What Is Bitcoin – History, How It Works, Pros & Cons
Bitcoin is a virtual currency, or cryptocurrency, that’s controlled by a decentralized network of users and isn’t directly subject to the whims of central banking authorities or national governments. Although there are hundreds of cryptocurrencies in active use today, Bitcoin is by far the most popular and widely used – the closest cryptocurrency equivalent to traditional, state-minted currencies.
Like traditional currencies, such as the U.S. dollar, Bitcoin has value relative to other currencies and physical goods. Whole Bitcoin units can be subdivided into decimals representing smaller units of value. Currently, the smallest Bitcoin unit is the satoshi, or 0.00000001 Bitcoin. The satoshi can’t be broken into smaller units. However, Bitcoin’s source code is structured to allow for future subdivisions beyond this level, should the currency’s value appreciate to the point that it’s deemed necessary.
Bitcoin is the most versatile cryptocurrency around. It can be used to purchase goods from an ever-growing roster of merchants (including recognizable companies like Expedia and Overstock.com) that accept Bitcoin payments. It can be exchanged with other private users as consideration for services performed or to settle outstanding debts. It can be swapped for other currencies, both traditional and virtual, on electronic exchanges that function similar to forex exchanges. And, unfortunately, it can be used to facilitate illicit activity, such as the purchase of illegal drugs on dark web marketplaces like the infamous (and now-shuttered) Silk Road.
For all its promise, Bitcoin remains a niche currency that’s subject to wild value fluctuations. Despite the wild-eyed pronouncements of hardcore proponents, it’s certainly not a legitimate investment or trading vehicle, as is the case with stable national currencies, such as the U.S. dollar and Japanese yen.
Bitcoin is a cryptocurrency, meaning it’s supported by a source code that uses highly complex algorithms to prevent unauthorized duplication or creation of Bitcoin units. The code’s underlying principles, known as cryptography, are based on advanced mathematical and computer engineering principles. It’s virtually impossible to break Bitcoin’s source code and manipulate the currency’s supply.
Although it was preceded by other virtual currencies, Bitcoin is known as the first modern cryptocurrency. That’s because Bitcoin is the first to blend certain key features shared by most subsequently created cryptocurrencies.
Intense privacy protections are baked into Bitcoin’s source code. The system is designed to publicly record Bitcoin transactions and other relevant data without revealing the identity of the individuals or groups involved. Instead, Bitcoin users are identified by public keys, or numerical codes that identify them to other users, and sometimes pseudonymous handles or usernames.
Additional protections allow users to further conceal the source and flow of Bitcoin. For instance, special computer programs available to all Bitcoin users, called mixing services, privately swap a specific Bitcoin unit for another Bitcoin unit of identical value, and thereby obscure the source of the owner’s holdings.
Bitcoin exchanges allow users to exchange Bitcoin units for fiat currencies, such as the U.S. dollar and euro, at variable exchange rates. Many Bitcoin exchanges also exchange Bitcoin units for other cryptocurrencies, including less popular alternatives that can’t directly be exchanged for fiat currencies. Most Bitcoin exchanges take a cut, typically less than 1%, of each transaction’s value.
Bitcoin exchanges ensure that the Bitcoin market remains liquid, setting their value relative to traditional currencies – and allowing holders to profit from speculation on fluctuations in that value. That said, Bitcoin users must understand that Bitcoin’s value is subject to wild swings – weekly moves of 50% in either direction have occurred before. Such swings are unheard of among stable fiat currencies.
Bitcoin’s block chain is vital to its function. The block chain is a public, distributed ledger of all prior Bitcoin transactions, which are stored in groups known as blocks. Every node of Bitcoin’s software network – the server farms and terminals, run by individuals or groups known as miners, whose efforts to produce new Bitcoin units result in the recording and authentication of Bitcoin transactions, and the periodic creation of new blocks – contains an identical record of Bitcoin’s block chain.
