What Is Bitcoin, and How Does it Work?
Bitcoin. the digital currency, has been all over the news for years. But because it’s entirely digital and doesn’t necessarily correspond to any existing fiat currency, it’s not easy to understand for the newcomer. Let’s break down the basis of exactly what Bitcoin is, how it works, and its possible future in the global economy.
Editor’s Note: we want to make it very clear right up front that we are not recommending that you invest in Bitcoins. Its value fluctuates quite a bit, and it’s very likely that you may lose money.
How Bitcoin Works
In layman’s terms: Bitcoin is a digital currency. That’s a concept that might be more complex than you realize: it isn’t simply an assigned value of money stored in a digital account, like your bank account or credit line. Bitcoin has no corresponding physical element, like coins or paper bills (despite the popular image of an actual coin, above, to illustrate it). The value and verification of individual Bitcoins are provided by a global peer-to-peer network.
Bitcoins are blocks of ultra-secure data that are treated like money. Moving this data from one person or place to another and verifying the transaction, i.e. spending the money, requires computing power. Users called “miners” allow their computers to be used by the system to safely verify the individual transactions. Those users are rewarded with new Bitcoins for their contributions. Those users can then spend their new Bitcoins on goods and services, and the process repeats.
The advanced explanation: Imagine it as BitTorrent, the peer-to-peer network that you definitely didn’t use to download thousands of songs in the early 2000s. Except instead of moving files from one place to another, the Bitcoin network generates and verifies blocks of information that are expressed in the form of a proprietary currency.
Bitcoin and its many derivatives are known as cryptocurrencies. The system uses cryptography—extremely advanced cryptography called a blockchain—to generate new “coins” and verify the ones that are transferred from one user to another. The cryptographic sequences serve several purposes: making the transactions virtually impossible to fake, making “banks” or “wallets” of coins easily transferable as data, and authenticating the transfer of Bitcoin value from one person to another.
Before a Bitcoin can be spent, it has to be generated by the system, or “mined.” While a conventional currency needs to be minted or printed by a government, the mining aspect of Bitcoin is designed to make the system self-sustaining: people “mine” Bitcoins by providing processing power from their computers to the distributed network, which generates new blocks of data that contain the distributed global record of all transactions. The encoding and decoding process for these blocks requires an enormous amount of processing power, and the user who successfully generates the new block (or more accurately, the user whose system generated the randomized number that the system accepts as the new block) is rewarded with a number of Bitcoins, or with a portion of transaction fees.
In this way, the very process of moving Bitcoins from one user to another creates the demand for more processing power donated to the peer-to-peer network, which generates new Bitcoins that can then be spent. It’s a self-scaling, self-replicating system that generates wealth…or at least, generates cryptographic representations of value that correspond to wealth.
How Are Bitcoins Spent?
In layman’s terms: Imagine you’re buying a Coke at the supermarket with a debit card. The transaction has three elements: your card, corresponding to your bank account and your money, the bank itself that verifies the transaction and the transfer of money, and the store that accepts the money from the bank and finalizes the sale. A Bitcoin transaction has, broadly speaking, the same three components.
Each Bitcoin user stores the data that represents his or her amount of coins in a program called a wallet, consisting of a custom password and a connection to the Bitcoin system. The user sends a transaction request to another user, buying or selling, and both users agree. The peer-to-peer Bitcoin system verifies the transaction via the global network, transferring the value from one user to the next and inserting cryptographic checks and verification at many levels. There is no centralized bank or credit system: the peer-to-peer network completes the encrypted transaction with the help of Bitcoin miners.
The advanced explanation: The technical side of things is a bit more complex. Each new Bitcoin transaction is recorded and verified onto a new block of data in the blockchain. (The two parties in the exchange are represented by randomized numbers that make each transaction essentially anonymous, even as they’re being verified.) Each block in the chain includes cryptological code linking it to and verifying it for the previous block.
In the conventional sense, Bitcoin transactions are incredibly secure. Thanks to complex cryptography at every step in the process, which can take quite a lot of time to verify (see below), it’s more or less impossible to fake a transaction from one person or organization to another. However, it is possible to “steal” bitcoins by discovering someone’s digital wallet and the password that they use to access it. If that information is found, via hacking or social engineering, a digital Bitcoin stash can dispensary without any way to trace the thief. Since Bitcoin isn’t regulated or secured in the same way your bank account or credit account is, that money is simply gone.
How Do You Turn Bitcoins Into “Real” Money, and Vice-Versa?
