Bitcoin. You can’t open a news site without reading about it, you can’t carry on a conversation about finances without talking about it and your social media feeds are probably peppered with comments about it. At least one of your friends has probably posted something like: “Four years ago I wanted $1,000 to buy bitcoin. We didn’t have it. That would be $70,000 now”, or “When I wanted to invest, bitcoin was less than $100”. There are a lot of would-a, could-a
Feel like everyone is getting swept up in the bitcoin frenzy, making money hand over fist while you sit idly by, not knowing how it works or what’s going on? Think
Before you go mortgaging your house or maxing out your credit cards to buy bitcoin, it’s crucial to understand what you’re getting into and the risks and rewards involved.
Bitcoin is the big guy in an entirely new category of digital money called cryptocurrencies. Since it’s the one currently getting all the headlines, we’ll answer some basic questions about bitcoin with answers that can also apply to the broader category of cryptocurrencies.
OK, what exactly is
Where did bitcoin come from? How can you create a currency out of thin air?
For something that already feels so ingrained in our culture, bitcoin is remarkably recent and its beginnings somewhat of a mystery. Bitcoin runs on open-source software created by someone using the alias “Satoshi Nakamoto” in 2008. It was introduced to the public in 2009. The value of a bitcoin was negotiated by supporters and adopters, and its value was
How does it work?
Bitcoins are created by users who use specialized computers to verify other users’ transactions and perform extremely complicated mathematical computations, they are then rewarded with new bitcoins proportional to the amount of computing power they donate. It’s called “mining”, and mining creates blocks of data which are added to the bitcoin blockchain. Creating bitcoins and blockchains go hand in hand.
Blockchains? Oh man, just when I was starting to understand…
Relax. A blockchain is simply a
Blockchains remove that middleman—the bank, in this case—by creating an open, decentralized database for any transaction involving value using math and cryptography. Blockchains grow as each block composed of recent transactions is completed and added to the ledger. They allow for a safer, less theft-prone environment. Think of it as a single ledger that is always up to date and accessible to everyone on the network. It’s encrypted, and since it’s decentralized no party involved in a transaction can control it; they can only verify if the transaction is valid. Once the network agrees, it’s added to the chain.
Blockchains make extremely secure transactions possible. Unlike your bank account number, your bitcoin address is public. But to access the account you need a private key, which is much more elaborate and more secure than a bank PIN number. That private key is the gateway to everything, with complete access to your account.
Blockchains are a revolutionary way of creating and providing online security and will have a much bigger impact on the way we do business than bitcoin itself will.
What about bitcoin “mining”? How does that work?
Mining is when a computer or a network of computers run the bitcoin software, and bitcoins are the reward for solving the complicated math and data of the blockchains. When a block of data is solved, a set number of bitcoins are released and whichever computers in the network
Bitcoin miners are large, power-hungry rigs with specialized chips that do nothing but process the math required to create the blocks. They are also very loud and generate a lot of heat. In the early years, individuals were able to mine enough bitcoin to make the expense of running these set-ups pay off, but as bitcoin has exploded, large companies have built huge mining farms with thousands of rigs to reap the rewards. It’s unlikely a home rig or two will generate enough bitcoin to cover the expense of running them. You might have better luck mining one of the other of the smaller cryptocurrencies.
How safe are cryptocurrencies?
Much safer than your bank account. Put it this way: the odds of someone guessing your 4-digit PIN number are 1 in 10,000. The odds of picking winning lottery numbers are 1 in 292 million. And the odds of picking someone’s private key are 1 in 1,461,501,637,330,902,918,203,684,832,716,283,019,655,932,542, 946! There have been a few incidents of poorly run, mismanaged exchanges that have had bitcoins stolen from them, but nobody has ever hacked a private key. So yeah, it’s safe.
What’s so great about cryptocurrencies?
Governments can’t touch them
Cryptocurrencies have a lot going for them. Since it’s a decentralized system, that means they aren’t controlled by any government and assets can’t be seized or frozen. The entire internet in every country on earth would have to shut down to wipe out your accounts. Governments also have no ability to devalue or manipulate the market value of a cryptocurrency. In the past, governments have devalued
You can’t counterfeit it
Every single bitcoin is tracked, and every transaction recorded. While fake paper currency is relatively abundant, it is practically impossible to counterfeit a cryptocurrency.
