By Barbara O’Neill, Ph.D., CFP®, AFC® firstname.lastname@example.org.
Pick up any personal finance textbook and you are likely to see an “Investment Risk and Reward Pyramid” graphic. The graphic will likely show low risk, low return investments, like cash equivalents and U.S. Treasury securities, at the base and high risk, high potential return assets, such as stock options, futures, and collectibles, at the peak. The pyramid indicates visually that high-risk assets should comprise a very small portion, if any, of an investor’s portfolio.
Add to the peak one more highly speculative asset: cryptocurrencies (a.k.a., virtual currencies), which are a frequently requested topic for future MFLN webinars. Financial practitioners need to be aware of this emerging asset class because it is likely here to stay and they will get questions.
Cryptocurrencies are “hot” and new, and clients may have FOMO (fear of missing out). Below are seven key characteristics of this emerging asset class:
There is no physical currency in either paper or coins as opposed to so-called fiat currencies such as Euros and the U.S. dollar. Rather, cryptocurrencies are virtual representations of value that reside in computers. They can be used as both a medium of exchange and as an investment asset.
No Government Backing
Cryptocurrencies such as bitcoin are not backed by any country or central bank but can sometimes be exchanged for fiat currencies. There is no equivalent to FDIC or SIPC insurance when extreme volatility or “flash crashes” occur. The “security” behind cryptocurrencies is a complex mathematical algorithm and users are identified by unique alphanumeric addresses.
Market forces of supply and demand determine cryptocurrency values. There have been wide swings in value over the past decade. Cryptocurrency owners have a “personal wallet” and buy and sell cryptocurrencies on the “spot market” (i.e., at a current price for immediate or quick delivery) or through initial coin offerings (ICOs), which are a way for companies to raise cash by selling digital tokens.
According to the U.S. Commodity Futures Trading Association, “virtual currencies are commonly targeted by hackers and fraudsters.” Common red flags of scams for cryptocurrencies (and all investments) are urgency, promises of huge returns, aggressive sales tactics, and confusing explanations.
There is nobody to complain to if cryptocurrency is stolen. In one of the most well-publicized cases in 2014, over $400 million vanished from a failed bitcoin exchange called Gox. In addition, if people lose their password or die without telling a trusted party their password, their cryptocurrency account will not be able to be accessed and all of its value will be lost forever “in the ether.”
The IRS views cryptocurrencies as a capital asset similar to stock, not as a currency. Thus, capital gains earned by “buying low and selling high” are taxable and capital losses are deductible. Cryptocurrency assets are also considered part of a decedent’s taxable estate. In reality, the onus is often on cryptocurrency owners to report their digital transactions because not all cryptocurrency exchanges issue 1099 forms. Cryptocurrency exchanges do generally provide transaction history.
Blockchain is the underlying technology behind cryptocurrencies. It is a permanent publicly distributed ledger system and is expected to grow exponentially and be adopted for use in a wide variety of industry sectors. A Journal of Financial Planning article at https://www.onefpa.org described it as follows: if individual cryptocurrencies are like individual websites, then blockchain technology is like the internet.