You’ve probably heard the stories about bitcoin…
The Norwegian student who bought 5,000 bitcoins for $26 in 2009. Four years later, he was a millionaire.
Or the early adopter who bought two pizzas for 10,000 bitcoins (worth $70 million at today’s prices).
But what is bitcoin, exactly? How does it work? How do you buy bitcoin? Where should you store it? And is it safe? This guide will take you through it step-by-step (without any confusing jargon).
PART 1: What Is Bitcoin, the Digital Currency?
PART 2: What Is Blockchain, the System That Makes It All Work?
PART 3: How to Buy, Store, and Spend Bitcoin
PART 4: Should I Be Worried about Hacks and Scams?
PART 5: What’s Next for Bitcoin?
PART 1: What Is Bitcoin, the Digital Currency?
Before we dive in, you need to know that bitcoin is actually two things:
1. bitcoin (with a small b)
This is the cryptocurrency; digital tokens sent back and forth to one another (or used to buy pizza). When people talk about bitcoin, this is what they’re usually talking about.
2. Bitcoin (with a capital B)
This is the revolutionary network on which the currency runs. It’s also known as the Bitcoin blockchain.
Let’s start with the cryptocurrency.
Infographic courtesy of Kriptomat
“I do think Bitcoin is the first [encrypted money] that has the potential to do something like change the world.” Peter Thiel, Co-Founder of Paypal
The basic concept of bitcoin is to make payments as easy as sending an email, without a central middleman getting in the way. Here’s how it works:
Bitcoin exists outside the traditional banking system. Anyone with a digital wallet can buy bitcoin and send it to anyone else in the world (so long as they, too, have a wallet). There is no middleman.
No government control
Most currencies around the world are controlled by their respective governments. For example, the US Federal Reserve controls the dollar’s interest rate and supply. Not bitcoin. No single person, bank or government owns the bitcoin system.
This is what we mean when we say bitcoin is ‘decentralized.’ Bitcoin and all its transactions are powered by its users. We’ll explain more in the ‘blockchain’ section below.
Securely locked with cryptography
Every bitcoin transaction is encrypted with public and private key encryption. Here’s a quick video to explain how that works:
You might have heard that bitcoin is anonymous, but that’s not strictly true. Every bitcoin transaction is tagged with your public key address. It’s a long number that looks something like:
Although this transaction doesn’t contain your name, if someone knows your wallet address, they can see the payments you’ve made or received. In other words, it’s pseudonymous.
Bitcoin transactions absolutely cannot be reversed. If you make a payment by accident or send it to the wrong address, it can’t be retrieved. It’s a blessing and a curse. It means payments cannot be altered making it secure against fraud, but if you get it wrong, your money is lost forever.
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Who Created Bitcoin?
Bitcoin was created by the elusive Satoshi Nakamoto. His name, however, is a pseudonym. The real creator remains a complete mystery.
In October 2008, Nakamoto published the famous bitcoin white paper on a cryptography mailing list. It outlined the vision and technology for the Bitcoin system:
“A purely peer-to-peer version of electronic cash would allow online payments to be sent directly from one party to another without going through a financial institution.”
In January 2009, he created the first 50 bitcoins in a process called “bitcoin mining.”
Who Is Satoshi Nakamoto?
The identity of Satoshi Nakamoto is one of the tech world’s biggest secrets. Countless journalists have tried to reveal his identity by analyzing his writing style, his coding, and various other scattered clues.
He writes in British English, for example, and codes in C++.
Newsweek famously published a front-page splash outing the bitcoin founder as Dorian Satoshi Nakamoto – an elderly Japanese American. Despite his computer-engineering background, it was later revealed that Dorian Nakamoto had never even heard of the cryptocurrency. (He apparently referred to it as ‘Bitcom’ in a later interview!)
More likely theories point to the likes of Nick Szabo and Hal Finney, who were involved in Bitcoin’s development and have been active in the cryptography community for decades. Some have even pointed the finger at Elon Musk. All have denied it.
Further reading: 24 Clues About Satoshi Nakamoto’s Identity
One thing is for sure, Satoshi Nakamoto is a genius with meticulous attention to privacy and anonymity.
He’s also a billionaire.
By tracking Satoshi’s transactions, we can see that he never sold his original bitcoins (other than a few test transactions). He owns about one million coins. At the time of December’s record prices, he was the 44th richest person in the world, worth over $19 billion.
There Will Only Ever Be 21 Million Bitcoins
One of the most interesting features of bitcoin is that its supply is capped. There will only ever be 21 million coins. Unlike dollars, which are created at will by the Federal Reserve, the creation of bitcoins will steadily diminish until 2140, when it will stop entirely.
There are currently 16.7 million bitcoins out there, which leaves just 4.3 million bitcoins left to be created.
In other words, the supply is incredibly limited.
