What Exactly is Bitcoin, Anyway?
Bitcoin is essentially a digital currency with no central authority. Unlike currency issued by governments, Bitcoin is completely user controlled and only has as much value as users are willing to pay for it. There are a finite number of Bitcoins, so as demand goes up, so does the price.
No one owns Bitcoin. Instead, something known as the “blockchain” is a publicly-displayed accounting ledger of who owns what Bitcoins and how these Bitcoins were spent. The ledger is powered by “miners” (discussed below). Despite the public nature of Bitcoin transactions, there is no personally identifiable information associated with the “blockchain”, making it difficult to pin transactions to the actual identities of the people behind those transactions.
Bitcoin Creation
As mentioned, no one actually owns Bitcoin and as a result Bitcoins cannot be created by a central authority (the Federal Reserve for example can print more US dollars if it desires). Instead, new coins can only be created at a finite rate in a process known as “mining”.
Anyone with a computer can “mine” for Bitcoins. Mining involves using the computer to perform heavy math problems which help process all the transactions of Bitcoins worldwide. The calculations are so resource intensive that your regular home PC is not capable of meaningfully mining for BTC. About every 10 minutes, a mining will stumble upon the proper “number” and be rewarded with 25 Bitcoins. Every 4 years, the amount of Bitcoins rewarded to miners is cut in half. Eventually, no more Bitcoins will be awarded (still over a hundred years away). At the time Bitcoin flow shuts off, there will only be 21 million Bitcoins in circulation. Since Bitcoins can be traded in fractions, this is not a big deal.
Mining is so difficult at this point that people do not mine Bitcoin on their own PCs. Instead, miners often join “co-op” networks where 10+ people will join together their PCs in a cooperative effort to mine coins. If the network hits a reward, the BTC are split amongst members of the party based on the amount of computational power each member contributed to the task.
The reason Bitcoin works this way is because Bitcoin is meant to mimic gold rather than fiat currency. Like gold, there is a finite number of Bitcoins. Just like gold, the more Bitcoins have been mined, the harder the remaining Bitcoins will be to get.
Why Bitcoin?
While Bitcoins were initially popular due to the near anonymity of the currency, the real appeal of Bitcoins lies in the fact that there is little to no transaction fee associated with trading the currency. Transactions are currently carried out for free by miners. Even when all the Bitcoins have been mined out, transactions will likely be able to be processed a miniscule fee. Credit card companies like Visa and currency processors like PayPal often charge a 2-3% fee to handle money.
Naturally, this is a waste of money for low margin businesses. Places like small restaurants, gas stations, and liquor stores often offer a 2-3% discount for cash purchases to avoid these fees. Bitcoin also avoids these fees and is naturally much easier to handle than cash.
The primary appeal for investors is that if more people take to buying and selling goods and services in Bitcoin, the price of Bitcoin will go up due to increasing demand without increasing supply.
How to Invest in Bitcoin (How to Buy Bitcoins)
Now that you know exactly what Bitcoins are, you are probably wondering exactly how you can go about buying them. Right now, it is not easy to purchase Bitcoin. Your best bet for now is to go onto something known as a “coin exchange”. These platforms are conversion systems which allow people to buy and sell Bitcoins for fiat currency (i.e. US dollars). Coins are sold from one user to another much like a stock. The price you can buy or sell the coin for depends on what users are willing to pay for it. The platforms make their money by charging a transaction fee for offering the marketplace.
An recommended exchange would be CoinBase. However, no exchange can be completely trusted (as discussed in subsequent sections), so be careful when buying BTC.
Since each coin exchange has its own user base, Bitcoin values depend on what that website’s particular user base is willing to pay at that particular time for a Bitcoin. One exchange might have Bitcoins worth $500 whereas another exchange has Bitcoins worth $550. Naturally people will trade back and forth between platforms to try and take advantage of these differences, so any difference in price will not remain elevated for long.
The biggest problem with these exchanges it that they have a habit of going out of business or their owners vanishing with their customers’ Bitcoins (often never to be recovered). Below, I will discuss this and other problems with Bitcoin as well as how to try and avoid being a victim of such a scam.
