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For some, it’s “magic internet money.” For others, it seems to be a religion. So what is bitcoin, really? How does it work, and what can it do for you?
This is a comprehensive guide designed to bring you up to speed as quickly as possible. We will go into depth on the ins and outs of bitcoin. You can’t become an expert overnight, but this is as good a place as any to get started.
This is a big topic and it may seem a bit complicated, so if you get lost, don’t worry. The most important things to know are:
- Bitcoin has a fixed supply. There will never be more than 21,000,000 bitcoins.
- Bitcoin can be sent anywhere in the world, instantly.
- Bitcoin cannot be shut down by any government.
Keeping that in mind, let’s start from the beginning.
The Birth of Bitcoin
Bitcoin is usually traced back to the financial crisis of 2008, but really it goes back a lot further than that. Economist and nobel laureate Milton Friedman identified the need for bitcoin as early as 1999:
“I think the internet will be one of the major forces for reducing the role of government. The one thing that’s missing, but that will soon be developed, it’s a reliable e-cash.”
Several attempts were made to create an internet currency, but these were quickly shut down by the authorities. The most notable was e-gold, which closed down in 2007— one year before bitcoin went online.
The mysterious bitcoin inventor, known only as Satoshi Nakamoto, commented on this situation in the early days of bitcoin’s development:
“A lot of people automatically dismiss e-currency as a lost cause because of all the companies that failed since the 1990's. I hope it's obvious it was only the centrally controlled nature of those systems that doomed them. I think this is the first time we're trying a decentralized, non-trust-based system.”
Trust was indeed the main reason bitcoin was created. Nakamoto also mentioned the fact that we are required to trust central banks that issue our money, and private banks that hold our deposits:
“The root problem with conventional currency is all the trust that's required to make it work. The central bank must be trusted not to debase the currency, but the history of fiat currencies is full of breaches of that trust. Banks must be trusted to hold our money and transfer it electronically, but they lend it out in waves of credit bubbles with barely a fraction in reserve. We have to trust them with our privacy, trust them not to let identity thieves drain our accounts.“
This quote sums up Nakamoto’s goal in creating bitcoin; to establish a currency, and a way to store and transfer that currency, that does not require trusting anyone.
So how did he do it?
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In the early days of banks, bankers recorded how much money everyone had in a big notebook. Of course, only the banker could write in the book, because if anyone could change it, they could give themselves more money than they actually had.
With bitcoin, a technique was discovered which allows everyone to look in the notebook without being able to change how much money anyone else has, or give more money to yourself. You can only subtract money from yourself, and add it to someone else.
President Obama was very critical of bitcoin when he first heard about it. He commented that “it’s like everyone is walking around with a Swiss bank account in their pocket.” One bitcoin advocate corrected him, saying that really it’s “like having a Swiss bank in your pocket, and you are the CEO.”
This is true, because you can create as many bitcoin accounts (called wallets) as you want.
But bitcoin is more than just being your own bank. It’s also a way to independently guarantee a limit on the money supply. There will never be more than 21 million bitcoin. So unlike paper money, nobody can get rich by just printing themselves more money.
All of this is made possible by math.
How is Bitcoin Secured?
It sounds a bit like magic at first, but when you dig into it, it really is just math. The whole system is based on cryptography, which was originally used by the military for encoding messages so they could not be understood if enemy forces intercepted them. Hence the term “cryptocurrency.”
When you log in to your email account, you use a password to prove that you are the owner of the email account. Your email service provider checks to make sure your password is correct before allowing you to enter your inbox. But in order to do this, they have to know what your password is, so they keep a copy of your password.
With cryptography, it is possible to create an equation where you can prove you know your password, without needing to tell anyone your password. This is called “public key cryptography,” and it is the basis of all bitcoin wallets. A bitcoin wallet is composed of a public key and a private key.
You can think of the public key as being similar to an email address, while the private key is like a password. And instead of sending emails, it sends money.
