14 December 2021

Things to know before you go crypto

Finance KnowCents Technology

More Australians are using crypto than ever before, with this year’s ATO figures showing around 800,000 people transacted with cryptocurrencies, up 200,000 from the year before.

Doctors with investments may be wondering: is this simply a bubble, scam or even a fraud? Or should you think of it more as a new, but hard to understand, asset class that could comprise some of the risky end of a portfolio? 

To find out more, let’s first talk about what we mean when we say “crypto”. 

There are basically three types of digital assets you can invest in: cryptocurrencies, fungible tokens and non-fungible tokens (NFTs).

Cryptocurrencies are the most well known, and they include coins such as Bitcoin (BTC), Ether (ETH) and Dogecoin (DOGE).

Bitcoin is the oldest and biggest of the cryptocurrencies floating around now, and just recently hit a peak of $US69,000 (A$96,000) before experiencing a “flash crash” last week and then a partial recovery. Quite a jump from its first real use as a currency, when it cost 10,000 BTC to buy two pizzas. 

The distinction between a token and a cryptocurrency really comes down to the idea of “local currency” for network fee purposes. Similar to how VISA charges a processing fee in AUD when you transact with it in Australia, the Ethereum network charges a transaction fee, payable in ETH, when you use its network. Tokens exist on various networks, but they cannot be used to pay network fees.

NFTs deserve their own article, but the simplest explanation of them is that they are meant to represent distinct things. For example, a photographer might release a limited number of copies of a particular photo and mint an NFT for each copy.

The holder of the NFT would then have a digital receipt proving that they have an authentic version of the art.

But typically, when people talk about “crypto(currency)”, they’re conflating the first two categories (cryptocurrencies and tokens). For this article, we’ll refer to these two assets as “coins”.

How can I make (or lose) money with crypto?

There are several different ways you can shove money into the crypto space in the hopes of getting more out the other side.

Speculation

The most popular and best-known way is through speculation.

If you buy Bitcoin now, you’re paying around US$50,000 because you think that at some point it will be worth more. This is also the main driver behind a lot of the purchases of “altcoins” (anything that’s not Bitcoin).

Why will it be worth more? That’s the speculation part.

NFTs are almost equally speculative but there’s a bit more cachet, given the non-fungibility, and depending on what the origin story is (for example, it’s a Banksy), you usually have a bit more information on which to gamble.

Usually, people will buy an NFT of a Banksy artwork, or a digital render of a gorilla, as a chance to display their wealth, and just as the value of real-world art can appreciate for a famous artist, so too can an NFT.

Lending

We are in the early days of decentralised finance (DeFi, for short). As a result, legions of software developers are attempting to bring as much of the traditional finance playbook over to DeFi as possible.

In particular, many projects exist to enable peer-to-peer lending. Instead of getting a loan from a bank, you put up your coins as collateral, and borrow a fraction of the value in some other coin (typically something pegged to the US dollar).

While there are ways to make money from borrowing, most of the money comes from being a lender.

Right now, there are many companies competing to become the leading lending platform on various blockchains and they’re offering various incentives to get users to lend particular coins to other users.

As opposed to traditional finance, nearly all these DeFi lending platforms avoid default risk by making sure that all loans are over-collateralised. This makes the idea of lending much more appealing for certain individuals because the risk of losing your original capital is shifted away from the debtor.

Liquidity providers

Being a liquidity provider (LP) essentially means that you are contributing a certain amount of money into a pool that others can use to trade from one coin to another.

So, let’s say you own a bunch of Bitcoin and Ether, and you’re not interested in trading one for the other, but you are interested in earning some money from them. In the world of crypto, this is done in what’s known as a liquidity pool.

In this example, an ETH-BTC liquidity pool is just a collection of Ether and Bitcoin that is available to other users to swap coins from one into the other (at a fluid conversion rate).

Since the Ether and Bitcoin sitting in that pool need to come from somewhere, individuals are incentivised to provide their Ether and Bitcoin for a cut of the trading fee, which is proportional to their share of the pool. 

If you contribute to a fairly active pool, you might expect a decent amount of revenue from the trading fees.

The catch for being a liquidity provider (and there’s a catch for everything) is that a high level of knowledge is necessary to understand the market circumstances that are required to ensure your share of the fees are greater than any potential losses incurred from lending your capital. 

Yield farming

As with traditional finance, it shouldn’t surprise anyone that DeFi has all sorts of exotic and derivative instruments. In particular, projects known as “yield farms” borrow these liquidity provider tokens from individuals, and leverage the accessed liquidity into higher yields.

Some of these returns are eye-watering (1000+ APY). But be mindful that these returns include the money you would have received in LP fees anyway, and they can be riskier. They also never exist for more than a few days, so be prepared to turn this into a full-time job – juicy returns often need to be vigilantly monitored.

