The Beginner’s Guide to Bitcoin
As the dominant cryptocurrency, bitcoin has reached several milestones since its launch over a decade ago. Today, almost all investors of note include this cryptocurrency in their investment portfolios. Why is bitcoin such a hot asset? What does it represent for the monetary system? Should you invest in it?
What Is Bitcoin?
To understand why bitcoin is so revolutionary, consider how accounting has been done for thousands of years until the advent of computers.
Traders, customers, and merchants would write their transactions in a book or ledger to keep track of who owes what to whom. These accounting ledgers could be easily cooked in order to increase profit on the margins. Businesses sometimes had parallel accounting ledgers—one real, accurately accounting for all costs and expenditures; one cooked, falsifying the numbers—to present to either governments or other business parties.
Bitcoin makes such falsification of transaction data impossible. It is a digital ledger that must be verified across thousands of computers, called nodes. Each block of data cryptographically links to other blocks, forming a blockchain, the underlying technology powering cryptocurrencies. This is why the terms “blockchain” and “digital ledger technology” (DLT) are used interchangeably.
Bitcoin is thus a decentralized virtual code that represents accounting that cannot be touched, printed, or counterfeited. It is secure and transparent; it has no master, neither a government nor a corporation. Everyone with a computer and Internet access can become a part of its unassailable network for verifying transactions.
Bitcoin is a digital currency—a digital medium of exchange. It is a deflationary currency in that there will only ever be 21 million bitcoins released into circulation; the supply cannot be increased. This feature is in stark contrast with the ever-growing supply of currency produced by the Federal Reserve, which in 2020 printed almost a quarter of all dollars now circulating in less than a year.
The immutability of its supply is the reason that bitcoin is often referred to as digital gold. Precious metals like silver and gold have long been regarded as hedges against inflation because, among other reasons, they are rare. That bitcoin can assume a similar function is acknowledged by even the world’s largest traditional banks, such as JPMorgan. Morgan has projected that bitcoin is supplanting gold as a hedge against inflation. Unlike gold as currently used, though, bitcoin can serve as both payment method and store of value, further increasing its value.
How Does Bitcoin Work?
How bitcoin works is linked to what makes the currency so valuable—so valuable that it has reached a market capitalization of almost a trillion dollars, surpassing the combined market value of Visa and MasterCard, the largest payment processors in the world.
Cryptocurrencies are powered by blockchains, i.e., by digital ledger technology. These are the roadways on which cryptographically shielded blocks of data travel. On the Internet, when you send someone a text message or an email, you need to know the virtual address of the other party. The transmission of a text communication from your location to the location of the other party is usually accomplished by such third-party apps as messengers (Telegram, Signal, WhatsApp) or by email clients.
In the case of bitcoin, the method is similar, but extra layers of security are involved, and the required app is called a cryptocurrency wallet. When you use such wallets, you are assigned a private key and a public key.
- A private key is a unique alphanumeric sequence providing access to your cryptocurrency. You alone should possess this key, just as it would be wise to have only one key to open a vault to all of your savings.
- A public key is a unique alphanumeric sequence that enables you to send bitcoins to other people and vice versa. A public key is a hashed presentation of an address. Hashing is a common method of transforming characters into different ones while retaining the value of the original characters. This is usually done for the purposes of data compression and cryptography.
With these two keys in hand, people can send each other data across the blockchain, a network of computers each of which verifies and confirms transactions as another block is added to the chain. The entire process is decentralized and cryptographic.
The History of Bitcoin
Bitcoin was pseudonymously introduced by a 2008 white paper entitled Bitcoin: A Peer-to-Peer Electronic Cash System. Although the paper was released under the name Satoshi Nakamoto, it is still not clear who this person is, or whether it was prepared one person or by a group of people. More important than this speculation is the question of why bitcoin was developed.
The very first sentences of the white paper suggest that libertarian philosophy had something to do with the emergence of bitcoin as a counterweight to the centralized financial system:
Commerce on the Internet has come to rely almost exclusively on financial institutions serving as trusted third parties to process electronic payments. While the system works well enough for most transactions, it still suffers from the inherent weaknesses of the trust-based model.
