You’ve probably heard a lot about Bitcoin in the news and in trading circles. But what is this new asset that has caused so much excitement (and perhaps overzealousness) in today’s markets. Here we explain what Bitcoin is, how it works, and how you can start trading in it.
What are Bitcoins?
Bitcoin is a global, decentralised digital crypto currency. Like all currencies, Bitcoin is a medium of exchange i.e. you can use Bitcoin as money to buy and sell things. Bitcoin is almost completely digital; there are some physical Bitcoins in existence, but the vast majority of Bitcoins are just numbers on a screen. It’s a currency designed to function over the Internet.
Bitcoin is a crypto currency. This means that encryption is used to make all Bitcoin transactions secure and private. Bitcoin is also decentralised; unlike most currencies which operate through a monetary system that is overseen by a central bank, Bitcoin has no central controlling authority and functions via peer-to-peer (P2P) mechanisms.
The History of Bitcoin
Bitcoin is the world’s first decentralised crypto currency. It was created in 2008 and then released in 2009 by an anonymous programmer or team of programmers taking the pseudonym Satoshi Nakamoto.
The currency was promoted by a number of early adopters including Hal Finney and Nick Szabo, the latter of whom has been accused of being the currency’s creator. Speculation about the identity of Satoshi Nakamoto has continued without any resolution.
Vulnerabilities in the currency’s design were dealt with in the first year. From 2010 onwards Bitcoin has remained highly robust.
Interest in the crypto currency slowly grew over the next couple of years. In 2011 and 2012 the first major organisations to accept Bitcoin emerged; these included Wikileaks and WordPress.
2013 saw sales of Bitcoin taking off with millions of units being sold per month. Governments started to take a critical interest in the crypto currency with China and Thailand effectively banning its usage Early 2014 Mt. Gox, at this time the world largest Bitcoin Echange, went bankrupt.
Barclay’s became the first bank to begin accepting Bitcoins in 2015. By then, thousands of online stores were trading with the crypto currency. The exchange value of Bitcoin has continued to skyrocket, surpassing $4000 USD in 2017.
What is Bitcoin mining?
In order for new Bitcoins to come into circulation, they have to be “mined”. Those who wish to obtain entirely new Bitcoins have to solve difficult mathematical problems online. Normally programmers write software to solve the problems for them. Those who successfully tackle one of the problems are rewarded with a new block in the blockchain (see below) and some Bitcoins.
Mining Bitcoins is designed to get progressively more difficult as the number of Bitcoins in circulation increases. The Bitcoin mining process is supposed to be similar to the process of mining for gold; the more gold is mined, the more difficult and expensive it becomes to find even more gold.
There’s only a finite amount of gold in the ground, and eventually all of it will be dug up and in circulation. Similarly, Bitcoin is also designed to be ultimately finite. After 21 million Bitcoins have entered circulation, the mining will stop. This finitude is intended to prevent Bitcoin being subject to the same limitless inflationary tendencies as many other currencies.
The unique brilliance of Bitcoin comes from its use of a system called the blockchain, also created by Satoshi Nakamoto. This is an encrypted ledger system that keeps track of all transactions made in the crypto currency.
Previous attempts to create a crypto currency had consistently failed because of a problem called “double spending”. This can’t occur with physical currency; for example, when you spend a 10 Euro note, the note is gone from your possession. But when you spend a digital 10 Euro, the digital information that makes up that money could be duplicated. So then, you could both keep the 10 Euro and spend it at the same time. A currency cannot work if transactions can be duplicated.
Satoshi Nakamoto wanted to solve this problem and also create a currency system that didn’t require the transactors to trust each other. The blockchain is a distributed network of communicating points running the same Bitcoin software. Every transaction is automatically noted down at one part of the network and then transmitted to the rest of the network.
Having multiple copies of the block chain in different places means the copies can be checked against one another. The block chain is public and encrypted. It allows the transfer of all Bitcoins to be recorded without compromising privacy. Without it, the currency could not function at all.
Bitcoins have to be kept in a Bitcoin wallet. The wallet doesn’t really store the coins per se; it stores the information that proves that you have ownership over a certain quantity of Bitcoins, and allows you to use the currency. As such, the wallet system works in tandem with the block chain and is an essential part of the currency’s functions.
Some wallets are entirely online whereas some work by an independent piece of software that also functions offline. It is also possible to create physical wallets on paper or on actual metal coins, although this is rarely done. The presence of the wallets injects an element of risk into the system, as users need to trust the provider of the wallet.
Public Keys and Private Keys
Bitcoins are not attributed to persons but to addresses. This is how transactions are kept private and anonymous. But in order for this to work, you must demonstrate ownership of your Bitcoins every time you use them by providing a private key. The network has a public key which it uses to check that the private key provided is correct.
It’s very important to keep and back up your private key. There is no other way to demonstrate ownership of Bitcoins than with the private key. If you lose the private key, it is impossible to reclaim ownership of your assets. Some individuals have lost a lot of money through this kind of carelessness.
Bitcoins as an Investment
Despite Bitcoin’s intended status as a medium of exchange, many traders have begun looking at the crypto currency in the same way as other forms of asset, as an opportunity for investment rather than just use. Since Bitcoin was not designed with this in mind, investors in the currency should attempt to proceed with caution and good awareness of precisely what they are doing.
Whether Bitcoins constitute a good investment is a difficult question. In the short term, they have shown a meteoric rise in value, increasing from under 1 USD each to over 1000 USD in the space of five years. Whether this rise will continue in the long term is very difficult to predict, but Bitcoins are currently one of the best performing assets in existence.
Some investors express concern about the volatility of the currency. It has been significantly more volatile than gold and the US dollar over the course of the last few years. Bitcoin appears prone to suffering periodic bubbles and crashes. Nonetheless, the currency has seen a strong upward trend in value over the whole course of its usage.
Data from the last two years suggests that the currency has been stabilising. Criticism from some investors, suggesting that the rise in value of Bitcoin is a modern equivalent of the famous economic case of “tulip mania” remain to be confirmed or disproven.
How to Trade in Bitcoin
Trading in Bitcoin essentially works the same way as trading in any other currency. Bitcoins are obtained through Bitcoin exchanges. These services will require you to sign up for an account. Make sure to choose a well-trusted exchange to avoid being a victim of fraud.
Trading in Bitcoin normally also involves incurring a transaction fee. These are continually increase as demand for Bitcoins goes up. Transaction fees are expressed in Satoshis per byte, where Satoshi is a term for the smallest useable fraction of a Bitcoin (equivalent to 0.00000001 BTC).
Bitcoin traders will normally exchange Bitcoins for dollars and vice versa, taking into account the changing exchange rates of these two currencies in order to profit.
Given its volatility, Bitcoin is considered a reasonably risky asset. This should be born in mind when evaluating Bitcoin in the context of the rest of your investment portfolio. Also remember that Bitcoin carries greater security and insurance risks than many other assets; your stock of Bitcoin will not be insured by the government in the same way as normal currency saved in a bank account.