Even the existing bitcoins are in short supply. As we’ve mentioned, Satoshi probably owns about one million. The Winklevoss Twins own roughly 1% of the bitcoins in circulation. And the FBI holds at least 144,000 bitcoins after seizing them from illegal activity.
It’s also guessed that up to 30% of bitcoins are lost forever (on broken hard drives and forgotten keys).
The 21 million bitcoin cap is partly why the price has skyrocketed. When there is a finite amount of something, the price tends to rise because everyone wants a piece (like gold or diamonds).
The finite supply is also why bitcoin is often likened to gold rather than traditional currency. There is only so much gold on the planet, just like there are only so many bitcoins.
Luckily, each bitcoin can be split into smaller units denominations, right down to one hundred millionth of a bitcoin.
Bitcoin Price: Why Is It so Volatile?
When it was launched in 2009, the first exchange valued one bitcoin at eight-hundredths of a cent.
Flash forward to January 2018, and that price soared to $20,000.
Along the way, bitcoin has experienced some heart-stopping swings in value. Since January 2018, bitcoin has dropped 60%. Bitcoin is much more volatile than traditional investments like bonds or stocks. It’s why many investors are nervous about getting involved.
Why? The simple fact is that bitcoin is brand new. It’s still less than a decade old. Compare that to traditional markets like gold, oil or the stock market. It takes time for a new market to settle and find a stable price.
Bitcoin also goes through ‘hype cycles.’ Every so often, bitcoin attracts mainstream attention (usually when there’s a new technology breakthrough). Excited investors flood in, which pushes the price up. When the excitement dies down, we see big drops in price.
Investing in bitcoin means bracing yourself for big, volatile movements.
Don’t Confuse Bitcoin with ‘Bitcoin Cash’ or ‘Bitcoin Gold’
These alternative currencies were created when they split off from bitcoin (known as “forking”). This happened because there was a dispute in the bitcoin community about how to go forward.
Read more: What Is a Hard Fork in Cryptocurrency?
When users disagree about the technology or the ethos of a particular coin, they may split off and create a new cryptocurrency using different tech and ideals.
To understand why, we need to know how bitcoin works.
PART 2: What Is Blockchain, the System That Makes Bitcoin Work?
Satoshi’s most impressive feat is not actually bitcoin-the-currency. It’s the system on which it runs: blockchain.
Also known as the Bitcoin protocol, this is what makes bitcoin transactions possible.
What Is Blockchain?
In the simplest possible terms, blockchain is exactly what it sounds like: a chain of blocks.
When you make a transaction with bitcoin, it is bundled into a “block.” That block is processed, verified, and approved before being added to the long chain of blocks that came before it.
That’s the short version. In practice, it’s more complex than that.
Imagine an Excel spreadsheet that everyone in the world can access.
Every bitcoin transaction ever made is written down in this Excel spreadsheet.
Scroll right to the beginning, and you’ll see Satoshi’s very first entry (the ‘genesis block’), preserved forever. You can also see the most recent transactions, logged in real-time, and everything in between.
In simple terms, blockchain is a completely public, transparent way of logging payments and transactions.
This is why you often see blockchain referred to as a ‘digital ledger.’
Of course, it’s not really a spreadsheet; it’s a chain. Every time a bitcoin transaction is made, it’s logged in a 1MB ‘block’ of data. The block is then added to the one that came before it.
(FYI, you can look for transactions on the bitcoin blockchain using our block explorer).
Blockchain Is Not Stored in One Place
No single person or entity owns the blockchain. It exists on a network of millions of computers all at once.
Using the spreadsheet analogy again, it’s almost like a Google doc. With Google docs, anyone can log in and make edits to the same spreadsheet. The changes are public and everyone with access can see (and approve) those changes in real-time.
This is a huge change in the way we do things. In the past, for example, you’d write a spreadsheet in private, then send it to someone via email. The other person would save it to their computer, make their changes in private before sending it back.
Using this old method, there are two different spreadsheets on different servers. One person can claim theirs is the superior document or make fraudulent changes.
Or a hacker can steal one of the documents.
Now think about it in terms of banks. Banks keep their own private spreadsheets and log their own transactions, all stored in one central location. It’s less transparent, not to mention easier to hack.
With blockchain, everything is transparent. Bitcoin transactions are 100% visible, traceable and accountable.
(Note: the Google docs analogy isn’t 100% accurate since the Google document is still stored on Google’s servers. The bitcoin blockchain is not hosted by any one central server. Thousands of copies are stored on servers all around the world, all at once).
What Is Bitcoin Mining?
Bitcoin mining is how we create bitcoins.
It’s also how we keep the blockchain running.
In very simple terms, miners are rewarded in bitcoins for creating the blocks and validating the transactions.