Such motives make sense if one remembers that bitcoin was being developed around the same time as the financial crisis of 2007 to 2008. In fact, one could say that the global sensation of GameStop (GME) stock trading in order to short-squeeze Wall Street hedge funds is a resurrection of the movement in digital form, an Occupy Wall Street 2.0.
In July 2010, two years later after the seminal white paper was published, bitcoin began trading in the range of $0.0008 to $0.08 per bitcoin (BTC). Now, in 2021, a single bitcoin can buy a small apartment in many real estate markets.
At first derided as “shady Internet money,” bitcoin is now widely acknowledged to be a legitimate currency. It has been adopted by many major banks, payment processors, and institutional investor, including PayPal, Square, Microsoft, MicroStrategy, Tesla, Grayscale Bitcoin Trust (GBTC), ARK Investment Management, Kinetics Portfolios Trust, and Boston Private Wealth. The widespread embrace Bitcoin by so many major organizations has inspired more and more people to take it seriously, in consequence of which bitcoin has broken many price records in just the last year.
How to Buy and Sell Bitcoin
The quickest way to start buying and selling bitcoin is to create an account on a cryptocurrency exchange. Such an account would also be your web-based crypto wallet. This means, though, that you would be entrusting your private key to the custody of the exchange, making them excellent targets for cybercriminals.
If you have ever seen a headline with the words “bitcoin” and “hacked,” you know that the story almost always involves cryptocurrency exchanges. By providing their private keys, people make it possible to build a single giant web wallet containing the cryptocurrencies of thousands of customers.
Once you have created an account on an exchange, you can start buying and selling bitcoin within an hour. Creating the account requires completing the exchange’s know-your-customer and anti-money-laundering protocols. Exchanges must implement these protocols to comply with governmental requirements.
Usually, verification of your identity is completed by submitting photo ID documents and/or a selfie in which you are holding a piece of paper with a message that the exchange has asked you to write.
Most cryptocurrency exchanges have more or less the same fees for completing transactions. But your location is an important factor to consider when choosing an exchange.
- Binance. A great international exchange with several payment options and withdrawal methods, including Automated Clearing House (ACH) and Single Euro Payments Area (SEPA). Both ACH and SEPA incur the lowest possible withdrawal fees. Binance has great apps for Android and Apple smartphones.
- Gemini. A solid crypto exchange option for citizens of the United States (unlike Coinbase, which has a tendency to be too political and to become unstable when the traffic is high).
- CEX.io. This UK-based exchange is one of the top choices for Europeans thanks to its SEPA integration, intuitive interface, security, and low fees.
Whichever exchange you choose, you must add your bank account or a payment processor like PayPal to the account in order to add funds in the currency of your country. With those funds you can then buy bitcoin. Doing this is necessary to avoid paying wire transfer fees. To minimize transfer fees, use either ACH or SEPA as the method of transfer whenever possible.
Once you are set up with a payment and withdrawal method on the exchange, you are ready to buy and sell bitcoins. Thankfully, the interface design of web crypto wallets has come a long way, so everything is intuitive and user-friendly. If you have ever used PayPal, you will know how to buy and sell bitcoins using any of the crypto exchanges listed.
When you are trading bitcoins, try to use the strategy of dollar-cost averaging. This trading strategy helps reduce the psychological pressures that attend trading a volatile asset like cryptocurrency. Dollar-cost averaging involves trading on a schedule without short selling, market betting, and timing.
How to Store Bitcoin Safely
As you trade on exchanges, you will have to rely on the password for the exchange account (which is also your wallet) as a proxy for your private key. Therefore, it would be best to keep it in one of the password managers that use military-grade AES 256-bit encryption. Such password managers, which include Bitwarden, Dashlane, and Keepass, are also great for storing the seed or recovery phrase for your real bitcoin wallet.
Once you’ve accumulated enough bitcoin to keep for the long haul, it’s time to transfer it from the crypto exchange to your wallet, the private key of which you hold. This can be a desktop or mobile software wallet like BlockFi or Ethereum or a hardware wallet like Nano Ledger S.
