Cardano – cryptocurrency with risks

You have probably heard of Bitcoin, Ethereum, Dogecoin and/or Litecoin. A newcomer, on the other hand, is gaining more and more importance and thus value: Cardano and its internal cryptocurrency ADA.

Topics in our legal advice

We explain the function and disadvantages of the Bitcoin alternative, which possible problems can occur through staking with ADA and which general risks you should be aware of in the area of cryptocurrencies.

Table of contents

1. Cardano and ADA – what is it?
2. Cardano hype: what’s behind it?
3. Cardano (ADA) – technical function
4. Advantages of Cardano
5. Disadvantages of Cardano
6. Keyword: Staking – Taxation
7. ADA and Cardano: 2 legal recommendations

Cardano and ADA – what is that?

Cardano is a cryptocurrency based on blockchain technology, similar to Ether and Bitcoin. Charles Hoskinson, the man behind the Cardano blockchain project, launched it in 2015.

When it comes to the crypto industry, Hoskinson is no stranger. In other words, he is one of the brains behind the second largest digital currency, Ethereum, Ether. The Cardano Foundation is located in Zug, Switzerland, in Crypto Valley.

The goal of the project was to eliminate as many existing blockchain problems as possible. When it comes to advancing blockchain development, the Cardano Foundation draws on a broad network of scientists.

Cardano – the hype around the crypto project

Cardano is playing an increasingly important role in the ranking of cryptocurrencies alongside Bitcoin and Ethereum. The Cardano coin is abbreviated with the letters ADA. Recently, its price has once again skyrocketed due to the upcoming processing of so-called “smart contracts” on the Cardano infrastructure.

The computer protocols act as an emulation of contracts and simultaneously check whether the contracts are being honoured. Smart contracts can then be used, for example, to automate the ordering of products or the management of copyright licences.

The Cardano upgrade presents itself as an alternative to Ethereum and the smart contract platform.

Are you considering investing in Cardano, Bitcoin, Ether or another cryptocurrency? In advance, you should be aware of the existing risks.

Herfurtner Rechtsanwaltsgesellschaft mbH will advise you comprehensively on all legal issues in the field of cryptocurrencies. In particular, on the areas of investment fraud, online trading, Bitcoin fraud, internet fraud and cybercrime.

Cardano’s use of proof-of-stake

The rise of ADA is also helped by the fact that it is an environmentally friendly cryptocurrency. Cardano is based on the innovative “proof-of-stake” approach.

This requires less computer power and thus energy than the standard “proof-of-work” method that underlies Bitcoin, for example.

Translated into German, proof of stake means proof of share. The system is based on the network agreeing on which participant has permission to create the next block in the blockchain. In addition to the random principle, the assets as well as the duration of the participants also play a role in the decision.

This eliminates the time- and energy-consuming mining that is used in the Ethereum and Bitcoin blockchain systems. Proof-of-stake also offers a considerable security factor compared to proof-of-work technologies. Here, it is impossible for one participant to occupy the entire network solely on the basis of outstanding computing power.

However, the proof-of-stake method also has a significant shortcoming: the nothing-at-stake problem. This problem is based on the risk that several blocks are generated in parallel.

Thus, the agreement based on trust of all participants regarding the correct “chain” is in danger.

The Alonzo Patch

The Alonzo update for Cardano was released at 23:44 UTC on 12 September 2021 in Germany. Essentially, this means that smart contracts, which are a kind of virtual contract, can now be traded on the blockchain.

How does Cardano mining work?

Due to the proof-of-stake design rather than the proof-of-work design, the Cardano blockchain is considered to be much more environmentally friendly than the Bitcoin network. In the proof-of-work process, new currencies are effectively mined through the computer power of the system.

Miners need this to do the difficult tasks, such as adding new blocks to the blockchain or validating transactions on the Bitcoin network.

The proof-of-stake method, on the other hand, does not rely on large amounts of computer power and mining equipment. As an alternative, a consensus method is used that relies on people known as “validators” – currency holders who approve transactions and new coins as part of the currency.

What are the chances of the Bitcoin alternative?

