It seems like crypto is everywhere now, whether it’s talk on Twitter about the hottest new token or Square changing its name to Block. After hearing your cousin talk about it non-stop over the holidays, you might be thinking about investing in some crypto. Or, you might even be working a side job in crypto/web3 and need to know how to handle the income from that role. This is going to be an introductory post on crypto, and we’ll talk about handling the tax nuances in a later post. For now, just remember that you need to keep track of all your crypto income (and losses), whether it’s profits you made from trading or tokens that you’ve received as compensation for your work.
Bitcoin and How It All Started
At this point, you’ve probably heard of Bitcoin (BTC). It was the first crypto protocol that was developed after Satoshi Nakamoto released the white paper in 2009 (you can read it here). Before talking about the different tokens though, let’s take a step back and look at the underlying blockchain technology. This part may get a little technical, so if you don’t care about the details on how crypto works, then skip ahead to the Ethereum section where we’ll talk about some of the more interesting modern crypto use cases.
You’ll often hear blockchain referred to as a “distributed ledger.” A ledger is a record used to keep track of things, and it usually requires a trusted intermediary to maintain it. A bank is trusted to keep a ledger of all the cash transactions and customer balances, just as a county clerk keeps a ledger of all the property records in an area.
Satoshi’s paper proposed a distributed ledger, where the ledger’s information is stored in thousands of devices in a distributed network of nodes. If a single node goes down, the system is not interrupted as the ledger will be maintained by all the other nodes. This ledger is called a blockchain, and every node in the system keeps the full blockchain’s history. In order to propose a new transaction to the blockchain, it has to follow certain rules in order to be “mined” by the nodes (i.e. you can’t send money that you don’t have). Once the transaction is mined, or verified, and the nodes post it to the blockchain, the blockchain’s history cannot be changed. This is how the trustless system (requires no intermediary) is able to operate.
In its simplest form, a block will contain X numbers of transactions. When you want to send someone bitcoin or any other cryptocurrency, you send the transaction request to a node (these nodes are also called “miners” in Proof of Work systems). That node will put the transaction into a block with other transactions, and then the block will get added to the chain. As a reward for mining the blocks, the nodes are paid in bitcoin for the service they provide. There are cryptographic proofs used to ensure that none of the blocks are malicious (i.e. trying to send cryptocurrency that isn’t yours). Since all the nodes store the entire blockchain, anyone can go back and view the transactions. The nodes are the critical components of the system as they validate the transactions and update the chain, keep the chain’s history, and keep the chain secure from bad actors. In BTC, this is done via Proof of Work (POW) which is often criticized for its energy use as it is computationally intensive (there are fixes for this, like switching from POW to Proof of Stake, which we’ll discuss in a bit). The computational intensity keeps the system secure, as a bad actor would need to invest in a lot of computing power to have the requisite scale to corrupt the system’s consensus. This is referred to as a “51% attack” or a “majority attack” as you’d need control of 51% of the computing power to be successful.
Bitcoin has a fixed supply of 21 million tokens. The “hash rate” refers to how many blocks get mined per unit of time. Bitcoin halves the hash rate every ~4 years which results in less and less being minted over time, until all 21 million are mined. This is conceptually similar to a real miner – back in the day you could go to a river with a sieve and find gold, but now you need to invest a lot more to find the diminishing supply of gold in the ground. This is why sometimes BTC is referred to as “digital gold”.
Ethereum and Smart Contracts
In 2014, at a crypto conference (you can watch here), Vitalik Buterin gave a presentation where he proposed a blockchain that could do more than just handling send/receive functions. He proposed a “smart contract” function where you can deploy code to the blockchain and have it executed when certain things happen. These digital contracts automatically execute when predetermined terms and conditions that are specified in their code are met. These programs automate the execution of agreements so that all participants can be immediately certain of the outcome, without any imerediary’s involvement. This was the genesis of Ethereum (ETH). This added functionality greatly expanded the use cases of blockchains, and has led to the emergence of DeFi (decentralized finance), dApps (decentralized apps), and DAOs (decentralized autonomous organizations). This effectively turned all the ethereum nodes into a giant computer running the smart contracts deployed to it, which is now referred to as the Ethereum Virtual Machine, or EVM.