But who checks the private key/password to make sure it is correct? That’s where miners come in.
Digging for Digital Gold
When you log into your email account, your email service provider checks the password you give them, and makes sure it matches the password they have on file for you. If the server goes down, there is no one to check your password, and you can’t log in.
With bitcoin, this can’t happen. Instead of just one computer checking passwords, there are many thousands of computers all around the world checking to make sure all of the private keys are correct. But why would they do this?
Every bitcoin transaction includes a fee. Every 10 minutes, a group of transactions are bundled together and saved to the record of transactions. This group of transactions is called a block. The miner who creates a block gets to collect all the fees. In addition to fees, any miner who makes a block gets a bitcoin reward. This is how new bitcoins are created.
In order for a block to be accepted, all of the transactions in the block must be correct, meaning all of the private keys must be correct.
The (In)famous Blockchain
Thousands of miners all around the world are competing for the privilege of making each block, and only one will win. In order to have a chance at winning, every miner must keep a copy of all of the blocks that were ever created. This is called a blockchain, and it includes every transfer of bitcoin that ever happened.
All of the transactions in the block are mathematically condensed to a single code, known as a “hash.” This hash is combined with another hash from the previous block called a “block header” to create a new block header.
Each miner needs to include the block header of the previous block to have a chance of creating a winning block. Including this number from the previous block is what “chains” the blocks together.
Why is Bitcoin Immune to Inflation?
In order for a miner to create a valid block, they must be recognized by other miners. And in order to be recognized by other miners, they must be running the same version of the bitcoin software as all the other miners. This requirement is coded into the software itself. And this software only allows for a maximum of 21 million bitcoins.
So anyone can change the software so that there are 22 million bitcoins instead, but none of the other miners will recognize their blocks as valid, and the miner with the modified software will be ignored. Creating a new variation on the bitcoin software is called a “fork.”
There are many hundreds of alternative cryptocurrencies that have been created in this way, but all of them are much less valuable because they don’t have the same support and recognition as the original bitcoin.
Another reason these other currencies are less powerful is because the more miners there are on a network, the more difficult it becomes to “mine” bitcoin. The more difficult it is to mine bitcoin, the more secure the network is, which means bitcoin is (arguably) the most secure cryptocurrency. This will be discussed more under “Risks.”
Bitcoin is designed so that the supply of new bitcoins is cut in half every 4 years. At first, each miner who added a block to the blockchain got a reward of 50 bitcoin; in 2012, this reduced to 25, and in 2016, to 12.5. The supply reduced to 6.25 in May of 2020, and will reduce again in 2024.
In the past, price has gone up dramatically with a few months of these supply reductions, called “halving.” In other words, bitcoin is designed to go up in value with time, just as traditional moneys, like dollars, are designed to go down in value.
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Bitcoin vs. Cash
Initially, bitcoin was designed to be an alternative form of cash. It has a number of advantages over cash.
- It can be sent at any time. Unlike traditional wire transfers, bitcoin can be sent at any time of day or night, and on weekends and holidays. Settlement is fast, with payment visible instantly, and confirmed with a high degree of security within a half hour.
- It can be sent in any amount. You may have seen minimum transaction amounts for credit and debit card purchases. Bitcoin has no minimum, so you can send even fractions of a cent. This opens up all kinds of new business models— for example, paying to read an article online without needing to pay a subscription.
- It can be sent without ID. When you open a bank account, you need to verify your ID. But anyone can create a bitcoin address, and send money anywhere in the world. This has led to bitcoin’s use in online “dark marketplaces” where illegal drugs are sold. But it also enables activists living under totalitarian regimes to safely obtain financing.
- It’s supply is known. For the reasons discussed above, bitcoin’s supply is fully predictable, which means that unlike paper money, it cannot be abused by a bank.
