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How Virtual Currency Works

How do virtual currencies work

It’s important to know how virtual currency works, especially now that Bitcoin is making a comeback. At the time of editing this article (6/24/2019), Bitcoin has passed $11,000, the highest price for Bitcoin in 15 months. This has come shortly after Facebook announced it will be launching its own cryptocurrency, Libra, in 2020. As more retirement investors are re-gaining trust in cryptocurrency (and putting their retirement funds into crypto investments), it is important to state that cryptocurrencies are highly risky and volatile. It is important to perform research and learn technicalities of virtual currency prior to making an investment.

What is Virtual Currency?

Virtual currency is a digital representation of value. It functions as a medium of exchange, a unit of account, and a store of value. Sometimes, it operates like “traditional currency.” In other words, the coin and paper money of a country that is designated as legal tender.

However, it does not have legal tender status in any jurisdiction. A virtual currency is “convertible” if it has an equivalent value in traditional currency. Also if it acts as a substitute for traditional currency.


Individuals can trade virtual currency between digitally for, or exchanged into, U.S. dollars, Euros and other traditional currency. In a virtual currency system, a user creates a “wallet.” A wallet is a digital computer file that contains information to send and receive units. When the wallet is created, a random wallet address is generated. This is a unique alphanumeric identifier, which is analogous to an e-mail address. Basic wallets can be created free of charge.

A wallet holds any number of public keys with their associated private keys. The public key and private key are similar to a user ID and a digital signature, respectively. A virtual user can electronically send his or her public key to anyone he/she wishes to exchange units of virtual currency. The public key contains information that verifies the wallet and the private key is authenticates a transaction.

If both parties sign the transaction, then that transaction is complete. A completed transaction is then introduced to a network of computers. These are monitored by competing groups of people many refer to as “miners.” Miners maintain the integrity of a sequential public list of all transactions that is the “blockchain.” Miners also validate transactions that go into the blockchain with the motive of earning virtual currency.

The Blockchain

After computers on the network confirm that a transaction is authentic, the transaction is posted to a “block.” A block is a grouping of transactions. When a specified number of confirmed transactions are grouped, that forms a block. Miners then compete against each other to find a solution to a mathematical puzzle that depends on the contents of the block. Once a solution is found, that block will become an addition to the blockchain. When a new block is added to the blockchain, it generates new coins and awards the miners who discover the mathematical puzzle solution that allows the new block to be added to the blockchain.

The cycle then repeats.

The public can view all transactions in a blockchain on any computer connected to the Internet. However, the blockchain transactional history only reveals the date, the time, the amount, and the wallet addresses associated with a transaction. The blockchain does not identify the actual identities of the wallet owners. There are nearly a thousand virtual currencies, but the most widely known and largest by capitalization is Bitcoin.

Other currencies mimicking Bitcoin that use blockchain technology are known as alternative coins or Altcoins for short.

Just a few examples of Altcoins are Ethereum, Litecoin, Ripple, Feathercoin, and Dogecoin.

Purchasing Cryptocurrency

If you want to buy virtual currency with a medium of exchange denominated in a traditional currency, then find a way to transfer traditional currency to someone who has virtual currency. This person must, of course, want to make an exchange. Although this exchange can occur with anyone holding a virtual currency, Virtual Currency Exchangers (a type of business) typically handles this transaction.

Currency Exchange

A Virtual Currency Exchanger functions much like an exchanger for traditional currency. However, it can exchange virtual currency for traditional currency or vice versa. Because Virtual Currency Exchangers may receive conventional checks, credit card, debit card, or wire transfer payments as an exchange, they are a link between virtual currency systems and conventional banking and money-transmittal systems.

A virtual currency exchanger may operate on one or more platforms. The exchange rate between traditional currency and virtual currency and between different systems is typically set by supply and demand and different exchangers compete for business.

Some virtual currency exchangers are registered with the U.S. Treasury Department Financial Crimes Enforcement Network (FinCEN) as Money Services Businesses. Registration carries with it the requirement of following Anti-Money Laundering (AML) rules, including Know Your Customer (KYC) rules. KYC principles require a registered exchanger to confirm and document the identities of its customers. Then, they must relate each account to a known beneficial owner.

IRS Tax compliance concerns associated with the use of virtual currencies

The primary virtual currency the most attention regarding taxable transactions and tax compliance is Bitcoin. This is because it’s the most traded and the largest by capitalization. Bitcoin is a virtual currency that exists only on the Internet. It does not have legal tender status (in contrast to U.S. dollars or Euros) and it has its own value units. The value of Bitcoin against the U.S. dollar, as with many other world currencies, is determined by supply and demand on the open market. It’s affected by factors that are typically difficult or impossible to forecast, such as an increase in investment into Bitcoin financial technology startups, security breaches, geopolitical regulatory issues, and Bitcoin exchange collapses.

In the simplest concept of supply and demand, when demand for Bitcoins increases, the price increases. And when demand falls, the price falls.

A tax compliance challenge taxpayers face when transacting in virtual currency is that it may be difficult for individuals to receive income from virtual currencies to determine their tax basis for calculating gains. They may have trouble determining the value of the currency when first obtained, or in maintaining documentation to determine their tax basis. However, some taxpayers may deliberately use virtual currencies as a way to evade taxes.

Because transactions can be difficult to trace and many virtual currencies inherently have a quasi-anonymous aspect, taxpayers may use them to hide taxable income. Furthermore, in the experience of the IRS, tax noncompliance increases when there is no third-party information reporting. In other words, taxpayers are less likely to report and pay taxes on income that the IRS doesn’t independently report by a third party.

Tax Gap Studies

IRS “tax gap” studies consistently show that, when third parties are subject to report income amounts, compliance is far higher. The most recent study of this was in April 2016 by the IRS. It came from data between the years 2008-2010. The conclusion was that the overall rate of under-reporting of income that was not subject to third-party information reporting was 63%. This is compared to 7% for amounts subject to substantial information reporting but no withholding. Also, 1% for amounts subject to substantial information reporting and withholding.

Because there is no third-party reporting of virtual currency transactions for tax purposes, the risk/reward ratio for a taxpayer in this environment is extremely low. The likelihood of under-reporting is significant.

Regulatory Challenges Posed by Virtual Currencies

Virtual currencies pose challenges for central banks, departments and ministries of finance. It also creates challenges for financial regulators. The main regulatory challenges virtual currencies pose are the prevention of money laundering, collection of taxes, consumer and investor protection and the calibration of monetary policy.


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