How to Use Cryptocurrencies
Uses of Cryptocurrency Overview
As previously detailed, there are a number of regulations surrounding Cryptocurrencies which vary by location (State Regulations) and by federal agency (FINCEN Regulations, IRS Regulations, SEC Regulations, and CFTC Regulations) and these regulations guide what you can and cannot do with any Cryptocurrency that you acquire. This blog will provide a high-level overview of the different things you can do with Cryptocurrency and how you can become more involved in the space. In addition to the below, entities can create their own tokens and offer them via an Initial Coin Offering (“ICO”) process, as well as create utility tokens, to generate funds for the company. Given the complexity involving ICOs and utility tokens, neither is discussed in this article. Please be aware that as the regulations change and vary from state to state, your state of residence can heavily determine what options, and Cryptocurrencies, are available to you.
At its core, Cryptocurrencies were invented to be just that, a currency. Cryptocurrencies can be used to buy various things, both digital and physical goods, as well as pay for services. In fact, the first time a Cryptocurrency was used in a transaction was on May 22, 2010, when two large Papa John pizzas were purchased and delivered in exchange for 10,000 Bitcoin. At the time, 10,000 Bitcoin were worth roughly $41, and two large Papa John pizzas were $25. As of this writing, 10,000 Bitcoin are worth in excess of $550 Million, and two large Papa John pizzas are approximately $32. Since that initial purchase, using Cryptocurrencies for purchases of physical personal property has become more popular. Companies such as Microsoft, AMC, and Overstock among others accept Bitcoin for payment. The Dallas Mavericks accept both Bitcoin and Dogecoin. Furthermore, some sellers of real estate accept payment in Cryptocurrency. Certain technologies, such as the Lightning Network, are being developed to help facilitate transactions among Cryptocurrency users. Lastly, as of September 7, 2021 Bitcoin is considered legal tender in El Salvador, and accordingly multi-national retailers such as McDonald’s and Starbucks now accept Bitcoin in their El Salvador locations.
Collectors and sellers of rare assets have also started to accept Cryptocurrency for payment. For example, in July of 2021, Sotheby’s announced that they would be accepting payment for the sale of a 101.38-carat diamond in Cryptocurrency. The diamond sold for a price of $12.3 Million. This transaction was on the heels of Sotheby’s selling a piece of artwork created by Banksy for $12.9 Million. Both of these sales pale in comparison to the Beeple created Non-Fungible Token (“NFT”) titled “Everydays – The First 5000 Days” selling for $69 Million in Ethereum. Recently, NFTs such as Cryptopunks, Lazy Lions, and Bored Ape Yacht Club, to name a few, have been selling for as much as eight figures in US Dollar terms. NFT owners generally only accept Cryptocurrencies as payment given that the ownership of a NFT is tracked on a specific Blockchain.
Although you can spend your Cryptocurrency, as you can tell from the Bitcoin Pizza transaction, the prices of goods relative to the value of Cryptocurrency can substantially decrease. Additionally, when you spend Cryptocurrency, per the current IRS guidelines, that is a taxable transaction. For that reason, many people prefer to hold their Cryptocurrency as a long-term investment.
Long Term Investing
One of the most popular non-technical terms for Cryptocurrencies investors is “HODL” which means to hold on to the coins. Given that Cryptocurrencies are an extremely new asset class, they are extremely volatile. For example, let’s look at Bitcoin.
In December of 2020, Bitcoin began the month at $19,7000, dropped as low as $17,570, and went as high as $29,300 before ending December just below $29,000. Then, in 2021 Bitcoin, as of this writing, has reached as high as $64,895 and as low as $28,600, and is currently hovering around $55,000. That type of volatility, a close to 300% rise, followed by a 50% decline and then roughly a 100% increase again, all within less than a year, is extreme. Not to mention, because Bitcoin is taxed as property, any purchase and subsequent sale of Bitcoin during the above described time period resulting in a gain would be taxed as ordinary income.
On the other hand, Bitcoin has a 10-year compound annual growth rate (“CAGR”) of between 150% and 200% as of this writing. For a point of reference, the S&P 500 has a 10-year CAGR of just over 11% over the same time. On a shorter time horizon, there have only been two years in which Bitcoin had a negative one-year return, 2014 and 2018. The other nine years since 2010 have resulted in seven years having over 100% yearly returns, with 2015 and 2019 only having 35% and 95% returns respectively. As of this writing, 2021 has had just about a 100% return. While I used Bitcoin as the example, it is a similar story for other Cryptocurrencies (including Ethereum and Litecoin to name two others). Below is a chart comparing the returns of the S&P 500 and the stock of some publicly traded companies against Bitcoin over the last decade. Other Cryptocurrencies are not included in this chart because for all intents and purposes, all other Cryptocurrencies are less than ten years old.
|Asset||October 2021 Price||October 2011 Price||Percent Increase|
An added benefit of holding the Cryptocurrency for longer than a year is that any gains from an eventual sale of the currency is treated as a long-term capital gain and therefore receives more favorable tax treatment. This strategy of long-term holding does not just apply to individuals, but to businesses as well. Companies such as Microstrategy and Tesla hold Bitcoin on their balance sheet. Since Microstrategy announced its first Bitcoin purchase in August 2020, its stock price has increased from under $150 per share to over $730 per share as of this writing. Coinbase is an example of a company that holds Ether on its balance sheet.
The above is not meant to be financial advice in any manner whatsoever, it is just an illustration as to why some people choose to take a long-term investing and holding the perspective with respect to their Cryptocurrency. Other people prefer to try and time the large swings in the value of the Cryptocurrencies and prefer to frequently buy and sell Cryptocurrencies.
