Cryptocurrencies and initial coin offerings (ICOs) have emerged over the last 10 years as investments. You could lose a lot of money if you invest without doing your research first.
How cryptocurrencies work
Cryptocurrencies, also known as virtual currencies or digital currencies, are a form of electronic money. They do not physically exist as coins or notes. A cryptocurrency unit, such as a bitcoin or ether, is a digital token. These digital tokens are created from code using an encrypted string of data blocks, known as a blockchain.
The Reserve Bank of Australia's website explains how cryptocurrency and blockchain technology works.
Cryptocurrencies are used as payment systems to execute contracts and run programs. Anyone can create a digital currency, so at any given time there can be thousands of cryptocurrencies in circulation.
Types of cryptocurrencies
Each cryptocurrency has different capabilities. Most were not created to be investments.
Bitcoin is a digital currency. Users in the Bitcoin network (bitcoin miners) use computer-intensive software to validate transactions that pass through the network. They earn new bitcoins in the process. Bitcoin is a decentralised global payment system, but it's bought and sold in large volumes as a speculative investment.
Ethereum uses blockchain technology to run an open source platform. It can process transactions, contracts and run other programs. This allows developers to create and run any program, in any programming language, on a single decentralised platform. In the Ethereum blockchain, miners work to earn 'ether', which is a crypto token. Ether can pay for fees and services within the network.
Litecoin is an electronic payment system. Litecoin transactions process faster than Bitcoin. There are also more Litecoins in circulation than there are Bitcoins. Some users see Litecoin as a 'lighter' version of, or backup for, Bitcoin.
Ripple is a transaction protocol designed to complement Bitcoin. It allows real-time transfers between users in any currency, including other cryptocurrencies. Ripple is a database in which users can store and transfer value in any currency on a protected network. Ripple uses tokens developers create, rather than mined or earned like other digital currencies. Some users don't see Ripple as a true cryptocurrency, but the technology has been popular with financial institutions.
You can buy or sell cryptocurrencies on an exchange platform using traditional money. The cryptocurrencies are kept in a digital wallet and some stores accept cryptocurrencies are payment for goods and services. But, they are not legal tender and not widely accepted.
You can withdraw some popular digital currencies like Bitcoin as cash through special ATMs.
See the Australian Taxation Office website for the tax treatment of cryptocurrencies in Australia.
How initial coin offerings (ICOs) work
An ICO is a way a project can raise money over the internet. You invest in an ICO by sending money or cryptocurrency to a blockchain project. In return you receive digital tokens related to that project.
ICOs are speculative, high-risk investments. Many ICOs are for projects that:
- are experimental
- are at a very early stage of development
- may not have even started yet
Some projects may take years before they become commercially viable, if at all. A large number of ICOs fail or do not increase in value.
ICOs sound similar to initial public offerings (IPOs). But ICOs usually don't offer any legal rights and protections. Investing in an IPO means you are investing in an established company or asset, rather than a project.
While ICOs use the internet to raise money they are not the same as crowd-sourced funding. Crowd-sourced funding offers basic investor protections under Australian law.
ICO white papers
There will usually be a 'white paper' that contains information about the ICO and the project it's funding. The white paper should provide:
- the names and contact details of the people behind the scheme
- information on what they are planning to do with your money
The information in the white paper isn't always accurate. Sometimes the information can be unbalanced or misleading. The white paper may overestimate how profitable the project will be to convince you to invest.
If the white paper claims the ICO is not a financial product, they may be trying to avoid regulation. If the promoter avoids regulation, you may have no consumer protection.
The white papers can be very technical. This can make it difficult to understand what your rights and obligations will be after you've bought the ICO tokens.
The risks of investing in cryptocurrencies and ICOs
You could lose a lot of money if you buy into an ICO or cryptocurrency without doing your research first.
The platforms where you buy and sell cryptocurrencies and ICOs are not regulated. You're not protected if the platform fails or is hacked.
ICOs are highly speculative investments and many have turned out to be scams. It's even harder to get your money back if it turns out to be a scam and the ICO is from an overseas entity.
Cryptocurrency failures in the past have lost investors significant amounts of real money. In most countries cryptocurrencies are not recognised as legal tender. You're only protected to the extent that they fit within existing laws, such as tax laws.
Investing in virtual currencies and ICOs is highly speculative. Values can fluctuate significantly over short periods of time.
The value of cryptocurrencies and ICOs depends on:
- its popularity at a given time (which can depend on factors like the number of people using it)
- how easy it is to trade or use it
- the perceived value of the currency
- its underlying blockchain technology
Scammers can use social media and messaging apps to push up the price of ICO tokens. They sell the tokens to other buyers at falsely inflated prices. This is known as a 'pump and dump' scheme.
Your money could be stolen
A computer hacker can steal the contents of your digital wallet.
Your digital wallet has a public key and a private key, like a password or a PIN. However, digital currency systems allow users to remain relatively anonymous and there is no central data bank. If hackers steal your digital currency or ICO tokens, you have little hope of getting it back.
You also have no protection against unauthorised or incorrect debits from your digital wallet.
It can be difficult for regulators to make sure proper investor protections are in place because ICOs are:
- sold internationally
- available online
- usually paid for with cryptocurrencies
It's often unclear where the entity's incorporated and what laws and regulations apply to it. See ASIC's media release on misleading ICO statements.
Some issuers disappear as soon as they've finished fundraising, which may indicate that it is actually a scam. When this happens, investors have very little or no chance of getting their money back.