Bitcoin vs. Gold
As bitcoin started to gain popularity and its value went up, the transaction fees became more expensive. But it still had the most established track record of value of any cryptocurrency, so many started to view its role more as a store of value.
Like gold, many people now regard bitcoin as a safe haven, a place to secure wealth for the long term. This is because in spite of its volatile price increases and crashes, overall, bitcoin has steadily been increasing in value since it was created. And while it has similar appeal as gold to investors, it also has some advantages over gold.
- Easier to divide. If you want to sell a certain amount of gold, it is very difficult to melt down 23.874% of your gold bar to get the exact amount.
- Easier to sell. There is extensive infrastructure online for converting cryptocurrency to cash or other assets.
- Easier to carry. You can carry millions of dollars worth of bitcoin without attracting attention. It’s hard to do that with a stack of gold bars.
- Easier to transfer. You can instantly send bitcoin worldwide, which is impossible with physical gold.
But What’s the Catch?
Okay, sounds great, right? But if it sounds too good to be true, it probably is.
The main drawback of bitcoin is its volatility. Overall, price has been increasing steadily since bitcoin was created, but those increases are accompanied by wild swings in value. In 2013, the value went from $20 per bitcoin to over $200 in a matter of days, and then crashed as low as $60. In 2017, the value increased to over $20,000 before crashing as low as $4,000. In December 2020, bitcoin began a bull run that hit a new all-time high of $40,000... At the time of this writing, it's floating around $36,000 for one bitcoin.
For many people, it can be nerve wracking to watch the value of their savings drop by 40% overnight. Also, the fact that bitcoin’s value is always going up means that nobody wants to spend it, so it will be difficult for it to catch on as a replacement for cash for everyday expenses..
Why is Bitcoin Such a Big Deal?
Did you ever dream about having a money printing machine when you were a kid? If so, you’re not the only one. Being able to create money out of nothing gives a huge amount of power. And bitcoin is going into direct competition with the people who have the power to create money.
There is approximately $90-100 trillion dollars of cash in the world. This includes all banknotes, coins, and checking and savings deposits. In addition to that, there’s at least $7 trillion worth of gold in the world, and some people who used to invest in gold now invest in bitcoin instead.
Some people have transferred all of their money into bitcoin. Others invest a small amount, just in case it takes off, or in case the conventional monetary system collapses. If 5% of the demand for cash and gold in the world transferred to bitcoin, the total bitcoin market value would be worth around $5 trillion dollars.
Since there can only ever be 21 million bitcoins, this would mean 1 bitcoin would be worth approximately $250,000. Of course, it is impossible to predict how much of the market for cash and gold that bitcoin will capture. It could be more, or it could be less.
Why Do People Buy Bitcoin?
So how could bitcoin possibly take over 5% or more of the world demand for cash and gold? Many people dislike the fact that the purchasing power of money constantly decreases, and some believe bitcoin is immune to this.
Others live in parts of the world where the currency collapses in value every few years— many Venezuelans and Argentinians turned to bitcoin and successfully protected their wealth in recent economic crises there. As their friends and neighbors notice that they still have money while everyone else’s savings were wiped out, interest in bitcoin is growing.
There are some people who genuinely believe that bitcoin gives them more freedom than the traditional banking system, and invest in bitcoin for that reason. Journalists living under totalitarian governments can also use it, and so can black market internet traders, or anyone seeking to evade economic sanctions.
There’s also huge speculative demand, and shrewd traders can make money 24 hours a day, 7 days a week, in the world’s first truly global market by trying to trade bitcoin’s wild price swings. Many people treat bitcoin trading like a casino.
And then there’s many folks who see all this going on, and see that the price could go up, so they buy in only for that reason. All of these factors form a perfect storm which leads to the dramatic price increases bitcoin has seen in the past.
The main risks involved with investing in bitcoin include 51% attacks, quantum computing, and competition from other currencies. Let’s go over these points one by one.
