Cryptocurrency: What are the key terms, risks & UK rules?
Cryptocurrency: What are the key terms, risks & UK rules?
Introduction.
In recent years, cryptocurrencies have made their mark on the financial landscape. But what are they, what are the most prominent cryptocurrencies, what are the risks and how can UK investors gain exposure to them?
Key terms in cryptocurrency.
In basic terms, cryptocurrencies are digital assets that operate on decentralised computer networks, which means that no single authority, such as a central bank, oversees or controls them. Instead, they rely on cryptographic protocols and computer networks to validate and record transactions. For many, the appeal lies in the global nature of these assets and the potential for faster, more efficient ways to exchange value.
Cryptocurrencies can be complicated, especially when jargon and specialised terms are used. To help you better understand the concepts discussed in this article and beyond, here are some key terms you should know:
Altcoin: Short for "alternative coin," altcoins are cryptocurrencies other than Bitcoin and were created to improve upon Bitcoin by offering different features, functionalities, or use cases. Examples include Ethereum (ETH), Ripple (XRP), and Solana (SOL).
Blockchain: A decentralised and distributed digital ledger that records transactions across multiple computers. Each "block" contains a list of transactions, and these blocks are linked together in a "chain." Blockchain technology ensures data transparency, security, and immutability.
Consensus Mechanism: A protocol that ensures all participants in a blockchain network agree on the state of the ledger. Common consensus mechanisms include Proof of Work (used by Bitcoin) and Proof of Stake (used by Ethereum 2.0). They are crucial for maintaining the integrity and security of the blockchain.
Cryptocurrency (Crypto): A digital or virtual currency that uses cryptography for security. Unlike traditional currencies issued by governments (fiat currencies), cryptocurrencies operate on decentralised networks based on blockchain technology. Examples include Bitcoin (BTC), Ethereum (ETH), and XRP.
DeFi (Decentralised Finance): A movement that leverages blockchain technology to recreate and improve traditional financial systems (like lending, borrowing, and trading) in a decentralised manner, without intermediaries like banks. DeFi platforms aim to increase accessibility, transparency, and efficiency in financial services.
Exchange: A platform where users can buy, sell, and trade cryptocurrencies. Exchanges can be centralised (managed by a company) or decentralised (operating without a central authority). Examples of centralised exchanges include Coinbase and Binance, while decentralised exchanges include Uniswap.
Exchange-Traded Fund (ETF): An ETF is a type of investment fund traded on stock exchanges. Crypto-specific ETFs aim to track the price of a specific cryptocurrency or a basket of cryptocurrencies, allowing investors to gain exposure without directly owning the digital assets.
ICO (Initial Coin Offering): A fundraising method where new cryptocurrency projects sell their tokens to early investors in exchange for capital. ICOs are similar to Initial Public Offerings (IPOs) in the stock market but are typically less regulated, making them riskier for investors.
Market Capitalisation (Market Cap): A metric used to determine the total value of a cryptocurrency. It is calculated by multiplying the current price of the cryptocurrency by its total circulating supply. Market cap helps investors understand a cryptocurrency's relative size and importance within the market.
Meme Coin: A type of cryptocurrency that gains popularity primarily through online communities and social media, often without a strong underlying technology or use case. Meme coins are typically highly volatile and speculative. Examples include Dogecoin (DOGE) and Shiba Inu (SHIB).
Private Key: A secret code that allows you to access and manage your cryptocurrency holdings. It's crucial to keep your private key secure and never share it with anyone, as it grants complete control over your digital assets.
Smart Contract: Self-executing contracts with the terms of the agreement directly written into code. Smart contracts automatically enforce and execute the terms when predefined conditions are met, eliminating the need for intermediaries. Ethereum is renowned for its smart contract capabilities.
Stablecoin: A type of cryptocurrency designed to maintain a stable value by being pegged to a reserve asset, such as the US dollar or gold. Stablecoins aim to reduce the volatility commonly associated with other cryptocurrencies. Examples include Tether (USDT) and USD Coin (USDC).
Token: A digital asset created on an existing blockchain, often representing a specific utility or asset. Tokens can serve various purposes, such as granting access to a platform, representing ownership, or facilitating transactions within a particular ecosystem. For instance, XRP is a token on the XRP Ledger.
