Diana Clement: Bitcoin - Virtual gold or junk?
LOOKING for a 21st-century investment that might (or might not) make you a small fortune? The virtual currency bitcoin is proving to be an answer for a small but growing number of Kiwis. Investors worldwide have reported making huge profits.
Bitcoins and other virtual currencies such as Litecoins can be used to buy real-world things. Internet service provider Slingshot allows you to pay your bill with bitcoins and there are a number of other businesses in Auckland accepting the currency, including Green Rental car hire and plumber Mr Pipes. Other businesses can be found at Coinmap.org.
Investors make money by buying bitcoins at one price and reselling when the market rises and converting their gains into real-world money. It's standard foreign exchange trading, just based on a virtual currency.
Bitcoins started out worth US$13 each and by December last year had jumped to more than US$1200. On Monday they were worth US$588.80.
A bit of background first. Bitcoins are a unit of currency that is virtual, not real. The virtual currency is exchanged using bitcoin software. You don't download bitcoins to your computer. They're stored on a public ledger called the "block chain", but you hold a private key in a wallet on your computer. The downloaded software needed to use bitcoins gives you an address, which you can use to pay or to receive bitcoin payments and transfers.
Bitcoins have value because people are willing to trade them and increasingly businesses are accepting them as payment for goods and services. The virtual coins are real enough that the FBI seized private keys worth more than US$19 million from a business it shut down for allegedly selling illegal drugs. The seized bitcoins were auctioned off.
Investors can earn bitcoins, trade them on an exchange, or buy direct from other investors. Every bitcoin has its own numerical ID, which makes this possible. There are at least 70 exchanges around the world. Some buyers pay small fees to use brokers to simplify the process.
Buyer beware, however. The exchanges are not regulated and not all exchanges are reputable. One, Mt Gox, collapsed this year and took, according to Wikipedia, 850,000 bitcoins worth US$450 million of investors' money, with it. The exchanges don't store your bitcoins, which suggests to me only those people in the process of trading at the time lost money.
There are bitcoin exchanges in New Zealand. One exchange, BitNZ.com, was hacked at 3am on Monday and 39 bitcoins were stolen, owner Daniel Newton reported on Reddit.com. Newton said he would refund the losses personally.
As well as exchanges, there are gateways such as Coined.co.nz that allow you to buy small amounts of bitcoins. The advantage of buying from New Zealand exchanges and gateways is that it can save on international currency transactions.
There is no regulation of these exchanges and gateways. The Financial Markets Authority says that virtual currency is on its radar.
It's possible to do person to person transactions. LocalBitcoins.com, for example, connects people from the same country together to trade. On Tuesday there were a dozen or more traders in New Zealand offering rates ranging from $649.72 to $703.86 per bitcoin. Payment could be made from any of the major banks and Co-operative Bank.
The bitcoin concept can be a little hard to grasp. They're mined by using powerful computers to solve complex algorithms. Bitcoin miners club together to answer these questions and receive bitcoins for their work, which enter the system.
Bitcoin mining is similar to the idea that governments print money when they need to. Bitcoins are added to the system by mining. The purpose of mining is to slow down the issuing of the currency so that the market is not flooded. Once 21 million bitcoins have been mined, mining will stop. It's most likely that when it reaches that point the market will stabilise. But at the moment it's providing speculative gains and losses for those with an appetite for risk.
There are plenty of warnings to be made about bitcoins. As with any new investment we haven't been through sufficient cycles to know how the market will behave.
What's more, the bitcoins belong to anyone who has a private key and can sign transactions for it. As the BitNZ example this week shows, anyone who got hold of the private key from your computer or intercepted an email could steal your money by taking the bitcoins.
If your bank account gets hacked and you've not done something stupid then the bank will have to refund your money and the Banking Ombudsman will stand up for you if you're treated unfairly. There is no such protection for bitcoin investors.
The Guardian newspaper in the UK reported that one bitcoin investor threw his laptop out containing the private key for virtual currency worth millions of dollars. He hadn't kept a backup and without the cryptographic key the money was gone.
The next warning applies to other investments such as foreign exchange. When you trade bitcoins you make paper gains. Unless you exchange those gains into another currency or spend them you have not crystallised the gain. Who really knows if bitcoins are viable long term. The market could collapse and everyone loses their money.
Bitcoins don't pay dividends or interest. So there is no yield from them. If you invest in shares, bonds or property, or even put your money in savings accounts, there is usually an ongoing income over and above capital gain. This is part of the total return.
Bitcoin investors would say that the capital gain is so much higher than these other investments that the lack of yield is immaterial.
That attitude can come back to haunt investors.
Another point is that once the total number of bitcoins is issued then it will become a zero sum game, as forex trading is. If you lose, I win, and vice versa.
In theory, bitcoin investors need to pay tax on their gains if they are actively trading. The Inland Revenue Department (IRD) has "no published position on crypto-currencies". I would say they're likely to be viewed in the same way as foreign currency trading.
If the bitcoins are being bought with the intention of long-term buy and hold investing then there is no tax to pay on the capital gains, although there is no guarantee that the IRD won't try to tax you. If the intention is to buy and sell at a profit, then you will probably be classed a trader. That means you are legally required to report that income to the IRD and pay tax on it.
I do wonder whether any of the bitcoin traders in New Zealand pay tax and if they don't how the IRD would ever find out except for auditing individual bank accounts. Because there is no central bitcoin organisation, the IRD can't ask for lists of Kiwi-based customers in the way it can with foreign banks.
In light of the fact that they should be paying tax, traders and miners should keep a record of trades including date of trade, description, quantity, price and fees.
For more information start at the information section on CoinDesk's website, which offers detailed explanations in plain English.