TABLE OF CONTENTS
What Is Bitcoin?
Bitcoin is a digital currency that was created in January 2009. It follows the ideas set out in a whitepaper by the mysterious and pseudonymous Satoshi Nakamoto.1 The identity of the person or persons who created the technology is still a mystery. Bitcoin offers the promise of lower transaction fees than traditional online payment mechanisms and, unlike government-issued currencies, it is operated by a decentralized authority.
Bitcoin is a type of cryptocurrency. There are no physical bitcoins, only balances kept on a public ledger that everyone has transparent access to. All bitcoin transactions are verified by a massive amount of computing power. Bitcoins are not issued or backed by any banks or governments, nor are individual bitcoins valuable as a commodity. Despite it not being legal tender, Bitcoin is very popular and has triggered the launch of hundreds of other cryptocurrencies, collectively referred to as altcoins. Bitcoin is commonly abbreviated as "BTC."
What Is Bitcoin
KEY TAKEAWAYS
- Launched in 2009, bitcoin is the world's largest cryptocurrency by market capitalization.
- Unlike fiat currency, bitcoin is created, distributed, traded, and stored with the use of a decentralized ledger system, known as a blockchain.
- Bitcoin's history as a store of value has been turbulent; the cryptocurrency skyrocketed up to roughly $20,000 per coin in 2017, but less than years later, it was trading for less than half of that.
- As the earliest virtual currency to meet widespread popularity and success, bitcoin has inspired a host of other cryptocurrencies in its wake.
Understanding Bitcoin
The bitcoin system is a collection of computers (also referred to as "nodes" or "miners") that all run bitcoin's code and store its blockchain. Metaphorically, a blockchain can be thought of as a collection of blocks. In each block is a collection of transactions. Because all the computers running the blockchain has the same list of blocks and transactions, and can transparently see these new blocks being filled with new bitcoin transactions, no one can cheat the system.
Anyone, whether they run a bitcoin "node" or not, can see these transactions occurring live. In order to achieve a nefarious act, a bad actor would need to operate 51% of the computing power that makes up bitcoin. Bitcoin has around 12,000 nodes, as of January 2021, and this number is growing, making such an attack quite unlikely.2
But in the event that an attack was to happen, the bitcoin miners—the people who take part in the bitcoin network with their computer—would likely fork to a new blockchain making the effort the bad actor put forth to achieve the attack a waste.
Balances of bitcoin tokens are kept using public and private "keys," which are long strings of numbers and letters linked through the mathematical encryption algorithm that was used to create them. The public key (comparable to a bank account number) serves as the address which is published to the world and to which others may send bitcoins.
The private key (comparable to an ATM PIN) is meant to be a guarded secret and only used to authorize bitcoin transmissions. Bitcoin keys should not be confused with a bitcoin wallet, which is a physical or digital device that facilitates the trading of bitcoin and allows users to track ownership of coins. The term "wallet" is a bit misleading, as bitcoin's decentralized nature means that it is never stored "in" a wallet, but rather decentrally on a blockchain.
Peer-to-Peer Technology
Bitcoin is one of the first digital currencies to use peer-to-peer technology to facilitate instant payments. The independent individuals and companies who own the governing computing power and participate in the bitcoin network—bitcoin "miners"—are in charge of processing the transactions on the blockchain and are motivated by rewards (the release of new bitcoin) and transaction fees paid in bitcoin.
These miners can be thought of as the decentralized authority enforcing the credibility of the bitcoin network. New bitcoin is released to the miners at a fixed, but periodically declining rate. There are only 21 million bitcoin that can be mined in total. As of January 30, 2021, there are approximately 18,614,806 bitcoin in existence and 2,385,193 bitcoin left to be mined.3
In this way, bitcoin other cryptocurrencies operate differently from fiat currency; in centralized banking systems, currency is released at a rate matching the growth in goods; this system is intended to maintain price stability. A decentralized system, like bitcoin, sets the release rate ahead of time and according to an algorithm.