First of all, Bitcoin is real money, in the purely economic sense. It has value and can be traded for goods and services. It’s unlikely that you can pay your bills or buy groceries totally in Bitcoin (though those services do exist and they are growing), but you can buy a surprising amount of online goods with your Bitcoin wallet. At the moment, the biggest companies accepting Bitcoin include online computer hardware retailer Newegg, digital video game seller Steam, the social network Reddit, and even more general retailers like Overstock.com or Subway restaurants. Here’s a list of companies currently accepting Bitcoin payments directly or through gift cards.
But as interesting as it is and as fast as it’s growing, Bitcoin simply can’t replace conventional, government-issued currency right now: your landlord probably won’t take a Bitcoin payment over a rent check. Even if you happen to have dozens of Bitcoins available and you’d like to spend the profit you’ve made on them on a new car, the car dealership probably doesn’t have the infrastructure to accept them as payment (although a private seller might!). So, if you have Bitcoins and you want cash in your country’s currency, or you have currency and you want to convert it to Bitcoin for buying, selling, or investing, you’ll need a conversion service.
Broadly, converting Bitcoin into more standard currencies like US Dollars, British Pounds, Japanese Yen or Euro is very much like converting any of those currencies from one to the other when you’re traveling. You start with one currency, state your desired amount, give the value of the first currency plus a transaction fee, and receive the value in the converted currency in return. But since Bitcoin has no cash component and isn’t available to be accepted by conventional credit or debit transactions, you need to find a dedicated market exchange.
Coinbase is the most popular market and exchange in the United States. (Note: this is not an endorsement.) It offers buying and selling services for Bitcoin and other, similar cryptocurrencies, and will exchange US dollars and other standard fiat currencies for Bitcoins, as well as buying Bitcoins for USD and 31 other national fiat currencies. The company doesn’t charge for exchanges between cryptocurrencies, but exchanging Bitcoins for dollars deposited to a US bank account will cost the user a 1.49% transfer fee. So, to move $10,000 worth of Bitcoin from your own wallet to your bank account would cost 1.74 Bitcoins for the actual value, plus either $14.9 USD or .00259 Bitcoin for the transfer fee. This is a fairly standard transfer for most of the verified markets and exchanges.
There are other options for turning Bitcoin into conventional money. Coinbase and other markets can trade Bitcoin for USD and other currencies deposited directly to single-use debit cards or gift cards, or even into more flexible systems like PayPal, generally for a much higher fee. You can trade Bitcoins directly to another person for cash, though this is much more dangerous than going through an established system. (On the same note, be cautious of individuals wanting to trade Bitcoins directly for cash, goods, and services. The untraceable nature of the system makes it susceptible to fraud—see below.)
Bitcoin Mining Has Diminishing Returns
A few years ago when the Bitcoin system was new, individual users “mined” for new Bitcoins at a rapid pace. Bitcoin mining software used local processors, and even extra processors like a computer’s graphics card, to calculate hashes for the next block in the blockchain. While the number of people using and “mining” Bitcoin was low, each user doing the mining would randomly confirm the next block at a higher pace, generating new Bitcoins for his or her account quickly.
But this boom in generation couldn’t last. The Bitcoin system is designed to make each new block more difficult to find than the last one, reducing the amount of randomized Bitcoins that are generated and distributed. That means that as time goes on, each individual mining for them has to work harder and harder (in a figurative sense—it’s the computer that’s working harder and using more electricity, and thus, costing more conventional money). As the number of individual Bitcoins grows, the amount of Bitcoins rewarded for a successfully completed hash is diminished. In fact, “whole” Bitcoins are no longer generated by a single user all at once, they’re rewarded with fractions of Bitcoins (which are still quite valuable).
Initially, users created customized “mining rigs” that used relatively cheap clusters of off-the-shelf CPUs and GPUs to increase their chances of generating Bitcoin. Now the system is so popular and so distributed that an individual user can no longer simply buy a screamin’ fast GPU and expect to make back enough Bitcoin to cover its value in conventional money. Custom-designed “miners” are now sold for this purpose, with software and hardware designed for the sole purpose of supplying the maximum amount of computational power to the peer-to-peer system, and thus creating better odds of completing blocks. More processing power, more hardware, more chances of getting that payout…but at the same time, you’re spending more and more of your actual resources on hardware and electricity.
As a result, those hoping to earn conventional wealth via Bitcoin would be better off trading for it or selling goods and services rather than trying to make a mining system and run it constantly.
A custom-designed Bitcoin miner, sold commercially on Amazon. At the current rate of generation, it takes months of mining runtime to earn back the value of the hardware in Bitcoins generated, plus the cost of the electrical power to run it.
