Money Smarts

The Ultimate Guide to Understanding Bitcoins

Bitcoin is a new currency that was created in 2009 as a cryptocurrency using blockchain technology. Transactions are made with no middle men – meaning, no banks!

In an era where financial instability seems to be a way of life, the search for a stable medium of exchange is underway. Enter Bitcoin. It’s an attempt by the free market – or more specifically, the Internet – to come up with a new and different currency.

Bitcoin has been described as “the first decentralized peer-to-peer payment network that is powered by users with no central authority or middlemen”. Simply put, it is a currency equivalent that is developing and being implemented beyond the control and authority of the world’s central banks.

What is Bitcoin?

Bitcoin was started in 2009 by developer Satoshi Nakamoto as an open source software. Payments passing through the system are recorded in a public ledger using its own unit of account, or “bit coin“. It is often referred to as a digital currency.

Satoshi Nakamoto ended his participation in the project by the end of 2010, but the system has grown considerably following his departure. This is due primarily to the fact that the Bitcoin protocols are published openly, and any developer can review and modify Bitcoin code.

How does Bitcoin work?

Bitcoin requires a mobile app or computer program that provides a personal Bitcoin “wallet”. That wallet enables you to both send and receive Bitcoins.

There are people involved in the Bitcoin network who are referred to as miners. These are people are compensated – with new Bitcoins – in exchange for verifying the validity of transactions. Their compensation is at least partially how new Bitcoins come into existence.

What is a blockchain?

The network uses a public ledger referred to as a blockchain, that records every transaction ever processed, which also allows a user’s program to validate transactions. This allows all users to have full control over sending payments from their own Bitcoin address.

CBInsights defines blockchains as “Blockchain technology offers a way for untrusted parties to reach an agreement (consensus) on a common digital history. A common digital history is important because digital assets and transactions are in theory easily faked and/or duplicated. Blockchain technology solves this problem without using a trusted intermediary.”

Bitcoins have several advantages over traditional financial accounts:
  • They are transferred person-to-person
  • There are no banks or clearing houses involved, and transactions complete in about 10 minutes, even on international payments
  • There are no spending limits
  • They can be used in every country, albeit with varying success
  • Your account cannot be frozen

Acceptance by merchants has been growing during the currency’s short history, due largely to the fact that transaction fees are far lower than the 2% to 3% fees normally charged by credit card issuers.

Bitcoin ATMs spring up first in Canada in 2013 and in the US in February 2014. In 2017, a few big name brands like Microsoft, Intuit, and Overstock.com accept bitcoins.

Who owns/controls Bitcoin?

In short: no one! Bitcoin is a network, similar to the Internet. In theory, it’s controlled by all of the network participants, though developers are constantly working to improve the software.

Who is using Bitcoin and how common is it?

About 1,000 physical businesses and 35,000 websites are reported to accept Bitcoins as payment. The total value of Bitcoins worldwide was estimated at $220 billion as of November 2017. However, given the size of the global economy, and the volume of daily transactions, these numbers represent a very tiny sliver of all of the potential merchants where you might transact business.

In addition to mining, you can acquire Bitcoins by accepting them as payment for goods and services, by buying them from private sources, or on Bitcoin exchanges.

How can I purchase Bitcoin in an exchange?

“Different exchanges have different payment methods that can be used for depositing funds including bank wires, direct bank transfers, credit or debit cards, bank drafts, money orders, and even gift cards.” as described by Investopedia. “Making deposits and withdrawals come at a price, depending on the payment method chosen to transfer funds. The higher the risk of a chargeback from a payment medium, the higher the fee.”

Some exchanges do not allow you to purchase Bitcoins with either credit cards or with PayPal. This is because such payment methods allow a buyer to chargeback the purchase, typically after the Bitcoins have already been transferred.

How are Bitcoin payments made?

Payments can be sent or received from your wallet application (unlike credit cards, you don’t need a merchant account to receive payments), from either your computer or mobile device. You simply need to enter a recipients address and hit “send”, and the transaction completes in about 10 minutes.

This kind of ease of use may fuel much wider use of Bitcoins going forward.

The downsides of Bitcoin

For all of its virtues, Bitcoin has some disadvantages that can hardly be ignored:

  • It’s far from universally accepted. Worldwide, relatively few merchants accept Bitcoins for payment. That may improve in the future, but at the moment the market for the payment method is extremely limited.
  • Bitcoin’s value fluctuates. The price in US dollars for Bitcoins has fluctuated from $2 to over $1,000 (and currently over $11,000), and it can take wide swings in between. That works to your advantage if you get them on the cheap, but it can be a huge disadvantage if the price plummets after you’ve come into a large position.
  • It is not legal tender in any country. Though Bitcoins are accepted (to varying degrees) in all countries, they are not legal tender anywhere. For example, in 2013 China banned Bitcoins from Chinese banks and more recently deemed coin offerings illegal. In all countries, Bitcoins can’t be used to pay taxes, settle most legal disputes, or even to pay most large obligations. It’s a currency that trades only between the very small army of willing participants.
  • Bitcoin as a store of value is debated. At present, Bitcoin was once thought of as a medium of exchange but it’s being argued as a competitive store of value.
  • Payments are irreversible. Once you make a payment you have no recourse. Since there is no central authority controlling and regulating Bitcoin, your only course of action will be to seek restitution from the other party. Translation: you can only transact with people and businesses that you have a high level of trust with.
  • Bitcoins are subject to technical glitches and hacks. Bitcoin is very much a cyber system, which means it’s subject to any technical limitations that any other web-based system is. For example, in June 2016, a technical glitch with an exchanged caused it to shut down impacting Bitcoin value. The network was temporarily suspended. Even though it was quickly restored, the glitch caused the value of Bitcoin to plummet in a matter of hours.
  • They can become worthless. Bitcoin only started in 2009, so there’s no deep history on it. In addition, the whole concept is the first of its kind, so there’s no assurance that it will continue or for how long. The significant negative legislation, particularly by large nations, like the US, China, and the EU, could curb its effectiveness and eventually seal its doom.

Have you ever used Bitcoin? What do you think of the network and its prospects for the future?

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Jason Vitug

Jason Vitug is founder at phroogal, creator of the award-winning project the Road to Financial Wellness, and author of the bestseller and NY Times reviewed book, You Only Live Once: The Roadmap to Financial Wellness and a Purposeful Life.

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