coughed up records to the IRS on over 14,000 account holders.
  • Buyer Beware. We’re just on the leading edge of the frontier of digital currency. The phrase “the wild west” comes to mind and is accurate. While there was great opportunity for those who braved the wild west frontier, there were also great dangers. Highway robbery, scalping, and snake oil medicine are phrases that also apply to this new cryptocurrency world. Consider points made in a recent public statement by the chairman of the SEC:
    • Digital currencies are extremely volatile. Prices can drop more than 50% in a single day.
    • Transactions are designed to be extremely difficult if not impossible to trace. You will likely have no recourse for fraud or theft. Hacking and counterfeiting are possible.
    • Much of what goes on with digital currencies occurs internationally. Good luck with enforcing any of your perceived rights overseas.
    • With no government backing, no central rule maker, and no intrinsic value (orange juice can be drunk, pork bellies can be fried), the value of any digital currency is entirely speculative for all that financial and nonfinancial meaning.
    • As of today, ICOs are completely unregulated. Some ICOs may be legit and deliver real value. But no regulation means beware of:
      • Guaranteed or “too good to be true” returns
      • High pressure sales
      • Unsound business plans and unaudited financial statements
      • Commission based sellers of the ICO
      • Potential Ponzi schemes where your investment is used to pay earlier investors
      • No regulation means private lawsuits if you’re defrauded or otherwise mistreated
  • Regulation. There currently is not much order to the world of digital currency, but you’d better believe it’s coming. Various authorities and bureaucracies are weighing in and competing for control. My bet is on the CFTC (Commodities Futures Trading Commission) because these things trade like commodities (oil, corn, pork bellies). It’s one thing to regulate the currencies and the ICO’s, but there are currently 127 digital currency exchanges that facilitate both basic currency use as well as speculation. No government agency is regulating these exchanges at present despite instances of hacking, errors, outages, and outright collapses. It’s the wild west right now, but things are going to get very complicated and very expensive very quickly.
  • Criminal Risk. The most ominous current regulatory risk is the heavy interest and watchful eye of FinCEN, a U.S. Treasury Dept. group otherwise known as the Financial Crimes Enforcement Network. Think money laundering and jail time. The Bank Secrecy Act has a whole section on Anti-Money Laundering laws and regulations that impact digital currency. Authorities hate anything that helps hide financial transactions for a whole host of reasons: tax evasion, drugs, terrorism, etc. Russia and Venezuela have plans to use digital currencies to evade sanctions. China and North Korea can’t be far behind. If you’re going to do anything with digital currency right now, make sure you’re on the right side of the law and regulations.Taxes. Bitcoins are taxed like property according to the IRS. So, keeping track of your cost and holding period for each individual Bitcoin and fraction is important in order to accurately calculate your gain (profit) and minimize your taxes. Note that capital gain treatment is available for individuals, but not for those dealing in Bitcoins as a business. A question for your tax advisor. And include Bitcoins in your estate planning like any other asset. Also, transacting in Bitcoins can trigger Form 1099 reporting responsibilities.
  • Understanding. This stuff is new and complicated. DO NOT go into any aspect of this without a lot of reading and studying. There is a lot of info on the web – as with the web in general, not everything about digital currencies online is true or accurate. We can help orient you on the regulatory and legal issues.

Let us know if you have any questions concerning digital currencies. We can explore this new medium of exchange together.

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Written by Walker Law PC

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