At the moment, there are between twelve and thirteen million Bitcoins in existence. They’ll become harder and harder to mine as more are generated. The system has an upper limit: after 21 million Bitcoins are generated, no more can be mined. Based on current trends, the last whole Bitcoin will be mined sometime in the 2040s, with the final portion of fractional coin rewards continuing for about 100 years. Once the upper limit is reached, the value of the currency will fluctuate almost entirely on supply and demand, though “miners” will still be able to earn Bitcoins by lending their processing power to the transaction system and receiving transaction fees.
Bitcoin’s Value Fluctuates More Than Standard Money
If you’re reading this guide, it’s probably because you’ve heard that Bitcoin is valuable. And it is. But that value changes rapidly, much more rapidly than any currency from a stable economy or even most stocks and bonds. The shifts in the value of Bitcoin can be huge, too: as a function of its total value, Bitcoin fluctuates more than ten times faster than the US dollar.
In 2010, each whole Bitcoin was worth less than a 25 cents in USD. In late November of 2017, each Bitcoin was valued at over $11,000 (before dramatically spiking downward to $9,000 almost immediately). Obviously that’s a huge rate of growth and a massive opportunity for anyone who got on board early—initial Bitcoin miners might be millionaires now if they’ve held on to their Bitcoins long enough. But those two points of data don’t tell the whole story: Bitcoin has gone through various dips and “crashes,” initially in a volatile period in late 2013 and early 2014. Each time the value recovered, but there’s no assurance that the current climb will continue, or that the entire cryptocurrency market won’t collapse.
The value of Bitcoin has grown and fluctuated wildly, much more so than conventional currencies, stocks, or commodities.
This makes Bitcoin a questionable method for investment. While it’s true that many people have made huge amounts of conventional wealth by mining and trading in Bitcoin, that wealth is just as volatile as the market itself, unless it’s transferred to more stable currencies or investments. The ups and downs of the Bitcoin market appear to be coming much faster and more frequently than fluctuations in major stock markets and exchanges. The current high price of Bitcoin might be just the start before an even larger boom, or it might be a temporary “bubble” with an upcoming crash followed by a recovery…or the entire Bitcoin market could implode tomorrow, leaving millions of people with nothing but worthless cryptographic sequences. There’s no way to know.
That doesn’t mean Bitcoin won’t have its place in the future, however. Let’s talk about some advantages and disadvantages to Bitcoin over traditional currency.
Anonymity and Privacy
Bitcoin purchases between individual users are entirely private: it’s possible for two people to exchange Bitcoins or fractions of coins between wallets simply by exchanging hashes, with no names, email addresses, or any other information. And because the peer-to-peer network uses a new hash for each transaction, it’s more or less impossible to link concurrent purchases to a single user. The nature of the peer-to-peer encrypted network makes it secure from the outside, as well: no one else can see your personal purchases or receipts without first getting access to your wallet.
No Required Transaction Fees (For Now)
Conventional non-cash purchases include transaction fees: pay with a Visa credit card, and Visa will charge the merchant a few cents to verify the transaction. And of course, the cost of that charge is passed on to you in the form of higher prices for goods and services.
At the moment, there are no mandatory transaction fees for Bitcoin. Individual users and merchants can submit their purchases to the peer-to-peer network and simply wait for it to be verified on the next block. However, this process can take time (and it takes more time the more the network is used). So to speed up transactions, many merchants and users add a transaction fee to increase the priority of the transaction in the block, rewarding users on the peer-to-peer network for completing the verification process faster.
As the global supply of Bitcoins reaches its 21 million coin limit, transaction fees will become the primary method for miners to earn Bitcoins. At this point, presumably most transactions will include a small fee simply as a function of completing the purchase quickly.
No Central Governing Authority or Taxes
Because Bitcoin isn’t recognized as an official currency by any country, buying and selling Bitcoins themselves and using them to purchase goods and services isn’t regulated. So anything you buy with Bitcoins is not subject to a standard sales tax, or any other tax that’s normally applied to that item or service. This can be huge economic boon if you’re wealthy enough and interested enough to do a lot of business exclusively in Bitcoin.
Without being subject to most monetary laws, Bitcoin is effectively a barter system. Imagine your current supply of Bitcoins as a gigantic stack of potatoes: if you trade ten thousand potatoes for a new TV, the government won’t ask for a sales tax in the form of eight hundred potatoes. It simply isn’t equipped to handle any transactions not performed in its own currency.
However, you should be aware that any conventional earnings you receive from dealing in Bitcoin will be treated in the usual way. So if you transfer $10,000 worth of Bitcoins to your bank account via a Bitcoin market, you will need to report it as income on your taxes. Dealing in Bitcoin doesn’t nullify other standard requirements for taxation, either: even if you purchase a new car via Bitcoin from a private seller, you’ll still have to register that car with the government and pay taxes based on its market value.
