By TJ Costello and Bruce Wright
Throughout history, various alternative currencies have been used to pay for goods and services. Sometimes, as with the famous “tulip mania” of 17th-century Holland, a speculative commodity investment can serve as an alternative currency — if enough people want it.
Today’s Bitcoin phenomenon, however, began as an alternative currency but has become a highly speculative investment in its own right.
Bitcoin’s origins are mysterious. Bitcoin and the database used in its implementation were launched in 2009, by a person or persons using the name Satoshi Nakamoto. That’s generally believed to be a pseudonym, however, and both press accounts and internet rumor have put forward several different candidates for the “real” Nakamoto.
Whoever created it, Bitcoin was designed as an alternative electronic currency to allow for easy, anonymous financial transactions across borders, without government interference or regulation.
Bitcoin has slowly gained acceptance not just in online transactions, but by a small but growing number of brick-and-mortar businesses as well, including Subway, Microsoft, Reeds Jewelers and, beginning in fall 2018, Dallas Mavericks ticket sales.
Bitcoin has earned its greatest fame as an investment, however. Originally worth pennies, at this writing the value of a single bitcoin is nearly $6,700, although values can and do swing wildly in a single day.
Bitcoin Basics
Buying and selling bitcoins is relatively easy. It’s as simple as downloading an app to one’s phone and creating an account that allows for the purchase or sale of bitcoins using a debit card or a bank account. One can also use a Bitcoin ATM; Texas has more than 100.
Each bitcoin is stored in a personal “wallet,” basically an encrypted electronic file with a unique ID, which resides either on a personal computing device or within a Bitcoin exchange, a digital marketplace for buying and selling bitcoins using conventional currency.
Bitcoin transactions are recorded in an online, encrypted database called blockchain. The names of buyers and sellers are never revealed — only their wallet IDs.
What’s a “Cryptocurrency?”
Bitcoin is a cryptocurrency, one of more than a thousand currently in use, but the most important by far in terms of valuation and acceptance.
Bitcoins, as with any other cryptocurrency, are actually strings of computer code that represent transferable units of value, each of which can be spent only once.
Each unit is produced or “mined” by using special software to solve complex mathematical problems, a requirement deliberately analogous to the labor involved in mining gold or other precious metals. Only a relatively small number of bitcoins are produced each day.
This artificial scarcity controls the supply of bitcoins, a job central banks such as the Federal Reserve handle for conventional currency. Bitcoin was designed to have a fixed total circulation of 21 million.
To ensure this, the complex computer algorithms needed to create bitcoins are becoming more difficult over time. “Mining” that could once be accomplished on a personal computer now requires huge data centers.
A Bitcoin Power Drain?
In the past year, the worldwide power demands of bitcoin mining have become astonishingly high (Exhibit 1).
According to Digiconomist, a web platform focused on digital currencies, in late March the electricity used in bitcoin mining equated to an annual rate of nearly 58 terawatts of electricity.
That’s 58 trillion watts — about the same annual energy consumption as 5.3 million U.S. households.
EXHIBIT 1: ESTIMATED WORLDWIDE ENERGY CONSUMPTION OF BITCOIN MINING
Bitcoin Demand Explodes
Bitcoin’s continued acceptance, as well as the scarcity engineered into the creation of bitcoins, is driving its rising popularity as a speculative investment. In response, futures markets have begun trading in Bitcoin and other cryptocurrencies.
The Chicago Board Options Exchange and the Chicago Mercantile Exchange began to list Bitcoin futures in December 2017, while NASDAQ plans to do so in 2018.
The value of an individual bitcoin was relatively stable for the first few years of the medium’s existence, followed by some growth in speculation in 2014. In 2017, however, Bitcoin value began an unprecedented rise (Exhibit 2).
At the start of 2017, a single bitcoin was worth $998; by December, its value had peaked at $19,343. As of April 9, 2018, the value of a bitcoin had receded considerably, to about $6,742, though with many wild price swings along the way.