Gambling

With the introduction of provably random number generation to the blockchain, it was inevitable that on-chain gambling would spring up. Right now, the various on-chain games are as simple as betting on a coin-flip or dice-roll; however, few entrepreneurs have ever lost money by overestimating the internet’s appetite for gambling, so you can expect to see more casino-style on-chain action arrive in the near future.

Gaming

Prior to 2020, the “play-to-earn” model of gaming basically didn’t exist. The idea is as simple as it is absurd: reward gamers for playing your game with cryptocurrency and reinforce their emotional investment in the game with a financial one.

The most lucrative play-to-earn game is Axie Infinity, on the Ethereum network. Throughout 2021, a novice Axie Infinity player could earn more than the Philippines minimum wage through playing the game. In fact, high-ranked players often made more than the Philippines average daily wage.

Money laundering  

As a doctor, you probably aren’t going to need to launder money. But just in case, NFTs have come under scrutiny for being heavily used as a way of laundering money.

People can create an NFT or buy one cheaply, and then sell it to another one of their wallets for a much higher amount. Because these wallets can be anonymous, it’s an effective method for turning dirty money into clean money in a way that’s difficult for authorities to track.

Where do I actually buy these things?

If you’re hoping to buy Bitcoin on nabtrade or SelfWealth, you had better not hold your breath. There are already myriad regulated crypto exchanges that offer the ability for you to transfer your AUD to the exchange via bank transfer. Two popular options are Binance and Crypto.com. If you want to use bank transfer as a low-fee way of getting capital to an exchange, you’ll need to verify your identity (aka KYC: Know Your Customer). If you’d rather not give your personal information to an exchange, there are other (also reputable) exchanges such as KuCoin that allow you to purchase coins via third-parties like Banxa. The trade-off here is that companies that let you use plastic usually take a hefty commission.

Are there any traps I should be aware of?

Well … in crypto, the idiom “if it’s too good to be true, it probably is” is a good one to keep in mind.

Before jumping into this space, it’s worth reading up on rug pulls and bank runs, because both have already lost people a lot of money. In fact, between network hacks, scams and other malicious activities, estimates place the amount of money lost or stolen to more than US$10.5 billion in 2021 alone.

And despite Bitcoin becoming a household name, be cautious of assuming it’s a safe bet. The price can easily drop 20% in a weekend – or even an hour. 

Ultimately, this is a very volatile space, and there are services on offer that have been banned to retail investors in conventional finance. This means that there may be more money to be made than in traditional finance, but there is often a reason these regulations exist – and they’re often written in blood.

What does the ATO think about crypto?

For tax purposes, you can think of cryptocurrencies as similar to shares in a company.

When you purchase or receive a coin, the (market) value of the coin at the time of reception is your cost basis and when you sell or gift that coin, the value of the coin (in AUD) will determine your capital gains or losses.

Interest borne from your coins is seen as a gift with zero-cost basis (i.e. 100% profit), so be prepared to consult a crypto-tax specialist if you’re anticipating a fair bit of interest from your coins.

The good news is that digital assets still enjoy tax discounts if held for more than one year and their capital losses can be rolled over like other investments.

Who has custody of my coins?

Possession can be another confusing topic in the crypto space. The safest and oldest method of coin custody is what’s known as a “cold wallet”, which is a USB device that’s not connected to the internet (the digital version of keeping your crypto under your mattress).

The most popular/trusted brands are Trezor and Ledger, and using a hardware wallet is highly recommended if you’re anticipating owning more than $1 million.

But some argue that if you care about any amount of money, you should be storing it in a hardware wallet.

The downside to using a cold wallet is that you have to pay network fees and wait for your transaction to get processed if you want to move coins from your wallet to an exchange when you finally decide to cash out.

Depending on the coins you’d like to trade, this could cost hundreds of dollars and take up to a few hours.

If you intend to trade with some frequency, you might be better off keeping your coins with your exchange account. However, be warned that while your coins are parked with your exchange, you have only so much control over them.

Exchanges suspend network withdrawals from time to time for maintenance, or other reasons, and if anything goes wrong and an exchange gets hacked, you’re not guaranteed to get your money back.

Exchange hacks are becoming less likely as time goes on and exchanges take cybersecurity much more seriously.

In the end, there’s a popular saying that refers to a crypto wallet’s private cryptographic key: if they’re not your keys, they’re not your coins.

The information in this article is for general information only and is not financial advice; please speak to a financial advisor for information on your own specific needs

Steven Pollack is a software engineer for a cryptocurrency hedge fund and has invested in cryptocurrencies.

COVID-19 live update