While almost everyone has heard of Bitcoin at this point, many people are fuzzy on the details: what is a bitcoin, exactly? How do I buy some? What would I use it for? Here are the answers to those and a few other questions you were afraid to ask.
The original article by Timothy E. Lee has been edited for length and clarity to provide a fast & easy read. For all the latest – and best – financial articles sign up (in the top right corner) to receive munKNEE.com’s free bi-weekly Market Intelligence Report newsletter (see sample here) or visit our Facebook page.
The currency’s astonishing gains—it was worth less than $1 in early 2011—has caused a lot of people to wonder if they should be paying attention to the technology…
1) What is a Bitcoin?
The term Bitcoin actually refers to two different things:
- capital-B Bitcoin is a payment network—like MasterCard is a payment network.
- lower-case bitcoin refers to the currency of the Bitcoin network—much like MasterCard uses dollars in the United States.
What makes Bitcoin different from MasterCard, PayPal, and other payment networks that existed in 2008 (when Bitcoin was invented) is that Bitcoin was the world’s first payment network that’s completely decentralized. The MasterCard network is operated by MasterCard Inc., but there’s no Bitcoin Inc. in charge of the Bitcoin network. Rather, it’s a peer-to-peer network that maintains a shared transaction ledger called the blockchain.
Inventing a new currency was an unavoidable consequence of making the Bitcoin network fully decentralized. On a conventional payment network, the network owner promises to redeem balances for conventional currencies like dollars or euros but there’s no Bitcoin company, so there’s no one to guarantee that Bitcoin balances will have any particular value. Instead, bitcoins float against conventional currencies, with their value determined by supply and demand.
Those physical “bitcoins” you see in a lot of pictures aren’t what a bitcoin “really” looks like. Bitcoins are just entries in the Bitcoin blockchain. If you own some bitcoins, that means you have some cryptographic private keys stored on your computer, on an external drive, or printed out on a piece of paper somewhere. These keys allow people to spend bitcoin balances in much the same way that the password to your bank’s website allows you to spend the balance in your bank account. You can’t withdraw bitcoins from the network the way you withdraw physical currency from your bank, however.
2) If Bitcoins aren’t tied to a conventional currency, how did they get so valuable?
- 2009: When the Bitcoin network was first created in 2009, bitcoins were barely worth anything.
- 2010: Bitcoin lore holds that the very first real-world Bitcoin transaction occurred in May 2010, when one early Bitcoin user paid another user 10,000 bitcoins for two pizzas.
- 2011: At the time, Bitcoins were trading for less than a penny each but, as the Bitcoin community grew, the currency’s value steadily climbed. By the time I started paying attention to Bitcoin in April 2011, its value had climbed to $1. This was at the start of the first great Bitcoin bubble.
- Media coverage of Bitcoin attracted new users, which caused the price to rise. The rising price, in turn, attracted more media interest.
- The value rose to more than $30 by June, before it crashed and fell to $2 before the end of 2011.
- 2013: This cycle repeated two more times in 2013.
- In May 2013, Bitcoin’s price briefly rose above $250, before falling by about 80%.
- Then in late 2013, Bitcoin’s price rose above $1,000 before once again crashing by 80%.
- The current boom—which has taken the currency from a low of $200 in early 2015 to a high above $18,000 in recent days—is the fourth major Bitcoin boom.
Each of these booms—and, for that matter, most bubbles throughout history—has been driven by the same basic publicity-price feedback loop. As an Internet writer, I’ve seen this process first hand.
- During times when the price is rising, there’s a lot of traffic to be had writing about Bitcoin, so reporters like me write articles (like this one!) about it.
- The articles cause more people to pay attention to the currency, and some of those people decide to buy.
- That pushes the price up even more, triggering more media coverage and more public interest.
…On one level, Bitcoin’s value is rising simply because more and more people are betting that its value will continue to go up over time. The question, of course, is whether they’re right about that.
3) Why would I want to use Bitcoin?
Honestly, if you’re an ordinary American consumer, you probably wouldn’t. Despite years of effort, Bitcoin startups haven’t had much luck building payment applications that ordinary people find useful.
International money transfers: One of the most often-discussed applications for the Bitcoin network is international money transfers.
- Conventional financial networks like Western Union and Moneygram are expensive, and it can often take a long time for money to go through. In theory, a Bitcoin-based money transfer system could be cheaper and faster.
