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Digital coins explained
Digital coins, such as Bitcoin, Ether and Litecoin, are digital mediums of exchange that use cryptography as a method to help ensure the security and data integrity of the system. Digital coins are a type of crypto asset (often called “cryptocurrencies”), and can be used in different ways. For example, some may be used as a way to purchase goods or conduct business online.
Digital coins, like other crypto assets, are not issued or backed by a Canadian central bank or monetary authority and in many cases parties in the crypto asset sector have not complied with applicable financial sector regulations. Some crypto assets, particularly those offered as digital tokens through initial coin offerings (ICOs) (also called initial token offerings (ITOs) or token generation events), may be subject to securities regulation. Learn more about digital token offerings.
How digital coins work
In some ways, sending and receiving digital coins and other cryptoassets is a lot like sending email. To start receiving email, you create an email address that you can share with other people. To send an email from that address, you need to know both your address and a password, which only you know and which you don’t share with other people. Similarly, to acquire cryptoassets, you are assigned an address (often called a “public key”) that you can share with others. When you obtain an address, you also receive a password (called a “private key”) that you can use to send digital coins from your address, and which you do not share with other people.
Of course, digital coins don’t function exactly like email. There are a number of differences:
- Unlike with email, where you get to pick your address and password, the public and private keys are assigned to you. Each key contains a string of letters and numbers. Your keys are linked together using an algorithm, which allows the system to confirm your public and private keys link up to the same account.
- You do not provide any personal information to set up public and private keys. This makes your transactions difficult to trace back to you. It also means, if your private key is lost or stolen, you cannot regain access to your digital coins by validating your identity.
- While records of your emails are usually stored on a central server maintained by your email service provider, records of your digital coin transactions are distributed publicly across hundreds, possibly even thousands, of computer systems around the world. These records are called a “blockchain,” a type of “distributed ledger.” Maintaining duplicate records on multiple systems is believed to make tampering more difficult.
Digital coin transactions do not happen instantaneously. Because records are kept on multiple systems, it takes time for these systems to validate transactions and agree to add them to the blockchain (i.e., their ledgers). Digital coin “miners” seek to validate and properly record transactions. For engaging in this work, miners may receive transaction fees and rewards (usually in the form of newly-issued crypto assets). These rewards are intended to encourage people to build and maintain the complex “mining systems” necessary to create digital coins and to keep digital coins transactions running.
Digital coin users often pay a fee for sending digital coins to another user. Fees vary depending on the digital coin used, and generally these fees are not regulated. High demand for digital coins may result in higher fees for users.
Purchasing digital coins
Digital coins, like other crypto assets, often are purchased through online crypto asset trading platforms (commonly called crypto asset “exchanges”), which allow users to buy, sell or exchange digital coins for other crypto assets or conventional money (like dollars), often for a fee.
Cryptoasset trading platforms operate around the world. These platforms may be especially susceptible to fraud and market manipulation. In addition, the same cryptoasset may trade for significantly different prices on different platforms.
These platforms are also subject to significant operational risks: because they hold the private keys for their users’ crypto assets, they are often the target of cyberattacks intended to gain access to these keys and steal users’ crypto assets. Cyberattacks may also be intended to disrupt trading on these platforms. Users may experience problems placing and executing trades over a platform, due to technical problems on that platform or because the platform has temporarily halted trading in one or more crypto assets. In addition, there is no guarantee that a platform will have sufficient cash on hand to meet users’ withdrawal requests. These platforms typically place limits on the amount of cash that a user can withdraw in a single day.
Some companies offer digital coins for sale at a physical kiosk, often branded as an “ATM,” which lets you insert cash in exchange for digital coins. If you already have a public key, the kiosk can send your digital coins to that public key; otherwise, the kiosk often can assign you new public and private keys and then print these keys off for you on a slip of paper. Before purchasing digital coins at a kiosk, make sure you understand the fees you are being charged. Keep any private keys you receive secure, and do not share them with anyone.
Risks of digital coins and other crypto assets
Before you consider purchasing any type of crypto asset, understand the risks, including:
- High volatility – Crypto assets are prone to large swings in market value, gaining or losing hundreds or even thousands of dollars over the course of a day. This makes holding crypto assets risky; any crypto assets you own could stand to lose some or all of their market value at any time.
- Lack of oversight – Regulation and oversight are intended to protect the interests of users. If a business offering digital tokens does not comply with applicable regulations, a user may have difficulty accessing remedies if they lose money as a result of a crypto asset transaction. Don’t assume that the “terms and conditions” or other contracts an individual typically agrees to when signing up for a crypto asset trading platform or other service will protect you – these are usually drafted by the service provider, and may be not be in the best interest of the user. Carefully review the terms and conditions associated with any crypto asset trading platform or other party that you use to purchase or sell crypto assets. News articles and online forums may help you learn more about the reputation of a crypto asset trading platform or other service and the quality of its services. However, it is crucial to read third party information with a skeptical eye. Similar to any unverified source, positive reviews might be drafted by employees, or other people paid by a service provider. Also, information could be outdated or inaccurate by the time you come upon it.
- Risk of fraud – Some fraudsters have tried to capitalize on market interest in crypto assets by creating new scams, or rebranding existing scams such as Ponzi schemes. They are looking for people who are seeking opportunities to get in “on the ground floor” with crypto assets. If you are ever approached about a crypto asset product, consider whether it fits the signs of investment fraud. Learn how transactions involving crypto assets are regulated in Ontario. When in doubt, contact your provincial or territorial securities regulator, such as the Inquiries and Contact Centre of the Ontario Securities Commission.
Cryptoassets may also be subject to other risks. Learn more about types of investment risk.
Caution
Before you consider purchasing a crypto asset, make sure you understand how they work.
Learn more at GetSmarterAboutCrypto.ca.
The Ontario Securities Commission’s Inquiries and Contact Centre is available to answer your questions.
You can also get unbiased responses to your investing questions at InvestingQuestions.ca.