Because new Bitcoin transactions constantly occur, the Bitcoin block chain, though finite, grows over time. As long as miners continue their work and record recent transactions, the Bitcoin block chain will always be a work in progress. In other words, there’s no predetermined length at which the block chain will stop growing.
On average, miners create a new block chain, which includes all prior transactions and a new transaction block, every 10 minutes. Every two weeks, Bitcoin’s source code is designed to adjust to the amount of mining power devoted to creating new block chains, preserving the 10-minute average creation interval. If mining power increased during the most recent two-week span, new block chains become more difficult to create during the subsequent two-week span. If mining power decreases, new chains become easier to create. For most of Bitcoin’s history, the trend has been toward greater mining power.
Bitcoin’s block chain is the sole arbiter of Bitcoin ownership. No complete record exists anywhere else. The block chain also serves as a payment processing system, like Visa or PayPal, with the miners functioning as the system’s employees.
A Bitcoin transaction hasn’t technically occurred until it’s added to the block chain, at which point it becomes irreversible – unlike traditional payment processors, Bitcoin doesn’t have any standardized facility for chargebacks or refunds. During the window between the transaction itself and the moment it’s added to the block chain, the relevant Bitcoin units are essentially held in escrow – they can’t be used by either party to the transaction. This prevents duplicate transactions, known as double-spending, and protects the system’s integrity.
Every Bitcoin user has at least one private key (basically, a password), which is a whole number between 1 and 78 digits in length. Individual users can have multiple anonymous handles, each with its own private key. Private keys confirm their owners’ identities and allow them to spend or receive Bitcoin. Without them, users can’t complete transactions – meaning they can’t access their holdings until they recover the corresponding key. When a key is lost for good, the corresponding holdings move into a sort of permanent limbo and can’t be recovered.
Users either manually create their own private keys or use a random number generator to do the same. Keys can be stored online (either in private cloud storage or on public Bitcoin exchanges), on physical storage media (such as thumb drives), or on paper, and only entered online during transactions.
Since private keys essentially give Bitcoin holdings value, security experts advise against storing private keys in easily accessible online locations or keeping only one private key copy. Savvy users store identical key copies on paper printouts and physical media not connected to the Internet.
Actual Bitcoin units are stored in “wallets” – secure cloud storage locations with special information confirming their owners (Bitcoin users) as the guardians of the Bitcoin units contained within. Though wallets theoretically protect against the theft of Bitcoin units that aren’t currently being used, they’re vulnerable to hacking – particularly public wallets used by Bitcoin exchanges, online marketplaces, and specialized websites that exist solely to store Bitcoin wallets known as “wallet services.”
The largest and most notorious Bitcoin hack involved wallets held by Mt. Gox, a Japanese Bitcoin exchange that shut down after hackers stole hundreds of millions of dollars in Bitcoin (in contemporary valuations) from its supposedly secure servers. Hackers often target public wallets that store users’ private keys, enabling them to spend the stolen Bitcoin. Ars Technica has a nice rundown of Bitcoin hacks large and small, current to late 2017.
Like keys, copies of wallets can be stored on the cloud, an internal hard drive, or an external storage device. Unlike keys, they can’t be stored on paper. As with keys, it’s strongly advised that users have at least one wallet backup. Backing up a wallet doesn’t duplicate the stored Bitcoin units, only their ownership record and transaction history.
Miners play a vital role in the Bitcoin ecosystem. As keepers of the block chain, they keep the entire Bitcoin community honest and indirectly support the currency’s value.
Miners are individuals or cooperative organizations with access to powerful computers, often stored at remote, privately owned “farms.” They perform incredibly complex mathematical tasks in an effort to mint new Bitcoin, which they then keep or exchange for fiat currency.
In an elegant twist, Bitcoin’s source code harnesses this computing power to collect, record, and organize previously unverified transactions, adding a new block to the block chain about every 10 minutes. This work also verifies the accuracy and completeness of all previously existing blocks, preventing double-spending and ensuring that the Bitcoin system remains accurate and complete.