- In practice, however, Bitcoin has struggled to gain traction as a platform for remittances. One way to see this is by looking at the prices charged by Bitcoin ATMs, which allow people to exchange cash for bitcoins and vice versa. The average transaction fee for a Bitcoin ATM—at least according to one website that tracks these things—is currently around 9% for buying bitcoins and 6% for selling them, so to send money to an overseas friend or family member using Bitcoin ATMs, you could wind up paying transaction fees as high as 15%. That’s on top of the transaction fee charged by the Bitcoin network itself, which has averaged around $5 in recent weeks.
- There are a number of companies working to improve the experience of making international payments using Bitcoin, especially in Asia. These companies may eventually figure out ways to make payments fast, convenient, and affordable—but they haven’t achieved critical mass yet.
Illicit transactions: Bitcoin has also shown enduring popularity with illicit transactions. A succession of underground websites have popped up on Tor to serve as a kind of eBay for illegal drugs. These sites rely on Bitcoin because they would immediately get shut down if they tried to get accounts on conventional credit card networks, but no one has the power to block anyone from using Bitcoin.
Unstable currencies or dysfunctional financial systems: There is also anecdotal evidence that Bitcoin is popular in countries like Argentina and Venezuela with unstable currencies or dysfunctional financial systems.
4) If Bitcoin has few practical applications, how can it be worth $150 billion?
One possibility is that Bitcoin speculators are simply delusional and Bitcoin’s price will inevitably plunge.
There are other possibilities, however.
- One is that the Bitcoin economy is still in its early years. It took the Internet about 25 years to go from being an experimental technology—ARPANET in 1969—to becoming a mass market phenomenon—Netscape in 1994. Bitcoin is a comparatively young technology, having been around for less than 8 years.
- It’s possible that Bitcoin will eventually become a key part of the global financial system—it will just take another 5, 10, or 20 years to work out exactly how to apply the technology in useful ways.
- It’s also possible that Bitcoin will have important applications that are not consumer-facing.
- For example, the Bitcoin network charges roughly the same transaction fees whether you’re sending $10 or $10 million, so Bitcoin could become a standard way to move large sums of money overseas for international trade or investment. Big companies are conservative institutions, so it might take several years to build the infrastructure necessary to support these kinds of transactions—and then several more years after that to convince companies to make a switch.
- Another reason for optimism: Bitcoin is becoming the reserve currency of a broader cryptocurrency economy, much as the dollar is the default currency in global trade.
- Bitcoin has deeper markets and more sophisticated currency exchange services than other cryptocurrencies so people wanting to buy any one of the dozens of lesser-known Bitcoin competitors often first trade their dollars in for bitcoins and then swap their bitcoins for dash or lite coins or whatever. As the broader cryptocurrency economy grows, it pushes Bitcoin’s value upward.
- A final possibility is that Bitcoin could primarily become a store of value much like gold.
- Gold has practical uses in industrial applications and jewelry, but most of the world’s gold is kept in vaults and under floorboards as a long-term means of storing wealth. People like to hold gold because it is compact, easy to conceal, and exists outside of conventional financial systems.
- Bitcoins have similar advantages. You can store millions of dollars’ worth of bitcoins on a thumb drive or even a piece of paper. As long as the encryption keys are secure, bitcoins can’t be seized by any government. Bitcoin also has a big advantage over gold because it can be transferred around the world electronically.
5) OK, I’m sold. How do I get some?
Before we answer that question, we want to emphasize that investing in bitcoin is insanely risky. Bitcoin has been known to lose 80% of its value in a matter of days and, while bitcoins recovered their value after previous crashes, the price is much higher today. There’s no guarantee that Bitcoin will recover after its next crash so please don’t invest money you can’t afford to lose.
That said, acquiring some bitcoins is pretty easy.
- To do this you go to a site called a Bitcoin exchange and set up an account.
- You then send dollars (or whatever currency they use in your country) to the account using an electronic bank transfer or similar mechanism.
- Once the money arrives in your exchange account, you can trade dollars for bitcoins at the current market price.
- Once you have your bitcoins, an important question is whether to leave the deposit with the Bitcoin exchange or withdraw them into your own custody.
- There are several ways to store bitcoins yourself.
- You can store the encryption keys on your own hard drive.
- You can store them on a Web wallet app that encrypts them client-side using a customer-supplied password.
- You can print out the encryption keys onto a piece of paper and store the paper (hopefully multiple copies) in a safe place.
- There are several ways to store bitcoins yourself.
