Bitcoin 101
What are some of the most important characteristics of Bitcoins?
How does Bitcoin work?
What are the advantages of Bitcoin?
What are the disadvantages of Bitcoin?
Is Bitcoin really used by people?
Is Bitcoin really legitimate?
Why do bitcoins have value?
What determines bitcoin’s price?
Why do people trust Bitcoin?
Are Bitcoins Regulated?
What happens when bitcoins are lost?
How are bitcoins created?
How do Bitcoin Transactions Work in More Detail?
BitCoin 101
BitCoin is a form of digital currency, created and held electronically. No one controls it. Bitcoins aren’t printed, like dollars or euros – they’re produced by lots of people running computers all around the world, using software that solves mathematical problems. It’s the first example of a growing category of money known as cryptocurrency.
What can bitcoins be used to buy? Increasingly, a lot of things, from electronics and store gift cards to hotel rooms. In that sense, it’s like conventional dollars, euros, or yen, which are also traded digitally.
However one of bitcoin’s most interesting characteristic and something that makes it different than conventional money is that it is decentralized. No single institution or country controls the bitcoin network. This puts some people at ease and makes others quite nervous.
In addition, Bitcoin transactions are anonymous, well kind of. The transaction itself has no identifying information but it can be traced back to an IP address. So, if you use your office’s network with a known static IP address linked to you, the transaction can be traced. (That is what happened to Ross Ulbricht, by the way). With that (rather large) caveat, bitcoins are anonymous- once you have a bitcoin, no one can find where you got it from one who gave it to. This is also both comforting and nerve-racking at the same time.
If a bitcoin is lost or stolen, that’s it. It is like losing your wallet with a twenty dollar bill in it. The money is gone. This is one of the reasons why Bitcoin Theft Insurance is expected to be so popular.
The above does not mean that Bitcoins are not regulated. Indeed, especially in the United States, there is a strong, if somewhat slow, trend toward both federal and state regulations. Led by New York, more and more states are creating bitcoin regulations modeled against the financial regulations of other currencies or commodities. Coinbase, one of the largest bitcoin companies, is currently regulated as a “bitcoin exchange” in 24 states.
One thing is for sure is that, as of 12/31/2014, there are over $4 billion in Bitcoins currently in circulation and over 82,000 merchants accepting bitcoins, including Microsoft, Dell, Intuit, Expedia.com and many more old world companies, and with growing regulation, especially in the United States, bitcoins are growing in legitimacy and its value proposition makes it unlikely that their growth will stop anytime soon.
Ben Bernanke, Chairman of the Federal Reserve, USA, commented “[Virtual currencies] may hold long-term promise, particularly if the innovations promote a faster, more secure and more efficient payment system.”
What are some of the most important characteristics of Bitcoins?
Bitcoin has several important features that set it apart from normal fiat currencies.
1. It’s decentralized
The bitcoin network isn’t controlled by one central authority. Every machine that mines bitcoin and processes transactions make up a part of the network and the machines work together. That means that, in theory, one central authority can’t tinker with monetary policy and cause a meltdown – or simply decide to take people’s bitcoins away from them, as the Central European Bank decided to do in Cyprus in early 2013. And if some part of the network goes offline for some reason, the money keeps on flowing.
2. It’s easy to set up
Conventional banks make you jump through hoops simply to open a bank account. However, you can set up a bitcoin address in seconds and with no fees payable.
3. It’s anonymous
Well, kind of. Users can hold multiple bitcoin addresses, and they aren’t linked to names, addresses, or other personally identifying information. However…
4. It’s completely transparent
…bitcoin stores details of every single transaction that ever happened in the network in a huge version of a general ledger, called the blockchain. The blockchain tells all. If you have a publicly used bitcoin address, anyone can tell how many bitcoins are stored at that address. They just don’t know that it’s yours. There are measures that people can take to make their activities more opaque on the bitcoin network, though, such as not using the same bitcoin addresses consistently, and not be transferring lots of bitcoin to a single address.
5. Transaction fees are minuscule
Your bank may charge you a £10 fee for international transfers. Bitcoin doesn’t.
6. It’s fast
You can send money anywhere and it will arrive minutes later, as soon as the bitcoin network processes the payment.
7. It’s non-repudiable
When your bitcoins are sent, there’s no getting them back, unless the recipient returns them to you. They’re gone forever.
How does Bitcoin work?
From a user perspective, Bitcoin is nothing more than a mobile app or computer program that provides a personal Bitcoin wallet and allows a user to send and receive bitcoins with them. Think of it as emailing money. This is how Bitcoin works for most users.