Bitcoin Mining
Bitcoin mining is the process by which bitcoins are released into circulation. Generally, mining requires the solving of computationally difficult puzzles in order to discover a new block, which is added to the blockchain.
Bitcoin mining adds and verifies transaction records across the network. For adding blocks to the blockchain, miners are rewarded with a few bitcoins; the reward is halved every 210,000 blocks. The block reward was 50 new bitcoins in 2009. On May 11th, 2020, the third halving occurred, bringing the reward for each block discovery down to 6.25 bitcoins.4
A variety of hardware can be used to mine bitcoin. However, some yield higher rewards than others. Certain computer chips, called Application-Specific Integrated Circuits (ASIC), and more advanced processing units, like Graphic Processing Units (GPUs), can achieve more rewards. These elaborate mining processors are known as "mining rigs."
One bitcoin is divisible to eight decimal places (100 millionths of one bitcoin), and this smallest unit is referred to as a Satoshi.5 If necessary, and if the participating miners accept the change, bitcoin could eventually be made divisible to even more decimal places.
History of Bitcoin
Aug. 18, 2008
The domain name bitcoin.org is registered. Today, at least, this domain is "WhoisGuard Protected," meaning the identity of the person who registered it is not public information.
Oct. 31, 2008
A person or group using the name Satoshi Nakamoto makes an announcement on the Cryptography Mailing list at metzdowd.com: "I've been working on a new electronic cash system that's fully peer-to-peer, with no trusted third party. This now-famous whitepaper published on bitcoin.org, entitled "Bitcoin: A Peer-to-Peer Electronic Cash System," would become the Magna Carta for how Bitcoin operates today.
Jan. 3, 2009
The first Bitcoin block is mined, Block 0. This is also known as the "genesis block" and contains the text: "The Times 03/Jan/2009 Chancellor on brink of second bailout for banks," perhaps as proof that the block was mined on or after that date, and perhaps also as relevant political commentary.6
Jan. 8, 2009
The first version of the bitcoin software is announced on the Cryptography Mailing list.
Jan. 9, 2009
Block 1 is mined, and bitcoin mining commences in earnest.
Who Is Satoshi Nakamoto?
No one knows who invented bitcoin, or at least not conclusively. Satoshi Nakamoto is the name associated with the person or group of people who released the original bitcoin white paper in 2008 and worked on the original bitcoin software that was released in 2009. In the years since that time, many individuals have either claimed to be or have been suggested as the real-life people behind the pseudonym, but as of January 2021, the true identity (or identities) behind Satoshi remains obscured.7
Although it is tempting to believe the media's spin that Satoshi Nakamoto is a solitary, quixotic genius who created Bitcoin out of thin air, such innovations do not typically happen in a vacuum. All major scientific discoveries, no matter how original-seeming, were built on previously existing research.
There are precursors to bitcoin: Adam Back’s Hashcash, invented in 1997,8 and subsequently Wei Dai’s b-money, Nick Szabo’s bit gold, and Hal Finney’s Reusable Proof of Work. The bitcoin whitepaper itself cites Hashcash and b-money, as well as various other works spanning several research fields. Perhaps unsurprisingly, many of the individuals behind the other projects named above have been speculated to have also had a part in creating bitcoin.
There are a few possible motivations for bitcoin's inventor deciding to keep their identity secret. One is privacy: As bitcoin has gained in popularity—becoming something of a worldwide phenomenon—Satoshi Nakamoto would likely garner a lot of attention from the media and from governments.
Another reason could be the potential for bitcoin to cause a major disruption in the current banking and monetary systems. If bitcoin were to gain mass adoption, the system could surpass nations' sovereign fiat currencies. This threat to existing currency could motivate governments to want to take legal action against bitcoin's creator.
The other reason is safety. Looking at 2009 alone, 32,489 blocks were mined; at the reward rate of 50 bitcoin per block, the total payout in 2009 was 1,624,500 bitcoin. One may conclude that only Satoshi and perhaps a few other people were mining through 2009 and that they possess a majority of that stash of bitcoin.
