Unless you’ve been living under a rock, you’ve certainly heard about Bitcoin. But what exactly is this “cryptocurrency”? Bitcoin Basics.
Cryptocurrencies such as Bitcoin are among those technological disturbances that are interesting on the one hand, but that you almost wish would go away on the other. Not only are cryptocurrencies new, but they’re also disruptive. To hear some of their proponents tell the story, cryptocurrencies are about to change everything that we’ve ever known about how we do business.
Bitcoin Basics – What Is Bitcoin?
What is Bitcoin? We’ll say upfront that Bitcoin is not an investment. That’s where a lot of people are getting this whole thing wrong. Bitcoin is a currency — a store of value and a medium of exchange. It can also be a trade (for buying low and selling high) or even a hedge against the stock markets, but it’s not something you would want to buy and hold onto for the long term. That’s because Bitcoin’s value is too unstable. (If you’re looking for an investment, you’d be better off with real estate or any of our other suggestions.)
As part of the fintech movement, Bitcoin is a digital currency that was created by software developer Satoshi Nakamoto (which apparently is just a pseudonym for a person who chooses to remain anonymous).
It exists entirely on the internet. Despite the cute pictures of representative coins that you see in ads and articles (including this one), there actually is no physical Bitcoin. It’s created by people and businesses on their computers. It’s used to buy and sell goods and services online and, increasingly, in physical marketplaces.
And in what is both a mystery and a primary advantage, Bitcoin is controlled by no one. This makes it comparable to gold and silver but completely unlike national currencies, which are issued by governments. That also means that transactions in Bitcoin are neither managed nor monitored by banks or governments. That makes it a nearly anonymous means of exchange.
Bitcoin Basics and Blockchain Technology: The Foundation of Cryptocurrencies
Blockchain technology is the foundation of Bitcoin. Essentially, this is a chain of information registration and distribution that is not facilitated by a trusted third party. This results in a system for digital transactions that is dependent on neither a bank nor a government agency.
This in and of itself is revolutionary against the backdrop of a world population conditioned to bank-sponsored exchanges of government-issued currency. Blockchain technology eliminates the monetary middle man and enables individuals and businesses to carry out transactions on a direct basis.
It starts with a private key. This piece of unique code contains encrypted details about each individual Bitcoin and its ownership. And it enables the owner to transact business without the need to reveal his or her identity. It’s widely believed that private key cryptography will generally eliminate identity theft and most fraudulent transactions.
Since the entire payment methodology operates within a network, rather than a handful of institutions, it’s also believed that the risk of centralized corruption or failure is significantly reduced.
Bitcoin transactions are authorized by the network’s application and maintenance of the blockchain protocol. In some ways, this technology is very similar to the way transactions take place on the web through intermediaries like credit cards and PayPal. It simply removes the bank in the middle and enables the participants to transact business directly with one another.
We’re going to run through this quickly and even skip over some lengthy jargon. But that’s because the mining process is fairly technical and very few people will ever do it. If you want more details, check out this article.
Among the network of Bitcoin users, there are individuals and businesses who keep records of all transactions. The network collects all transactions made in a given period into a list, which is called a “block.”
This is where a “miner” comes into the picture. The miner confirms the transactions and enters the information into a general ledger. The general ledger is a long list of individual blocks, known as a “blockchain.” An updated copy of the block is given to everyone who participates in it, providing verification of activity.
The miners take each block and apply a mathematical formula to it. This creates a shorter, random sequence of letters and numbers which is known as a “hash.” The hash is stored at the end of the blockchain, and then each block is sealed off.
The miners are able to do this using software written specifically to mine blocks. After a miner successfully creates a hash, they get a reward of 25 Bitcoins. At that point, the block is updated, and everyone in the network is informed. That gives miners the incentive to continue mining for more Bitcoins and expanding the number of Bitcoins in existence.
According to Bitcoin protocol, only 21 million Bitcoins can ever be created by miners. However, each Bitcoin can be divided into what is known as 100 million “Satoshi.” That means that in theory at least, something on the order of 2.1 zillions Satoshi can ultimately be created. And with Bitcoin currently trading at close to $20,000, that’s looking more likely all the time.
Why would anyone want to use Bitcoin?
It’s easy to use. At least among other users on the network. It takes only a few minutes to set up a Bitcoin address, no questions asked and no fees collected. Sending or receiving money can be accomplished in a matter of minutes. It’s easy to see the value of this speed, especially with international transactions.
It’s practically anonymous. You can set up multiple bitcoin addresses that are not linked to your name, address or any other personally-identifying information. Even if you have publicly used a Bitcoin address, no one will know that it’s yours.
Every transaction is a done deal. This is both an advantage and a drawback. Unlike credit cards, there is no chargeback provision. Once you send payment in Bitcoins, they’re gone forever. This will make it difficult to reverse a transaction with an unreputable party, but it will also reduce the amount of fraud that has become typical with credit cards.
This is believed to make Bitcoin more secure than credit cards since you don’t need to provide an account number, and expiration date or security code, as is typical with credit card transactions.
With Bitcoin, you use two keys, a public key and a private key. The public key, which is also your Bitcoin address, can be seen by everyone. But your private key is a secret. When you enter a transaction, you combine your public and private keys together. That creates a certificate verifying that the transaction came from you. But as long as you don’t publish your private key, your information and your account are completely safe.