All of these options have risks. If you leave your money on deposit with the exchange, the risk is that the exchange itself will lose your bitcoins due to hacking, mismanagement, or fraud.
- In 2014, the then-biggest Bitcoin exchange, called Mt. Gox, declared bankruptcy after millions of dollars in bitcoins were stolen by hackers.
- Other early Bitcoin services simply disappeared from the web, taking customers’ bitcoins with them.
The Bitcoin economy doesn’t have anything resembling FDIC insurance, so if your exchange loses your bitcoins or goes bankrupt, you might be out of luck. [That being said,]…exchanges have matured significantly since 2014.
Holding bitcoins yourself is risky, too.
- If your hard drive crashes and you don’t have backups, your bitcoins could be lost forever.
- If you print out your bitcoins and then lose the paper, your bitcoins will be gone forever.
- If you put the bitcoins in a Web wallet and forget the password, your bitcoins will be lost forever.
- If someone puts bitcoin-stealing malware on your computer, you could lose your bitcoin regardless of how you store them.
In short, there’s no completely safe way to hold on to bitcoins, and technical newbies are at particular risk. Investors in Bitcoin are at much greater risk of losing their investments to accidents or thefts than investors in conventional assets like stocks and bonds.
6) I just made a killing! How do I cash out?
If your cash is still deposited at a Bitcoin exchange,
- you just execute another trade to convert your bitcoins back to dollars at the new—hopefully higher—price
- then you withdraw the funds to your bank account.
The bitcoin market is very liquid, so unless you have millions of dollars in bitcoins, cashing out won’t be difficult. Major bitcoin exchanges do have daily dollar withdrawal limits to minimize fraud, however, so, if you sell thousands of dollars’ worth of bitcoins, it might take a few days or weeks to transfer the cash into your conventional bank account.
We’ve seen some people argue that Bitcoin’s $150 billion market capitalization isn’t real because people can’t cash out all of that value simultaneously but that’s misguided. The same basic point applies to any asset: if Jeff Bezos tried to sell all of his Amazon shares at once, the stock would crash but people still say he has a net worth of nearly $100 billion. There’s enough liquidity in Bitcoin markets that all but the very wealthiest Bitcoin holders can quickly and easily convert their holdings to conventional currency and even the wealthiest holders could cash out their holdings gradually over time if they wanted to.
7) Is it true that Bitcoin wastes a ton of energy?
Yes. The Bitcoin network maintains its shared transaction ledger, called the blockchain, using a computationally intensive process called mining. Miners compete with each other for the right to add blocks to the blockchain—each comes with a reward of 12.5 Bitcoins—or around $125,000.
- Because electricity is the biggest cost for Bitcoin mining, however, and this is a competitive market, we should expect miners to keep spending more and more money on electricity until electricity spending is on par with the size of the block reward.
- One back-of-the-envelope calculation suggested that each Bitcoin transaction uses 271kWh of electricity—enough to power a typical American home for nine days. The fact that these figures are often quoted on a per-transaction basis has caused a fair amount of confusion.
- The Bitcoin network generates blocks at a rate of about six per hour, and mining a block takes essentially the same amount of energy whether it contains one transaction or 2,000 (the current average) and
- for a given bitcoin price, it would take roughly the same amount of energy if, someday, the Bitcoin network is processing tens of thousands or even millions of transactions per block…[which] means that:
- we can’t save energy by reducing the number of bitcoin transactions
- and increasing the number of bitcoin transactions doesn’t directly increase energy consumption.
- What does cause Bitcoin’s energy usage to rise however, is when Bitcoin’s price goes up. A higher price means the 12.5 bitcoin reward becomes more valuable, and so miners spend more resources to capture the larger prize. Fortunately, this is a problem that will solve itself in the long run.
- The per-block reward halves, in Bitcoin terms, every four years. It has fallen twice—it started out at 50 bitcoins in 2009—and is scheduled to fall to 6.25 bitcoins per block some time in 2020, then to 3.125 bitcoins per block around 2024. As the per-block reward falls, the network’s energy consumption will fall proportionately.
While it’s true that the Bitcoin network is an environmental disaster, using vastly more energy per transaction than any other payment network, we can expect the network to become less wasteful, at least on a per-transaction basis, in the coming years and decades.
If you’re an ordinary person in the United States or another rich Western country and you don’t want to buy drugs or speculate on Bitcoin’s future value, however, Bitcoin might not have much to offer you—at least not yet.