It’s the investment people are talking about. Bitcoin, Ethereum, Cardano – welcome to the world of cryptocurrency.

The craze of this new type of investment has taken over the world by storm, with the cryptocurrency market worth over US$1.03 trillion.

But what is cryptocurrency?

Cryptocurrency is a virtual currency/digital asset that operates on blockchain technology. This means there is no central authority like the Reserve Bank of Australia or other financial institutions that manage the value of cryptocurrency. Instead, the value of cryptocurrency is dictated by the users via the internet.

Cryptocurrency is distributed using blockchain technology and can be traded on crypto exchanges. Some retailers also accept it as payment for goods and services.

What is blockchain technology?

Blockchain is a database that stores information in a digital format. It is more secure than other databases because it does not require the use of a trusted third party.

A blockchain is also a ledger that records digital currency transactions in code. Effectively it is like a cheque book that is distributed across multiple computers around the world and the transactions are then linked together on a chain of previous transactions.

Everyone using Bitcoin and other cryptocurrencies has their own copy of the book which creates a unified transaction record. The transactions are then logged in the software as they happen and every copy of the cryptocurrency blockchains is simultaneously updated.

To reduce the risk of fraud, each transaction is verified using one of two main techniques: proof of work or proof of stake.

What is proof of work?

Proof of work is a method used to verify transactions in a blockchain where an algorithm provides a mathematical problem that computers try to solve. Each computer, referred to as a miner solves a mathematical problem that helps verify a group of transactions, referred to as a block) and then adds them to the blockchain ledger.

The first computer to solve the mathematical problem is rewarded with a small amount of cryptocurrency.

Proof of work can use a huge amount of computer power and electricity so the miners may not break even despite being rewarded with cryptocurrency.

What is proof of stake?

Some types of cryptocurrency use the proof of stake verification method to reduce the amount of power required to check transactions. Under the proof of stake method, a person is limited in the number of transactions they can verify based on the amount of cryptocurrency that they’re willing to risk. When a miner risks a set amount of cryptocurrency it will be locked up in a communal safe.

Effectively the stake operates like security. If you’re willing to stake a higher amount of cryptocurrency you are more likely to be chosen to verify transactions.

When a validator is chosen to verify transactions they will be rewarded with cryptocurrency. To discourage fraudulent activity if you verify invalid transactions you will lose a portion of what you staked.

Why are proof of stake or proof of work important?

Proof of stake and proof of work rely on the principle of majority rules to verify that transactions are legitimate. Each verified transaction still needs to be checked and validated by the majority of ledger holders.

It is impossible for hackers to alter the blockchain ledger unless over half of the ledgers were the same as their fraudulent copy. It simply wouldn’t be possible for this to happen due to the amount of resources required.

How does cryptocurrency mining work?

Cryptocurrency mining is basically the process involved in getting rewarded with cryptocurrency for the work that you complete.

Is cryptocurrency mining profitable?

The answer to the question of if cryptocurrency mining is profitable depends on several factors. Firstly, what is the cost involved? You need to weigh up the cost of electricity to mine, the cost of the machines, the internet connection and the software that you will use.

A regular PC cannot be used to mine for cryptocurrency. You need to use at least two gaming machines to mine for cryptocurrency. Some machines have been designed to optimise cryptocurrencies like Bitcoin and Bitcoin Cash. They can cost upwards of $10,000 due to demand for them, so before you invest, you need to weigh up the cost versus profit.

Other cryptocurrencies that do not have dedicated hardware such as BitcoinGold, Ethereum and Zcash can be mined by using a GPU (graphics processing unit). They are however slower compared to mining farms.

They will then need to be set up in a low temperature environment so that there isn’t a risk of overheating.

Ultimately the profitability is influenced by the above factors and the value of the different cryptocurrencies. There are a number of websites that can tell you what the profitability will be by comparing the value of the cryptocurrency with the difficulty, the electricity rates and the hardware at prices to set up your mining operation. One website that you can use is CoinWarz.

Whether or not you choose to mine for cryptocurrency will also depend on how much time and money you’re willing to invest before you make a profit. It can take years to mine a single Bitcoin.

So how do I get cryptocurrency then?

Sometimes it’s more cost effective to simply buy cryptocurrency. Coinbase lists Cardano at $2.03 vs Ehereum at $4,532 and Bitcoin at $59,000, so whatever way you look at it, it’s not a small investment unless you’re willing to take a risk with an unknown type.

How do I buy cryptocurrency?

To buy cryptocurrency you will need to choose from one of the many cryptocurrency markets or cryptocurrency exchanges.

These exchanges give you the ability to create a digital wallet for your cryptocurrency so you can buy and sell cryptocurrency. The standard fees to buy and exchange cryptocurrency range from 0% – 1% with the most common fee being 0.5%.

The crypto exchanges are generally based in Australia, the United States or the UK however you can trade in many currencies including AUD, GBP, USD or even NZD if you want.

According to comparison website Canstar, some people want the widest selection of cryptocurrency whereas others just want a platform that is easy to use. Due to increased demand, it is much easier to find an Australian based cryptocurrency exchange.

After buying or selling cryptocurrency you will be issued with a smart contract, which is basically a digital contract that is legally enforceable according to contract law.

What are the different types of cryptocurrency?

The most popular types of cryptocurrencies include Bitcoin and Ethereum, but there were over 6,000 in circulation in 2021.

It is thought that the code for Bitcoin first started being written in 2007 by Japanese man Satoshi Nakamoto and then the domain was purchased in 2008. Then in 2009, 50 bitcoins were released on the website.

As of November 2021, Nakamoto, who may be one, or several people, owns between 750,000 and 1,100,000 Bitcoin, which is approximately $101 billion.

What is the return on cryptocurrency?

As with all investments there is a certain amount of risk when you invest. Compared to traditional currency investing, cryptocurrency has an excellent return. The monthly return on traditional currency can be lower than 1.0%. The share market fares slightly better at just under 2.0% whereas Bitcoin’s monthly return could be as high as 30%, so if you’re looking to make a quick buck, it may be right for you.

It is worth noting that 30% is the gross return before any of the costs associated with buying or mining cryptocurrency have been considered.

After you dispose of any cryptocurrency, you will need to let the ATO know that you have exchanged, traded, sold or given the cryptocurrency to another person when you file your next tax return.

If you transfer your cryptocurrency from one digital wallet to another digital wallet it is not considered disposal provided you retain ownership of it.

After you buy and sell your cryptocurrency you will need to work out the cost of the ownership which may include the purchase price and any other costs associated with acquiring, holding or disposing of it.

The ATO stipulates that after you dispose of any cryptocurrency you will need to let them know what your capital proceeds are. The capital proceeds refer to the amount that you gain from selling your cryptocurrency.

You will therefore need to keep records of your crypto assets so you can keep accurate records. The ATO has a comprehensive list of the records that you will need to keep.   These records should show the cryptocurrency, the sale or purchase price in Australian dollars, the data and time of the transaction, what the transaction was for and the private key amongst other details.

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