Behind the scenes, the Bitcoin network is sharing a public ledger called the “block chain”. This ledger contains every transaction ever processed, allowing a user’s computer to verify the validity of each transaction. The authenticity of each transaction is protected by digital signatures corresponding to the sending addresses, allowing all users to have full control over sending bitcoins from their own Bitcoin addresses.
What are the advantages of Bitcoin?
- Payment freedom– It is possible to send and receive any amount of money instantly anywhere in the world at any time. No bank holidays. No borders. No imposed limits. Bitcoin allows its users to be in full control of their money.
- Very low fees– Bitcoin payments are currently processed with either no fees or extremely small fees. Users may include fees with transactions to receive priority processing, which results in faster confirmation of transactions by the network. Additionally, merchant processors exist to assist merchants in processing transactions, converting bitcoins to fiat currency and depositing funds directly into merchants’ bank accounts daily. As these services are based on Bitcoin, they can be offered for much lower fees than with PayPal or credit card networks.
- Fewer risks for merchants– Bitcoin transactions are secure, irreversible, and do not contain customers’ sensitive or personal information. This protects merchants from losses caused by fraud or fraudulent chargebacks, and there is no need for PCI compliance. Merchants can easily expand to new markets where either credit cards are not available or fraud rates are unacceptably high. The net results are lower fees, larger markets, and fewer administrative costs.
- Security and control– Bitcoin users are in full control of their transactions; it is impossible for merchants to force unwanted or unnoticed charges as can happen with other payment methods. Bitcoin payments can be made without personal information tied to the transaction. This offers strong protection against identity theft. Bitcoin users can also protect their money with backup and encryption.
- Transparent and neutral– All information concerning the Bitcoin money supply itself is readily available on the Block Chain for anybody to verify and use in real-time. No individual or organization can control or manipulate the Bitcoin protocol because it is cryptographically secure. This allows the core of Bitcoin to be trusted for being completely neutral, transparent and predictable.
What are the disadvantages of Bitcoin?
- Degree of acceptance– Many people are still unaware of Bitcoin. Every day, more businesses accept bitcoins because they want the advantages of doing so, but the list remains small and still needs to grow in order to benefit from network effects.
- Volatility– The total value of bitcoins in circulation and the number of businesses using Bitcoin are still very small compared to what they could be. Therefore, relatively small events, trades, or business activities can significantly affect the price. In theory, this volatility will decrease as Bitcoin markets and the technology matures.
- Ongoing development– Although Bitcoin software is based on decades old and proven technology (Public Key Intrasture) it is still in beta with respect to its application to virtual currency New tools, features, and services are being developed (such as multi-signature technology) to make Bitcoin more secure and accessible to the masses. Most Bitcoin businesses are new and still offer no insurance.
Is Bitcoin really used by people?
Yes. There is a growing number of businesses and individuals using Bitcoin. As of end of 2014, there was over 82,000 merchants that took bitcoins with Microsoft, Dell, Intuit, Expedia.com and many others. At the end of 2014, the value of all bitcoins in circulation exceeded US$ 4 billion with over 100,000 bitcoin transactions happening every day.
Is Bitcoin really legitimate?
Yes. For example, just in the last year:
- IRS officials have declared bitcoin to be property,
- former SEC chairman Arthur Levitt is consulting with Bitcoin startups;
- Kathleen Moriarty—the legendary lawyer who ushered the first exchange traded fund (ETF) through the SEC two decades ago—is handling the Winklevoss Bitcoin ETF application;
- the CFTC has approved several bitcoin derivatives for institutional investors;
- the SEC has issued Second Market’s Bitcoin Investment Trust a ticker symbol (GBTC);
- the New York Stock Exchange and a former CEO of Citigroup have participated in a US$75 million investment in Coinbase;
- the Governor and former Attorney General of Texas, Greg Abbott, accepted bitcoin during his campaign; and
- Republican candidate for President in 2016, Rand Paul, is accepting bitcoin for his campaign.
Why do bitcoins have value?
Bitcoins have value because they are useful as a form of money. Bitcoin has the characteristics of money (durability, portability, fungibility, scarcity, divisibility, and recognizability) based on the properties of mathematics rather than relying on physical properties (like gold and silver) or trust in central authorities (like fiat currencies). In short, Bitcoin is backed by mathematics. With these attributes, all that is required for a form of money to hold value is trust and adoption. In the case of Bitcoin, this can be measured by its growing base of users, merchants, and startups. As with all currency, bitcoin’s value comes only and directly from people willing to accept them as payment.
What determines bitcoin’s price?
