This article is the first in a series on the emerging world of digital assets. Additional articles explore Initial Coin Offerings, digital tokens, the virtual currency regulatory landscape, and tips to avoid fraud and scams in this area.

Social and traditional media have been abuzz with articles and information about the rising phenomenon of virtual currencies. Words and phrases like blockchain, cryptocurrency, distributed ledger, initial coin offering, and digital tokens populate our newsfeeds.

Significant uncertainty currently surrounds virtual currencies in general and their potential value as investments in particular. Only time will tell whether (and, if so, which) virtual currencies will become a mainstream component of our financial markets -- and whether investments in this emerging sector make sense as part of a diversified portfolio.

Before you make any investment decisions, it is critical to understand some of the concepts underlying this emerging world of virtual currencies.

stack of gold coins with zeroes and ones on them

Image source: Getty Images.

What are virtual currencies?

According to the Commodity Futures Trading Commission, virtual currencies are "a digital representation of value that functions as a medium of exchange, a unit of account and/or a store of value." In other words, each currency is represented by alphanumeric codes that may be generated and recorded on a blockchain network and recognized as a method of payment by users on that network. In some cases, you can spend and trade virtual currencies, but these products do not have the same legal status as money, or "legal tender," in the United States, Canada, Mexico, and most other jurisdictions.

The Internal Revenue Service states that virtual currencies are to be treated as property for U.S. federal tax purposes, with transactions required to be reported in U.S. dollars. If virtual currency is used to pay wages, it is subject to federal income tax withholding, and gains and losses from the sale or exchange of virtual currency have tax implications. If you hold virtual currencies for personal or investment purposes, the IRS requires you to report any gains or losses, which would be subject to capital gains tax rules.

One popular type of virtual currency is known as cryptocurrency, or simply crypto. The term crypto refers to the process of cryptography, which is a mathematically intensive encryption process designed to enhance data protection and authentication. Some people are interested in cryptocurrencies for their perceived anonymity and ability to keep transactions secret, and one of the earliest and perhaps most well-known cryptocurrencies is bitcoin.

What is bitcoin?

Bitcoin is a cryptocurrency developed in 2009 by an anonymous person or group of persons operating under the nickname Satoshi Nakamoto. Like other cryptocurrencies, bitcoin is distinct from "fiat currencies" such as the dollar, euro, renminbi, or yen. Unlike a fiat currency, bitcoin isn't represented or organized by a physical paper unit or coin. Rather, each bitcoin is a unique alphanumeric string of computer code. Rather than being issued like fiat currencies by a central bank, a currency such as bitcoin is controlled by technology that determines how many bitcoins are produced and how transactions that use bitcoin are recorded. Proponents of the crypto world believe that bitcoin can be an attractive alternative to fiat currencies because it is not controlled by any central bank or government.

Bitcoin is exchanged on the Bitcoin Network, a peer-to-peer payment system that operates using cryptography. Users can send and receive bitcoins by broadcasting digitally signed messages to the network using a cryptocurrency wallet. Transactions on the Bitcoin Network are recorded on a publicly distributed ledger called a blockchain and validated by a proof-of-work system called mining.

What is blockchain?

Blockchain, also known as distributed ledger technology, is the technology that powers bitcoin and many other virtual currencies. In the case of bitcoin, blockchain functions through the participation of many individuals who offer their computing power to maintain the Bitcoin Network and record transactions (for instance, when someone trades or spends bitcoins). Those who employ math and technology to create new bitcoins are known as "miners."

Miners engage in complex computing problems to facilitate the verification and posting of bitcoin transactions. As a reward for solving these computing problems, a bitcoin miner is awarded a new bitcoin. All of this computing takes a lot of energy, which is why today's mining centers tend to be located in regions where energy is inexpensive.

Blockchain technology is the critical feature of bitcoin because it prevents users of bitcoin from double-spending their coins and creates a permanent record of transactions.

Are there other cryptocurrencies?

Bitcoin is one of thousands of cryptocurrencies. The purpose, functionalities, and use of these cryptocurrencies may vary. Some share similarities with bitcoin. For instance, Litecoin, created in 2011 by MIT-cum-Google coding prodigy Charlie Lee, is similar in many respects to bitcoin but it is not identical, since it uses a different mining algorithm.

Ethereum (2015), on the other hand, is in fact a platform for "smart contracts," which are known as conditional transactions: computer code that enable certain events to be triggered when certain pre-defined conditions are met, such as the ability to unlock real products (renting a car, for instance) when payment is made. Ethereum has its own cryptocurrency known as Ether, which can be the form of payment used on these smart contracts.

Use caution

Knowing about virtual currencies and investing in them are two very different things. Investing in virtual currencies can take different forms. You can purchase coins in the hope they will appreciate or invest in platforms that facilitate blockchain technology and other aspects of the virtual currency revolution and hope they succeed. Doing so carries significant risk. Only invest what you can afford to lose, and be aware that you may lose some or all of your investment.

Like other types of investing, virtual currency investing has its share of fraud and scams, not to mention cyber attacks. There are also major questions about how these currencies are regulated both domestically and across the globe. Less regulation means less protection for investors.

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