The Three Problems With Investing in Bitcoin
If Bitcoin becomes a mainstream currency, there is no doubt that it will explode in value and be worth many times more than what it is worth today. After all, there is only $7B tied up in Bitcoin and over $220 trillion in total world wealth. However, there are a few big risks associated with this investment that you should be aware of before going any further.
The US Government Could Easily Shut Down Bitcoin
The main problem with Bitcoin is that it could easily be shut down by the US government. I will say that not once but twice in the nation’s history have certain alternative forms of currency been shut down by the government (see: bimetalism from the 1800s and gold during the Great Depression). Owning gold as an investment was banned less than 100 years ago by “executive order”. There is no reason to think that the government of the United States could do this again.
The US government will do whatever it takes to protect the dollar. The Federal Reserve exists for this entire purpose. If Bitcoin ever represents a legitimate threat to the dollar to the point where people begin to prefer trading in Bitcoin rather than dollars, the US government will take active steps to shut this down. The only hope for Bitcoin in the longterm is widespread adoption by other countries to the point where the US government may not be able to stop its trade. The longer the government waits for action, the harder it will be for them to stop. Chinese companies (i.e. Baidu) have widely expressed interest in Bitcoin, strengthening its hope for a safe future.
Bitcoin’s Small Pool Makes Market Manipulation Very Easy
Since all the Bitcoins in the world amount to less than $10B in value, it is very easy for market manipulators to change its price in one way or the other. Since coin exchanges often only represent a small portion of the total Bitcoins in circulation, it does not take many resources to drive the price up or down. Just a few million dollars can cause serious waves in the price of Bitcoin if a huge buy or sell order is executed to drive the price up or down. Investors would be wary to avoid buying coins at a price that significantly varies from the week’s mean price as well as spreading out investments over the periods of a few months for best results.
Bitcoins Can Easily Be Stolen With Little Recourse
The final pitfall of Bitcoins (though not really a threat to its long-term viability) is the ease at which users can steal Bitcoins from one another. Exchanges regularly disappear overnight, taking thousands of Bitcoin with them in the process. Additionally, if your computer is hacked, your virtual wallet can easily be emptied overnight and there is no way you can get those Bitcoins back.
If you are serious about putting any significant sum of money into Bitcoins, you need to create something known as a paper wallet. Here is a rough idea of how it works:
- Bitcoins are associated with “addresses”. Addresses have no personally identifiable information but are just a code associated with the blockchain. Bitcoins can be sent to any of these addresses. Anyone can create a new private Bitcoin address.
- Bitcoins can only be sent from one address when the sender puts in their secret key. If someone gets access to your secret key (something like a password), your Bitcoin wallet can be emptied.
- Coin exchanges automatically set you up with a virtual wallet and store your Bitcoins on that particular wallet.
- A paper wallet involves creating your own private address (detailed in the link above) and then printing out a QR code containing your secret key. By doing this on a computer never connected to the internet, you can make sure there is no digital record of your secret key.
- After you buy Bitcoins on an exchange with your virtual account, you can then send all those coins to your paper wallet address for safe keeping. If you keep the paper slip in a secure location, your Bitcoins cannot be stolen. However, if you lose your piece of paper, you will lose access to your money as well if you have no other record of the key.
- As you are ready to cash in the Bitcoins, you can use the QR code and a mobile phone to transfer coins from your paper wallet to another wallet to either spend them or sell for cash. You could even use a mobile device to spend coins directly from the paper wallet.
By using a paper wallet, you are the only one to own or have access to your Bitcoins. Not using a paper wallet leaves you open to coin exchanges vanishing with your coins.
Investing in Bitcoins: Conclusion
Investing in Bitcoin is inherently risky, but the rewards could be great if the currency takes off. Alternatively, the currency could represent a bubble and completely lose value should the government step in and try and shut down the ownership of Bitcoin.
If you do decide to invest in Bitcoin, be sure to spread out your investment so that you do not end up buying on a particularly high day for the currency. Additionally, do not keep any substantial sum of money on a coin exchange. Instead, if you are planning for holding for any length of time, go through the process of creating a paper wallet to safely store your Bitcoins. Finally, however unlikely, be prepared for the possibility of losing your entire investment – Bitcoin investing is not for the faint of heart.
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