So if Bitcoin is so great, why isn’t everyone using it? Well, obviously, it has some drawbacks too, especially at the current time.
Possible Government Interference
Any time something new comes around and challenges the status quo, the government is going to get involved to make sure that things remain the way they are supposed to be. The fact is that the US government, and other governments, are looking into Bitcoin for a variety of reasons. Just in the last few days, the US government has started seizing some accounts from the biggest Bitcoin exchange. More is likely to come in the future.
No Monetary Sovereignty
Perhaps the biggest weakness of bitcoin is that it is not a “recognized” sovereign currency—that is, it is not backed by the full faith of any governing body. While this could be seen as strength, the fact that Bitcoin is a fiat currency which is accepted only on the perceived value of other bitcoin users makes it highly vulnerable to destabilization. Simply put, if one day a large number of merchants who accept bitcoin as a form of payment stop doing so, then the value of bitcoin would fall drastically.
The current high value of Bitcoin is a function of both the relative scarcity of Bitcoins themselves and its popularity as a means of investment and wealth generation. If confidence in the Bitcoin market is suddenly and drastically reduced—for example, if a major government declared Bitcoin use illegal, or one of the largest Bitcoin exchanges was hacked and lost all of its stored value—the value of the currency will crash and investors will lose huge amounts of money.
The United States Treasury does not recognize bitcoin as a conventional currency, but does recognize its status as a commodity, like stocks and bonds. Similarly, the US Internal Revenue Service considers bitcoins property and taxes them as such if they are declared. No other country has declared bitcoin to be a recognized currency, but engagement with bitcoin and other cryptocurrencies varies from place to place. Some countries are investigating bitcoin as a growing commodity market, some take the same stance as the US declaring them assets, and some have explicitly banned their use for transfer of goods or services (though the means of enforcing those bans are limited).
Lack of Protections
The Bitcoin network has no built-in protection mechanisms when it comes to accidental loss or theft. For instance, if you lose the hard drive where your Bitcoin wallet file is stored (think corruption or drive failure with no backup), the Bitcoins held in that wallet are lost forever to the entire economy. Interestingly, this is an aspect which further exacerbates the limited supply of Bitcoins.
Additionally, if your wallet file is stolen or compromised and the Bitcoins contained within it are spent by the thief before the rightful owner, the double spending protection mechanism built into the network means the rightful owner has no recourse. Unlike if, for example, your credit card is stolen, you can call the bank and cancel the card, bitcoin has no such authority. The Bitcoin network only knows that the bitcoins in the compromised wallet file are valid and processes them accordingly. In fact, there is already malware out there which is designed specifically to steal Bitcoins.
Bitcoin markets are vulnerable to attack or fraud. Major exchanges like GBH and Cryptsy have been shut down with all the Bitcoin entrusted to their care presumably stolen by the operators. Japan-based Mt. Gox, formerly the handler of over half the Bitcoin transactions on the planet, was shuttered after a theft of hundreds of thousands of Bitcoins. The 2014 incident caused a huge (but temporary) drop in the value of Bitcoin worldwide.
Limited Concurrent Transactions
The Bitcoin block system requires connection and confirmation from the peer-to-peer network to be verified. Because each block contains a limited record of transactions and an upper limit to the amount of new transactions that can be written, there’s a limit to how many people can buy and sell with the system at any given time. As more and more vendors and individuals use Bitcoin to do business, the number of transactions per second increase, and the peer-to-peer network is becoming congested, with some operations without transaction fees taking hours to clear. Whereas conventional payment systems like credit cards can simply expand their connections and processing power to speed up processing, the isolated peer-to-peer nature of bitcoin doesn’t allow it to scale with the global financial system.
Black Market Appeal
A central principle to the design of the Bitcoin system is that there is no single transactional processing authority. As a result, no single user can be locked out of the system. Combine this with the inherent anonymity of transactions, and you have an ideal medium of exchange for nefarious purposes.
Bitcoin has become an ideal means for commerce in illicit goods and services. The quintessential case is the Silk Road, a dark web site that allowed users to anonymously trade items like drugs and fake identification, all bought with Bitcoin thanks to its untraceable nature. The story of Silk Road’s illegal trade didn’t even stop after the US Drug Enforcement Agency and Department of Justice shut down the site and seized its digital holdings in 2013. A Secret Service agent was charged with stealing over $800,000 of bitcoin from the investigators, who had held the seized digital currency to be auctioned off for the benefit of the law enforcement agencies.