One of the first use cases of smart contracts was DEXs (decentralized exchanges). Most new users usually go to Coinbase, Binance, or another similar website to buy their first cryptocurrencies. These are Centralized Exchanges (CEXs) as they are run by one company who acts as the broker, similar to how Fidelity handles your stock trades. Now DEXs exist though, the largest being Uniswap, where people put their crypto into collateral pools and you can trade against the liquidity without any intermediary being involved. Uniswap takes a fee for processing the transaction, but it’s all automated.
Smart contracts have also changed how companies are financing themselves. Crypto companies now are structuring themselves around their tokens. If a VC investor wants to provide funding to programmers to support their project, instead of buying stock certificates, they buy the protocol’s tokens. In the last year, a lot of companies have started distributing the tokens to their users as well, to reward the early adopters! This is a big change from prior capital markets where the VCs and founders kept all the rewards, and users couldn’t buy into a company they liked/used until the company IPO’d.
Ethereum also enabled the creation of NFTs. Ethereum (more specifically, the ethereum ERC-20 token) is considered a fungible token. This is similar to the US Dollar – if I give you $1 and you give me a different $1 back, neither of us would care as they are fungible. The same goes for 1 ETH (ERC-20); 1 ETH is worth 1 ETH, just as $1 is worth $1. However, Ethereum also developed the ERC-721 token, which is a non-fungible token or NFT. This means that each NFT is unique and not interchangeable with other ERC-721 tokens. Artists have used this to sell digital versions of their art while cutting out the art dealer as the middleman. Just digitize the artwork and tie it to an ERC-721 token (NFT) and you can sell the NFT to any buyer online.
Solana, Avalanche & Other Altcoins
The one big knock on ETH is that it currently has very high fees, which they call gas (the fees based on usage, and usage has gone up with all these dApps and smart contracts being deployed). Ethereum is currently working on addressing this via “sharding” an engineering concept where instead of running one chain, you run multiple at the same time and figure out a way to consolidate them into one master chain in order to increase bandwidth. There are other companies working on “rollups” which will also help to lower fees. These rollups are referred to as Level 2 (L2) protocols, because they run on top of the ETH chain to make it faster. However, because it’s taken time to deploy these scaling solutions, you’ve had the emergence of “altcoins,” or other L1 protocols that compete with Ethereum, like Solana (SOL) and Avalanche (AVAX). These basically took ETH’s smart contract concept and increased the throughput to make it cheaper and faster. However, in crypto there is something called the “trilemma” which means you have 3 things you need to balance: speed, security, and decentralization. Some industry participants allege that by focusing on speed, these altcoins have sacrificed decentralization. Decentralization is important because the more nodes you have validating transactions, the more difficult it is to shut down or corrupt the system. In addition to decentralization, ETH also has the first mover advantage. Since SOL and AVAX are newer, they don’t have as many dApps on them yet.
This year, ETH is moving to Proof of Stake (POS) instead of the computationally intensive POW that is currently used. This means that going forward you will stake 32 ETH to be a validator node, and if you do anything malicious you can lose this “skin in the game.” This change will address the criticism that crypto mining is energy intensive. Notably, BTC is also looking to move to a POS model. As discussed, ETH is also working on sharding which should lower fees, as will the proliferation of roll up protocols.
Crypto Use Cases & Web 3.0
While it’s been around since 2009, blockchain technology is still in its early phases. Let’s compare it to the internet, whose birthday is generally considered to be 1983. 10 years later, we were still using dial-up internet and sending messages on AIM. Google wasn’t founded until 1998 (15 years later), there was the infamous “dot com crash” of 2000, and Facebook didn’t come into existence until 2004. All of which confirms, it takes time for new technologies to find their “killer use case.” This brings us to Web 3.0.