A hardware wallet like the Nano Ledger S perfectly balances security and convenience. The point is to separate your general computer and Internet activity from access to your Bitcoin assets. In order for thieves to steal your crypto coins, they would not only have to steal your hardware wallet but also somehow guess your 12-word or 24-word recovery phrase (also called a seed phrase). Which would be impossible.
Either keep this phrase written on a piece of paper and hide it or store it in the vault of a password manager, further fortified by a biometric two-factor authentication USB security key like the Kensington VeriMark Fingerprint Key.
Having a hardware wallet like Nano Ledger S eliminates the danger of keystroke-logging malware used to collect your private data. By using a hardware wallet or a USB security key to maintain a separate method of input, you prevent such intrusions.
The Importance of Bitcoin Wallets
The problem with exchanges is that they obtain your private key when you create an account with them. Holding your private key is equivalent to holding your digital funds, whether those funds are in the form of bitcoins or any other cryptocurrency. Of course, it is in the best interest of exchanges to safeguard these keys in addition to providing insurance. Otherwise, they can get a bad reputation and be driven out of business.
Similarly, to safeguard your wallet’s private key means safeguarding the ownership of your bitcoin.
A seed or recovery phrase is derived from your private key. It usually consists of 12 words or 24 words that enable you to recover all of your funds if your hardware wallet breaks down or is lost. After all, your digital assets still exist virtually on the blockchain, in the form of the transaction blocks that were part of the blockchain when you bought your bitcoins or other digital coins.
Don’t lose your private key. If you lose your private key, you lose access to these assets . . . forever.
According to Chainalysis data, 20 percent of existing bitcoins, worth about $140 billion, have been lost. This means that the people who bought the bitcoins have lost their private keys, the keys that they need to access the coins. The assets still exist on the blockchain. They’re out there. But no one can get at them.
This $140-billion problem dramatizes the unassailability of blockchain technology. You can’t crack the security. But the massive losses also dramatize the importance of not losing your private key and recovery phrase, however you choose to store them.
Final Thoughts on Bitcoin
Bitcoin is only the first step in making decentralized finance a reality. Once you are in this financial ecosystem without masters, you realize that blockchain technology can be used for many more purposes than just cryptocurrency. Ethereum’s smart contracts enable creation of a wide range of decentralized applications (dApps) that may eventually replace the banking system’s current methods of borrowing and lending altogether.
Bitcoin is an on-ramp to a thrilling new world of finance. But as you explore it, don’t let your excitement carry you away. Always do your homework. Don’t get scammed.
Holding cryptocurrency requires more personal responsibility than holding other forms of money. Guard your crypto wallet as you would guard a physical key to your safe deposit box. If you lose it, you won’t be able to replace it.
Frequently Asked Questions
Do I have to pay taxes on Bitcoin gains?
Yes. Different nations classify bitcoin differently: as an asset, a commodity, or a currency. In almost all cases, though, bitcoin is subject to capital gains tax. Professional traders must pay income taxes. In the United States, bitcoins are treated as property on which you must pay capital gains taxes only after you exchange your bitcoins for U.S. dollars.
Can I buy less than a single bitcoin?
Yes. Like the units of all cryptocurrencies, the value of a bitcoin can be infinitely divided into smaller units while still retaining their full exchange value. Each fraction of a bitcoin has a traceable and verifiable transaction history. When bitcoins were first produced, a single bitcoin was equivalent to less than a dollar. Now a single bitcoin is equivalent to $50,000 or more, depending on exactly when you are reading this guide.
Is Bitcoin safe and legal?
Some nations prohibit the use of cryptocurrencies on religious grounds. For example, in February 2021, a bitcoin promoter on Facebook was arrested in Egypt. But no one can know whether you are buying bitcoins unless you show them your Bitcoin wallet. It is pretty much impossible to ban cryptocurrencies as long as the Internet itself is not banned.
Bitcoin is also safe. The underlying blockchain technology is open-source, and it has no leaders or masters who could somehow sabotage it. Just make sure you hold on to your private key and recovery phrase.