What You Need to Know About Bitcoin

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When "Bitcoin" appeared as a clue in the New York Times Sunday crossword puzzle earlier this year (the five-letter answer was "e-coin"), it was confirmation that the cryptocurrency had officially entered the zeitgeist. Such virtual currencies use computer-generated encryption to secure and track transactions, independent of a central bank. Bitcoin made headlines last year because of its meteoric rise from $963 per bitcoin at the start of 2017 to a high of nearly $20,000 in December. This year's news has been about bitcoin's descent, to a low of $7,000 in February, from which it was recently on the rebound.

Quiz: How Well Do You Really Understand Bitcoin?

The craze over bitcoin and its ilk--there are more than 1,000 digital currencies, although bitcoin is the best-known and the oldest--is as mythic as its beginning. (The true identity of bitcoin's creator or creators remains a hotly debated mystery.) Bitcoin was born in the aftermath of the financial crisis, when distrust of financial institutions was at a high, and a currency divorced from a central bank found wide appeal. The currency of choice for black-market buying crossed over to the mainstream with the purchase of a pizza in 2010. Techies glommed on, and by 2016, bitcoin was an investing phenomenon. Along the way, bitcoin has spawned as many skeptics as believers, while regulators grapple with how to oversee this newfangled asset and the potential for fraud that comes with it. One thing is sure: Whether bitcoin or any other cryptocurrency survives, the technology behind it is here to stay.

What can I buy with bitcoin? Just about anything. You can buy towels, bedding and other goods at Overstock.com. Or purchase movies and games at Microsoft's online Windows and Xbox stores. At Gyft.com you can apply your bitcoin toward gift cards to use at Starbucks, Target, Uber and Whole Foods. Expedia, the travel booking website, lets you pay for hotel reservations with bitcoin.

Are digital currencies such as bitcoin a good investment? Only for pure speculators who understand the risks. Bitcoin has no revenue, earnings or underlying asset value. Its price rise is driven by demand alone, and that shows signs of a frenzy. By contrast, when a stock price rises, even that of a speculative penny stock, the move is typically based on an expectation of earnings or revenue growth. With bitcoin, "you buy it in the hope that someone will pay you more for it later," says Mark Dodson, a money manager with Hays Advisory. At worst, that's a classic definition of Wall Street's "greater fool theory." At best, it describes speculation, not investment.

Of course, bitcoin bulls say that there's still room to run on the price of bitcoin and that the technology behind the digital currency--called blockchain--makes the coin a worthwhile investment. But there are better ways to bet on the technology (more on that later).

What if I still want to buy? If you must buy a cryptocurrency, invest only what you are willing to lose, and prepare for a wild ride. "Knock yourself out" if you want to buy bitcoin, Dodson tells friends and clients who ask about digital currencies, "but assume the price is going to zero." This is something you put your mad money into, not your savings. The IRS classifies digital currencies as property, so you'll owe capital gains tax on any profits that you earn when you sell or spend.

How do I acquire bitcoin? There are several ways to go about it. Here's one: First, open an account online at a digital-currency trading platform, called an exchange. Coinbase ( www.coinbase.com ) is one of the biggest. You can store or spend your bitcoin from that account.

Next, link your bank account to the Coinbase account. Forget about using your credit card: Several major card issuers, including Bank of America and JPMorgan Chase, now decline cryptocurrency transactions, and others are likely to follow suit. Once your account is funded, you can buy. You donÕt have to purchase a whole bitcoin (in mid February, one bitcoin traded for $10,189). You can buy a fraction as small as one one-hundred-millionth of a bitcoin, says Philip Gradwell, of Chainalysis, a blockchain software company. Fees apply when you buy or sell. Coinbase charges a 1% to 4% fee for purchases, depending in part on how they're funded.

Keep your bitcoin at Coinbase or store it in a "wallet," a custodial account for cryptocurrency, at another firm. Crypto-security expert Richard Ma recommends opening a separate wallet if you hold more than $10,000 worth of digital currency because exchanges have been prone to being hacked. Blockchain Wallet ( https://blockchain.info/wallet ) is one of his favorites because it is user-friendly. Xapo ( https://xapo.com/wallet ) is popular, too. You may have to pay a fee to set up an account and to send coins to someone, or to exchange your coins for cash or other digital currencies.

Are there bitcoin alternatives I can invest in? Yes, but think twice before doing so. New digital coins, also called tokens, are launched all the time in what are called initial coin offerings, or ICOs. Dozens of tokens are listed on Coinmarketcap.com , a website that ranks cryptocurrencies by market value. Any one of those currencies could overtake bitcoin in market value. But many will disappear. "You don't know who the winners will be," says Jan van Eck, of VanEck Associates, an investment firm and exchange-traded fund provider.

How does an ICO work? ICOs, like initial public offerings (IPOs), raise money for companies. But IPOs are typically for businesses already in operation. With some ICOs, groups sell coins to raise money in order to start a business. Gradwell says ICOs are analogous to a company that sells tokens for fair rides before the fairground is built. You're asked to invest without answers to key questions. Says Gradwell: "Are they going to build the fairground? And then, will people want to go on the rides?" Approach any ICO investment cautiously. Check to make sure the ICO is registered with the Securities and Exchange Commission. Go to www.sec.gov and search the Edgar database for the required registration statement, known as Form S-1. If you don't find one, that's a red flag.

