Bitcoin, Litecoin, Ethereum, Tether, Dogecoin, and more than 10,000 others make up the rapidly expanding cryptocurrency market. Currently unregulated, the crypto market has exploded in popularity. The prospect for a new-age digital bartering system that resides outside of the banking system has lured in well over $1 trillion. Individuals, merchants, charities and some governments are now accepting cryptocurrencies as legal tender.
El Salvador became the first country to recognize Bitcoin as legal tender in September 2021. To encourage the use, citizens were given seed money of $30 in Bitcoin to download an app. Later this year the government plans to launch a $1 billion Bitcoin bond offering. According to reports, half of the proceeds are set to purchase Bitcoin and the other half will help build a city near a volcano that will use geothermal energy to help mine Bitcoin, dubbed “Bitcoin City.”
Also last September, China, by contrast, outright banned all cryptocurrency under the premise that it threatened to destabilize the financial system. They further defended their position citing concerns over the negative impact on the environment from the intense computing power required to mine the data. China also cited Bitcoin’s potential to be used as an avenue for illegal money laundering and illicit activities. The ban came during the development of China’s state-owned digital yuan currency that is currently being piloted.
In the United States, Bitcoin and other cryptos are legal and currently unregulated. The unpredictable price swings and the threat of regulation could delay wider acceptance. Securities Exchange Commission Chair Gary Gensler has referred to crypto as the “Wild West,” which could mean taming regulations are on the horizon.
Bitcoin was created by a person or group under the pseudonym Satoshi Nakamoto. The purpose is to enable peer-to-peer transactions outside of the banking system using a digital currency instead of centralized currencies.
Bitcoin’s launch in January 2009 had impeccable timing. As the banking system came under immense pressure during the great financial crisis, mistrust of the financial system grew, and cryptocurrency became an interesting alternative to government-regulated fiat currency.
At its launch, one Bitcoin was worth less than a penny. In November 2021, one Bitcoin hit a high of nearly $68,000. Unlike stocks or bonds, Bitcoin trades 24/7. The price is set by investors bidding up or selling down the asset, which continues to be quite volatile.
Bitcoin is built on blockchain technology. Think of blockchain as a bank ledger system that keeps track of transactions. However, the transactions in the ledger are recorded by individuals all over the world who are independent from one another, not a government.
The reward for recording the transactions, a.k.a. “mining” the data, is payment in Bitcoin. To get paid, miners must do two things: verify one megabyte of transactions (one block) by solving complex mathematical puzzles and be the first to arrive at the answer.
Once a set number of transactions have been recorded, the block is complete, and another block begins. For every 210,000 blocks mined, the Bitcoin reward for mining the data is halved. This happens roughly every four years. When Bitcoin launched, the reward for mining one block was 50 Bitcoins. Today, the reward is around 6.25 Bitcoinz.
To date, 19 million Bitcoins have been put into circulation. The cap, which is set at 21 million coins, is expected to be reached in the year 2140.
Transacting with Bitcoin
To transact with Bitcoin, you must first have an online wallet. You would fund your wallet with a debit card, credit card or bank account then purchase your crypto. You could use your crypto to transact with other individuals anywhere in the world or spend it at a growing list of participating merchants. Think Venmo but with crypto instead of dollars.
QR codes are used for sending and receiving. These transactions can be made electronically on your phone or computer, spent with a physical pre-paid debit card, or even with paper printed QR codes.
The IRS taxes Bitcoin as if it were an investment. Each swipe of the crypto debit card is counted as a short-term capital gain if held for less than a year, or long-term capital gain if held for more than a year. The standard capital gains tax rates apply, which is ordinary income on short-term gains, and 0%, 15%, or 20% on long-term gains depending on your tax bracket.
Even though cryptocurrency is in its infancy, based on the enormous market cap and growing acceptance as a medium of exchange, Bitcoin and perhaps a few others are likely here to stay.
Andy Drennen is a CERTIFIED FINANCIAL PLANNER professional and a member of Financial Planning Association of Greater Kansas City. He is Senior Portfolio Manager, Director of ESG Strategies for Simmons Bank. The views and opinions expressed in this article are those of the author and are not endorsed by, and do not necessarily reflect the views of Simmons Bank. Simmons Bank does not provide tax, accounting or legal advice.