Bitcoin, Blockchain and Initial Coin Offerings

The terms bitcoin, blockchain and initial coin offering (ICO) may seem synonymous to those lacking familiarity with digital currency and the technology underlying it. Though there is a strong link between the three terms, they do not refer to the same thing.

In simplistic terms, bitcoin is a digital currency. Its encryption characteristics make it describable as a cryptocurrency as well. A blockchain is a digital ledger. These digital ledgers can be used for virtual currencies as well as other digital assets (e.g., a medical record). An initial coin offering allows individuals and entities to purchase a new digital currency or token.

In this Investor Professor column, we explain the three terms to give you a better understanding of each. The purpose is not to promote digital currencies as a new asset class worthy of consideration, but rather simply to provide a better understanding of them.

The Origins
The concept of bitcoin dates back to a 2009 white paper credited to Satoshi Nakamoto, “Bitcoin: A Peer-to-Peer Electronic Cash System.” As of this writing, Nakamoto’s identity remains unknown. The individual or group posting online as Nakamoto has never revealed their identity. They have also not made any known appearances either online or in the real world since 2010.The white paper presented an idea for a “purely peer-to-peer version of electronic cash.” This system was envisioned as allowing the transfer of payments outside of financial institutions. Transactions would be tracked via what was described as “an ongoing chain of hash-based proof-of-work.”

According to the bitcoin.org website, the concept of cryptocurrencies was first discussed approximately 10 years earlier by Wei Dai, a computer engineer, on an email list. The original idea was to have a digital form of currency outside the realm of central authorities.

Blockchain
A blockchain is basically a distributed ledger. A decentralized network of computers running software worldwide provides the capability to permanently record information on this ledger. This information can’t be changed, is transparent to all and has no central authority or single control point. If one computer goes down on the network, there’s no disruption to the blockchain, which continues to record information and update that information to every computer on the network. This technology allows for the tracking of records such as ownership, media and medical records. Technically, the data on the blockchain is recorded in blocks.

A block contains a transaction data, a time stamp and typically a hash. A hash is a set of numbers and letters. The hash contains data and links to a previous block. The process allows the data’s record to be amended (e.g., adding the transaction of one person selling the digital currency to another person), but makes it difficult to edit the record. An edit would require altering all records in the chain associated with the data.

The Nakamoto paper specifically addressed the issue of trust. Under the system described, the data was not only encrypted, but blocks had to be verified by others on the network. This verification process is designed to prevent fraud, such as someone trying to duplicate a bitcoin so that two versions of the same bitcoin can be used.

There are several reasons why blockchain technology has attracted interest. It can be used on a distributed network of computers using open source software—put another way, blockchain technology is relatively cheap. Once a transaction is added to the digital ledger, it cannot be altered without changing prior transaction data. The data is encrypted, providing security. Additionally, the information is transparent to all accessing it.

Bitcoin and Other Digital Cryptoassets
Bitcoin is essentially the “reward” system that keeps the eco-system of this distributed network operating. The digital currency bitcoin is created (“mined”) by computers (or nodes) on a blockchain verifying the transactions on the network. In other words, bitcoin is a form of compensation verifying transactions.

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Bitcoin has been used as a digital currency and only exists in electronic form, not in physical form the way a nickel or a quarter does. Bitcoin is not backed by any government or any physical asset (e.g., gold), and its value is solely determined by the number of people who view it as being worth a certain amount. There is a set amount of bitcoin that will be created (21 million). Proponents argue that this characteristic makes bitcoin a disinflationary currency.

There were well over 800 other digital assets as of December 2017, including ethereum and litecoin, with more still being created. Jack Tatar, co-author of “Cryptoassets: The Innovative Investor’s Guide to Bitcoin and Beyond” (McGraw-Hill Education, 2017) defines these as cryptoassets with subclasses of cryptocurrencies (like bitcoin and litecoin), cryptocommodities (ethereum) and the growing area of cryptotokens, which are the applications being built to address new business ideas.

Digital assets require both a private and public key for security purposes. Because of the blockchain, a public key is known to all, but the private key provides security for the holder of a digital asset. These assets can be held on an exchange (such as Coinbase), which has access to your private key, or off-network (aka “cold storage) on a device such as a flash drive, which is more secure. Unlike with banks (FDIC) or brokerage firms (SIPC), there are no protections should an exchange fail. If your digital assets are held off-network, care must be taken to ensure your private key is both not lost and is kept in a secure location (such as a safe deposit box).

Initial Coin Offerings
An initial coin offering is a solicitation to buy virtual coins or tokens. Depending who is promoting the ICO, prospective buyers may be told to expect some type of return on their investment.

ICOs should not be confused with IPOs. An IPO is an initial public offering of equity made by a corporation. Equity gives you ownership privileges, including claims on assets in the event of bankruptcy and (in most cases) voting rights. An ICO may or may not be an offering of securities. Even if it is a security offering, an ICO may not convey the same rights and privileges an actual (initial or secondary) equity offering offers.

This is a key point because an ICO is often a bet on the specific digital coin, token or even platform succeeding. ICOs are often not an investment in blockchain technology itself. If the ICO represents the offer and sale of securities, the offering itself must either be registered with the U.S. Securities and Exchange Commission (SEC) or have received an exemption for it.

Before participating in an ICO, it is absolutely critical to demand and read all documentation involving the ICO. This documentation can include white papers and a business plan. You should fully understand how you would be able to get your money back and whether or not the token offered can be traded on other platforms.

As is the case with any investment offering, be wary of any promoter promising high returns. Excitement over cryptocurrencies has attracted the attention of fraudsters. Exercise a high degree of skepticism before participating in any ICO.

Tax Consequences
The Internal Revenue Service treats digital currencies, such as bitcoin, as property. Any gains or losses from the exchange of digital currencies for other property counts as capital gain or loss for tax purposes.

The IRS elaborated in Notice 2014-21: “A taxpayer generally realizes ordinary gain or loss on the sale or exchange of virtual currency that is not a capital asset in the hands of the taxpayer. Inventory and other property held mainly for sale to customers in a trade or business are examples of property that is not a capital asset.”

For those who mine digital currencies, the fair market value of the virtual currency as of the date of receipt counts as gross income. If the mining constitutes a trade or business, the net earnings are subject to the self-employment tax.

The Risks of Being an Early Investor
According to cryptocurrency website CoinSchedule, 210 ICOs were completed in 2017, raising a cumulative $3.88 billion. As of mid-March, 142 ICOs have been completed during the first quarter of 2018, raising a cumulative $4.68 billion. Among the largest were Filecoin—a storage network whose tokens it claims can be exchanged for other cryptocurrencies and the U.S. dollar—and Hdac, a forthcoming platform for “internet of things” contracts and machine-to-machine transactions.

During the dot-com bubble of the late 1990s, many new companies were formed to take advantage of the then-emerging World Wide Web and the popularity for it. Most of these companies no longer exist. Many have gone bankrupt or were acquired at valuations far below what they commanded during the bubble. Of the comparatively small group of survivors, some continue to trade at prices below their peak levels.

It’s worth noting that the largest current technology companies now either didn’t exist the during the dot-com bubble (e.g., Facebook and Netflix) or have significantly altered their business models since then (e.g., Amazon and Apple). Similar patterns have occurred with many other significant technological advances. For example, Motorola, Nokia and Research in Motion (Blackberry) were all dominant in the mobile phone field before Apple and Samsung emerged with more popular phones.