Cardano – a project driven by scientists in Switzerland – has already come a long way. For example, it has many users in Africa. Among them Ethiopia, where it is used in the school system, for example.

What potential opportunities are opening up for institutions, companies, public authorities but also private individuals? And what are the risks?

Cardano vs. Bitcoin – advantages

Since the proof-of-stake mechanism consumes less energy than the proof-of-work approach, Cardano is seen as a more environmentally friendly Bitcoin alternative. At the same time, the system is more scalable, allowing it to process more transactions at once.

The ability of the Cardano blockchain to process smart contracts increases its utility compared to Bitcoin.

Cardano vs. Bitcoin – Disadvantages

First of all, Bitcoin is the most valuable cryptocurrency in the world, not just the oldest. While Ada has a market cap of around $82 billion, Bitcoin’s market cap is 10 times larger at $16 trillion. As a result, Ada is more likely to experience extreme fluctuations in its behaviour.

Bitcoin, on the other hand, benefits from its rarity. The limit set by Bitcoin creator Satoshi Nakamoto is 21 million. Scarcity is a natural price driver and also makes Bitcoin interesting for investors as a protection against inflation. Cardano also has a cap of 45 million ada, although this has had far less impact on the price so far.

Staking and ADA

Private investors are probably already familiar with the basics of cryptocurrency taxes, at least if you look at the tax officials’ interpretation of the tax rules.

For the purposes of § 23 EStG, each cryptocurrency is regarded by the tax authorities as a separate asset (EStG).

Consequently, a private disposal transaction according to § 23 EStG with cryptocurrencies exists if the period between acquisition and disposal of the cryptocurrency is shorter than one year.

In addition, the €599 exemption limit (not the €600 limit!) must be exceeded in order to receive a refund. If there is more than one year between purchase and sale, the capital gain is completely tax-free. According to the tax authorities, Section 23 EStG assesses each Bitcoin sale transaction separately according to the so-called first-in-first-out (FiFo) procedure.

When privatised assets are sold, a capital gain or loss arises from the difference between the sale price and the acquisition costs as well as any income-related expenses (e.g. transaction fees).

Cost of disposal:

• Acquisition price +
• Expenses incurred in the receipt of income.

= Corresponds to the profit or loss

Staking: Staking of Cardano tokens

Especially with regard to the taxation of Cardano (ADA), there can be some tax pitfalls.

As long as private investors “only” own Cardano, the tax office should assume that the legal interpretation described above applies. So, in summary, the capital gain from the sale of Cardano is exempt from federal and state income tax after one year.

However, if Cardano’s “staking authority” is delegated to a staking pool, unusual situations may arise. The Staking Rewards, which vary in amount, are already given to the individual investor as consideration for his investment.

For the individual investor, the Staking Rewards are likely to be treated as other income under Section 22 No. 3 EStG and thus taxable.

This income would only be exempt from income tax if it amounts to less than 256 euros in the calendar year – minus the income-related expenses such as fees of the respective gaming pool operator. The 256 euros is also an exemption limit, not an allowance.

A possible tax trap is that the Cardano used for the operation is treated as income by the tax authorities.

The tax holding period for Cardano used for staking would be extended from one year to ten years under this proposal.

With the “standard” configuration of Staking, you run the risk of falling into another tax trap. This has the effect that all stakes are automatically returned to the Stakers. This should also increase the tax retention period from one year to ten years.

2 legal recommendations for the use of Cardano (ADA)

1. With regard to staking, you should discuss regular staking, especially on a larger scale, with a lawyer familiar with the taxation of cryptocurrencies to clarify the tax consequences.
2. In general, you should thoroughly familiarise yourself with the dangers of trading cryptocurrencies and investing in Cardano ADA or other cryptocurrencies.

These include scamming methods, fake online trading portals, volatility of cryptocurrencies and thus possible extreme price fluctuations, various fraud schemes, etc.

Our lawyers will conscientiously advise you on all legal questions in this area.

If you have invested in or made payments to one of the companies on this list, our lawyers will be at your disposal at short notice.