Although some people prefer to HODL their Cryptocurrency, others attempt to take advantage of the extreme volatility and profit from short-term trading of various Cryptocurrencies. This trading is not just limited to Cryptocurrency only platforms such as Coinbase and Gemini, but also platforms that allow for investing and trading of traditional assets. In fact, Robinhood reported in August that 41% of its total revenue in the Second Quarter of 2021 was derived from commissions on Cryptocurrency trading and that more than 60% of its customers traded Cryptocurrency in the Second Quarter. Coinbase saw 8.8 Million individual users during the Second Quarter, good for $462B in trading volume. Clearly, there are a large number of investors that trade Cryptocurrencies.
A key difference between the Cryptocurrency market and the traditional stock market from a day trader’s perspective is that that the Cryptocurrency market is never closed. The Cryptocurrency market is open twenty-four hours a day, seven days a week. Certain exchanges crash from time to time and are unable to execute trade orders that are placed, or even allow orders to be placed, but the market itself is never closed. Another challenge with pursuing day trading of Cryptocurrencies is the sheer volume of different currencies. The number of different coins along with the still-evolving regulations can make it very hard to properly research the various Cryptocurrencies to the same depth an investor can research a publicly-traded company. Additionally, certain Cryptocurrency exchanges allow investors to trade on leverage, sometimes up to as much as a 300 to 1 leveraged amount. Given the extreme volatility that Cryptocurrency markets are subject to, day trading Cryptocurrencies is extremely hard to profit from, and day trading Cryptocurrencies with leverage is an extremely risky endeavor. Again, the foregoing is not meant to be financial advice in any manner whatsoever, it highlights why certain people are attracted to pursuing a day trading strategy involving Cryptocurrencies.
Borrowing and Lending
As is done with traditional asset classes, such as real estate, an owner of Cryptocurrencies can use their Cryptocurrency holdings as collateral for loans. The interest rates on these loans vary depending on the type of Cryptocurrency being used as collateral, the loan-to-value ratio of the collateral, the term of the loan, and the platform on which the loan is being created under. For instance on one platform created for Cryptocurrency lending and borrowing, if you wanted to take a loan of $100,000 USD collateralized by Bitcoin the interest rate associated with the loan ranges from 1.00% to 8.95% percent depending on whether the loan-to-value ratio is 25% or 50%. However on a different platform, for the same $100,000 USD Loan, the interest rates range from 6.5% to 13.25% depending on whether the loan-to-value ratio is 20% or 50%.
In addition to these platforms offering the ability for Cryptocurrencies holders to obtain loans collateralized by their Cryptocurrency, they also offer Cryptocurrency holders the ability to earn interest on their holdings. Similarly to how the interest rate that a borrower must pay varies from Cryptocurrency to Cryptocurrency and from platform to platform, so does the yield that a holder can earn by depositing their Cryptocurrency into a borrowing and lending platform. For instance, on one platform someone depositing Bitcoin can earn 6.20% interest on their first Bitcoin deposited and 3.51% on all subsequent Bitcoins in their account, while on that same platform interest rate for Ether is 5.35% for the first 100 Ether deposited and 5.05% for any subsequent Ether deposited. Interestingly, USDC (a stablecoin tied to the value of the US Dollar) can be deposited and the person depositing the coins can earn 8.88% interest on those holdings. However, on a separate platform, a participant can receive up to only 4.5% interest on Bitcoin, 5% interest on Ether, and 8.25% on USDC.
While using Cryptocurrency as collateral for loans may seem like a great idea, because of the extreme volatility inherent in Cryptocurrencies there is a high risk of the value of the collateral falling below the loan-to-value ratio, and thus requiring more collateral to be deposited or risk losing the already posted collateral. It is also extremely important to note that a growing number of state security regulators have been looking into the borrowing and lending platforms to determine whether the interest payments that users are receiving are unregistered securities. As of this writing, no action has been taken against these platforms, but that does not mean that future action will not be taken.
As you can see, there are quite a few different ways to approach using your Cryptocurrency once you have acquired it. As a reminder, you can purchase Cryptocurrency from various exchanges, you can participate as a miner for a specific blockchain to acquire the Cryptocurrency for that blockchain, or you can be paid for goods or services in Cryptocurrency. Similarly to being paid for goods or services in Cryptocurrency, you can also pay someone else for goods or services with Cryptocurrency. Given the extreme volatility that Cryptocurrencies incur, some people choose to hold their Cryptocurrency for years as the technology becomes more widely adopted, while others attempt to profit in the short term from frequent trades. Finally, some people also choose to use their Cryptocurrency as collateral for obtaining loans; and others choose to lend their Cryptocurrency in return for interest payments. As previously stated, these are just a few ways that Cryptocurrencies can be used, and the available uses vary greatly from state to state. If you have any questions regarding the above, please do not hesitate to reach out.
The information provided herein is general in nature and is purely for informational purposes and does not constitute legal advice, nor does it create an attorney-client relationship. You should accept legal advice only from a licensed legal professional with whom you have an attorney-client relationship.
As the law continues to evolve on these matters, please note that this article is current as of date and time of publication and may not reflect subsequent developments. The content and interpretation of the issues addressed herein is subject to change. Cole Schotz P.C. disclaims any and all liability with respect to actions taken or not taken based on any or all of the contents of this publication to the fullest extent permitted by law. This is for general informational purposes and does not constitute legal advice or create an attorney-client relationship. Do not act or refrain from acting upon the information contained in this publication without obtaining legal, financial and tax advice. For further information, please do not hesitate to reach out to your firm contact or to any of the attorneys listed in this publication.
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