Intrigued by the possibility of cryptocurrencies?

Intrigued by the possibilities offered by Bitcoin and other cryptocurrencies but wondering if they are worth a punt? As with any other potential investment it’s important to fully understand it before you put your money down.

Here are four things to understand about cryptocurrency:

The mechanics

Bitcoin was the first kid on the cryptocurrency block and others have followed in its wake including Ethereum, Dogecoin, and Ripple.

Rather than being a physical note or coin, cryptocurrencies are a digital token created from code using an encrypted string of data blocks, known as a blockchain.

A blockchain is a decentralised database that can be accessed by all users. Users earn or create blocks (or units of a digital currency) by solving complex cryptographic puzzles and verifying transactions.

The blockchain keeps track of the ownership of the currency units and holds a history of every transaction ever made on the blockchain.

Benefits of blockchain technology include accuracy, transparency, and speed.

Cryptocurrencies are held in a digital wallet and units can be bought and sold on an exchange platform using conventional money.

Purchasing power

You might expect you should be able to use an alternative currency to buy goods and services. But Coinmap.org shows there are limited places in Australia where you can pay for something with a cryptocurrency.

There are a couple of Bitcoin ATMs in Australia and some individuals will accept Bitcoin as an exchange for some other goods or service.

Investing firepower

People mainly buy Bitcoin and other cryptocurrencies because they think they’ve spotted an investment opportunity. But, as with any other emerging market, that means they’ve had to be prepared to hang on tight through periods of intense price volatility.

Transaction costs and times can also be concerns for people who have jumped into cryptocurrencies. For instance, as the Bitcoin blockchain grows the time needed to process a single transaction is lengthening (one of the reasons why other cryptocurrencies have appeared).

The price volatility means that investors can potentially pay a lot more than they intend or cash out for less than they hope when they decide to buy or sell.

Unlike traditional investments there are no dividends or cash payments associated with cryptocurrencies.

Other risks

Apart from the impact of price volatility there are other risks that need to be considered before jumping into cryptocurrencies.

Unlike traditional currencies, cryptocurrencies are not backed by major governments or developed economies and the market is largely unregulated.

Market conditions can make it difficult to liquidate your holding in a timely manner.

Another risk is related to cryptocurrency exchange platforms. Because these are not regulated if the platform fails or gets hacked, investors are not protected and will have no legal recourse.

Likewise, if your digital wallet is hacked or an incorrect debit is made, you have no protection.

Another thing: don’t assume that cryptocurrencies are escaping the attention of the taxman. As with any other investment, trading in cryptocurrencies could result in a capital gains or income tax liability.