DeFi, blockchain, decentralized, crypto, bitcoin. These are just a few crypto-related terms you may have heard tossed around recently. The term "crypto" in cryptocurrency stands for cryptography, which is the study of secure information and encryption. Maybe this is why cryptocurrency seems a bit "cryptic" to most of us accountants.
What exactly is cryptocurrency?
Cryptocurrency is a type of digital currency that is not governed by a centralized authority. Therefore, cryptocurrency has become known as a "DeFi" or "decentralized" currency. If you think of the U.S. dollar for example, this type of currency is centralized — the value is determined by a centralized authority.
Most of us know someone who has purchased cryptocurrency. Many people are treating it as a form of investment as they would stocks or bonds, especially because the cryptocurrency market has the added bonus of trading 24/7. However, there are others who regard crypto with much more skepticism — after all, there is no governing body or third party managing crypto. To buy crypto without regret, one must do intensive research to understand the principles of crypto along with the pros and cons between the different coins. Businesses and consumers are struggling to keep up with this demand.
How cryptocurrency and blockchain relate
If you've been researching crypto, you've likely come across the term "blockchain." While the concept of blockchain may sound complex, it isn't as challenging as you might think. Blockchain is essentially a ledger of transactions, almost like an electronic check registry. This check registry is duplicated across networks of thousands of computers, or nodes. These nodes interact with the associated blockchain by validating, confirming, securing and writing blocks to the chain.
Here's an example. Someone makes a cryptocurrency transaction request within their network via their laptop or phone. When this transaction is made, the request is broadcast to all computers that are serving the blockchain. During this process, the credentials of the individual making this request are verified. Once verification has been completed, a block is written and added to the blockchain.
This may not sound very secure. However, there are protocols in place to ensure each transaction is safe. Each cryptocurrency transaction is validated using a new kind of verification system called "proof of work."
It's also important to note that each type of cryptocurrency has its own blockchain. That means bitcoin, dogecoin and ethereum each have their own individual blockchains.
Uses of cryptocurrency
The future of crypto is a bit obscure. Many people still believe that crypto will continue to be a peer-to-peer payment system where individuals can pay friends or family back much in the same way that we use Venmo today. Others believe it may be useful to replace transactions such as wires that quickly become time consuming and troublesome. Currently, a popular use of cryptocurrency is using it to earn interest, much the way you might invest in other sources. The basic principle is that the demand for cryptocurrency will go up, and therefore its value will go up. Currently, there are more than 19,000 different cryptocurrencies being traded.
There are some financial implications of owning cryptocurrency that your clients should be aware of. To the IRS, crypto is still considered a taxable property. If a client purchased bitcoin, for example, and were down largely in their investment, they can sell it. They can recognize this as a loss come tax time. For example, if your client has crypto on their balance sheet and they buy a million dollars' worth, the price may drop to half a million. A writedown must take place. However, if the price increases by a dollar, the flipside is not necessarily true. There are unrealized losses happening, but no unrealized gains.
Recently, the Financial Accounting Standards Board came out with a project regarding what to do with cryptocurrency, how to value it, etc. In addition, the Securities and Exchange Commission sent out a bulletin stating that they want certain crypto companies to start carrying cryptocurrency on their balance sheet and offset it with the liability. Overall, the feeling in the accounting industry is there is little guidance on how to classify cryptocurrency. However, FASB and the SEC are trying to determine how classification should proceed.
Types of cryptocurrency
The total market cap for the cryptocurrency industry is just under $1.3 trillion. Bitcoin and ethereum make up the largest share of the industry. Bitcoin, like many other cryptocurrencies, was originally designed as a peer-to-peer currency without the need for a centralized authority governing its use.
Another type of cryptocurrency, stablecoin, is arguably the most unique. This coin is one that is tied to the value of another currency, such as the U.S. dollar or another cryptocurrency. Stablecoin is considered much more stable in nature compared to bitcoin or dogecoin alone. Most cryptocurrencies rise and fall in value rapidly, even in a matter of days. A stablecoin is closer to that nature of the U.S. dollar, where changes in value are smaller over a larger course of time.
As you can imagine, because stablecoins are backed by other currencies, their overall risk and stability is determined by the backing currency. If a stablecoin is backed by the U.S. dollar, for example, that stablecoin is a bit more consistent because there is a mediating party to control valuations of the backing currency. If the stablecoin is backed by a more volatile currency, such as Bitcoin, there can be more volatility to valuation. Stablecoins are sometimes used to convert cryptocurrencies such as Bitcoin to U.S. dollars for a variety of reasons.
There is another evolving currency called central bank digital currency. The idea behind this currency would be that it is one issued by the government or a central bank. While there are some benefits to this proposed currency, such as reducing counterfeiting and money laundering, there is resistance to this form of currency. Many are worried there would be an overstep of citizen's privacy as tracking would be much easier.
Another innovation in the cryptocurrency world is that of cryptocurrency applications, a cryptocurrency that runs on an existing blockchain. For example, you may have a Crip, a gaming cryptocurrency that resides and operates on the ethereum blockchain. A great way to think about this is just like your smartphone. You have applications on your smartphone that run on Apple's operating system. Cryptocurrency applications do not have their own blockchains and run on the blockchains of other cryptocurrencies and perform a service.
In gaming, there are already hundreds of games that run on the blockchain. Most of them adopt something called a play-to-earn model. The idea is that as you play this game, you are earning additional tokens that are associated with the game. This may sound similar to using your credit card and gaining airline miles in return. If you've heard of the metaverse, this is just one example of a cryptocurrency application.
The future of crypto
The lack of regulation when it comes to cryptocurrency has led to some bad actors and resulting suspicion of this new industry. While the U.S. government hasn't stepped in yet and made regulations, there are many who believe such regulations are coming.
As there are more and more stories of people losing money through cryptocurrency, world governments are becoming increasingly focused on trying to mitigate risk and place rules in place to do so. Cryptocurrency is not backed by organizations like the Federal Deposit Insurance Corporation, and this is of great concern to both individuals and governments.
Even with the suspicion and uncertainty of this industry, there are still many retailers looking at accepting cryptocurrency. I recommend that businesses consider the volatility of the market. There are currently many third-party platforms accepting cryptocurrency, so the possibility of paying a fee and having cryptocurrency payments converted to your country's currency is quite possible. Many within the financial industry are anticipating the future to involve crypto, but currently this is yet to be seen.
Cryptocurrency won't necessarily replace the U.S. dollar; it's more about decentralized applications running on a decentralized blockchain. Cryptocurrency could potentially change business-to-business transactions due to the great speed and security offered by blockchain technology. There have been suggestions that blockchain could be leveraged to aid in recordkeeping. Processing professional transactions such as real estate or similar purchases could maintain transaction records making these processes far more trackable.
While cryptocurrency is still in its early stages, this new wave of currency is quickly evolving. It's important to learn what you can about cryptocurrency and maintain an open mind, but keep in mind the potential dangers and risks. Recommending that your clients also do so may be in your best interest as a trusted advisor.