Web 1.0 refers to the advent of the internet, where it was primarily used for messaging and protocols like https were just being developed. Web 2.0 launched off the back of Web 1.0, with websites like Facebook and Amazon changing the way we live. However, now there is a frustration with the concentration of power that the Web 2.0 “big tech” companies have amassed. There are only a few large cloud computing companies and a few large social media companies out there, with no obvious alternatives. Web 3.0 is considered the “decentralization” phase of the internet, where the power is taken back from the giants. This system will allow users, contributors, and content creators to share in the upside with the developers via token distribution, creating better alignment of incentives. Blockchain is the technology that will enable that transition.
To be fair, some things will likely always run on Web 2.0 protocols as there are benefits to scale. Decentralized nodes will probably never be as efficient as an Amazon server farm. However, with people working remotely now, and trust in governments and big tech companies lower than ever, the economy that crypto enables doesn’t seem like it’s going away. Some of the smartest programmers are working on this tech now, and while there may not be a “killer app” yet, it seems like crypto is here to stay.
Meta/Facebook brought the term “metaverse” to the mainstream (although they weren’t the first to come up with it), pitching us on a world where we’ll be taking meetings as avatars in augmented reality (AR) or virtual reality (VR) conference rooms. With NFTs, people are already adopting their avatars. Just look at all the Twitter profile pictures of peoples’ NFTs. Owning a CryptoPunk is a status symbol now. What started as an “overpriced jpeg” is now a source of identity for people in their online communities. If we want to avoid a handful of companies controlling the metaverse, crypto protocols will be instrumental in achieving this. They will allow you to keep your digital identity and assets and use them across the internet/metaverse.
While wide adoption of the metaverse is likely some years away, there are some interesting crypto uses already in existence. For example, there is an ethereum-based game called Axie Infinity. This Web 3.0 video game is allowing people in emerging markets to earn more money in cryptocurrency than they could at a traditional job in their local economies (read more here). Companies are now giving tokens to their early adopters building a more engaged community. These token holders get to vote on governance proposals to steer the direction of the DAO/dApp, or simply sell them for money if they’re not interested in participating in the organization long-term. It’s still in the early days of these use cases, but it’s evolving rapidly and it seems safe to say that gone are the days where crypto was accused of only being used for illicit transactions or held as a hedge against inflation (though the latter still remains one of the many reasons people hold it!).
Crypto as an Investment
Hopefully, you can see that each protocol is very different. If you’re buying BTC, you’re buying an asset with a fixed supply of 21m that can ever come into existence. This means that it has similar characteristics to gold and can act like a hedge against inflation. However, there are other protocols that issue LOTS of tokens as rewards to users. Token issuance of this nature is inflationary, and so adoption of the protocol needs to be growing as fast as the token issuance to provide an attractive investment opportunity. Ethereum falls somewhere in between – it’s not hyperinflationary but it’s not “digital gold.” One could argue that by buying ETH you’re betting on increasing adoption of the Ethereum Virtual Machine as we move towards Web 3.0. However, don’t forget the altcoins like SOL and AVAX that are trying to steal Ethereum’s market share!
Like any other investment, you need to do your research and recognize that there’s a lot of other people and industry participants doing the same. It seems like the easy gains of “buy bitcoin in 2009, roll profits into Ethereum, roll profits into NFTs and altcoins” are behind us (I could be wrong though… things change fast in the crypto world!). If you have your rainy day fund set up and you’re saving sufficient amounts for retirement and your other life goals, then an allocation to crypto in your investment portfolio might make sense if you find all of this interesting (some experts are saying it makes sense as part of a diversified portfolio now, like Ray Dalio). Just understand that it’s a new technology, trading close to all time highs, and it’s likely to be volatile both up and down. If you’re ok with this risk profile and have the cash to invest, good luck and let us know what you like!
Lastly, make sure you’re keeping track of your crypto transactions. If you’re working for a crypto protocol and getting tokens as compensation, keep track of this too. Most of the crypto exchanges and wallets don’t do this for you yet, and you’ll need to report the income and gains/losses from sales at the end of the year on your taxes. We’ll go into more tax details in a later post, but for now be aware of this as it’s easier to keep track of this stuff while you’re doing it rather than scrambling to get everything organized on tax day.