Cryptocurrencies: Should You Invest in Them?

The introduction of spot bitcoin exchange-traded funds (ETFs) in early 2024 represents a milestone in the 15-year history of the pioneering digital currency and the investment industry that's grown around it.

Now, cryptocurrencies may be used in a widely held, actively traded investment product that's common to many individual investors' portfolios. The Securities and Exchange Commission (SEC) decided January 10 to approve trading for the first time in exchange-traded funds (ETFs) that hold spot cryptocurrency. 

But does that mean it's finally time to jump into the cryptocurrency pool? Consider checking the water first. 

The approval from a long-crypto-resistant SEC is just one more indicator that cryptocurrencies could be moving closer to the investor mainstream. Despite significant volatility and risk, bitcoin and other digital currencies have only grown in popularity.

But if you're considering investing in spot bitcoin ETF products available at Schwab and elsewhere, there are some key things you should know first.

Beyond learning the basics of cryptocurrencies, investors should keep the industry's risks in mind. The value of even the most popular cryptocurrencies like bitcoin have been volatile, the market isn't very transparent—compared to stocks, for example—transactions are irreversible, consumer protections are minimal or nonexistent, and regulators still haven't clarified their approach to regulating them. Separately, before investing in cryptocurrency-related ETFs, investors may want to understand exactly how such ETFs are structured and managed before they decide—after all, ETFs, like any investment vehicle, have risks too. 

Let's review key issues surrounding cryptocurrencies. 

The SEC's relationship with the cryptocurrency market and related investments has been historically chilly, and it hasn't exactly thawed despite the recent spot bitcoin ETF approval. 

In fact, many published reports considered the SEC's decision something of a reluctant fait accompli. In October 2023, the SEC chose not to appeal a federal court ruling saying it had been wrong to reject an investment firm's application to create spot bitcoin ETFs. The SEC has long been skeptical of cryptocurrencies, with multiple agency leaders concerned the market is too volatile, investor protections are inadequate, and regulations are insufficient. Still, many saw the handwriting was on the wall and that SEC approval was inevitable.

With the approval came what some viewed as strong language from SEC Chair Gary Gensler: "While we approved the listing and trading of certain spot bitcoin ETP shares today, we did not approve or endorse bitcoin. Investors should remain cautious about the myriad risks associated with bitcoin and products whose value is tied to crypto."

The agency had rejected multiple applications for ETFs that would invest directly in bitcoin over the last several years before granting permission to 11 spot bitcoin ETFs that began trading on January 11, 2024.

Schwab feels the introduction of bitcoin ETFs won't change existing barriers to bitcoin becoming a new global currency. It will likely take more than appropriate regulation and consumer protections to make all cryptocurrencies viable against other established national currencies. Time will tell because a viable currency usually requires three characteristics:

• It can be used as an inexpensive, reliable medium of exchange.
• It can be a unit of account.
• It can be a store of value and legal tender honored as a means of payment.

As long as bitcoin remains highly volatile and subject to hefty transaction fees, it seems likely that it'll have only limited use as a medium of exchange, a unit of account, or a store of value. 

Because the value of bitcoin is currently not tied to the value of a basket of goods or services, its value as an inflation hedge is a matter of speculation and is unpredictable. Throughout much of 2021 and 2022, bitcoin experienced both sharp rallies and sharp price declines even though inflation data consistently ticked higher. However, as bitcoin gained significantly as rates started to decline in 2023, it began looking significantly less like an inflation hedge. 

The IRS currently treats cryptocurrencies as property, not a currency. In the eyes of the IRS, cryptocurrency transactions are taxable events, which means when you sell a bitcoin and turn it into U.S. dollars or trade it for another asset, a taxable event has taken place. It's a situation that often catches many cryptocurrency investors off-guard—that paying for a product or service with cryptocurrencies also can trigger a tax liability. 

Because cryptocurrencies are treated as property by the IRS, they fall under the same tax rules as other assets, which means the capital gain and loss tax rules apply to cryptocurrency transactions. If you hold a cryptocurrency for a year or less, any realized gain will be subject to the short-term capital gains tax rates, which are the same as the ordinary income tax rates that apply to wages. Meanwhile, gains on cryptocurrencies held for over a year are subject to the lower long-term capital gains tax rates.

If you sell a cryptocurrency at a loss, you'll be able to use that loss to offset other capital gains, and if the loss exceeds your gains, you'll potentially be able to use the remaining loss to offset up to $3,000 of your ordinary income. Any leftover losses would be carried forward infinitely to offset gains in future tax years. 

For help, refer to IRS Notice 2014-21 or consult with a tax advisor.

As of today, the IRS has not provided specific guidance on the taxation of cryptocurrency ETFs or bitcoin ETFs in particular. However, it's important for potential bitcoin ETF investors to be aware they're buying ETF shares, not bitcoin. ETFs are generally treated for tax purposes as securities, just like stocks or bonds. 

Where this could get complicated for investors—at least without further IRS guidance—involves "wash sale" rules. A wash sale refers to selling a "security" at a loss for a tax benefit, then buying the same or a similar security 30 days before or after that sale. The wash sale rules typically apply to ETFs—again, they're securities—but bitcoin is not a security; its considered property, which means it's not impacted by the wash sale rules. 

The question the IRS has yet to answer is whether someone could sell a bitcoin ETF and then buy a "substantially identical" cryptocurrency ETF or bitcoin itself without triggering the wash sale rule. Unfortunately, without additional guidance from the IRS on this topic, we can’t be sure of the answer. If you end up with a loss from a cryptocurrency or bitcoin ETF, we recommend meeting with a tax advisor to determine if the wash sale rules apply to your particular situation. 

• Financial loss. Bitcoin and other cryptocurrency prices historically have been highly volatile, and fluctuations could result in significant losses if sold at the wrong time.
• Future regulation. Cryptocurrency issuance and trading is currently not extensively regulated, and additional oversight and regulation in the future is likely. U.S. Treasury Secretary Janet Yellen previously noted her concern over cryptocurrencies being used "for illicit financing."
• Fraud and cybercrime. These already have occurred. Given the concerns above, cryptocurrencies could come under scrutiny from the Financial Crimes Enforcement Network (FinCEN) for noncompliance with the Bank Secrecy Act (BSA) and anti-money laundering requirements. Bitcoin exchanges have been subject to computer outages caused by excessive demand, and because the ledgers are held on the internet, a large-scale cyberattack could limit access in an emergency—which is something less likely to happen with cash or gold. However, it's worth noting again that the new spot bitcoin ETFs are traded on traditional, regulated exchanges like the NYSE rather than spot exchanges. Bitcoin is a commodity—hence the "spot" label—but ETFs receive a higher level of oversight and transparency as compared with commodities traded on unregulated spot exchanges.
• Theft or loss. A log-in ID and password is usually required to access a cryptocurrency exchange. If this is lost, hacked, or stolen, access could be denied or lost. While uncommon, bitcoin can be held like ordinary money in a purse or wallet so they can be spent without a computer. This creates the same risks inherent in all cash currencies: They could be lost, stolen, or destroyed by accident. Again, trading in spot bitcoin ETFs has its own distinct set of risks, but these risks are significantly different from those tied to holding or spending physical bitcoin.

Whether you should invest in individual cryptocurrencies or derivative products depends on your goals, risk tolerance, and other investing considerations just as it would be with any other asset or security. We suggest clients approach cryptocurrency as a speculative investment outside traditional asset allocation models and consider the high volatility and risks involved.