Someone in possession of that much bitcoin could become a target of criminals, especially since bitcoins are less like stocks and more like cash, where the private keys needed to authorize spending could be printed out and literally kept under a mattress. While it's likely the inventor of bitcoin would take precautions to make any extortion-induced transfers traceable, remaining anonymous is a good way for Satoshi to limit exposure.
Special Considerations
Bitcoin as a Form of Payment
Bitcoins can be accepted as a means of payment for products sold or services provided. Brick and mortar stores can display a sign saying “Bitcoin Accepted Here”; the transactions can be handled with the requisite hardware terminal or wallet address through QR codes and touch screen apps. An online business can easily accept bitcoins by adding this payment option to its other online payment options: credit cards, PayPal, etc.
Bitcoin Employment Opportunities
Those who are self-employed can get paid for a job related to bitcoin. There are a number of ways to achieve this, such as creating any internet service and adding your bitcoin wallet address to the site as a form of payment. There are also several websites and job boards that are dedicated to digital currencies:
- Cryptogrind brings together work seekers and prospective employers through its website
- Coinality features jobs—freelance, part-time and full-time—that offer payment in bitcoins, as well as other cryptocurrencies like Dogecoin and Litecoin
- Jobs4Bitcoins, part of reddit.com
- BitGigs
- Bitwage offers a way to choose a percentage of your work paycheck to be converted into bitcoin and sent to your bitcoin address
How to Buy Bitcoin
Investing in Bitcoins
There are many bitcoin supporters who believe that digital currency is the future. Many individuals who endorse bitcoin believe that it facilitates a much faster, low-fee payment system for transactions across the globe. Although it is not backed by any government or central bank, bitcoin can be exchanged for traditional currencies; in fact, its exchange rate against the dollar attracts potential investors and traders interested in currency plays. Indeed, one of the primary reasons for the growth of digital currencies like bitcoin is that they can act as an alternative to national fiat money and traditional commodities like gold.
In March 2014, the IRS stated that all virtual currencies, including bitcoins, would be taxed as property rather than currency. Gains or losses from bitcoins held as capital will be realized as capital gains or losses, while bitcoins held as inventory will incur ordinary gains or losses. The sale of bitcoins that you mined or purchased from another party, or the use of bitcoins to pay for goods or services, are examples of transactions that can be taxed.9
Like any other asset, the principle of buying low and selling high applies to bitcoins. The most popular way of amassing the currency is through buying on a bitcoin exchange, but there are many other ways to earn and own bitcoins.
Types of Risks Associated With Bitcoin Investing
Although Bitcoin was not designed as a normal equity investment (no shares have been issued), some speculative investors were drawn to the digital currency after it appreciated rapidly in May 2011 and again in November 2013. Thus, many people purchase bitcoin for its investment value rather than its ability to act as a medium of exchange.
However, the lack of guaranteed value and its digital nature means the purchase and use of bitcoins carries several inherent risks. Many investor alerts have been issued by the Securities and Exchange Commission (SEC), the Financial Industry Regulatory Authority (FINRA), the Consumer Financial Protection Bureau (CFPB), and other agencies.
The concept of a virtual currency is still novel and, compared to traditional investments, bitcoin doesn't have much of a long-term track record or history of credibility to back it. With their increasing popularity, bitcoins are becoming less experimental every day; still, after only a decade, all digital currencies still remain in a development phase. "It is pretty much the highest-risk, highest-return investment that you can possibly make,” says Barry Silbert, CEO of Digital Currency Group, which builds and invests in Bitcoin and blockchain companies.10
Regulatory Risk
Investing money into bitcoin in any of its many guises is not for the risk-averse. Bitcoins are a rival to government currency and may be used for black market transactions, money laundering, illegal activities, or tax evasion. As a result, governments may seek to regulate, restrict, or ban the use and sale of bitcoins (and some already have). Others are coming up with various rules.
