A Beginner's Guide to Bitcoin
There has been a lot of talk about Bitcoin and other digital currencies in the news recently. Prices have skyrocketed and many investors are asking, “is there a place in my portfolio for these new currencies?” In this blog we will answer some basic questions about the most well-known digital currency, Bitcoin.
What is Bitcoin?
Bitcoin is a decentralized digital currency that you can buy, sell, and exchange directly without an intermediary, such as a bank. It is an electronic payment system based on cryptographic proofs. Unlike fiat currencies, its value is not backed by anything physical, but by supply and demand characteristics.
How does it work?
The basic principle of bitcoin is based on a running ledger of transactions. Imagine instead of exchanging money for every transaction when it occurs, a community of people agree to keep track of these transactions in a ledger and to settle the differences at the end of each month. Bitcoin takes this system one step further, as the participants do not settle at the end of each month, but simply keep the active ledger of each user’s inflows and outflows.
For example, if Steve wants to send Jeff 1 Bitcoin (BTC), Steve writes in the ledger “Steve pays Jeff 1 BTC.”
How is it secured?
In order for a digital currency to be secure, users need to have confidence that only legitimate transactions appear on the ledger. To ensure this, digital signatures are used. The defining component to digital signatures is cryptology, (hence digital currencies are also referred to as crypto currencies).
Each user has a public and private key for their accounts. The digital signature is a combination of a message specific to a transaction and the user’s private key. To validate the transaction, the message and private key need to be confirmed as matching the transaction and the account’s public key during the verification process.
In our example above, Steve would write “Steve pays Jeff 1 BTC” and use an electronic signature comprised of (Specific Message, Steve’s Private Key). This means someone cannot copy the signature and try to apply it to a different transaction, such as “Steve pays Mike 5 BTC.” That transaction would be rejected.
What is the technology behind it?
Blockchain is a revolutionizing technology that will change the way many business models transact today and it is the underlying technology that is used to keep the “ledger” for Bitcoin transactions. Each new Bitcoin transaction is added to a “block” of records, which are then verified and secured across a decentralized network of computers. These “blocks” have limited storage capacities and when each “block” is filled, it is “chained” onto previously filled blocks, forming a string of data known as the “blockchain.”
With each transaction, the new block of data as well as all proceeding blocks are simultaneously verified by computers around the world. This constant verification of the entire blockchain across a decentralized network creates a trusted record because no one can tamper with the blockchain data. Any attempt to alter or delete a piece of data on the blockchain will be identified by all the other computers on the network as invalid, thrown out, and replaced with the correct blockchain of data.
In Bitcoin’s case, this computing power is not located all under one roof and a unique user operates each computer, or group of computers. If one user tampers with Bitcoin’s record of transactions, all other records would cross-reference each other and pinpoint the error. Thus, the blockchain system establishes an accurate and permanent order of events that is open for all users to see.
Here we have focused on Blockchain’s use when it comes to Bitcoin, but it is also possible for Blockchain and other technologies like it to transform our economies. They have the potential to hold and secure a variety of information like legal contracts, health care records, financial information, identification, or a company’s product inventory.
What is Bitcoin mining?
Bitcoin miners receive Bitcoin as a reward for completing “blocks” of verified transactions which are added to the blockchain. The Bitcoin reward that miners receive is an incentive that motivates them to assist in the primary purpose of mining: to legitimize and monitor Bitcoin transactions, ensuring their validity.
In order to create a verified block, a miner must complete two steps:
- You have to verify ~1MB worth of transactions. This is the easy part.
- You have to be the first miner to arrive at an acceptable answer to a numeric problem. This process is also known as proof of work.
- Mining rewards are paid to the miner who discovers a solution to a complex hashing puzzle first. A cryptographic hash is a variable in a three variable equation: Cryptographic Hash (Input) = Output.
- The cryptographic properties of the hash mean that users cannot use the hash and the output to solve for the input, the only way to arrive at the correct input is guessing and checking.
- It takes vast amounts of computational power to find an acceptable answer as the possible inputs are 2 to the power of 256 (a 78 digit number). The acceptable answers are adjusted so that each block takes about 10 minutes to create.
Back to our example: once the signed ledger entry that “Steve pays Jeff 1 BCT” is entered, it is classified as an unverified transaction. Bitcoin Miners then verify the transaction, group it with other verified transactions, and race to complete the hash function problem. The first one to do so creates the new block in the chain and the transaction is verified. The more blocks that are added, the farther down the chain this transaction moves and the more secure it gets. Many users consider a transaction that is 6 or more blocks down the chain (one hour old) to be completely verified.
Who controls it?
Bitcoin is independent of any centralized monetary authorities. This is a major attraction for some users who are concerned that the seemingly perpetual printing of money by the world’s Central Banks will continue to erode the value of their currency over time.
This lack of a controlling authority also means that Bitcoin can be lost over time due to locked accounts or lost passwords. This phenomenon will decrease the available amount of bitcoin in the long term.
Is it regulated/legal?
It is legal to buy, sell, own, and transact in Bitcoin and other cryptocurrencies in the United States. Bitcoin is not directly regulated by governments or central authorities like federal regulatory agencies because it does not belong to any one nation, organization, or private company. However, the exchanges in the U.S. where you buy Bitcoin are regulated and held to the KYC (Know Your Customer) and AML (Anti-Money Laundering) practice standards. As such, transfers of Bitcoin to destinations on the dark web, or ones not honoring these standards, will most likely result in an account freeze.
Starting in 2021, the IRS is asking a direct question on the first page of tax forms about cryptocurrency transactions, as taxpayers are required to report gains/losses. The IRS is also launching a new anti-tax fraud initiative called “Operation Hidden Treasure,” Forbes reports. Its focus will be to identify concealment and unreported cryptocurrency transactions.
What is the relationship to U.S. Dollars?
There are two ways that an investor can acquire Bitcoin – the first is to be rewarded for mining and the second is to purchase them on an exchange using a fiat currency. Most investors do not have access to the time or computing power to mine Bitcoin, so they purchase them. In this case it is similar to exchanging Dollars for Euros. The key difference is there is a finite amount of Bitcoin available. The laws of supply and demand tell us that as long as demand increases and supply is controlled, the price should continue to appreciate.
As with any new investment or technology, there are many factors at work – here is a short list of the pros and cons of Bitcoin.
- Improved accuracy by removing human involvement in verification
- Eliminating third parties (banks) can lead to a reduction in costs
- Decentralization makes it harder to tamper with, as governments and central banks cannot act to change the value of the currency
- Transactions are ideally private, secure, and efficient
- It is transparent technology that does not have a single owner
- As fiat currencies around the world are devalued through money printing, Bitcoin is designed to offer a store of value
- Significant technology cost (computer processing power) is needed to mine bitcoin
- While it is possible for Bitcoin to be used in illicit activities via the dark web, the development of regulated exchanges and Bitcoin’s permanent and publicly distributed ledger serve as a meaningful deterrent, as all transactions can be tracked
- The potential for Governments to attempt regulation
- The power needed to mine bitcoin can be an environmental issue if that power is drawn from “dirty” sources
Investing in digital currencies
It is important to note, that while the focus of this article was Bitcoin, there are thousands of digital currencies available to investors. Some are purely a currency, while others are ways to invest in the advanced technologies that back them.
How we can help
As with any investment, it is important to weigh the risk against the potential returns. If you are interested in finding out if investing in cryptocurrency is right for you, or if you would simply like to learn more, contact us online or at 410-685-9685.