Bitcoin has exploded into the mainstream for investors – but a couple of years ago, the world’s leading digital currency was almost a closed shop.
In recent months, Bitcoin traders around the world have won or lost huge fortunes investing in the digital currency.
Now, Bitcoin and other cryptocurrencies are rising in popularity, it’s time to cut through some of the mystery surrounding how a digital currency works.
A Bitcoin is really a base and topping:
- The Bitcoin token is like a digital credit note confirming that traders own a code snippet that represents one or more Bitcoin
- The Bitcoin protocol is a ledger database that sits on the internet recording every Bitcoin transaction and attributing their ownership to a token. This is popularly called the ‘blockchain’
Together, the token and protocol make a Bitcoin.
What is a virtual currency?
The blockchain allows traders to sell or swap Bitcoin with other traders or retailers without the transaction passing through any bank or payment gateway.
“Bitcoin uses peer-to-peer technology to operate with no central authority or banks; managing transactions and the issuing of bitcoins is carried out collectively by the network,” says the Bitcoin web site.
“Bitcoin is open-source; its design is public, nobody owns or controls Bitcoin and everyone can take part. Through many of its unique properties, Bitcoin allows exciting uses that could not be covered by any previous payment system.”
The ‘virtual’ in virtual currency means Bitcoin are not minted or printed by any central bank but only exist within the blockchain and are not supported by any link to a physical asset.
Bitcoin is important as the first digital currency.
Now almost 2,000 difference digital currencies are circulating around the web, but Bitcoin is the largest and most popular with investors.
Bitcoin was introduced in 2008.
Understanding the blockchain
Who started the cryptocurrency bandwagon is a matter of conjecture. History books will say the inventor was a software developer named Satoshi Nakamoto. Unfortunately, no one knows who Nakamoto is or even if he really exists.
Nakamoto proposed an electronic payment system based on mathematical proof – the blockchain – that was a secure means of exchanging value without recourse to a central authority.
The idea has revolutionised the financial world as governments, financial institutions and corporations rush to adopt the principles of the blockchain into their business models.
The blockchain makes their transactions faster and more secure as each protocol link within the chain is embedded with details of the previous and following link. This makes fraud extremely unlikely as the crooks would have to unravel and rewrite the entire chain undetected to get away with any digital currency.
Why isn’t Bitcoin a currency?
Bitcoin is often called a digital or virtual currency, but in the strictest definition, governments designate Bitcoin an investment.
A currency is issued by a central bank, like the US Federal Reserve or Bank of England.
They fall into two categories – commodity currencies that are anchored to underlying assets, such as gold or ‘fiat’ currencies that are backed by the promise of the issuing government. Only five fiat currencies are in circulation – the US dollar, British pound, the euro, the Japanese yen and Chinese yuan.
Bitcoin and fiat currencies are all traded electronically, but there the similarities end.
The lack of official recognition as a currency makes trading Bitcoin an investment – and with that comes taxation. Any profits made from trading are generally taxed as capital gains, whereas exchanging currencies is tax-free if any gain is made.
How Bitcoin differs from cash
Apart from holding Bitcoin in an electronic wallet online, Bitcoin has several other differences from cash.
- Decentralisation is one of the most important factors cited by digital currency traders.
Not having any regulation means Bitcoin changes with the market and is not manipulated by a government or central bank. Bitcoin is ethereal and only exists on a computer network.
- A capped supply is attractive to traders who know the capital limit placed on Bitcoin by Nakamoto is around 21 million, and once that level is reached, that’s it, no more Bitcoin can be generated by the system.
For traders that means their holding cannot be diluted by the creation of more Bitcoin or devalued by a government or central bank manipulating exchange values for political or economic reasons.
The theory of supply and demand suggests as demand increases for a limited supply of Bitcoin, their value increases.
- Anonymity for traders comes with a stack of anecdotal evidence that blind transactions encourage criminals, terrorists and tax dodgers to pile into Bitcoin.
Traders are identified by codes on their wallets, not by name.
Yes, anonymous transactions and a lack of money laundering regulations means money can move across borders digitally, but exchanges are the weak spot in the system.
Traders must convert their Bitcoin profits to fiat money somewhere – and that’s at an exchange. Governments in most countries demand that exchanges are registered and that they must identify their customers and supply the details of their Bitcoin transactions to the tax authorities.
- Irreversible transactions do not let anyone reverse an exchange of Bitcoin after 60 minutes have ticked past.
Unlike the regulated payment system, Bitcoin has no bank or card processor to unwind a transaction.
This makes refunding Bitcoin difficult if someone disputes a transaction with another trader or has fallen victim to a fraudster, but the tamper-proof blockchain also provides security to users worried about losing their Bitcoin.
- Microtransactions are easy with Bitcoin, as each unit breaks down to one hundred millionth of a Bitcoin – otherwise known as a satoshi.
This almost infinite divisibility allows small traders to buy in at a fraction of a Bitcoin – a peak price of around $20,000 a Bitcoin in December 2017 would have shut many less well-off traders out of the market if they could not buy in for less.
Who runs the Bitcoin network?
As a decentralised payment system, no one owns Bitcoin, but a team of dedicated software developers maintain the blockchain and are continually updating the code.
The team includes coders, researchers, testers and other contributors who document any changes and translate the software into different languages.
Bitcoin is open source software, which means anyone who cares can copy and adapt the code without the fear of breaching a licence or copyright.
How much does Bitcoin investing cost?
The cost of entry to the Bitcoin market depends on how the digital currency is accessed.
Bitcoin miners can generate their own coins by solving complex mathematical problems at the cost of their time, while buying Bitcoin through an exchange is likely to see set-up and administration costs applied by the trader.
Receiving Bitcoin is free, but spending can become costly if someone wants fast confirmation of a transaction.