Virtual Currency: A Primer on Bitcoin and Why Bitcoin Matters
When our clients first began discussing Bitcoin a few years ago, I wasn’t sure what they were talking about. I had never heard of Digital or Cryptocurrency. Fast forward a few years and these conversations have moved mainstream. I was sharing with my wife in Portland, Oregon the other day that Malls (Clackamas Town Center) now have Bitcoin ATM machines where people can purchase and exchange Bitcoins for other paper currencies or other paper currencies into Bitcoins. I wouldn’t have imagined this 10-years ago.
However, many of you remain unfamiliar with Bitcoin and its various cousins of Virtual Currency.
For ease of discussion, I’ll use Bitcoin to include all similar Cryptocurrencies. Most versions of these competing currencies often called “altcoins” are derived from the Bitcoin open source code project and share many common attributes. A worldwide network of enthusiast’s run Bitcoin mining software to validate transactions and monitor and update the public ledger known as the “blockchain.” The easiest way to think about this is a cloud-based spreadsheet or ledger showing the balance of each Bitcoin wallet.
The technical aspects of blockchain are beyond this article; however, as a Financial Professional (CPA), I look at the blockchain as an immutable record or complete history of every Bitcoin transaction conducted. That is, the history can never be changed. Plainly speaking, this means that before Bitcoin can be used in a transaction, there is an audit confirmation that that the Bitcoins exists (meaning they are real and authorized back to their creation), that the bitcoins are in the custody of the user that holds the private key to the wallet and that the receiver of the Bitcoin has provided his public address into which the currency is transferred.
In traditional cash-based currency transactions, the currency is assumed to be authentic, yet occasionally is found to be counterfeit. The assumption is that the user of the cash in facts owns it; however, sometimes it’s stolen or ill-gotten. The receiver is assumed authorized to receive the funds, but on rare occasions, there is a fraud by way of a false intermediary. And finally, there is not normally an audit trail as to where the funds move in a currency transaction. Bitcoin solves for these traditional currency based structural weaknesses. Auditors, regulators, and governments should seek to embrace the values and virtues of Bitcoin rather than fear and attempt to restrict its use.
Bitcoin and other Cryptocurrencies are disruptive technologies that are experiencing growing acceptance. As Your financial service advisers and professionals, we stay engaged with developing technologies like digital money to better help You, our clients and other financial professionals navigate the digital frontier.
What is Money?
My exploration about Bitcoin transpired into an alarming journey. One that includes a better understanding of what money is and is not. And how money, banking, and commerce are impacted by the flow of money, and how digital currencies, like Bitcoin, provide opportunities that traditional currencies are unable to achieve. This isn’t to suggest that Bitcoin is without fault. Like any currency, Bitcoin is subject to valuation swings, abuse by unscrupulous users and loss or theft typically due to the holder of a private key not properly securing it.
My first “Wow” moment was understanding the purpose of money. I had believed that money represented value. Ignore the concept of gold-based or metal-backed currencies, as the backing of the currency, isn’t really relevant. Money is merely and ultimately the representation of a medium that clears credit obligations. Nothing more, nothing less.
Money is not used simply because it’s easier than direct barter. Money is not used merely because the government authorizes it. Money is a means of exchanging obligations between parties. That’s it. Money represents the means by which independent parties agree to exchange goods, services, and obligations with the faith that others will accept the same. Bitcoin solves a thousand-year-old problem of requiring a trusted intermediary to exchange value between two parties.
Money is merely and ultimately the representation of a medium that clears credit obligations. Nothing more, nothing less.
Currency as a Communication Channel
Renowned author and forward thinker George Gilder refers to money, as “a measure of economic learning Money is the channel that carries the information to investors, workers, small-business men, major corporations, and entrepreneurs.” It has no separate value other than what independent people agree it provides. Ultimately, this is true of precious metals and all other commodities. Their value is purely subjective and fully dependent upon what people’s belief that such commodities can be used to offset obligations If others don’t easily accept the offered token of value, its ultimate use is no more than its physical properties.