For example, in 2015, the New York State Department of Financial Services finalized regulations that would require companies dealing with the buy, sell, transfer, or storage of bitcoins to record the identity of customers, have a compliance officer, and maintain capital reserves. The transactions worth $10,000 or more will have to be recorded and reported.11
The lack of uniform regulations about bitcoins (and other virtual currency) raises questions over their longevity, liquidity, and universality.
Security Risk
Most individuals who own and use bitcoin have not acquired their tokens through mining operations. Rather, they buy and sell bitcoin and other digital currencies on any of a number of popular online markets, known as bitcoin exchanges.
Bitcoin exchanges are entirely digital and, as with any virtual system, are at risk from hackers, malware, and operational glitches. If a thief gains access to a bitcoin owner's computer hard drive and steals their private encryption key, they could transfer the stolen bitcoin to another account. (Users can prevent this only if bitcoins are stored on a computer that is not connected to the internet, or else by choosing to use a paper wallet—printing out the bitcoin private keys and addresses, and not keeping them on a computer at all.)
Hackers can also target bitcoin exchanges, gaining access to thousands of accounts and digital wallets where bitcoins are stored. One especially notorious hacking incident took place in 2014, when Mt. Gox, a bitcoin exchange in Japan, was forced to close down after millions of dollars worth of bitcoins were stolen.12
This is particularly problematic given that all Bitcoin transactions are permanent and irreversible. It's like dealing with cash: Any transaction carried out with bitcoins can only be reversed if the person who has received them refunds them. There is no third party or a payment processor, as in the case of a debit or credit card—hence, no source of protection or appeal if there is a problem.
Insurance Risk
Some investments are insured through the Securities Investor Protection Corporation. Normal bank accounts are insured through the Federal Deposit Insurance Corporation (FDIC) up to a certain amount depending on the jurisdiction.
Generally speaking, bitcoin exchanges and bitcoin accounts are not insured by any type of federal or government program. In 2019, prime dealer and trading platform SFOX announced it would be able to provide bitcoin investors with FDIC insurance, but only for the portion of transactions involving cash.13
Fraud Risk
While bitcoin uses private key encryption to verify owners and register transactions, fraudsters and scammers may attempt to sell false bitcoins. For instance, in July 2013, the SEC brought legal action against an operator of a bitcoin-related Ponzi scheme.14 There have also been documented cases of bitcoin price manipulation, another common form of fraud.
Market Risk
Like with any investment, bitcoin values can fluctuate. Indeed, the value of the currency has seen wild swings in price over its short existence. Subject to high volume buying and selling on exchanges, it has a high sensitivity to any newsworthy events. According to the CFPB, the price of bitcoins fell by 61% in a single day in 2013, while the one-day price drop record in 2014 was as big as 80%.15
If fewer people begin to accept bitcoin as a currency, these digital units may lose value and could become worthless. Indeed, there was speculation that the "bitcoin bubble" had burst when the price declined from its all-time high during the cryptocurrency rush in late 2017 and early 2018.
There is already plenty of competition, and although bitcoin has a huge lead over the hundreds of other digital currencies that have sprung up because of its brand recognition and venture capital money, a technological break-through in the form of a better virtual coin is always a threat.
Splits in the Cryptocurrency Community
In the years since Bitcoin launched, there have been numerous instances in which disagreements between factions of miners and developers prompted large-scale splits of the cryptocurrency community. In some of these cases, groups of Bitcoin users and miners have changed the protocol of the bitcoin network itself.
This process is known as "forking," and it usually results in the creation of a new type of bitcoin with a new name. This split can be a "hard fork," in which a new coin shares transaction history with bitcoin up until a decisive split point, at which point a new token is created. Examples of cryptocurrencies that have been created as a result of hard forks include bitcoin cash (created in August 2017), bitcoin gold (created in October 2017), and bitcoin SV (created in November 2017).
A "soft fork" is a change to protocol that is still compatible with the previous system rules. For example, bitcoin soft forks have increased the total size of blocks.
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