What Is Bitcoin And How Does It Work?
Bitcoin is the first cryptocurrency in existence and one of the most popular today. Financial media eagerly covers each high and decline, making Bitcoin an unavoidable part of the landscape.
While the high volatility might produce great headlines, it hardly makes Bitcoin the best choice for beginner investors or people looking for a stable store of value. Understanding the ins and outs can be tricky—let’s take a closer look at how Bitcoin works.
Bitcoin is a decentralized digital currency that you can buy, sell, and exchange directly without an intermediary like a bank. Bitcoin’s creator, Satoshi Nakamoto, originally described the need for “an electronic payment system based on cryptographic proof instead of trust.”
Every Bitcoin transaction that’s ever been made exists on a public ledger accessible to everyone, making transactions hard to reverse and difficult to fake. That’s by design: Core to their decentralized nature, Bitcoins aren’t backed by the government or any issuing institution, and there’s nothing to guarantee their value besides the proof in the heart of the system.
“The reason it’s worth money is simply that we, as people, decided it has value—same as gold,” says Anton Mozgovoy, co-founder & CEO of the digital financial service company Holyheld.
Since its public launch in 2009, Bitcoin has risen dramatically in value. Although it once sold for under $150 per coin, as of March 1, 2021, one Bitcoin now sells for almost $50,000. Because its supply is limited to 21 million coins, many expect its price to only keep rising as time goes on, especially as more large institutional investors begin treating it as a sort of digital gold to hedge against market volatility and inflation.
Bitcoin is built on a distributed digital record called a blockchain. As the name implies, blockchain is a linked body of data, made up of units called blocks that contain information about every transaction, including date and time, total value, buyer and seller, and a unique identifying code for each exchange. Entries are strung together in chronological order, creating a digital chain of blocks.
“Once a block is added to the blockchain, it becomes accessible to anyone who wishes to view it, acting as a public ledger of cryptocurrency transactions,” says Stacey Harris, a consultant for Pelicoin, a network of cryptocurrency ATMs.
Blockchain is decentralized, which means anyone organization does not control it. “It’s like a Google Doc that anyone can work on,” says Buchi Okoro, CEO and co-founder of the African cryptocurrency exchange Quidax. “Nobody owns it, but anyone who has a link can contribute to it. And as different people update it, your copy also gets updated.”
While the prospect that anyone can edit the blockchain might sound highly risky, that’s actually at the heart of what makes Bitcoin secure. For starters, for a transaction block to be added to the Bitcoin blockchain, it must be verified by the majority of all Bitcoin holders. The unique codes used to recognize users’ wallets and transactions must conform to the right encryption pattern.
These codes are long, random numbers, making them incredibly difficult to fraudulently produce. According to Bryan Lotti of Crypto Aquarium, a fraudster guessing the necessary code to your Bitcoin wallet has roughly the same odds as someone winning a Powerball lottery nine times in a row. This level of statistical randomness blockchain verification codes, which are needed for every transaction, dramatically reduces the risk anyone can make fraudulent Bitcoin transactions.
Bitcoin mining is the process of adding new transactions to the Bitcoin blockchain. It’s a tough job. People who choose to mine Bitcoin use a technique called proof of work, deploying computers in a race to solve mathematical puzzles that verify transactions.
The Bitcoin code rewards miners with new Bitcoins. “This is how new coins are created”, and recent transactions are added to the blockchain, says Okoro.
In the early days, the average person could mine Bitcoin, but that’s no longer the case. The Bitcoin code is getting more and more challenging over time, requiring more and more computing resources. Today, Bitcoin mining requires powerful computers and access to massive amounts of cheap electricity to be successful.
Bitcoin mining also pays less than it used to, making it even harder to recoup the rising computational and electrical costs. “In 2009, when this technology first came out, every time you got a stamp, you got a much larger amount of Bitcoin than you do today,” says Flori Marquez, co-founder of BlockFi, a crypto wealth management company. “There are more and more transactions [now, so] the amount you get paid for each stamp is less and less.” By 2140, it’s estimated all Bitcoins will have entered circulation, meaning mining will release no new coins, and miners may instead have to rely on transaction fees.
In the U.S., people generally use Bitcoin as an alternative investment, helping diversify a portfolio apart from stocks and bonds. You can also use Bitcoin to make purchases, but the number of vendors that accept the cryptocurrency is still limited.
Big companies that accept Bitcoin include Overstock, AT&T and Twitch. You may also find that some small local retailers or certain websites take Bitcoin, but you’ll have to do some digging.
That said, PayPal has announced that it will enable cryptocurrency as a funding source for purchases this year, financing purchases by automatically converting crypto holdings to fiat currency for users.