Miners are responsible for securing the network. They won’t accept any invalid transactions, because if there is a problem in a block they create, the other miners won’t accept it. However, if one miner controls more than half of the network, they can accept their own bad block, and “double spend” funds. This is called a 51% attack.
Basically, this means that they control enough of the network to trick everyone into thinking that there are two valid blockchains.
At this point, such an attack would require a huge amount of computing power. Since much of the bitcoin network is concentrated in China, it has led to concerns about the centralization of the network.
However, China benefits from selling bitcoin mining hardware, and Chinese miners have no interest in harming the bitcoin network since their livelihood depends on it. Other bitcoiners, concerned with this trend, are also making efforts to keep the network decentralized to mitigate this risk.
Another fear is that an advanced computer could be developed which could render the encryption algorithms underlying bitcoin obsolete. Last year, Google announced that they’d developed a quantum computer which could theoretically crack some legacy bitcoin wallets.
But the bitcoin community has already discussed quantum resistance. If it actually became a risk, it is likely that the bitcoin community would probably agree on adding quantum resistance fairly quickly.
There is intense competition for the future of cryptocurrency, and many competitors out there want to dethrone bitcoin as the king of crypto. Many of them claim to be technically superior, but bitcoin proponents retort that bitcoin is built to be robust, not high performance.
There are many cryptocurrencies that focus on slightly different functionalities than bitcoin; some emphasize anonymity, some are more programmable, while some trade decentralization for higher speed and lower fees.
But bitcoin advocates argue that the base layer of internet money must be very stable, and they argue that bitcoin mining fulfills this goal. Since producing bitcoin via mining requires large amounts of energy, they argue that bitcoin has a more solid economic value than other cryptocurrencies, which are more heavily influenced by speculation.
They also argue that high performance technology can be built on top of bitcoin, much in the same way that the modern internet is still based on the same simple protocol that was used in the early days of the internet. The most well known example of this line of thinking is the lightning network, which is built on top of bitcoin and allows instant, low cost transfers.
It’s hard to say how all of this competition will pan out. It may be that bitcoin’s competitors eventually capture more of the market. On the other hand, bitcoin die hards believe that bitcoin will become the bedrock of a new world financial system. In any case, bitcoin has a very strong support base, and is very likely here to stay.
How to Become a Bitcoiner
Bitcoin can be intimidating at first. If you make a mistake, you could lose your funds forever. But as time goes on, more and more services are developed which make it easier to use. Here’s the main things you need to know about if you want to use bitcoin.
Every bitcoin address is part of a wallet. There are many different wallets out there; here’s the main types.
- Paper (cold storage) wallet. This is the original wallet, which you can generate on websites like bitaddress.org. This type of wallet is a form or “cold storage” which means it is not connected to the internet (as opposed to a “hot wallet”), and is thus not vulnerable to hackers. With this method you do need some kind of wallet software to send bitcoin. You can easily receive bitcoin, though, which makes this type of wallet good for long term saving.
- Mobile wallet. A number of wallets exist as iOS and Android apps. You can use them to send and receive bitcoin from a smartphone. This is a more convenient, but less secure option.
- Desktop wallet. Desktop wallets are much like mobile wallets, but on a computer. Like mobile wallets, they are convenient but a bit less secure.
- Online wallet. Online wallets, like those offered by Coinbase or other cryptocurrency exchanges, are not truly wallets. They are actually custodial services. Most keep the majority of funds in cold storage, but some exchanges have been known to suffer from hacks resulting in loss of customer funds. If you use this option, be sure to choose a reputable service. Some security purists and conspiracy theorists shun online wallets due to fears that the government could seize exchange funds in the future.
- Hardware wallet. This is the most expensive form of wallet, but if offers a good balance of security and convenience. A hardware wallet is a device, similar to a USB flash drive or external hard drive. Funds are stored on the device, offline. When you want to send funds, you can momentarily connect the device to the internet. Most hardware wallets have robust internal security features.
