Everything you need to know about Bitcoin
In this article, we explore the basics of the granddaddy of cryptocurrency and how it works.
Bitcoin was introduced as the first ever cryptocurrency in the market in 2009. It is a decentralised currency that you can buy and sell without an intermediary such as a bank. As opposed to fiat money (which is backed and regulated by the government), Bitcoin is powered by peer-to-peer technology and software driven cryptography. It is a currency backed by code instead of items with a physical value like the US dollar. This allows online payments to be sent directly from one party to another without going through a financial institution.
At its core, Bitcoin is free and open-source software (FOSS), code that lives on the internet. Individuals can run the code or copy it and create their own version. The Bitcoin network is a financial system that allows the transfer and custody of Bitcoin.
Who Invented Bitcoin?
The founder of Bitcoin goes by the pseudonym Satoshi Nakamoto. He wrote a white paper titled Bitcoin: A Peer-to-Peer Electronic Cash System. The white paper explains the theory and design of a system for a digital currency free from control of any government bodies, financial institutions, or organisations.
In his white paper introducing the open-source technology, Satoshi Nakamoto wrote:
What is needed is an electronic payment system based on cryptographic proof instead of trust, allowing any two willing parties to transact directly with each other without the need for a trusted third party. Transactions that are computationally impractical to reverse would protect sellers from fraud, and routine escrow mechanisms could easily be implemented to protect buyers.
In 2009, the Bitcoin network was launched. Nakamoto worked on the Bitcoin project with developers until 2010. In 2010, Satoshi Nakamoto withdrew from the project and left it on its own. The software is open source, which means anyone can view and use the code at no cost. To this day, no one knows the identity of its founder.
In short, Bitcoin aims to create communication channels to allow transactions to be performed without a third party.
How is Bitcoin Created?
There is a limited supply of 21 million Bitcoins that will ever be produced. These are introduced to the supply of Bitcoins at a fixed rate of 1 block every 10 minutes. The total number of coins will be circulation by year 2140. Every 4 years on average, the software makes it twice as hard to mine bitcoin by reducing the number of rewards.
Bitcoin mining is the process where more coins are brought into existence. All transactions are publicly broadcast on the network. Miners (people who mine Bitcoin) combine multiple transactions together into blocks by completing a cryptographic calculation. Think about it like solving a math puzzle. You can only progress to level 2 after clearing level 1. The first one to correctly solve the next block broadcasts it to the next network. A block will be added to the network and a new amount of Bitcoin is created. The miner is then rewarded with an amount of this newly created Bitcoin.
How Does Bitcoin Work?
Bitcoin (BTC) is run by an open-source code called blockchain. This creates a shared public ledger, and there is a record being created for each transaction. Each transaction is a “block” that is “chained” to a code, hence the term blockchain. Today, blockchain technology is used for cryptocurrencies that have followed Bitcoin.
A bitcoin wallet comes with both a public key and a private key. Both work in tandem to allow the owner to digitally sign transactions, providing proof of authorisation.
The diagram shows how digital coins are being transferred from one owner to the next. The transfer is done by digitally signing a hash of the previous transaction and the public key of the next owner.
How to Store Your Bitcoin
There are 2 types of digital wallets used to store Bitcoins:
Hot wallet: Stored in the cloud. These include mobile wallets, desktop wallets, and web wallets. Exchange wallets are typically also hot wallets. Hot wallets are connected to the internet, making it easy for us to buy and sell. Basically, anything that can be accessed through a computer browser, desktop, or smartphone app is a hot wallet. The only issue with a hot wallet is security. Leaving your Bitcoin in a hot wallet makes it vulnerable to being hacked and stolen.
Cold wallet (aka cold storage): An encrypted portable device that looks like a thumb drive or USB stick. This is the most secure way to store your bitcoin, or any cryptocurrency for that matter. If you have a large amount of Bitcoin (or any other cryptocurrencies), it is wise to keep them in a cold wallet for peace of mind.
For long term investors in Bitcoin, it might be prudent to keep it in cold storage. For traders who are buying and selling Bitcoin, keep it in a hot wallet such as an exchange. Alternatively, we could hold some in hot wallet and some in cold wallet.
Should You Buy Bitcoin?
All financial assets come with pros and cons of ownership. Bitcoin is no exception.
Pros of Bitcoin
Private, Secure Transactions: Of all the cryptocurrencies out there, Bitcoin is known for being the most secure. Transactions do not contain any personal or private information like names or credit card numbers. This reduces the risk of consumer information being stolen.
Growth Potential: Over the last decade, Bitcoin returned more than 10,000 times. A $1,000 investment would have turned into more than $10 million in 10 years. Moving forward, the growth might slow down as it becomes more mature and established.
No Central Authority: As a decentralised currency, there is no intervention from banks and government intermediaries. This means no third party can ban or impose regulations on Bitcoin.
Having said that, buying Bitcoin requires us to link our bank account to the exchange. This could be a potential security concern that we need to be aware of.
Cons of Bitcoin
Volatility: As with all cryptocurrencies, the price of Bitcoin is highly volatile. We must be able to handle the volatility that comes with buying Bitcoin.
Privacy Concerns: As Bitcoin uses blockchain technology, many believe that it is more secure than electronic money transfers. While this might be true, Bitcoin can still be susceptible to hacking. In May 2019, hackers stole over $40 million worth of Bitcoin from Binance, the world’s largest cryptocurrency exchange. Binance subsequently refunded its customers, incurring huge losses in the process.
Not SIPC Insured: The Securities Investor Protection Corporation insures investors of SIPC member brokerage-firms against loss of cash or securities under certain circumstances. This does not apply to cryptocurrencies, including Bitcoin.
No Central Authority: Because Bitcoin is not regulated, there is no recourse if you make an error with a transaction on your wallet. Every transaction comes with a unique code. If you accidentally input the incorrect code or lose your password, you risk sending your Bitcoins to the wrong destination, and they will be lost forever. This is a double-edged sword.
Bitcoin as a Store of Wealth
We commonly refer to Bitcoin as being a good store of wealth, just like gold. We can start by looking at some of the attributes that make an asset a good store of wealth.
A good store of wealth must:
Retain Its Purchasing Power Over Time
Bitcoin has been, by far, the best performing asset over the last 10 years.
Be Easily Exchangeable And Accessible
Bitcoin is a digital asset, making it more portable than physical cash.
Some people view it as buying a call option on digital gold. Like gold, Bitcoin cannot be devalued from money printing by central banks. It is Bitcoin’s limited supply that makes it attractive, especially during times when central banks are printing money aggressively (also known as quantitative easing).
How Much Should I Invest in Bitcoin?
Bitcoin falls under the cryptocurrency asset class. When investing in any asset class, portfolio allocation is crucial. This is especially true for an asset class for cryptocurrency. Due to the volatility of cryptocurrency and the uncertainty that comes with it, an allocation of 1 to 5% is prudent. Of course, if you are someone who understands Bitcoin and cryptocurrency on a much deeper level, and are comfortable with greater exposure, then go ahead and allocate more.
It might be worthwhile for us to ask ourselves the following questions before investing in Bitcoin:
What is the maximum amount that I could invest in Bitcoin without losing sleep?
How well do I understand the fundamentals of Bitcoin?
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