“They have 346 million users, and they’re connected to 26 million merchants,” says Spencer Montgomery, founder of Uinta Crypto Consulting. “It’s huge.”
You can also use a service that allows you to connect a debit card to your crypto account, meaning you can use Bitcoin the same way you’d use a credit card. This also generally involves a financial provider instantly converting your Bitcoin into dollars. “Crypto.com and CoinZoom are two services that have regulation in the U.S.,” Montgomery says.
In other countries—particularly those with less stable currencies—people sometimes use cryptocurrency instead of money.
“Bitcoin provides an opportunity for people to store value without relying on a currency that a government backs,” Montgomery says. “It gives people an option to hedge for a worst-case scenario. You’re already seeing people in countries like Venezuela, Argentina, Zimbabwe—in countries heavily in debt, and Bitcoin is getting tremendous traction.”
That said, when you use Bitcoin as a currency, not an investment, in the U.S., you do have to be aware of specific tax implications.
Most people buy Bitcoin via exchanges, such as Coinbase. Exchanges allow you to buy, sell and hold a cryptocurrency. Setting up an account is similar to opening a brokerage account—you’ll need to verify your identity and provide some funding sources, such as a bank account or debit card.
Major exchanges include Coinbase, Kraken, and Gemini. You can also buy Bitcoin at a broker like Robinhood.
Regardless of where you buy your Bitcoin, you’ll need a digital wallet in which to store it. This might be what’s called a hot wallet or a cold wallet. A hot wallet (also called an online wallet) is held by an exchange or a provider in the cloud. Providers of online wallets include Exodus, Electrum and Mycelium. A cold wallet (or mobile wallet) is an offline device used to store Bitcoin and is not connected to the Internet. Some mobile wallet options include Trezor and Ledger.
A few important notes about buying Bitcoin: While Bitcoin is expensive, you can purchase fractional Bitcoin from some vendors. You’ll also need to look out for fees, which are generally small percentages of your crypto transaction amount but can add up on small-dollar purchases. Finally, be aware that Bitcoin purchases are not instantaneous, like many other equity purchases seemingly are. Because miners must verify Bitcoin transactions, it may take you at least 10-20 minutes to see your Bitcoin purchase in your account.
Like a stock, you can buy and hold Bitcoin as an investment. You can even now do so in special retirement accounts called Bitcoin IRAs.
No matter where you choose to hold your Bitcoin, people’s philosophies on investing it vary: Some buy and maintain long term, some buy and aim to sell after a price rally, and others bet on its price decreasing. Bitcoin’s price over time has experienced significant price swings, going as low as $5,165 and as high as $28,990 in 2020 alone.
“I think in some places, people might be using Bitcoin to pay for things, but the truth is that it’s an asset that looks like it’s going to be increasing in value relatively quickly for some time,” Marquez says. “So why would you sell something that’s going to be worth so much more next year than it is today? The majority of people that hold it are long-term investors.”
Consumers can also invest in a Bitcoin mutual fund by buying shares of the Grayscale Bitcoin Trust (GBTC). However, it’s currently only open to accredited investors who make at least $200,000 or have net worths of at least $1 million. This means the majority of Americans aren’t able to buy into it. In Canada, however, diversified Bitcoin investing is becoming more accessible. In February 2021, Purpose Bitcoin ETF (BTCC) started trading as the world’s first Bitcoin ETF. The Ontario Securities Commission has also approved the Evolve Bitcoin ETF (EBIT). American investors looking for Bitcoin or Bitcoin-like exposure may consider blockchain ETFs that invest in the technology underlying cryptocurrencies.
An important note, though: While crypto-based funds may add diversification to crypto holdings and decrease risk slightly, they do still carry substantially more risk and charge much higher fees than broad-based index funds with histories of steady returns. Investors looking to grow wealth steadily may opt for index-based mutual and exchange-traded funds (ETFs).
In general, many financial experts support their clients’ desire to buy cryptocurrency. Still, they don’t recommend it unless clients express interest. “The biggest concern for us is if someone wants to invest in crypto and the investment they choose doesn’t do well, and then all of a sudden they can’t send their kids to college,” says Ian Harvey, a certified financial planner (CFP) in New York City. “Then it wasn’t worth the risk.”
The speculative nature of cryptocurrency leads some planners to recommend it for clients’ “side” investments. “Some call it a Vegas account,” says Scott Hammel, a CFP in Dallas. “Let’s keep this away from our real long-term perspective; make sure it doesn’t become too large a portion of your portfolio.”
Bitcoin is like a single stock, and advisors wouldn’t recommend putting a sizable part of your portfolio into any company. At most, planners suggest putting no more than 1% to 10% into Bitcoin if you’re passionate about it. “If it were one stock, you would never allocate any significant portion of your portfolio to it,” Hammel says.