How Big Is Bitcoin?
In the grand scheme of things, Bitcoin is hardly a force. But the currency is still very new, and already it’s making important inroads.
Japan approved Bitcoin as a legal tender on April 1. This is significant since Japan is the third-largest economy in the world and has one of the world’s most widely circulated currencies. In response to the announcement, 260,000 stores across the country plan to begin accepting it.
This past summer, Lifewire.com listed “7 Major Retailers and Services That Accept Bitcoin.” The list includes Overstock.com, travel site Expedia, eGifter, Foodler, electronic retail giant Newegg, Shopify (including all 75,00-plus merchants on the platform) and Dish Network. Other services include Microsoft, Intuit and PayPal.
Meanwhile, according to the website Coin ATM Radar, there are already nearly 1,000 ATMs across the U.S. that work with Bitcoin, including more than 100 in New York and Los Angeles and nearly as many in Chicago and Atlanta.
At the moment, there are three primary ways to store Bitcoin:
- In a “software wallet” on the hard drive of your computer
- With an online, web-based service
- With a vault service that holds your Bitcoin offline
There are also mobile wallets that enable you to hold and transact with Bitcoin via apps on your smartphone. The mobile wallet stores your private keys for your Bitcoin addresses. This could be a serious advance, since it makes the use of Bitcoin entirely mobile, much like cash in your wallet or a credit or debit card.
Bitcoin Basics – Bitcoin Limitations
Bitcoin is not without limitations, at least at this point in the stage of cryptocurrency development.
One big problem is the lack of universal acceptance. It can be somewhere between difficult and impossible to buy Bitcoins using either a credit card or PayPal. Many banks are either restricted from engaging in cryptocurrency transactions entirely or at least hesitant to engage in them.
A large part of the restriction against credit cards and PayPal also comes from the network itself. Since credit cards and PayPal enable buyers to engage in chargebacks, Bitcoin users and exchanges are understandably reluctant to accept them in payment for the cryptocurrency. After all, while it’s very easy for a buyer to execute a chargeback, it’s very difficult for the seller to prove that a digital currency actually changed hands.
The lack of a chargeback capability with Bitcoin itself could prove to be an inherent limitation. Buyers will be understandably reluctant to pay in a currency that leaves them no recourse in the event of less-than-satisfactory service or merchandise.
Storage method vulnerabilities. Bitcoins stored on your computer have the potential for the hard drive to become corrupted. This method of storage will require that you regularly back up your wallet. Online web wallets have inconsistent security protocols. While some use multifactor authentication to provide maximum security, others use the standard ID and password. And we all know how that method is hardly foolproof.
Government actions/reactions. Governments around the world are nervous about cryptocurrencies in general. At a minimum, cryptocurrencies have the potential to replace national currencies, and that’s something that no government wants to happen. For another, governments are unsure how to tax cryptocurrency transactions and income sources.
Right now, the IRS is using summonses and software to identify cryptocurrency users. The agency is targeting cryptocurrency exchanges, requiring that they provide lists of users and transactions.
The anonymous nature of cryptocurrency payments raises the possibility of income tax evasion and illegal activity.
It remains to be seen how any of these issues will be worked out since cryptocurrencies have been around for only a few years and are largely untested. This can result in a schizophrenic path forward into a completely uncertain future.
Does Bitcoin Have Any Competitors?
Bitcoin is hardly the only cryptocurrency available, despite the fact that it’s the best known of the batch. In fact, Investopedia has identified at least six other cryptocurrencies, including:
- Litecoin (LTC)
- Ethereum (ETH)
- Zcash (ZEC)
- Ripple (XRP)
- Monero (XMR)
Of the six, Ethereum is perhaps the biggest competitor to Bitcoin at the moment, although that could change quickly. An important fact: The whole cryptocurrency development is in its infancy. Right now, Bitcoin is the most popular, but in a year or two or five, that situation could change.
Cryptocurrencies are in what is very similar to the startup phase for the internet. At that time, some companies that were projected to be the leaders fizzled out. Others that no one saw coming eventually became the dominant players. So it may be with cryptocurrencies.
Bitcoin Basics – Where to Buy Bitcoin
At the moment, there aren’t any mutual funds or exchange-traded funds (ETFs) for Bitcoin. However, Van Eck is moving toward creating an ETF, while Fidelity is working on a “new service… that enables Bitcoin and blockchain users to track their investments alongside their more traditional investment categories, like stocks and mutual funds.”
If you want to hold Bitcoin, you can buy it either directly from Bitcoin holders in the marketplace or from designated exchanges.
Bitcoin exchanges in the U.S. include:
Some of these exchanges, like Coinbase and xapo, also offer a wallet to hold your Bitcoin in. And you can often purchase Bitcoin without having to pay any transaction fees.
Bitcoin Basics Conclusion
Some people are scurrying about, scooping up Bitcoin and treating it as an investment. And although the currency has risen in value by an impressive by 7.5 times in the last year alone, remember that Bitcoin should NOT be considered an investment.
The fundamental value of Bitcoin is that it represents a virtual medium of exchange. That means that it is a digital commodity that is primarily of practical value and not an investment in the usual sense.
What are your thoughts about Bitcoin? Do you own any? Do you think that this is a legitimate disruptive force in our future? Or do you think that it is merely a speculative bubble that will burst in its own time?