Say someone purchases a camera online using a credit card. The bank issuing the card sends the camera store money and the store sends the person the camera. But if the person who purchased the camera cancels the transaction after receiving the camera, the bank gets its money back and the store is out a camera. It’s criminal, but it happens all the time. A transaction with a cryptocurrency is final and recorded by the blockchain. There is no recourse.
Settlements are Immediate
Banks are notorious for holding deposits, especially with international transactions. With cryptocurrencies, there are no holds on deposits or waiting to access your money.
It’s available to everyone
Cryptocurrencies are making financial markets accessible to people all over the world. Some countries with flawed banking systems and hyperinflation are even turning to cryptocurrencies to use as their own currency.
Transactions carry insignificant fees
If you’ve ever wired someone money, you know what we’re talking about. Instead of ridiculous fees of up to 25 percent per transaction, it costs far less to purchase, transfer and receive cryptocurrencies, often just a few cents or a couple of dollars.
OK, that all sounds great. Should I buy it? How can I buy it?
There are three reasons to purchase cryptocurrency: to trade, make purchases, and to hold as an investment. The easiest way to buy one of the major cryptocurrencies, like bitcoin and Ethereum, is
Another way to purchase cryptocurrency is through dedicated ATMs. Bitcoin ATMs are rapidly popping up everywhere. To use one, you retrieve a code by entering your phone number, insert your money, then receive a printed public & private key for the funds along with a receipt. You’re paying for the convenience though as there is usually a high markup paid to the exchange.
Where do I keep my cryptocurrency? What are bitcoin “wallets”?
A cryptocurrency wallet is a place to store your private keys, not the money itself. It’s usually a free app you can download
We mentioned exchange sites such as Coinbase, and there are others including kraken.com, exodus.io
Not all wallets support all cryptocurrencies. It’s important to research what type of wallet works best with the type of coin you are buying or trading.
Great, but what you do with bitcoin? Can you spend it?
Exchanging your bitcoin for the cash equivalent is easy on sites like Coinbase. Since it’s tied to your checking account, you simply hit “withdraw”, and the money will show up in your checking account. Due to the recent heavy volume
As for making purchases with cryptocurrencies, more and more businesses are accepting bitcoin as payment, including big players such as Microsoft, Dell
Alright, it all sounds great. What are the risks?
Cryptocurrencies are extremely volatile
Unlike standard currencies, cryptocurrencies have experienced wild swings, as you have no doubt been reading about in the news. Bitcoin’s rise has been stratospheric. Just imagine the havoc on the economy if the U.S. dollar was as volatile.
If someone steals your private key, your money is gone for good
That’s why it’s so important to keep your private keys secure. You have absolutely no recourse after someone gets your money.
It’s still not clear if governments will try and regulate cryptocurrencies
China has already banned initial coin offerings (ICOs). Governments and big banks are uneasy with so much potential money that isn’t being taxed or regulated, so it will be interesting in the next couple of years to see how they respond. Some regulation might not be a bad thing though, as it could lead to cryptocurrencies being accepted more widely.
What makes the price of bitcoin so volatile?Blame, or thank, the age-old law of supply and demand. More and more people are buying bitcoin, driving up the price of coins in circulation.
Is bitcoin really a bubble that’s bound to burst?
Correct…to a point. Remember the Dot-com bubble, when so many online companies raised billions and billions of dollars and then disappeared, leaving investors high and dry? The same thing will probably happen with cryptocurrencies. But remember what came out of the internet bubble, behemoths like Amazon, Google
What about these other cryptocurrencies?
Any cryptocurrency except bitcoin is called an “altcoin”, and there are lots of them out there, just without the PR and headlines. Currencies like Ethereum, Litecoin, DASH
So, what if aliens descend, zap the electric grid and bring the internet down? What happens to my bitcoin then?
Afraid you’d be out of luck; however, you’re more likely to lose out by ignoring cryptocurrencies and the dramatic, economy-shaking changes they are already making.
About the Author
Merlin Rothfeld has been actively involved in the financial markets since 1996. After receiving his degree in Business Finance, Merlin worked for a large financial planning firm in California where he applied traditional, long term investment strategies.