Each time a new block chain is created, a predetermined number of fresh Bitcoin are minted. Miners are “rewarded” these Bitcoin for their effort and often also receive transaction fees paid by buyers. Sellers have an incentive to charge transaction fees, which usually amount to less than 1% of the transaction amount, because miners are permitted to prioritize the recording of fee-loaded transactions irrespective of transaction order. In other words, sellers who charge transaction fees usually get paid faster. Unsurprisingly, Bitcoin transaction fees are quite common.
Did You Know: As Bitcoin grows more valuable (albeit amid gut-wrenching market volatility) and more commonly accepted, so too does the business of mining Bitcoin. But it comes at a notable cost: the consumption of vast amounts of electricity, often powered by non-renewable sources. According to the Bitcoin Energy Consumption Index, Bitcoin mining consumed approximately 51 trillion terawatts of electricity per year as of February 2018. That figure has risen steadily and inexorably over time, irrespective of day-to-day market movements, prompting policymakers to take a closer look at Bitcoin’s carbon footprint.
Bitcoin’s own source code places a strict limit on the number of Bitcoin units that can ever exist: 21 million. This is achieved by slowing, over time, the rate at which the creation of new block chain copies produces new Bitcoin. Every four years or so, this rate halves. The last Bitcoin is projected to spring into being sometime around 2140 – that is, if the currency still exists and people still care enough to mine it. After that, miners’ sole compensation will be Bitcoin transaction fees.
This enforced scarcity is a key point of distinction between Bitcoin and traditional fiat currencies, which central banks produce by decree, and supply of which is theoretically unlimited. In this regard, Bitcoin has more in common with gold than the U.S. dollar.
Taken together, the security risks around Bitcoin are the currency’s single greatest drawback, and are worthy of special consideration for anyone considering converting U.S. dollars into Bitcoin.
The fact that Bitcoin units are virtually impossible to duplicate does not mean that Bitcoin users are immune to theft or fraud. The Bitcoin system has some imperfections and weak points that can be exploited by sophisticated hackers looking to steal Bitcoin for their own use. The Mt. Gox incident, as well as a host of smaller, less publicized incidents, underscore that Bitcoin exchanges are particularly vulnerable to theft by hacking.
Two of Bitcoin’s perceived strengths – its political independence and strong anonymity protections – actually make it more attractive to thieves and fraudsters.
In many jurisdictions, Bitcoin occupies a legal gray area, meaning local law enforcement authorities view theft prevention as a relatively low priority. Moreover, it’s often difficult for the authorities to prosecute those responsible for Bitcoin heists, many of which originate in politically unstable or unfriendly nations and affect a global population of Bitcoin holders.
Those who use Bitcoin for illicit purposes face additional risks. Dark web marketplaces – online, international black markets whose users buy and sell illicit substances, stolen goods, and prohibited services – are frequent heist targets. Bitcoin users who participate in the dark web are likely already breaking the law, and thus have limited recourse in the event of a hack or theft. After all, they can’t very well contact local authorities and say that the funds they received for selling illegal drugs were stolen.
It usually takes more technical skill to steal Bitcoin than physical cash. Most Bitcoin heists involve sophisticated hack attacks by highly accomplished outsiders or rogue exchange employees.
Common modes of Bitcoin theft include the following:
The cybersecurity industry is locked in a constant arms race with hackers and other cyber-criminals, whose sophistication and operational scope increase by the week. In this environment, there’s no such thing as a complete guarantee of security – particularly when money is involved.
However, prudent Bitcoin users employ these common-sense strategies to reduce their exposure to theft and general security breaches:
Bitcoin’s origins date back to the early 1980s, when the algorithms that support modern cryptocurrency were first developed. Its closest predecessor was Bit Gold, a proto-cryptocurrency developed in the late 1990s by Nick Szabo. Though Bit Gold never gained widespread traction, it shared many features in common with Bitcoin, including ironclad protections against duplication, the block chain as the ultimate transaction ledger, public keys identifying individual users, and built-in scarcity.