Sending and Receiving Funds
Sending and receiving funds is relatively simple. The public key acts as an address. A public key looks like this 18jeRSLoDGv2Jq79c8t8C79axTcoscmAVk. To receive funds, all you need to do is share this address with someone. To send funds, you will need your private key, which looks similar, but is a bit longer.
Usually the private key is stored inside of whatever software you use to send funds.
How to Buy, Sell, & Invest in Bitcoin
To invest in bitcoin, all you have to do is buy some bitcoin. There are many ways to do this. Here are the main methods.
- Centralized Exchange. This is the most common method used to buy and sell bitcoin. There are many companies that sell bitcoin and other cryptocurrencies, usually via direct link to your bank account or wire transfer. The biggest among these are Coinbase, Kraken, and Bitstamp.
- P2P Exchange. P2P or person to person exchanges link buyers directly with sellers. Some of the most well known P2P exchanges include localbitcoins.com and paxful.com. In this way, you can purchase bitcoin with cash in person, or by many other methods, including PayPal and other transfer services via escrow services built into the website.
- Mining. In the early days of bitcoin, anyone could mine on a PC. Nowadays, mining requires highly specialized equipment, and is more like a full time job than a hobby.
- Self-directed IRA. Many alternative investment firms now offer the "Bitcoin IRA." These companies specialize in setting up self-directed IRAs for cryptocurrencies. The crypto IRA dealers work with SDIRA custodians and vault storage providers to set-up your account, rollover retirement funds, and ensure that you're compliant with the IRS tax rules.
Some of the more well known Bitcoin IRA companies are Coin IRA, a subsidiary of Goldco Precious Metals, Regal Assets, and BitIRA.
It’s a good practise not to keep large amounts of money in hot wallets. If you are storing bitcoin online, always make sure to double check the URL of the website before entering your password.
Take care when clicking links related to bitcoin. If you get an email from a bitcoin related service, be sure to verify the authenticity before replying or clicking any links, and never give anyone personal information or passwords, even if they claim to be an employee of a company.
If you invest a lot of money in bitcoin, you should not advertise it openly on social media. If you do decide to meet someone in person to buy or sell bitcoin, you should follow the same procedure you would for selling other valuable items, like meeting in a public place.
What is the Best Strategy for Investing in Bitcoin?
Generally, the safest strategy for investing in bitcoin is to hold it long term in a safe place, most likely a hardware wallet or a paper wallet.
Due to the price fluctuations, some investors recommend cost-averaging. Instead of buying a large amount of bitcoin at one time, cost-averaging entails making regular purchases, sometimes on a weekly or monthly basis. This reduces the risk of buying high and missing out on better buying opportunities in the future.
It is very easy to trade bitcoin— buy low, sell high. Sounds simple, right? In reality, the majority of day traders lose money, although a select few do very well. The situation here is similar to day trading stocks.
What Does the Future Hold?
The future of bitcoin is uncertain. But one thing is for sure— bitcoin is changing the world, and there’s no turning back the clock.
Central banks are starting to respond to the cryptocurrency revolution by working on their own digital currencies. It’s unlikely, however, that they will be willing to give up their power to control monetary policy. So as long as there are people out there who don’t trust bankers, bitcoin is likely to maintain its appeal.
The value of a technology is usually proportional to the size of the problem it solves. Bitcoin’s explosive growth is driven by structural problems, and although bitcoin has already made a splash on the world stage, those same problems are still very clear and present.
Many analysts view the cryptocurrency boom as similar to the dotcom boom of the 1990’s. So is bitcoin the next Amazon or Facebook? There’s certainly a chance it may be. And there’s a chance that the effects of this phase in the development of the internet could be even bigger.
While the internet has revolutionized the retail and media industries, cryptocurrencies like bitcoin are disrupting finance, banking, and even money itself, in much the same way. Disrupting money and finance may be the biggest way in which the internet impacts our lives yet.
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