Virtual currency is a digital version of “value.” This value functions as a medium of exchange and may be used to purchase goods, services, or stored for investment. Essentially, it’s digital money and is quickly gaining popularity.
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There are two main forms of virtual currency. Virtual currency that can be converted or “cashed out” into a physical manifestation is known as fiat currency. It can exist both digitally and physically. Examples include bank loans, stocks and bonds, and non-gold standard currencies, such as the dollar or euro.
Virtual currency that has no equivalent value in real currency is known as convertible currency. It exists only in the digital sphere and lives on the internet. You’ll see the words “virtual currency” thrown around a lot in this blog.
Virtual currency is the Internal Revenue Service (“IRS”)’s blanket term for cryptocurrency. The IRS’ use of this phrase is intentional. Using a broad term, the IRS can impose taxation on many events and scale down later if needed. It would be much harder to broaden tax laws surrounding a narrow topic.
In this article, we’ll focus on defining cryptocurrency and how someone can acquire it. In future articles, we'll break down all you need to know about virtual currency and taxation.
WHAT IS VIRTUAL CURRENCY?
Although it may still be used to purchase goods and services, cryptocurrency bears one principal distinction to fiat currency: it isn’t government-regulated and is considered “decentralized technology.” It derives its value from its users.
As more people utilize cryptocurrency, its demand and subsequent value increases. While this may not necessarily sound impressive, it bears several benefits including the decentralized nature of cryptocurrency allowing it to remain unaffected by government control or manipulation.
Decentralized technologies such as cryptocurrency are built upon what is known as “blockchain technology.” A blockchain is a system of recording information in a way that makes it difficult, if not impossible, to change or hack data.
A blockchain is a type of Digital Ledger Technology (“DLT”), a method by which multiple users can access, validate, and record data in a non-duplicative manner. It is essentially a “digital ledger” of transactions that are duplicated and distributed across the entire network of computer systems using that particular blockchain.
Each block in the chain contains several transactions, and every time a new transaction occurs on the blockchain, a record of that transaction is added to that user’s ledger. Attempts to tamper or access the blockchain are immediately evident, as no transaction can be duplicated.
Instead, nefarious attempts are visibly distinguishable because the cryptocurrency “obtained” by hacking cannot be verified on the blockchain, thus providing economic security and reassurance that one’s property will remain in their possession until such a time that the owner chooses to dispose of it.
DIGITAL GOLD MINING
Cryptocurrency is obtained through a process known as “mining”, which involves solving complex, computer-generated mathematical problems to earn “coins”. These coins are what we know to be cryptocurrency.
In the world of cryptocurrency, you may hear the terms “coin" and "token" frequently used interchangeably. While they sound like the same thing, they’re not.
A digital coin is created on its own blockchain and acts in much the same way as traditional money. It can be used to store value. Bitcoin, Solana, and Maker are different types of “coins.” Their functions are essentially the same, but the names just represent a different brand.
Tokens, on the other hand, have far more use than just digital money. They can be used to operate applications, verify smart contracts, and are used to build non-fungible tokens.
Presently, there are over 15,000 different types of cryptocurrencies that exist in the virtual currency market.
Popular cryptocurrencies include:
- Bitcoin (BTC), presently valued at $50,000 per coin.
- Ethereum (ETH), presently valued at $4,000 per coin.
- Solana (SOL), presently valued at $185 per coin.
- Maker (MKR), presently valued at $2,500 per coin.
Now of course, many will wonder: if all you need to earn cryptocurrency is to solve a bunch of math problems, why doesn’t everyone do it?
Firstly, most cryptocurrencies are a finite resource. Take Bitcoin for example: Creator Satoshi Nakamoto placed a cap on the number of Bitcoins that could be mined to 21 million.
While the exact reasoning for this limit is unknown, it does allow a significant advantage for cryptocurrency holders. By keeping the supply scarce, Nakamoto has ensured that its value will either remain stagnant or more likely, climb with years to come.
For this reason, Bitcoin is sometimes referred to as “digital gold.” In fact, almost 19 million coins have already been mined.
Cryptocurrency enthusiasts estimate that almost all cryptocurrency will be mined within the next decade and project an exponential increase in the value of Bitcoin in years to come.
Cryptocurrency mining increases in difficulty: as more coins are mined, it becomes harder to unlock the remainder. In the early days, miners used to be individuals sitting at their computers solving complicated, cryptographic mathematical equations.
As time goes by, it has become exponentially harder to solve the remaining cryptographic equations. In fact, most computer processors are no longer able to support the complex functions required to mine coins.
Top-of-the-line graphics cards are required to execute mining functions and computers must be connected to the internet at all times. Maintaining a constant internet connection and paying for graphics cards can get expensive quickly.
Potential miners can incur thousands of dollars of start-up costs. As a result, many miners abandon their efforts and do not earn a profit. Furthermore, miners are not solving equations in isolation.
Rather, they are competing against other miners in a “race against the clock”, where they are actively working to mine the same coins as their peers. For this reason, individuals join mining pools, where multiple miners attempt to solve the same equations and increase their chances of success.
Cryptocurrency mining requires that all coins be “verified” on the blockchain. Without verification, they are worthless.
There are two main ways to verify and add a block to a distributed ledger:
- through proof-of-work (PoW), or
- proof-of-stake (PoS) algorithms.
PoW algorithms require miners to designate specific computing machines for the process, thus verifying their mining.
Think of it this way: In beginning algebra, your teacher required you to “show your work” for full credit on a math problem. If you didn’t show your work, they couldn’t be sure that you used the correct processes to reach your answer. That’s how PoW verifications function.
PoS algorithms are slightly more complex. Miners are required to “stake” their own cryptocurrency assets to verify the validity of their newly mined coins and the algorithms used to obtain them. If the coins are validated, miners stand to earn quite a bit of money.
If the coins cannot be validated, the miner loses their stake. The staking method is a clear message to all miners that anything but the highest quality coins will not be tolerated.
If either of these two methods are used to validate coins, they can be added to the blockchain and become eligible for sale.
Cryptocurrency consumers can also purchase coins from brokers, third parties, or other cryptocurrency holders. However, all cryptocurrency originates with mining.