Get a handle on virtual currencies – The Motley Fool

This article is the first in a series on the emerging world of digital resources. Further articles explore the initial coin offerings, digital tokens, the virtual currency regulatory landscape and tips to avoid fraud and scams in this area.

Social and traditional media have been in turmoil with articles and information on the growing phenomenon of virtual currencies. Words and phrases like blockchain, cryptocurrency, distributed ledger, initial offer of coins and digital tokens populate our news flows.

The significant uncertainty currently surrounds virtual currencies in general and their potential value as investments in particular. Only time will tell if (and, if so, which ones) virtual currencies will become a major component of our financial markets and if investments in this emerging sector make sense as part of a diversified portfolio.

Before making any investment decisions, it is crucial to understand some of the concepts behind this emerging world of virtual currencies.

  stack of gold coins with zero and those on them

Image source: Getty Images.

What are virtual currencies? [19659008] According to the Commodity Futures Trading Commission, virtual currencies are "a digital representation of the value that functions as a medium of exchange, unit of account and / or reserve of value". In other words, each currency is represented by alphanumeric codes that can be generated and recorded on a blockchain network and recognized as payment method by users on that network. In some cases, you may spend and exchange virtual currencies, but these products do not have the same legal status as money, or "legal tender," in the United States, Canada, Mexico, and most other jurisdictions.

The Internal Revenue Service states that virtual currencies must be treated as US federal tax properties, with transactions required to be reported in US dollars. If the virtual currency is used to pay salaries, it is subject to federal income tax withholding and the gains and losses arising from the sale or exchange of virtual currency have tax implications. If you hold virtual currencies for personal or investment purposes, the IRS requires you to report any gains or losses that would be subject to tax rules on capital gains.

A popular type of virtual currency is known as cryptocurrency or simply cryptography. The term cryptography refers to the cryptographic process, which is a mathematically intensive cryptographic process designed to improve data protection and authentication. Some people are interested in cryptocurrencies for their perceived anonymity and the ability to keep transactions secret, and one of the oldest and perhaps most well-known cryptocurrencies is bitcoin.

What is bitcoin?

Bitcoin is a cryptocurrency developed in 2009 by an anonymous person or a group of people operating under the nickname Satoshi Nakamoto. Like other cryptocurrencies, bitcoin differs from "fiat currencies" such as the dollar, the euro, the renminbi or the yen. Unlike a fiat currency, bitcoin is not represented or organized by a unit of physical card or coin. Rather, every bitcoin is a unique alphanumeric string of computer code. Rather than being issued as a fiat currency by a central bank, a currency such as bitcoin is controlled by the technology that determines the number of bitcoins produced and the way in which transactions using bitcoins are recorded. Proponents of the cryptic world believe that bitcoin can be an interesting alternative to legal currencies because it is not controlled by any central bank or government.

Bitcoin is exchanged on the Bitcoin network, a peer-to-peer payment system that operates using cryptography. Users can send and receive bitcoins by transmitting digitally signed messages to the network using a cryptocurrency portfolio. Transactions on the Bitcoin network are recorded on a publicly distributed ledger called a blockchain and validated by a work trial system called mining.

What is blockchain?

Blockchain, also known as distributed ledger technology, is the technology that powers bitcoins and many other virtual currencies. In the case of bitcoin, the blockchain works through the participation of many people who offer their computing power to maintain the Bitcoin network and record transactions (for example, when someone trades or spends bitcoins). Those who employ math and technology to create new bitcoins are known as "miners".

Miners engage in complex IT problems to facilitate verification and publication of bitcoin transactions. As a reward for solving these computer problems, a bitcoin miner receives a new bitcoin. All of this needs a lot of energy, which is why today's mining centers tend to be located in regions where energy is cheap.

Blockchain technology is the core feature of bitcoin because it prevents bitcoin users from spending their coins and creates a permanent transaction record.

Are there other cryptocurrencies?

Bitcoin is one of thousands of cryptocurrencies. The purpose, functionality and use of these cryptocurrencies may vary. Some share the similarities with bitcoin. For example, Litecoin, created in 2011 by the codifying prodigy of MIT-cum-Google, Charlie Lee, is similar in many respects to bitcoin but is not identical, since it uses a different mining algorithm.

Ethereum (2015), on the other hand, is actually a platform for "smart contracts", known as conditional transactions: an IT code that enables certain events to be triggered when certain predefined conditions are met, such as the ability to unlock products real (by renting a car, for example) at the time of payment. Ethereum has its cryptocurrency known as Ether, which may be the form of payment used on these smart contracts.

Use caution

Knowing on virtual currencies and investing in them are two very different things. Investing in virtual currencies can take different forms. You can buy coins in the hope that they will appreciate or invest in platforms that facilitate blockchain technology and other aspects of the virtual currency revolution and hope they succeed. This involves a significant risk. Invest only what you can afford to lose, and be aware that you may lose some or all of your investment.

Like other types of investment, virtual currency investing has its share of fraud and fraud, not to mention cyberattacks. There are also important questions about how these currencies are regulated both nationally and throughout the world. Less regulation means less protection for investors.

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