Cryptocurrency Technology
Cryptocurrency technology is something that all financial professionals need to understand at a basic level. In the future, cryptocurrency technology will be the basis of many systems we use, whether we understand the underlying technology or not. We’ll be focusing on Blockchain technology in this post, but know that many other forms of cryptocurrency exist.
Blockchain
Blockchain is exactly what it sounds like. It’s a chain of blocks of information. The information contained in the block can vary greatly, but there are a few key elements that each block has.
The Hash
Each block contains the hash of the previous block in the chain. Think of a hash as a unique identifier such as a serial number. The hash is the rung connecting the blocks in the chain.
Specifics
Each block contains specific information.
Security
Each block has its own hash. As the information within the block is edited, this hash changes. This is part of what makes it so hard to hack Blockchain. Blocks are protected by very strong encryption.
Decentralized
Blocks are recorded using a Distributed Ledger Technology, which is stored on thousands of computers around the world.
Each block containing its own unique hash as well as the hash of the block before it in the chain are what make the Blockchain completely auditable. One can follow from a current block all the way back to the original block in the chain.
Distributed Ledger Technology and hashes are what make the Blockchain almost impossible to hack. One would have to change the information within the block, change the hash of the next block in the chain to match the new hash, and make this change everywhere the block is recorded at the same time.
Part of the mining effort described below requires proof of work, which takes powerful computers several minutes to create. Coordinating a global effort to change a single block within the Blockchain would require significant resources that, at this time, do not exist.
Main Points of Blockchain
Difficult to Hack
This is different from hacking a site that deals with blockchain technology. As we’ve seen in the news over the last couple of years, several exchanges have been hacked resulting in the loss of millions of dollars.
Completely Auditable, Decentralized & Encoded
This is the main reason why it is virtually impossible to hack a blockchain. No one person, organization or government controls the blockchain once it has been publicly distributed.
Business Applications for Blockchain
Business applications for Blockchain are just beginning to be understood. The underlying technology creates many different opportunities. Some have been very public and successful – think BitCoin. Others, such as supply-chain tracking and smart contracts, are still in their infancy.
The recent economic downturn has significantly hampered investment in the development of applications leveraging the Blockchain. However, Blockchain is a proven technology that we believe will continue to see future development.
The ability to create something digital, unique and auditable, while being almost unhackable and stored on a distributed ledger, presents a lot of opportunities. It’s likely that as the Blockchain becomes more adopted and understood, more business uses will be determined.
Cryptocurrencies
When someone mentions Blockchain, the first thing most people think of is cryptocurrency. It’s important to recognize that not all cryptocurrencies are based in the Blockchain. For the purposes of this article, we are speaking about Blockchain-based cryptocurrencies.
Currently, there are estimated to be over 20,000 different cryptocurrencies in circulation. Different cryptocurrencies have different properties and slight variations of the underlying technology used to develop them. That’s what makes them different from one another.
What are Cryptocurrencies?
Cryptocurrencies are an application of Blockchain and other technologies to create tradeable units, just like coins, that can be exchanged for real-world goods and services. Essentially, they are a currency that is not controlled by any nation or government. However, for the currency to have value, people have to believe in it and a significant number of people need to use it.
This isn’t much different from traditional fiat currencies such as the Yen, Euro or US Dollar. But because of the volume of cryptocurrencies being traded, the fact that they aren’t supported by government, and the fact that they are not yet widely accepted or regulated, these currencies represent a much more risky investment.
Cryptocurrency Trading
Trading cryptocurrencies is much like trading any other currency. However, there are a few key things to keep in mind.
Cryptocurrencies and their trading have no oversight or regulation. This means that a lot of old get-rich-quick schemes have resurfaced, ranging from pyramid to pump-and-dump schemes. This presents a lot of risk and means cryptocurrencies need to be viewed as the highest-risk category of investment in your portfolio.
Mining Cryptocurrency
Mining for cryptocurrency involves using high-powered computers to validate the transactions that create a complete block on the cryptocurrency’s Blockchain. Once these have been located, proof of work has been completed and validated, a new coin is issued to the first miner to prove the block. This miner also receives transaction fees for the transactions they validated that were included in the block. Both of these are paid in the cryptocurrency that was mined.
To Hold or To Sell?
After payment has been received, the miner can either hold the cryptocurrency or sell it immediately.
Tax Implications
If the coin is sold immediately, there is no change in value from when it is produced, so there is no gain or loss, just regular business income. If the coin is held and disposed of later, the transaction can create a gain or loss of value of the cryptocurrency that was sold. Whether or not this is considered business income or a capital gain depends on the nature of the miner.
If the mining operation is part of a commercial venture, it constitutes regular business income. If the miner is a hobbyist, it may constitute a capital gain.
Non-Fungible Tokens (NFTs)
Non-fungible tokens (NFTs)are units of cryptocurrency that can’t be replicated. There are two kinds of businesses that involve NFTs – NFT producers and NFT traders.
For businesses that produce NFT’s, they record the sale of the NFT once it is sold into the open market. At the time of this article, there is no clear guidance from Canada Revenue Agency (CRA) about whether or not sales tax should be charged. However, it does seem to be the trend according to a recent article in Forbes. In our opinion, businesses that are involved in NFT’s should register for and collect sales tax in their jurisdiction.
The CRA guidance is actually clearer than you would think. If you’re earning more than 30K per period in gross sales, you need to collect sales tax where applicable. This applies to all types of business, so naturally we assume this would apply to cryptocurrency.
For businesses that trade NFT’s, the treatment is similar to that of cryptocurrencies – both from a tax and a bookkeeping perspective.
Other Business Opportunities
There are many more opportunities to be involved in the world of Blockchain. From developing new technologies and smart-contracts, to owning ATM’s that accept cryptocurrency. It’s vital that you seek professional tax and bookkeeping advice if you’re going to play in this world.
Key Risks of the Blockchain
Not Tested in Court
Governments are still trying to figure out what to do with Blockchain technology, especially cryptocurrencies. As in most new technologies, the pace of technological change and improvement far outpace the development of laws and regulations related to it.
There are relatively few court cases involving cryptocurrencies or Blockchain technology that have received judgment in Canada. In the US, the cases mostly surround cryptocurrencies, and range from criminal to civil in nature. A big part of the challenge with the wider adoption of Blockchain technologies relates to the uncertain legal landscape.
One thing is for certain, all tax authorities want their cut.
Reliance on Technology
All Blockchain relies on distributed ledger technology. By default, this relies on the existence and continued operation of the internet. Further, it also relies on high-powered computers. This reliance on the availability of high-powered computers means reliance on the natural resources required to produce the hardware.
Further, an internet or network outage can leave investors unable to trade or convert their cryptocurrency holdings into other forms, exposing them to significant risk due to the volatile nature of cryptocurrencies. This risk needs to be considered by those who are involved in the short-term trading of cryptocurrencies. Your Internet Service Provider (ISP) won’t refund your lost trading income if the internet goes out for an hour or two.
Improvements in Technology
New technologies are developed all the time. It’s possible that in the future computers will be powerful enough to hack a Blockchain. If it can be made, it can be taken apart. Furthermore, it’s possible that new technologies could be developed that may render Blockchain technology obsolete. It needs to be pointed out that this risk exists for most technology-related properties.