Note that Bit Gold isn’t to be confused with BitGold, an existing Canadian company that “helps people securely acquire, store, and spend gold with unprecedented simplicity.”
The first public record of Bitcoin dates to October 2008, when a pseudonymous person or organization known as Satoshi Nakamoto published a white paper with the technical outlines for a new, decentralized cryptocurrency. Nakamoto’s identity remains unknown, though speculation centers on a handful of U.S.-based individuals (or various groupings thereof) who were active in the cryptocurrency movement of the 1990s and 2000s. Nakamoto released Bitcoin’s open-source code in January 2009, marking the beginning of public mining and trading, and ceased public communication shortly thereafter.
Bitcoin was built on the theoretical and technical foundations of Bit Gold and b-money, a contemporaneous cryptocurrency model that was never developed. Aside from being the first cryptocurrency to gain widespread traction outside the cloistered ultra-libertarian movement, its biggest claim to fame is as the first cryptocurrency marked by totally decentralized control – in other words, no user is more influential than any other.
Bitcoin experienced some growing pains in its first few years of life. In 2010, a coding flaw resulted in the creation of huge numbers of un-mined Bitcoin, temporarily crashing the currency’s value. A subsequent fix repaired the block chain and erased the unauthorized Bitcoin. Something similar occurred in 2013, though the effects were less drastic. Bitcoin’s open source code has been modified to make such systemic flaws less likely in the future.
For the first three years of its life, Bitcoin was mainly used as a means of private exchange. Toward the end of 2012, WordPress, an online publishing platform, became the first major company to accept Bitcoin payments. Others, including OkCupid, Baidu, Expedia, and Overstock.com, followed in 2013 and 2014. Baidu later stopped accepting Bitcoin under pressure from the Chinese government, which viewed Bitcoin as a threat to its own fiat currency.
In 2013, Bitcoin’s market value exceeded $10 billion for the first time. That year, the first Bitcoin-dispensing “ATM” (more accurately, an automated currency exchange machine) appeared in Vancouver, British Columbia, and their number exploded in the subsequent years. Genesis, the leading Bitcoin ATM manufacturer, makes two types of machines: a one-way device that allows users to insert paper fiat money for conversion to Bitcoin units, which are then deposited into their digital wallets; and a two-way device that permits Bitcoin-fiat conversions as well.
2014 saw the first major Bitcoin crime scandals. In January, prominent U.S. Bitcoin proponent Charlie Shrem was arrested after a money laundering investigation found he’d illegally procured Bitcoin for use in black market transactions. In February, Mt. Gox filed for bankruptcy after the extent of its breach became clear. In 2015, Barclays became the first major bank to process Bitcoin transactions, though its embrace was initially limited to charitable contributions.
The “mainstreaming” of Bitcoin continued through 2018. Day traders, hedge funds, and even professional money managers piled into the space, spurring a wave of speculation. Bitcoin’s value increased tenfold in 2017, skyrocketing from about $1,000 at the start of the year to around $10,000 at the close.
As the most popular cryptocurrency by a significant margin, Bitcoin has far greater liquidity than its peers. This allows users to retain most of its inherent value when converting to fiat currencies, such as the U.S. dollar and euro. By contrast, most other cryptocurrencies either can’t be exchanged directly for fiat currencies or lose substantial value during such exchanges.
In this regard, Bitcoin is more like fiat currencies than most other cryptocurrencies – though it’s not yet possible to buy and sell Bitcoin in virtually any quantity at any time, as is the case with the U.S. dollar and other major world currencies.