Wallet: A digital tool, either software-based or hardware-based, that allows users to store, send, and receive cryptocurrencies securely. Wallets hold the private keys needed to access and manage your crypto assets. Wallets can typically be divided into two camps:
Software Wallets: Applications or online services (e.g., MetaMask, Exodus) that store your private keys on your device or in the cloud.
Hardware Wallets: Physical devices (e.g., Ledger Nano S, Trezor) that store your private keys offline, offering enhanced security against hacking.
From bitcoin to a broader market.
Within this growing sector, bitcoin remains the most recognisable cryptocurrency. Since then, thousands of other digital assets have appeared, each with varying purposes and technologies behind them.
Bitcoin introduced the world to the idea of digital scarcity and decentralised money. Speculation has often shaped its value, although some supporters see it as a store of value or a potential hedge against economic uncertainty.
Ethereum, meanwhile, built upon Bitcoin's concepts by adding 'smart contracts' - self-executing programs on the blockchain. These smart contracts have enabled a wide range of decentralised applications, from decentralised finance (DeFi) platforms that allow users to lend, borrow, and trade without intermediaries to non-fungible tokens (NFTs) that represent unique digital assets.
Beyond bitcoin and Ethereum lies a much broader market of cryptocurrencies. Many of these projects seek to address various challenges in the financial and technological landscape. For instance, some focus on improving payment speeds and reducing transaction costs, while others aim to enable entirely new financial services, such as decentralised lending and insurance.
In December 2024, the biggest cryptocurrencies in the world, by market capitalisation are:
Bitcoin - BTC (£1.64 T): Designed to be a potential digital store of value.
Ethereum - ETH (£376 B): Known for its smart contract functionality and decentralised applications.
Tether - USDT (£110 B): A stablecoin pegged to the US dollar, used for trading and as a hedge against volatility.
XRP (£108 B): The native token of the XRP Ledger. Built for enterprise use and cost-efficient cross-border payments.
Solana - SOL (£82 B): Recognised for its high-speed and low-cost transactions, supporting various decentralised applications.
Binance Coin - BNB (£80B): Originally launched as a utility token for the Binance exchange, BNB is now used for transaction fee discounts and powering the Binance Smart Chain.
Dogecoin - DOGE (£46 B): Started as a meme-inspired cryptocurrency, Dogecoin is popular for tipping and charitable donations, supported by a strong community.
USD Coin - USDC (£33 B): A stablecoin pegged to the US dollar, widely used for trading, lending, and potentially as a stable store of value.
Cardano - ADA (£29 B): Focuses on a research-driven approach to create a secure and scalable blockchain for smart contracts and decentralised applications.
Tron - TRX (£19 B): Aims to build a decentralised internet, enabling content creators to own and control their data without intermediaries.
Volatility and risk.
Cryptocurrencies are considered extremely high-risk investments due to their significant price volatility, the level of complication involved, the lack of regulation and the opportunity for scammers to leverage the knowledge gap.
Equally, the value of digital assets can change rapidly. As such, it is not uncommon to see substantial price swings within short periods. There is no guarantee of returns, and many investors have experienced significant losses.
As with any financial decision, thorough research and education is essential. New entrants to the cryptocurrency market should only invest what they can afford to lose and remain extremely cautious. The volatile nature of the crypto market means that even assets with seemingly strong utility and exposure are not immune to downturns.
Regulation and the UK context.
In the UK, the Financial Conduct Authority (FCA) has begun to establish and enforce regulations for certain aspects of the cryptocurrency industry. While this does not eliminate risk, regulated firms are expected to meet standards designed to protect consumers. Staying informed about regulatory developments and ensuring that you deal with authorised providers can reduce some of the uncertainty involved in this sector.
It is important to remember, though, that no amount of regulation guarantees safety or profitability. The inherent risks of cryptocurrency remain, regardless of oversight.
How cryptocurrencies are taxed in the UK.
In the UK, cryptocurrency assets are subject to various taxes depending on their use.
Capital Gains Tax (CGT) applies to profits made from selling, trading, or using crypto.