The price of a bitcoin is determined by supply and demand. When demand for bitcoins increases, the price increases, and when demand falls, the price falls. There is only a limited number of bitcoins in circulation and new bitcoins are created at a predictable and decreasing rate, which means that demand must follow this level of inflation to keep the price stable. Because Bitcoin is still a relatively small market compared to what it could be, it doesn’t take significant amounts of money to move the market price up or down, and thus the price of a bitcoin is still very volatile.
Why do people trust Bitcoin?
Much of the trust in Bitcoin comes from the fact that it requires no trust at all. Bitcoin is fully open-source and decentralized. This means that anyone has access to the entire source code at any time. Any developer in the world can therefore verify exactly how Bitcoin works. All transactions and bitcoins issued into existence can be transparently consulted in real-time by anyone. All payments can be made without reliance on a third party and the whole system is protected by heavily peer-reviewed cryptographic algorithms like those used for online banking. No organization or individual can control Bitcoin, and the network remains secure even if not all of its users can be trusted.
Are Bitcoins Regulated?
Strangely enough, given the “open source” philosophy of Bitcoins, the growing answer is Yes. Especially in the United States, the buying and and using of bitcoins are increasing subject to regulation. Consider the following:
»The Internal Revenue Service has stated that employers are permitted to pay their employees in bitcoins and that bitcoins may be used for the purchase or goods and services. However, the transaction will be taxed as if it was made in US currency based on the US value of the bitcoin on the date of the transaction.
»The U.S. Marshall’s office recently sold to the public $30 million dollars of bitcoins.
And on the state level…
Following New York’s led is California, New Jersey, among others.
What happens when bitcoins are lost or stolen?
When a user loses his wallet, it has the effect of removing money out of circulation. Lost bitcoins still remain in the block chain just like any other bitcoins. However, lost bitcoins remain dormant forever because there is no way for anybody to find the private key(s) that would allow them to be spent again. Because of the law of supply and demand, when fewer bitcoins are available, the ones that are left will be in higher demand and increase in value to compensate.
Go to Bitcoin Theft Insurance to learn more about protecting yourself from stolen bitcoin.
How are bitcoins created?
New bitcoins are generated by a competitive and decentralized process called “mining”. This process involves that individuals are rewarded by the network for their services. Bitcoin miners are processing transactions and securing the network using specialized hardware and are collecting new bitcoins in exchange.
The Bitcoin protocol is designed in such a way that new bitcoins are created at a fixed rate. This makes Bitcoin mining a very competitive business. When more miners join the network, it becomes increasingly difficult to make a profit and miners must seek efficiency to cut their operating costs. No central authority or developer has any power to control or manipulate the system to increase their profits. Every Bitcoin node in the world will reject anything that does not comply with the rules it expects the system to follow.
Bitcoins are created at a decreasing and predictable rate. The number of new bitcoins created each year is automatically halved over time until bitcoin issuance halts completely with a total of 21 million bitcoins in existence. At this point, Bitcoin miners will probably be supported exclusively by numerous small transaction fees.
How do Bitcoin Transactions Work in More Detail?
Bitcoin transactions are sent from and to electronic bitcoin wallets, and are digitally signed for security. Everyone on the network knows about a transaction, and the history of a transaction can be traced back to the point where the bitcoins were produced.
Here’s the funny thing about bitcoins: they don’t exist anywhere, even on a hard drive. We talk about someone having bitcoins, but when you look at a particular bitcoin address, there are no digital bitcoins held in it, in the same way that you might hold pounds or dollars in a bank account. You cannot point to a physical object, or even a digital file, and say “this is a bitcoin”.
Instead, there are only records of transactions between different addresses, with balances that increase and decrease. Every transaction that ever took place is stored in a vast public ledger called the block chain. If you want to work out the balance of any bitcoin address, the information isn’t held at that address; you must reconstruct it by looking at the block chain.
To send bitcoins, you need two things: a bitcoin address and a private key. A bitcoin address isn’t like a bank account; you don’t need mountains of paperwork and ID to set one up. In fact, they are generated randomly, and are simply sequences of letters and numbers. The private key is another sequence of letters and numbers, but unlike your bitcoin address, this is kept secret. Think of your bitcoin address as a safe deposit box with a glass front. Everyone knows what is in it, but only the private key can unlock it to take things out or put things in.
When someone wants to send bitcoins to someone else, she uses her private key to sign a message with her bitcoin address (the source transaction(s) of the coins), amount, and the recipient’s address (the output for the transaction(s) of coins).
She then sends them from her bitcoin wallet out to the wider bitcoin network. From there, bitcoin miners verify the transaction, putting it into a transaction block and then send it alone. The transaction is recorded for all to see in the Block Chain (general ledger).
Source: Taken, in significant part, shamelessly from Bitcoin.org and CoinDesk.com