Security Issues and Regulation
Transactions made through a blockchain database are considered fairly secure.
Individual wallets and exchanges, however, are often hacked. Bloomberg Business News has documented “a long history of thefts at cryptocurrency exchanges and [digital] wallets, dating back to 2014.”
In January 2018, hackers broke into a Tokyo-based exchange and stole $534 million worth of a cryptocurrency called NEM coins.
Given that cryptocurrencies are designed to avoid government oversight, U.S. Securities and Exchange Commission (SEC) Chairman Jay Clayton noted in December 2017 that cryptocurrency markets “feature substantially less investor protection than traditional securities markets, with correspondingly greater opportunities for fraud and manipulation.”
As cryptocurrencies become mainstream, regulators such as the Commodity Futures Trading Commission are grappling with many issues related to them, expressing concerns about price manipulation and fraud as well as money laundering and tax evasion.
In January 2018, the SEC shot down proposals from two exchange-traded funds seeking to offer investors a way to trade in cryptocurrencies on traditional exchanges.
In February, inspectors from Japan’s Financial Services Agency increased its scrutiny of cryptocurrency exchanges and even raided the offices of the Tokyo exchange hacked for NEM coins.
In December 2017, the Texas State Securities Board halted investment offerings by a company soliciting cryptocurrency-based investments it promised would deliver annualized returns of 100 percent or more.
This administrative order made Texas the first state to challenge a risky crypto-investment.
EXHIBIT 3: POPULAR CRYTOCURRENCIES AND RECENT TRADING VALUES
Tax Implications
In a 2014 guidance memo, the Internal Revenue Service (IRS) stated that cryptocurrencies are not legal tender but are property exchangeable for goods and services, and thus are subject to federal laws applicable to transactions such as those concerning artwork, stocks or bonds. The decision means all transactions typically subject to taxation are still taxable if bitcoins or any other cryptocurrencies are used.
Sales of bitcoins also are subject to capital gains taxes. The value of a Bitcoin transaction is calculated based on the fair market value of the virtual currency as of the date of payment. Mined bitcoins also are considered gross income for tax purposes.
Cryptocurrency exchanges and brokers are not required to report their transactions to the IRS as a stockbroker would, for instance. Recent court rulings, however, have made it clear that the IRS may seek supposedly anonymous transaction data.
In 2016, the IRS required Coinbase, the nation’s largest cryptocurrency exchange, to hand over records on about 14,000 customers. The recently implemented federal Tax Cuts and Jobs Act also eliminated certain tax loopholes used by some cryptocurrency traders.
It should be noted that the state of Texas doesn’t accept Bitcoin (or any other currency other than U.S. dollars) in payment for its taxes. All sales of taxable items in Texas are still subject to sales tax, even if the transaction is valued in bitcoins or another cryptocurrency.
A Bubble?
In economic terms, a bubble occurs whenever the price of a commodity or asset rises greatly beyond its fundamental value, due to extreme investor enthusiasm — what former Federal Reserve Board Chair Alan Greenspan famously called “irrational exuberance.”
When enthusiasm wanes, the bubble may pop, bringing prices crashing to earth, as it did with dot-com stocks in the early years of this century.
According to CoinMarketCap.com, the value of bitcoins rose by about 1,318 percent in 2017 alone. Many believe Bitcoin could be the next economic bubble.
Bubbles, however, are clearly seen only in retrospect, and while cryptocurrency values have fallen considerably in 2018, no one can predict with any certainty whether this trend will continue.
Yet cryptocurrencies in general aren’t going away anytime soon.
As they become more accepted, governments will consider how to protect constituents, regulate trades and make transactions more transparent — and, perhaps, prepare for a future in which some form of cryptocurrency may be the transaction method of choice among both investors and consumers.
This story originally published by Texas Comptroller.
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