It a self-regulating system. Miners maintain the blockchain. In return, they get bitcoins.
Anyone can mine bitcoins. However, due to the competition, it now requires an immense amount of computing power. To illustrate the point, giant bitcoin mining facilities are located in Iceland just to keep the temperatures of their hardware down.
In the past, Satoshi mined the very first block with his reportedly modest home computer. He was rewarded with 50 bitcoins for doing so.
How Exactly Does Bitcoin Mining Work?
Bitcoin miners are responsible for producing the 1MB ‘blocks’ that become part of the blockchain.
To create this block, they must solve a mathematical puzzle. This is not literal. The miner is not solving puzzles on a piece of paper. Instead, their computer is trying to ‘guess’ a pre-set 64-digit number, or “hash.”
The first miner to get ‘less than or equal to’ the hash, mines the block and is rewarded with bitcoin.
The current reward is 12.5 BTC per block.
The Bitcoin Halving
Remember we explained that bitcoin supply is capped at 21 million? That’s because the reward for mining is halved every four years.
The mining reward has been halved twice so far. The reward began at 50 BTC per block. It is now 12.5 BTC.
At this rate, we’ll hit the 21 million supply cap in 2140, after 64 halvings.
PART 3: How to Buy, Store, and Spend Bitcoin
How to Buy Bitcoin
Bitcoin is typically bought and sold on an ‘exchange.’
There are hundreds of bitcoin exchanges out there so it’s important to choose wisely. Many exchanges have been hacked over the years, and investors have lost their money, so do your due diligence to find a reputable exchange in your country.
To set up an account at these exchanges, you’re often required to upload a picture of your photo ID and proof of address. This is to ensure they comply with anti-money laundering (AML) laws and know-your-client (KYC) laws.
Can you buy bitcoin anonymously? Yes, some exchanges don’t require ID or proof-of-address. BitMEX is one example where you only need an email address. You can also buy in cash (see below).
Once registered with an exchange, you can link a bank account, or – occasionally for smaller amounts – a credit card or PayPal account.
Now, you can buy bitcoin with USD or your local currency.
Whichever exchange you choose, your bitcoins are stored in a wallet on their platform. We highly recommend you now transfer your bitcoin to a private wallet where you control the encryption keys (this is not as complicated as it sounds, and we’ll look at this in the next section).
How to Buy Bitcoin with Cash
If you’d rather not link your bank account to a bitcoin exchange, you can pay cash. Localbitcoins connects you with local cryptocurrency sellers who accept cash for bitcoin.
To make this transaction, however, you will definitely need a private wallet and address. We’ll look at how to set this up in our next section:
How to Store Bitcoin
You store your bitcoin and all cryptocurrencies in a ‘wallet.’
However, choosing the right wallet is perhaps the most important part of this entire guide.
You’ve probably heard that bitcoin is vulnerable to hacks and thieves. There are countless scare stories of people losing thousands.
But it’s important to know that these hacks are not related to the bitcoin system itself (or blockchain). Instead, the hacks usually target exchanges and poorly-maintained wallets.
Storing bitcoin can be safe and secure, but only if you do it correctly.
Recommended reading: 8 Cryptocurrency Best Practices (Keep Your Crypto Safe!)
Explaining Bitcoin Wallets and Encryption Keys
As we explained earlier, there are two aspects to storing and transferring bitcoin:
Public key – your wallet address that everyone can see (people need your public key to send you bitcoins)
Private key – a second key that only you have access to. This allows you to unlock the wallet.
When you keep your bitcoins on an exchange (like Coinbase), they hold the private key for you. This is called an ‘online wallet.’ While they are convenient and user-friendly, they are less secure.
Why? Because if the private key is on their servers, it can be stolen by hackers, who are more likely to target a large exchange.
So it’s important to make sure you hold the private key. That means moving your bitcoin off the exchange and into a private wallet.
Hardware Wallets (Cold Storage)
Hardware wallets are your most secure option. Think of them like an external hard drive or USB stick for bitcoin. For the vast majority of time they are offline, so cannot be hacked (except for the short periods when you connect to transfer bitcoin). This is known as “cold storage.”
Read More: What is Cold Storage for Bitcoin?
Of course, there is the risk of losing the hardware wallet, which is why some people keep them locked in secure bank vaults.
With a desktop wallet, your private key is stored as a file on your computer.
The main advantage here is that you control the private key. They are usually free and easy-to-use, too.
However, your bitcoins are lost forever if your computer is lost, stolen or destroyed (unless you backed them up elsewhere). A hacker can also access your computer and take them.
In the past, using a desktop wallet meant downloading the entire bitcoin blockchain. Nowadays, light wallets are available which makes it a little easier. Some of the most popular wallets include Exodus and Electrum.
A paper wallet is simply a piece of paper with your private and public key written on them.
