You heard about this Bitcoin thing?
We’re guessing: yes, you have. The first and most famous digital cryptocurrency has been racking up headlines this year due to a breathtaking rise in value — cracking the $1,000 threshold for the first time on January 1 before ascending to nearly $19,000 this month.
Bitcoin involves technology, currency, math, economics and social dynamics. It’s multifaceted, highly technical and still very much evolving. This explainer is meant to clarify some of the fundamental concepts and provide answers to some basic Bitcoin questions.
But first: A quick backstory
Bitcoin was invented in 2009 by a person (or group) who called himself Satoshi Nakamoto. His stated goal was to create “a new electronic cash system” that was “completely decentralized with no server or central authority.” After cultivating the concept and technology, in 2011, Nakamoto turned over the source code and domains to others in the Bitcoin community, and subsequently vanished. (Check out the New Yorker’s great profile of Nakamoto from 2011.)
What is Bitcoin?
Simply put, Bitcoin is a digital currency. No bills to print or coins to mint. It’s decentralized — there’s no government, institution (like a bank) or other authority that controls it. Owners are anonymous; instead of using names, tax IDs, or social security numbers, Bitcoin connects buyers and sellers through encryption keys. And it isn’t issued from the top down like traditional currency; rather, Bitcoin is “mined” by powerful computers connected to the internet.
How does one ‘mine’ Bitcoin?
A person (or group, or company) mines Bitcoin by doing a combination of advanced math and record-keeping. Here’s how it works. When someone sends a Bitcoin to someone else, the network records that transaction, and all of the others made over a certain period of time, in a “block.” Computers running special software — the “miners” — inscribe these transactions in a gigantic digital ledger. These blocks are known, collectively, as the “blockchain” — an eternal, openly accessible record of all the transactions that have ever been made.
Using specialized software and increasingly powerful (and energy-intensive) hardware, miners convert these blocks into sequences of code, known as a “hash.” This is somewhat more dramatic than it sounds; producing a hash requires serious computational power, and thousands of miners compete simultaneously to do it. It’s like thousands of chefs feverishly racing to prepare a new, extremely complicated dish — and only the first one to serve up a perfect version of it ends up getting paid.
When a new hash is generated, it’s placed at the end of the blockchain, which is then publicly updated and propagated. For his or her trouble, the miner currently gets 12.5 Bitcoins — which, in December 2017, is worth more than $225,000. Note that the amount of awarded Bitcoins decreases over time.
What determines the value of a Bitcoin?
Ultimately, the value of a Bitcoin is determined by what people will pay for it. In this way, there’s a similarity to how stocks are priced.
The protocol established by Satoshi Nakamoto dictates that only 21 million bitcoins can ever be mined — about 12 million have been mined so far — so there is a limited supply, like with gold and other precious metals, but no real intrinsic value. (There are numerous mathematical and economic theories about why Nakamoto chose the number 21 million.) This makes Bitcoin different from stocks, which usually have some relationship to a company’s actual or potential earnings.
Without a government or central authority at the helm, controlling supply, “value” is totally open to interpretation. This process of “price discovery,” the primary driver of volatility in Bitcoin’s price, also invites speculation (don’t mortgage your house to buy Bitcoin) and manipulation (hence the recent talk of tulips and bubbles).
Bitcoin has made Satoshi Nakamoto a billionaire many times over, at least on paper. It’s minted plenty of millionaires among the technological pioneers, investors and early Bitcoin miners. The Winklevoss twins, who parlayed a $65 million Facebook payout into a venture capital fund that made early investments in Bitcoin, are now billionaires according to Fortune.
How do I buy Bitcoin?
If you’re willing to assume the risk associated with owning Bitcoin, there is an increasing number of digital currency exchanges like Coinmama, CEX, Kraken and Coinbase — the largest and most established of them — where you can buy, sell and store Bitcoins.
Getting started is about as complicated as setting up a Paypal account. With Coinbase, for example, you can use your bank (or Paypal account) to make a deposit into a virtual wallet, of which there are many to choose from. Once your account is funded, which usually takes a few days, you can then exchange traditional currency for Bitcoin.
What can I do with Bitcoin?
You can use Bitcoin to buy things from more than 100,000 merchants, though still few major ones. You can sell it. Or you can just hang on to it. Note that there are no inherent transaction fees with Bitcoin, although exchanges like Coinbase typically charge a fee when you buy or sell.
Is all of this legal?
Short, qualified answer: yes, for now, as long as — like any currency — you don’t do illegal things with it. For instance, Bitcoin was the sole currency accepted on Silk Road, the dark Web marketplace for drugs and other illicit goods and services that was shuttered by the FBI in 2013.
Since then, Bitcoin has largely evaded regulation and law enforcement in the US, although it’s under increased scrutiny as it attracts more mainstream attention. Though it’s legal to buy and sell Bitcoin, miners and exchanges occupy a gray area that could be vulnerable to future regulation and/or law enforcement action.
What are the risks?
Legal and regulatory hazards aside, as both an investment and currency, Bitcoin is very risky. When you wake up in the morning, you know pretty precisely how much a dollar can buy. The financial value of a Bitcoin, however, is highly volatile and may swing widely from day to day and even hour to hour.
Bitcoin transactions cannot be traced back individuals — they are secured but also obscured through the use of public and private encryption keys. This anonymity can be appealing, especially with companies and marketers increasingly tracking our every purchase, but it also comes with drawbacks. You can never be certain who is selling you Bitcoin or buying them from you. Opportunities for money laundering abound; last year, authorities in the Netherlands arrested 10 men for just this.
Theft is also a risk. The Bitcoin subreddit is rife with individuals’ stories and even established exchanges are targets. Mt. Gox, based in Japan,in 2014 and earlier this month. There are few avenues for pursuing refunds, challenging a transaction or recovering such losses. Once a transaction hits the blockchain, it’s final.
OK, so what about — wait, there are more risks?
Because Bitcoin is so new and decentralized, there is plenty of murkiness and many unknowns. Even the technical rules for mining are still evolving and up for debate.
The IRS views Bitcoins as property, not currency. There are tax implications and a federal judge recently ruled that Coinbase must surrender records to the IRS on transactions of $20,000 or more.
Then there’s the fundamental question of whether you should trust a particular exchange. Even Coinbase, the most established of them all has struggled to keep up with demand, plagued by site outages, scaling issues and customer service complaints. Even if it’s venture-backed, every Bitcoin player today is by definition a startup and comes with all of the associated risks.
Now I sort of understand Bitcoin. WTF is Bitcoin Cash?
In August 2017, different sects within the Bitcoin mining community had a disagreement about the rules governing the mining process — specifically, what constitutes the appropriate size (in megabytes) of a block. Unable to form a consensus, there was a fork in the blockchain, with the Bitcoin originalists going one way and the group favoring larger blocks going another.
Though they share a common digital ancestry, each now has its own individual blockchain with slightly different protocols. (For what it’s worth, Bitcoin miners are sticking with 1MB blocks, Bitcoin Cash uses 8MB blocks.) Forking is almost assured to happen again in the future.
Are there other cryptocurrencies?
Yes. More than a thousand, with more sprouting up every day. Aside from Bitcoin, which is the real progenitor of them all, other well-known alternative currencies include Ethereum, Ripple and Litecoin. We’ll take a look at the pros and cons of each, and how they stack up, in a future explainer.