While this is not exactly a weakness in Bitcoin (after all, drug dealers using cash doesn’t undermine the value of the currency itself), the unintended consequence of its usage for dubious purposes could be considered one. In fact, the US Treasury Department recently applied money laundering rules to bitcoin exchanges.
Subjects of Debate and Controversy
Lastly, let’s indulge a bit of controversy surrounding Bitcoin. While these topics of conversation are interesting, most everything in this section is conjecture and should be taken with a grain of salt—we just think they’re worth noting to get a full picture of the Bitcoin story.
The primary designer of the bitcoin specification is a “person” named Satoshi Nakamoto. Person is put in quotes here because Nakamoto has not connected “his” identity with a publicly known person. Satoshi Nakamoto could be an individual man or woman, an internet handle, or a group of people, but nobody actually knows. Once their work of designing the Bitcoin network was complete, this person or persons essentially disappeared.
Multiple individual people and teams of developers have been theorized to be the “real” Satoshi Nakamoto, with no conclusive proof for any one of them at the time of writing. Whoever he, she, or they are, Satoshi Nakamoto is estimated to be in possession of billions of US dollars worth of Bitcoin at current market rates.
Resistance From Conventional Investors
Many experts in standard money markets and investments consider Bitcoin a poor choice for investing money. The extreme volatility of Bitcoin versus investments like stocks, bonds, and standard commodities makes larger and older institutions wary. In addition, some investors and investigators consider Bitcoin and other cryptocurrencies to be either a passing fad (an economic bubble) and thus an extremely risky means of investment, or a fraud in and of itself, a “Ponzi scheme” for the benefit of Satoshi Nakamoto and other early investors.
On the other hand, it’s possible that some of these statements are made specifically to manipulate the value of Bitcoin: JP Morgan Chase has been accused of publicly calling the worth of Bitcoin into question via CEO statements while investing in it at the same time. As stated above, use caution when dealing in Bitcoin either as a means of purchasing goods or services or investing.
Bitcoin Cash Fork and Other Cryptocurrencies
On August 1st, 2017, long debates between bitcoin proponents and disagreements on how to solve its problems resulted in a currency split. The Bitcoin standard was broken in two, with the original system unaffected and the new Bitcoin Cash standard added. This was less like a stock market split and more like a software fork. Every person or organization who owned Bitcoin in any amount immediately owned an equal amount of Bitcoin Cash, with sales and transfers of both currencies occurring normally after the split. Like the original Bitcoin, Bitcoin Cash is entirely digital and has no real-world physical component (despite the name).
The split is a hard fork in software terms. The separate Bitcoin Cash peer-to-peer system allows for eight times more transactions per block, making it a better (but not necessarily equal) competitor to credit and debit cards for constant online and in-person sales. The operators of Bitcoin Cash hope that it will become a more widely-accepted currency for standard purchases, like coffee shops or supermarkets.
Because of the newer system, Bitcoin Cash has not benefited from the explosive growth of value that the original Bitcoin Cash has experienced. At the time of writing, Bitcoin Cash (BCH) is trading at approximately $325 per unit, less than 10% of the value of the original Bitcoin. That’s not necessarily a bad thing for the new standard: a currency with a smaller range of market fluctuation and a slower, more steady growth rate may be appealing to businesses. But at the moment, Bitcoin Cash transactions aren’t supported by any notable merchants, aside from existing cryptocurrency exchanges and wallets.
Without major support from large online or physical retailers, Bitcoin Cash seems unlikely to become as successful as the original Bitcoin. It’s more likely that the forked standard will join the ever-expanding list of competing cryptocurrencies without any notable application beyond the cryptocurrency market itself. These competing currencies use peer-to-peer systems similar to the original Bitcoin, but with significant changes in cryptographic methods and terms. Examples include Litecoin, Ethereum, and Zcash.
None of the competitors to Bitcoin has reached any notable fraction of its current value, and support from retailers outside of the growing and somewhat speculative niche of cryptocurrency exchanges is minimal.
Bitcoin and cryptocurrency are fascinating developments, a mark of the desire for participants in the information age to lessen their dependency on the economic and legal systems that prop up institutions from before the 21st century. It’s certainly made plenty of fortunes in its brief existence…and lost more than a few as well. The long-term viability of Bitcoin as a medium for wealth has yet to be determined.
If you’d like to get involved in Bitcoin or any of its competitors, make sure to do your research and use caution. Bitcoin can be a lucrative hobby and an exciting investment, but as with any other kind of investing, it’s always best to diversify for safety. If you’d like to read more about Bitcoin, we recommend checking out Bitcoin.org, the Bitcoin Wiki, and the Bitcoin Wikipedia page.