They are incredibly secure since they are never connected to the internet. You cannot hack a piece of paper.
However, you can lose a piece of paper very easily. So make sure you keep it somewhere safe.
Just don’t be this guy who showed his paper wallet to everyone watching Bloomberg TV. Within seconds, his account was empty (although the culprit offered to give it back after proving their point).
‘Cold’ Software Storage
Some electronic and software wallets now facilitate offline or ‘cold’ storage options. This is a best-of-both-worlds option. Like electric wallets, they are easy to use, but they are also stored offline for additional security. Electrum, mentioned previously, offers this functionality.
lastly, you can choose a mobile wallet. These are handy if you plan to store small amounts of bitcoin and spend them from time-to-time. Some are designed with spending in mind, such as Samourai for Android and Edge for iPhone.
None of the wallets mentioned here should be considered recommendations and many other options are out there. Do you own research and due diligence before using any of the services listed here.
Where Can I Spend Bitcoin?
The number of shops and businesses accepting bitcoin is increasing rapidly. Here are just some of the things you can buy with bitcoin:
- Games, movies, and apps through Microsoft.
- Flights with Expedia and Surf Air.
- Spaceflight with Virgin Galactic.
- Just about anything from Overstock.
- Goods from any Shopify store that accepts bitcoin.
Even if you can’t pay directly with bitcoin, there is often a workaround.
A new platform called Bakkt, powered by the New York Stock Exchange and Microsoft, aims to provide a system to convert bitcoin to dollars. So you could theoretically buy a coffee at Starbucks.
You can even pay for tuition at Lucerne University in Switzerland.
And, in the bitcoin tradition, you can buy pizza through pizzaforcoins.com.
PART 4: Should I Be Worried about Scams and Hacks?
Bitcoin has a reputation for its connection to hacking and scams.
There is, of course, some truth to this.
In 2014, hackers successfully targetted the world’s largest bitcoin exchange, Mt. Gox . The hackers stole 850,000 bitcoins from the exchange (worth about $473 million at the time).
Even in 2018, hackers stole $35 million worth of bitcoin from the South Korean exchange Coinrail.
Again, however, this reaffirms the importance of storing bitcoins safely in a hard wallet and not on an exchange.
Bitcoin has also been connected to numerous scams and Ponzi schemes.
Fake exchanges, fakes bitcoins, and fake crowdfunding campaigns (known as ICOs – initial coin offerings) are still out there.
Until bitcoin exchanges are regulated by government authorities, more will pop up. Here are some of the worst offenders to look out for:
1. Scam wallets – these are the most common scams. They’ll look like a legitimate online wallet, but you’ll know they’re nefarious because they ask how much you’re depositing. They’ll set up an address for you, but it will link to their wallets, not yours
2. Dodgy miners – these scammers claim to mine bitcoin for you. You pay them money and never see it again.
3. Exchange scams – these exchanges look like legitimate bitcoin exchange websites. The giveaway is that they accept credit card payments for large amounts of crypto, or offer better-than-usual exchange rates.
The best way to avoid these dodgy schemes is to do your due diligence. Research every exchange before you sign up. Make sure they are trusted and make sure you are on the correct website.
Ignore anything that seems too good to be true. It probably is.
PART 5: The Future of Bitcoin
Although bitcoin is less than a decade old, we are just at the beginning.
Bitcoin, and its revolutionary blockchain technology, has opened the floodgates.
There are now almost 2,000 cryptocurrencies out there. Some aim to compete directly with bitcoin. Others are expanding on the idea and branching out into new territories (see ethereum).
Bitcoin itself is constantly evolving.
Right now, its biggest hurdle is scalability. Without getting too technical, Bitcoin is slow compared to many of its peers.
Bitcoin can currently handle seven transactions per second. Compare that to Visa which handles 24,000.
It also takes ten minutes to confirm a bitcoin transaction. At peak times, like during the ‘gold rush’ in December 2017, it takes days to process bitcoin payments.
If bitcoin aims to become a day-to-day cash system, it needs to be faster.
However, there’s a huge disagreement in the community about how to do this. In fact, this is why bitcoin cash ‘forked’ (but that’s a whole other story. Read about bitcoin cash here.)
Bitcoin developers are now working on the Lightning Network, which will help settle small amounts fast on the bitcoin blockchain.
Is Bitcoin the Future of Money?
It’s perhaps too early to call bitcoin the future. It has some big hurdles to overcome including speed, reputation, and mainstream adoption.
One thing’s for sure, however. Bitcoin triggered a revolution. Cryptocurrencies and blockchain are here to stay. Countries like Venezuela and Iran are even copying the idea by creating their own national cryptocurrencies.
As for blockchain, a huge 84% of companies are now experimenting with the technology.
The future of money might not be bitcoin, but it will be cryptocurrency. Get ready for it.
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