Income Tax is levied on cryptocurrencies received as payment for goods or services, as well as on earnings from activities like mining and staking.
Additionally, crypto holdings are included in estates for Inheritance Tax purposes.
To comply with HM Revenue and Customs (HMRC) regulations, investors must maintain detailed records of all transactions and report their crypto activities through the Self-Assessment tax return system.
There is more information about how cryptocurrencies are tax on Gov.uk.
How to get exposure to cryptocurrency as an investment in the UK.
Access to cryptocurrencies in the UK is regulated by the Financial Conduct Authority (FCA). At the time of writing, individuals who wish to engage with the cryptocurrency markets have little choice other than buying and holding the assets directly; crypto ETFs are generally only open to professional investors rather than retail.
Therefore:
Buying typically starts with choosing a reputable cryptocurrency exchange registered with the FCA. New users can either apply for an account on the website or by downloading an app, before submitting their identification documents to the platform.
Once the identity verification has been completed, users must pass an FCA test to ensure they are not taking excess risk and understand what they are getting involved in.
Next, a user will need to transfer fiat currency (GBP in the UK) to an exchange wallet to enable trading. However, it is often the case that banks block card transactions given the high instance of card fraud; as such, a user will likely have to make an authorised bank transfer.
Finally, once the transferred funds have cleared, a new user can use the exchange to swap their fiat currency for a cryptocurrency in a process similar to buying shares on an investment platform.
Once acquired, crypto holdings can be stored in various ways. Software wallets, available online or on mobile devices, offer convenience, while hardware wallets provide enhanced security by keeping the private keys offline.
Crypto wallet addresses are made up of long strings of numbers and letters, which can be given out should you wish to send or receive funds (like a bank name, account number and sort code). To make things easy, most wallets have the option to show a QR code that others can scan. Users must exercise the utmost caution when transferring funds, as if one digit is missing or incorrect, the funds will not arrive and will be lost forever; for this reason, many will try small transfers first to ensure functionality before saving the details and completing the final transfer.
As a side note, there is a saying in the cryptocurrency industry: "Not your keys, not your coins". This alludes to the risks of storing cryptocurrency on exchanges as several high-profile exchanges have faced legal challenges, collapse and so forth – leaving investors with little or no hope of getting their funds back. Therefore, many investors will choose to only use exchanges as on/off ramps for investment and transfer their holdings to a hardware wallet for total independence.
Whichever method is chosen, it is crucial to take security extremely seriously. Cryptocurrencies are digital assets, and without proper safeguards, they can be at risk of theft, loss and fraud.
Conclusion.
Cryptocurrencies have significantly reshaped the financial landscape and appear to be here to stay; each cryptocurrency offers unique features and use cases that contribute to the diversity of the market.
However, investing in cryptocurrencies comes with considerable risks. Digital asset volatility means prices can fluctuate dramatically, with the potential for substantial losses. Additionally, the complexity of blockchain technology and the presence of scams and fraud highlight the importance of thorough research and cautious participation.
The Financial Conduct Authority (FCA) plays a crucial role in regulating the cryptocurrency market in the United Kingdom. By enforcing strict registration, anti-money laundering (AML), and know your customer (KYC) standards, the FCA aims to create a safer and more transparent environment for investors.
Diversification is a common strategy for those considering entering the cryptocurrency market. Allocating only a small portion of your investment portfolio to high-risk assets like cryptocurrencies can help manage potential losses while allowing for growth opportunities. Additionally, using secure wallets - whether software-based for convenience or hardware-based for enhanced security - is crucial in safeguarding your digital assets.
What’s next?
Wherever you are in the country, we invite you to book a free initial consultation with one of our experienced financial advisers for expert advice and guidance on any matters relating to retirement planning, pensions, investments and more. Based in Tunbridge Wells, Kent, we proudly serve clients across the UK.
Locally, we serve clients across Kent, including Ashford, Maidstone, Sevenoaks and Tonbridge. In East Sussex, we have clients in Bexhill, Crowborough, Eastbourne, Hastings, Heathfield and Uckfield.
Don't forget, this article offers general financial information and should not be taken as personal advice. Remember that investments and pensions can go up and down in value, so you could get back less than you put in. Tax rules can change and will depend on your individual circumstances.