Hundreds of merchants accept Bitcoin payments. Thanks to heavyweights like Overstock.com jumping on board, it’s possible to buy virtually any physical item using Bitcoin units. If you’re serious about reducing your exposure to fiat currencies, Bitcoin’s growing mainstream acceptance is likely to be a big help.
Bitcoin transactions that cross international borders are no different from Bitcoin transactions that stay in-country. There aren’t any international transaction fees or red tape to navigate, as is often the case with credit card payments, ATM cash withdrawals, and international money transfers. International credit card and ATM fees can range up to 3% of transaction value, and sometimes higher, while money transfer fees can be as high as 15%.
While most other cryptocurrencies lack international red tape, cross-border Bitcoin transactions are easier simply because Bitcoin is more popular around the world.
Compared to other digital payment methods, such as credit cards and PayPal, Bitcoin comes with lower transaction fees. Though such fees are variable, it’s rare for a Bitcoin transaction to cost more than 1% of its value. Compare that to 2% to 3% for most other digital payments.
Holding U.S. dollars or other fiat currencies in an online bank account, or executing online credit card and PayPal transactions, doesn’t protect your privacy any more than physically handing cash or a credit card across the shop counter. Though your online accounts are hopefully protected from all but the most sophisticated hack attacks, they’re clearly associated with you – meaning private merchants and public authorities can track how you spend and receive your electronic funds.
By contrast, Bitcoin’s built-in privacy protections allow users to completely separate their Bitcoin accounts from their public personas, if they so choose. While it’s possible to track Bitcoin flows between users, it’s very difficult to figure out who those users really are.
Since Bitcoin isn’t created or controlled by any state entity, such as a central bank, it’s not beholden to political influence. Since it exists outside any political system, it’s also much harder for governments to freeze or seize Bitcoin units, whether in the course of legitimate criminal investigations or as retribution for political acts, as is often the case in repressive states like Russia and China.
Due to its completely decentralized nature, popularity, and liquidity, Bitcoin is also unbeholden to its creators. Many less popular cryptocurrencies are characterized by concentrated holdings – the majority of existing units are held in a handful of accounts. This allows the currencies’ creators to manipulate supply and, to an extent, value relative to other cryptocurrencies, negatively impacting other holders.
Bitcoin’s built-in scarcity feature – only 21 million will ever exist – is likely to support its long-term value against traditional currencies, as well as non-scarce cryptocurrencies (such as Dogecoin, a popular Bitcoin alternative). In a way, Bitcoin’s scarcity imbues the currency with intrinsic value – similar to gold and other precious metals.
Most traditional (fiat) currencies controlled by national governments are non-scarce. Central banks can create new units of currency at will, and often do – for example, the U.S. Federal Reserve began a program of quantitative easing that created trillions of dollars in the aftermath of the late-2000s global financial crisis. Though the long-term effects of such policies are unclear, they make many economists uneasy.
As the world’s most popular cryptocurrency, Bitcoin has seen more than its fair share of medium-specific scams, fraud, and attacks. These range from small-time Ponzi schemes, such as Bitcoin Savings & Trust, to massive hack attacks, such as the breaches that felled Sheep Marketplace and Mt. Gox.
Other cryptocurrencies don’t have the critical mass of users necessary to make such malfeasance profitable to criminals, and such activity is more likely to be prosecuted by law enforcement agencies when traditional currencies and payment platforms are involved.
Despite high-visibility prosecutions of the most egregious offenders, Bitcoin remains attractive to criminals and gray market participants. Obviously, dark web marketplaces like Silk Road and Sheep expose rank-and-file users to fraud and the threat of criminal prosecution.
More disturbingly, the pursuit of nefarious activity by seemingly upstanding Bitcoin users – such as Charlie Shrem – threaten to corrode Bitcoin’s reputation. And it’s unclear that the international legal system is properly equipped to tackle the problem. If shady uses for Bitcoin outweigh legitimate ones over time, and the authorities can’t effectively put a stop to the shenanigans, the entire system faces marginalization.
