What is Bitcoin? A beginner's guide to the world's most popular type of cryptocurrency
- Bitcoin is a cryptocurrency, a type of digital, private money that operates without the involvement of a bank or government.
- Bitcoin trades on online exchanges, and since its price has mushroomed since its 2009 debut, it's increasingly attracting investors' interest.
- As an investment asset, bitcoin offers capital appreciation and an inflation hedge, but its volatile price swings make it a high-risk, long-term investment.
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Scarcely a news cycle goes by without some mention of Bitcoin. But even by its own standards, the cryptocurrency was having an intense moment in the fall of 2020. First, its prices on trading exchanges tumbled around Thanksgiving - only to roar back and set an all-time high of $19,857 on November 30: a 177% year-to-date increase that put the S&P 500's 14% rise to shame.
But while it has certainly attracted plenty of attention, not just of late but throughout its 11-year-old life, Bitcoin still remains a mystery to casual and experienced investors alike. This shouldn't really be the case, since the basics of Bitcoin and how it works are relatively easy to understand.
Here's a brief Bitcoin biography: An overview of its origins, operations - and how to invest in it.
What is Bitcoin?
Bitcoin is a cryptocurrency, an electronic version of money that verifies transactions using cryptography (the science of encoding and decoding information).
As Bitcoin educator, developer, and entrepreneur Jimmy Song explains, Bitcoin is "decentralized, digital, and scarce money":
- It's digital because it exists as a set of code that determines how it operates
- It's decentralized because this code is run by thousands of computers (AKA 'nodes') spread across the globe
- It's scarce because its code limits its overall number to only 21 million bitcoins
When you use bitcoin to buy something, it records the transaction on a blockchain, which is essentially a ledger or database whose entries can't be modified or erased.
Transactions are validated by Bitcoin through a process known as a proof-of-work, in which "miners" (i.e., people with computing hardware) attempt to calculate the cryptographic key for the next block in Bitcoin's blockchain.
"It's called mining because it's like looking for gold. Anyone with a shovel can dig and look for gold, just as anyone with a computer can look for proof-of-work," says Song.
These technicalities aside, one of the main draws of Bitcoin - and one of the reasons why it has attracted so much hype in recent years - is that it's a form of private money that operates without the involvement of a central bank or government.
"Bitcoin is used to transfer funds from one party to another without requiring a middleman such as a bank. Because the technology is open source and entirely decentralized, it is protected from influence by external sources such as governments, who typically control fiscal policy and fiat currency circulation," says Simon Peters, a market analyst at eToro.
A brief history of Bitcoin
This independence from central authorities is key to understanding the beginnings of Bitcoin, which was first formalized by a person identified only as "Satoshi Nakamoto" in an October 2008 whitepaper. Working with various members of a cryptography mailing list, the pseudonymous Nakamoto launched Bitcoin on January 3, 2009.
Other individuals had attempted to develop forms of electronic money before (e.g. e-Cash, DigiCash, Hashcash), but most had failed to solve the 'double-spend' problem, in which bad actors can spend the same e-money twice. Nakamoto's main solution to this problem was to introduce a timestamped, permanent transactions ledger: the blockchain.
This effectively makes every bitcoin traceable and unique, insofar as the transaction history of each individual bitcoin is publicly visible on the bitcoin blockchain. "Any attempted alteration of the ledger would be rejected by other participants," says Peters.
The blockchain technology behind the Bitcoin network is what excites most people about the digital currency. Because the record-keeping technology is decentralized - so no single group has control - advocates believe it has the power to transform the world's financial institutions and business dealings for the better, resulting in faster but more secure transactions, along with improved transparency and communications.
Early uses of bitcoins
At the very beginning of its life, Bitcoin was used to make trial purchases and payments, with developer Laszlo Hanyecz famously using 10,000 bitcoins to buy two pizzas on May 22, 2010. It then became more commonly used in online marketplaces and for international contracts and import/export operations.
It was also around this time that traders first began speculating with the currency, with the now-defunct BitcoinMarket.com launching as the world's first bitcoin exchange in March 2010.
Having been worth precisely $0 when it debuted in 2009, bitcoin has experienced more than its fair share of pricing ups and downs, with its worth rising or plummeting by hundreds of dollars in a matter of hours. Still, the major trend has been that the currency's price has risen over the longer term, with each new peak being higher than the last in most cases.
Concerns over bitcoin's legitimacy
One reason for the volatility: Considerable suspicion and skepticism that have dogged the cryptocurrency throughout its history. Bitcoin's blockchain may be immune to interference, but bitcoin itself may not be, skeptics have said.
Research published in 2019 concluded that "there was serious market manipulation in Mt. Gox exchange," which was the largest cryptocurrency marketplace until hacking forced its 2014 shutdown, incurring the loss of some 744,408 bitcoins.