If currencies are nothing more than communication channels used to provide offsets to obligations, then they no longer need to be physical. Currencies can just as easily reside virtually. Enter Bitcoin: An independent methodology to offset credit obligations in a secure manner with auditable transactions and easily maintained in Bitcoin accounts (generally referred to as “wallets or “e-wallets”), or simply exchanged into any accepted common currency through the use of one of the many Bitcoin exchanges.
In this case, Bitcoin becomes just one of several methods to transact business. Much like PayPal or gift cards, Bitcoin’s ability to facilitate commerce is in its ability to have a demonstrable market value, ease of acquisition and disposal and the belief that others will accept its use in commerce. Just like traditional money, except you never touch it.
Objections to Bitcoin are genuine. Some have argued Bitcoin is too easily accessed by “bad intentions” and is used to facilitate illegal activities like money laundering, drug trafficking, and tax evasion. And frankly, Bitcoin has been used in such matters. But in comparison to how often untraceable cash is used, it’s used for such purposes is negligible. Furthermore, most that have attempted to use Bitcoin for nefarious purposes have been put behind bars, including a U.S. DEA agent and U.S. Secret Service agent who did not fully understand that every transaction is transparent and traceable.
As Bitcoin matures these undesirable uses will be minimized and mitigated. Under the blockchain, Bitcoin transactions are traceable to each and every user. So, unlike conventional money, there’s a trail from buyer to seller. In a sense, Bitcoin is superior to traditional currencies in terms of its ability to be audited. Bitcoin transactions are taxable. Again, using the block chain and e-commerce wallets, regulators and taxing authorities have a greater capacity to capture and summarize economic transactions because there’s a digital record.
There’ve been bad actors, poor business plans, and thieves who have provided Bitcoin services and harmed users.
The Upside & Taxes
Bitcoin provides many advantages over traditional currencies. Most notably, it’s decentralized. Governments or central banks do not mint Bitcoins. Rather, Bitcoins are “mined” by discrete and independent computer systems competing to be the first to solve extremely tedious mathematical problems. Bitcoins are assigned to the system that solves the next step in the complex algorithm. Bitcoins are released on a calculated basis to coincide with growth and there is a limited number that can be mined over many years. This is a very monetarist economic system in that the money supply is controlled.
The decentralization of the underlying currency release allows for controlled growth and provides stability for users since politically motivated officials are unable to independently shrink or add to the money supply. Although prices for Bitcoin fluctuate with economic subjective value, much like the stock market, Bitcoins trade within relevant ranges and are stable enough for most business transactions.
The decentralized nature of Bitcoin facilitates its use and disbursement into the Bitcoin ecosystem. For U.S. income tax purposes, regulations treat Bitcoin as property rather than currency, so tax treatment is quite simple. The value of the Bitcoin(s) received the day of the transaction is the income to be reported. The net sales price received from selling the associated Bitcoin is the sales price of the property and any resulting gain or loss is treated as a sale of a property. I represent a large and successful Bitcoin mining operation and even before the Treasury regulations, we were treating Bitcoin income in this manner.
Because Bitcoin is decentralized and virtual, it has several outstanding benefits. One is that it’s easy to use for commerce in that all one has to do is place their value in their e-wallet and transfer the value to the corresponding party’s e-wallet. No cost is associated with the transaction between parties. This is superior (for the customer) to traditional banking and their associated bank fees. Accordingly, business stands to profit greatly from the proliferation of Bitcoin. Yet ease of transfer and low costs aren’t the only benefits.
Bitcoin and other cryptocurrency are disruptive technologies that are experiencing growing acceptance. As advisers and professionals, it’s in our best interest to embrace these changes and become familiar with the workings of such digital money to better help our clients navigate the digital frontier.
Daniel frequently provides Media Content via Workshops, Podcasts and Printed Articles concerning new “AltCurrency” aka Bitcoin and others. If you wish for Daniel to speak to your Professional Group, please contact us.
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