Although Bitcoin is the most liquid and easily exchanged cryptocurrency, it remains susceptible to wild price swings over short periods of time. In the wake of the Mt. Gox collapse, Bitcoin’s value fell by more than 50%. Following the FBI’s announcement that it would treat Bitcoin and other virtual currencies as “legitimate financial services,” Bitcoin’s value spiked by a similar amount. In late 2017, Bitcoin’s value doubled several times, only to halve in the first weeks of 2018 – wiping out billions in market value almost overnight.
While Bitcoin’s volatility sometimes offers short-term benefits for speculative traders, it renders the currency unsuitable for more conservative investors with longer time horizons. And since Bitcoin’s purchasing power varies so widely from week to week, it’s difficult for consumers to use as a legitimate means of exchange.
One of Bitcoin’s biggest drawbacks is a lack of standardized policy for chargebacks or refunds, as all credit card companies and traditional online payment processors have. Users affected by transaction fraud – for instance, they purchase goods that the seller never delivers – can’t request a refund through Bitcoin. In fact, Bitcoin’s decentralized structure makes it impossible for any single party to arbitrate disputes between users. While miners take responsibility for recording transactions, they’re not qualified to assess their legitimacy.
Some newer cryptocurrencies, such as Ripple, have rudimentary chargeback and refund functions, but this feature has yet to be built into Bitcoin.
Bitcoin spawned a host of successor cryptocurrencies. Though many are structurally quite similar to Bitcoin, others make notable improvements.
Some newer cryptocurrencies make it even harder to track money flows or identify users. Others use “smart contract” systems that hold service providers accountable for their promises. Some even have in-house exchanges that let users exchange cryptocurrency units directly for fiat currency units, eliminating third-party exchanges and reducing associated fraud risks.
Over time, one or more of these alternatives could usurp Bitcoin as the world’s dominant cryptocurrency. That could negatively impact Bitcoin’s value, leaving committed, long-term users holding the bag.
Bitcoin mining consumes vast amounts of electricity. According to Business Insider, some of the biggest Bitcoin mining companies are based in China, where most power comes from dirty coal plants and horrific smog routinely makes even low-key outdoor activity unsafe for healthy adults.
In the long run, widespread adoption of low- or no-emissions energy production will hopefully mitigate the environmental ills of Bitcoin mining. In the meantime, however, it’s a growing threat to an already fragile planet.
The list of merchants that accept Bitcoin is steadily lengthening. You can now buy plane tickets (Expedia), furniture (Overstock.com), and web publishing services (WordPress) with Bitcoin.
However, before you rush out and cash in your dollars for Bitcoin, remember that Bitcoin has a long way to go before it’s a legitimate currency on par with the U.S. dollar, euro, or pound. And despite the seductiveness of cryptocurrency as a means of exchange, there’s no guarantee that Bitcoin – or any other decentralized, virtual currency not controlled by a national bank – will ever be a viable alternative to fiat currencies.
Some experts believe that, in the coming decades, national governments will rework their currencies with state-sanctioned means of exchange that have some cryptocurrency features, like built-in scarcity and virtually impenetrable counterfeiting protections. Others believe that fiat currency and cryptocurrency will continue to exist in parallel, but that cryptocurrencies will fail to expand beyond the niche currently occupied by gold and other precious metals – that of an alternative investment whose primary purpose is to hedge against inflation.
For the time being, treat Bitcoin as you would any speculative asset: Move cautiously, or not at all, and never invest money that you can’t afford to lose.
Do you use Bitcoin as an alternative currency? Have you ever mined Bitcoin?
Brian Martucci writes about frugal living, entrepreneurship, and innovative ideas. When he’s not interviewing small business owners or investigating time- and money-saving strategies for Money Crashers readers, he’s probably out exploring a new trail or sampling a novel cuisine. Find him on Twitter @Brian_Martucci.
What Is Bitcoin – History, How It Works, Pros & Cons
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