Similar charges have been made with regards to the cryptocurrency Tether. A so-called "stablecoin," it's widely used to purchase bitcoins in regions (particularly Asia) where using traditional fiat currencies for such a purpose isn't legal. Its operators originally claimed that every Tether token was backed 1:1 by US dollars held in reserve, yet researchers have suggested that this backing is a myth and that Tether is a tool used just to inflate bitcoin prices.
Then there's Bitcoin's association with criminals and shady operators. Most notoriously, it was the medium of exchange used by Silk Road, a clandestine black market eventually shut down by the FBI in 2013.
This stigma has stuck ever since, and not without cause. While recent research suggests that bitcoin is now mostly used for financial speculation or wealth preservation (much like gold), some $2.8 billion was laundered in 2019 using the cryptocurrency.
Why invest in bitcoin?
Bitcoin may be a relatively new asset, but it has provided outsized returns in almost every year of its existence. More broadly, its advocates believe that its fixed supply makes it the perfect way to store wealth and that it should appreciate significantly over the long term as more institutional investors - investment banks, mutual funds, pension plans - pile into it.
"We have already seen increased interest from institutional investors and corporations" in 2020, says Peters. "This is in part to the increasing view that bitcoin can act as a strong hedge against inflation in portfolios, as well as potentially growing in price and in consumer adoption substantially in the future."
How to invest in bitcoin
There are two main ways to invest in bitcoin. Either you set up an account with one of the many dedicated cryptocurrency exchanges now in existence, or you buy it through an investment platform that includes the option to buy cryptocurrencies.
While cryptocurrency exchanges were once shady, unregulated operations, the major exchanges now operating are all regulated and in compliance with applicable laws. In the United States, some of the most popular are:
Alternatively, you can buy bitcoin through a number of financial apps and platforms, including Robinhood, Cash App, and PayPal. Such apps tend not to offer as wide a selection of cryptocurrencies as the dedicated exchanges, but if you're interested only in bitcoin then it doesn't make a real difference.
If you do decide to invest in bitcoin, here are five pointers worth keeping in mind in order to reduce your exposure to risk:
1. Consider buying a bitcoin wallet
If you're buying bitcoin via an exchange, and if you're planning on holding large sums of the cryptocurrency, it may be a good idea to transfer them to your own hardware wallet. Hardware wallets are basically small, offline computers that store the private keys controlling your bitcoin funds, with good examples being manufactured by the likes of Ledger and Trezor.
2. Invest only what you can afford to lose
This sage advice applies to any investment, but especially here. Bitcoin has fluctuated quite wildly over its brief existence and continues to do so - like that $3,000 drop in prices the third week of November 2020. The moral is: Your holdings may decline significantly in the short-term, so don't invest any funds that you might need to call on for an emergency, lest you be forced to sell during one of these downswings.
3. Think long-term
Given its volatility, it usually pays to have more of a long-term perspective when investing in Bitcoin. Viewed over the past decade, it has performed extremely well, so - unless you want to take up day-trading - buying and holding it may be the best strategy.
4. Watch the stock market
Bitcoin has shown an increasing correlation with the S&P 500 in 2020, particularly as the current economic climate has pushed investors towards more speculative investments. As such, it may be worthwhile watching stocks for telltale signs of an impending movement in the bitcoin market.
5. Remember tax liabilities
In the United States, bitcoin is taxable. You are liable for capital gains tax when selling the currency at a profit, or even just spending it (if the price has appreciated since you bought it). So be sure to keep records of all your transactions.
The financial takeaway
It's hard to say where Bitcoin will be in the next five or 10 years.
Its ability to operate at scale has been seriously questioned, so it's unlikely that bitcoin will become a fully fledged currency, replacing traditional dollars or euros, anytime soon.
Still, 2020 saw the business intelligence company MicroStrategy adopt bitcoin as its primary reserve asset, with the likes of Square and UK-based fintech Mode soon following suit. It also saw PayPal launch its own cryptocurrency trading service, adding to the conviction that the momentum behind Bitcoin and crypto in general is only building.
"In my view, whilst adoption will continue to increase at a steady rate, the largest role I see bitcoin having is its increased use as an asset in investment portfolios," says Simon Peters. Some bullish analysts have set fairly astronomical target for price increases, with former Goldman Sachs hedge-fund chief Raoul Paul going as high as $1 million by 2025.
Given that bitcoin has no real fundamentals besides a limited supply and a growing network of developers, users and holders, it's hard to fully subscribe to such optimistic forecasts. Nonetheless, past years have been very kind to the cryptocurrency, and there are no real signs that its bubble (if it is a bubble) is going to burst just yet.
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