See Also: 8 Ways to Invest in Blockchain Without Buying Bitcoin

What other risks come with buying digital currencies? For starters, hackers could steal your bitcoin. In January, cyber thieves stole more than $500 million worth of cryptocurrency from Coincheck, a Japanese exchange. Or you could lose access to your bitcoin, in much the same way your cash is gone when you lose your wallet. When you own bitcoin, you have two Òkeys,Ó similar to the login ID and password you use to access traditional online financial accounts. One is called a private key; the other, a public key. The public key is analogous to your account number. The private key is akin to your personalized digital signature and is your proof of ownership. Lose your private key and you lose your claim to the bitcoin. Some wallet firms, including Xapo, will hold onto your private key for you.

Lastly, digital-currency accounts don't have the same level of insurance that protects customers if a bank or brokerage goes belly-up. There is some cushion, though. Big exchanges typically hold insurance policies against a cyberattack; proceeds from the policies can be used to pay you back for any stolen coins. And although digital assets aren't covered, any U.S. dollars held in an account at Coinbase are FDIC-insured, up to $250,000.

Is it the technology behind bitcoin, but not bitcoin itself, that I should be focusing on? Yes. Some say blockchain technology could be as world-changing as the internet. Companies all over the world are exploring ways blockchain can help them save money, store sensitive data, streamline transactions and improve information flow. "Every major financial institution and technology company is investing in blockchain," says van Eck. Alphabet, Citigroup, Goldman Sachs and Overstock.com are among the biggest blockchain investors today, according to research firm CB Insights. Gartner, the research firm, predicts that by 2030, 30% of global businesses will use blockchain technology.

How does blockchain work? Think of blockchain as an unalterable, official ledger of transactions stored on a vast network. Anyone can get on the network to help maintain the ledger, and everyone on the network collectively controls it. There is no central authority. It's super-secure because of the way the ledger is built--each transaction is connected to the last--and because it exists on thousands of computers. A hacker would have to break into every computer on the network at the same time--an impossible task--to do damage.

In the case of bitcoin, each transaction is sent to a vast worldwide network of computers that run the bitcoin software. (Anyone can download the software at https://bitcoin.org .) These computers are run by people who compete to approve the transaction by solving a complicated math problem. The first to solve the problem wins a reward of newly created bitcoins. That's why they're called bitcoin miners. (Mined bitcoins are taxable as income.) Network participants okay the new transaction, which is added to a block of other recently approved trades, and the block is connected to the chain, which is a record of all bitcoin transactions ever made. "The chain is immutable. It has never been hacked," says Laurie Rosini, an attorney with Perkins Coie in the firm's blockchain technology and digital currency group. Among business users, Walmart is exploring ways to use blockchain to improve food tracking and safety and Vanguard is testing whether it can smooth trades and simplify management of its U.S. stock index funds.

See Also: Flying Blind With Bitcoin

Can I invest in blockchain? Yes. For now, an ETF is probably your best bet. If you're looking for a pure blockchain tech company to invest in today, good luck. We found six publicly traded U.S. firms that are wholly tied to blockchain technology. But none earned a penny in the past 12 months; one trades for less than 2 cents a share; and three have market values that fall below $50 million.

That said, ETFs focused on this technology are fairly new, too. The four blockchain-related ETFs currently open launched this past January. All invest in firms that are exploring, adopting or enabling the use of blockchain technology. The good news is that the portfolios are filled with familiar companies. For example, each fund owns shares in IBM, Intel, Microsoft, Nvidia and Oracle.

Reality Shares Nasdaq NexGen Economy ETF (symbol BLCN ), which tracks a proprietary index, is our favorite. It charges 0.68% in annual fees and has $100 million in assets. The ETF starts with firms that have at least $200 million in market value and $1 million in average daily trading volume. It then zeroes in on companies that are expected to benefit the most--either from cost savings, for example, or operational efficiencies--from blockchain technology, ranked by a proprietary score. BLCN holds 59 stocks, and at last report, the fund's top three holdings were Cisco Systems, Intel and Overstock.com.

Cops on the Bitcoin beat

State and federal regulators have keen eyes on digital currencies. Digital-currency exchanges and wallets must register and comply with rules set by the Treasury Department's Financial Crimes Enforcement Network (Fincen). These include collecting and verifying customer information.

And the Securities and Exchange Commission and the Commodity Futures Trading Commission are cracking down on fraudulent schemes. Virtual currencies mean "potential riches and the next big thing" to would-be investors, said CFTC chairman J. Christopher Giancarlo at a congressional hearing in February, but for scam artists, they're "a way to separate the unsuspecting from their money."

Earlier this year, the CFTC charged a Las Vegas, Nev.-based firm called My Big Coin Pay, and two men associated with it, with fraud and misappropriation of funds. The CFTC alleges that the men took more than $6 million from 28 investors, touting its digital currency, MBC, as a solid investment backed by gold (when it was not). Then they spent $645,000 of the money on a house, more than $500,000 on antiques and fine art, and $340,000 on jewelry, among other purchases, the CFTC charges.

Last December, a new unit of the SEC targeting cyber-related scams filed fraud charges against Quebec-based PlexCorps and two partners in connection with an initial coin offering. PlexCorps had raised $15 million selling a digital token called PlexCoin to tens of thousands of investors by promising them a 13-fold return in less than a month. The partners said they would invest the proceeds to deliver returns. Instead, according to the SEC complaint, they took the money and used some of it for personal home-improvement projects, including lawn care and painting.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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