Cryptocurrencies may have been little more than a hobby since their introduction in the late 1990s, but the technology’s potential has finally started to catch the eye of mainstream financial institutions and professionals. The Winklevoss twins—famous for their involvement in Facebook Inc.—plan to launch the world’s first Bitcoin exchange-traded fund (ETF) later this year, while the underlying technology has some of the world’s largest banks filing a flurry of patents.

As Bitcoin’s popularity grows, financial advisors are facing some tough questions and decisions from prospects and clients. They may explain the risks associated with these currencies and advise against them, but the decision is ultimately up to the client, and advisors should at least be familiar with how to identify and purchase cryptocurrencies. They should also be able to inform clients of any tax or legal issues surrounding cryptocurrencies in their jurisdiction.

In this article, we will take a look at cryptocurrencies like Bitcoin and what financial advisors need to know in order to best serve their clients. (For related reading, see: Risks and Rewards of Investing in Bitcoin.)

Cryptocurrency, Blockchain Technology

A cryptocurrency is a medium of exchange using cryptography to secure transactions and control the creation of units of currency. Unlike a central bank that prints physical currency, cryptocurrencies rely on blockchain technology to decentralize the process. A blockchain is essentially a ledger that’s kept by all participants in the market. When someone wants to add to it, these participants run algorithms to evaluate the proposed transaction and approve it.

In 2009, Bitcoin became the first major decentralized cryptocurrency in the market, but faced a number of growing pains. Mt. Gox became the most popular Bitcoin exchange by 2013—handling about 70% of all transactions—but the organization collapsed in early 2014 after 850,000 Bitcoins worth $450 million went missing. The currency also became infamous as a currency in the underground bazaar Silk Road before its shutdown.

Many other cryptocurrencies have sprung up since then, but Bitcoin remains the most popular with each BTC selling for about $546.10 as of Aug. 2, 2016. The ubiquity of the currency throughout the Internet has made it a popular alternative in countries where domestic currencies may be unstable or at risk for devaluation, while its maturity has made it a lot more reliable than many newer currencies that have struggled to gain traction. (For related reading, see: Bitcoin Tax Guide: Lost or Stolen Bitcoins.)

Bitcoins Pros and Cons

Cryptocurrencies may have a place in society’s future, but that doesn’t necessarily make them safe investments right now. In many ways, investing in these currencies now is akin to investing in an emerging market currency rather than the dollar or the euro. It might make sense as a speculative move, but the dramatic swings in value make it a sub-par currency for transactions, where stability is much more important than price appreciation.

Some pros of cryptocurrencies include:

  • Fraud: Cryptocurrencies are impossible to counterfeit (unlike physical currencies) and cannot be reversed (like credit card chargebacks).
  • Settlement: Cryptocurrency transactions are immediately settled without any third-party approvals (like credit cards) or contracts.
  • No fees: Cryptocurrencies don’t incur any transaction fees since the miners are compensated by the network (they're paid to verify transactions).

Some cons of cryptocurrencies include:

  • No security: Cryptocurrencies can be electronically stolen and there is no recourse for the individual, unlike with a credit card.
  • Scalability: There are a lot of questions about the scalability of cryptocurrencies on a technical level, which means they may be far off from replacing credit cards.
  • Applications: There are relatively few merchants that accept Bitcoin payments as of right now, which means the usefulness as a currency may be limited.

The Bottom Line

Cryptocurrencies have become very popular over the past several years, which means that financial advisors should be able to discuss them with their clients. Since these currencies are often highly speculative, advisors should make clients aware of the potential risks associated with them. They may also want to consult with an accountant or legal professional to determine if there are any other risks with using cryptocurrencies in their jurisdiction. (For related reading, see: Blockchain Company Files for New Bitcoin ETF.)