Beginner's Guide to Bitcoin
Some people think it’s the greatest invention since the printing press. Others think it’s the biggest scam of all time. So what is bitcoin, really?
The answer to that question is not so simple, which helps explain why different people have such radically different views on bitcoin. Many experienced bitcoiners describe learning about bitcoin as “going down the rabbit hole.” And even experienced programmers and cryptographers who have studied and worked with bitcoin for years still express amazement at the technology. So are you ready to go down the rabbit hole?
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Why Was Bitcoin Invented?
In business, people often say that the value of a solution is proportional to how big of a problem it solves. Bitcoin was specifically designed to deal with the problem of inflation.
Inflation has been a persistent problem affecting many countries around the world, although some are hit harder than others. In 1920’s America, a few thousand dollars could buy you a new house, while a new Ford Model T cost just $260.
Other countries have it much worse, however. There have been numerous instances of hyperinflation over the last century. One of the worst took place in Germany in the 1930’s and is considered one of the causes of World War 2, the most horrific war in human history. So it’s probably safe to say that inflation is a big problem.
Inflation occurs when the bank responsible for issuing a nation’s money takes actions to expand the supply of money. In a market economy, value is determined by supply and demand, so increasing the supply decreases the demand for money, which lowers the price.
Bitcoin’s mysterious creator, Satoshi Nakamoto, cited inflation as his main justification for developing bitcoin. When he made the first bitcoin transaction on January 3rd, 2009, he included a headline from the English newspaper The Times:
“The Times 03/Jan/2009 Chancellor on brink of second bailout for banks.”
This shows how concerned Nakamoto was with banks creating money out of thin air. This is why he designed bitcoin to be a deflationary, rather than inflationary currency— to act as a counterbalance to the conventional financial system.
There’s a lot to know about bitcoin, but one of the most basic and important things to understand is that there will never be more than 21,000,000 bitcoins. Many believe that this means that as the central banks of the world continue printing money, the value of dollars, euros, and other conventional currencies will continue to go down, while bitcoin’s value will continue to go up, and up, and up.
What Makes Bitcoin So Special?
Bitcoin is a savings account, a payment network, and a currency all at the same time. It allows us to
- Send and receive money to/from anyone with an internet connection.
- Store money securely.
- Mint new currency.
So bitcoin competes with money transfer services like Western Union, banks that offer savings and checking accounts, and national central banks with print paper money and regulate the financial system— all at the same time!
The most amazing thing about this is that bitcoin does all of this in a decentralized and distributed fashion. This means there is no single entity that is in control of the bitcoin network, and it also means that no one can shut it down.
Attempts were made in the past to create non-governmental currencies— the most famous were e-Gold and the Liberty Dollar. But these alternate currencies were shut down when they got into legal troubles with the US government.
With a centralized network, if the center of the network goes down, the whole network goes down. But with a decentralized network, the network continues functioning, even if many of the network participants go offline.
Many bitcoin proponents see the banking system as a form of financial slavery, where the value of our money is stolen by means of inflation. For them, bitcoin is a means of freedom from tyrannical governments. In fact, WikiLeaks was one of the first organizations to start accepting bitcoin donations, after their bank accounts were shut down due to their whistleblowing activities.
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How Does Bitcoin Work?
Bitcoin is a marvel of cryptography and software engineering. If you’re just starting out, it will probably seem intimidating, but don’t worry. You don’t really understand how your phone or computer works, do you? But you understand what it can do for you, and a little about how to use it, and so you can benefit from it.
Bitcoin is no different. Doing a deep technical dive can be very fun if you have the time for it, but we’ll just look at the most essential parts of how bitcoin works here. It’s a lot like a bank’s computer— it’s just a big list of different accounts, and how much money each account has. But unlike the bank, only you have the power to change the amount of money in your account.
Public-Private Key Pairs
Think of a public private key pair like one of those one-way mirrors. On one side, it looks like a mirror, but on the other side you can see through it like glass. A public-private key pair is a bit like that, and it’s the foundation of how bitcoin works.
When you use a centralized money transfer service like PayPal, PayPal checks your password when you make a transaction to make sure it is you. In order for them to do this, they have to know your password. That means if you put money in PayPal, you have to trust PayPal. Not with bitcoin, though.
Some very cool math makes it possible for you to show everyone that you know your password, without you needing to tell them your password. A bitcoin password is called a private key, and is mathematically linked to a public key. You can think of a public key as being a bit like an email address.
You use your private key to sign a transaction, and then anyone can compare your signature to your public key and verify that you are the real owner of the bitcoin you are sending.
So now we know that every transaction has a signature. This signature is combined with some other data related to the transaction, and then bundled together with many other transactions into a group called a “block.” There’s some more cool math involved called “hash functions” and a “merkle tree.” It’s called a tree because multiple transactions get “hashed” into each other, which kind of looks like a tree.
What this math accomplishes is condensing all of the transaction data into a single number called the “block header.” If any of the data in the block changes, it will change the block header. The block header is then connected to another block, which effectively “locks” all of the data in. The block headers connect each block together, forming a “chain.”
This is an excellent way of preserving data and making it tamper proof, and this technology has been adopted by governments and corporations around the world for sensitive data. But what makes it really secure is that there is a distributed network for people all over the world that keep copies of the blockchain.
You may have downloaded music or movies online before using a distributed network. Network “seeds” make a copy of the file available, and you can download from dozens of seeds at once. When it comes to bitcoin, each block is saved by thousands of people around the world. This makes it very secure, because even if the computers of 90% of the people forming the network melt down, the network will still keep going strong.
But why do so many people keep copies of the blockchain? Is it just out of the goodness of their hearts?
No. They are after the block reward, the ultimate goal of bitcoin “mining.”
Mining is what really secures the bitcoin network, and many believe it is the key to bitcoin’s value. In the case of bitcoin, “mining” refers to using a computer to try to guess a very large number. Guessing the correct number takes many millions of guesses, and each one of those guesses requires computation. The one who guesses right gets a block reward— currently worth 6.125 bitcoin, or around $56,000 USD at the time of writing.
That computation requires electricity, which means that to produce a fake transaction generally ends up costing a lot more than whatever money you could make with it. This is kind of a complex topic, and if you want to learn more about it, I can recommend this guide. But for now, the main thing is just to understand that creating bitcoin requires expending real resources, which makes the network very secure and gives bitcoins real economic value.
The difficulty of finding a block increases the more people try to join the network. The fact that it requires electricity means that if someone tried to take over the network by controlling more computing power than anyone else, bitcoin would become more valuable due to the increased cost of mining. This would attract more miners, which would make the takeover much less likely to succeed.
So far, bitcoin has proved to be unstoppable.
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What Do People Use Bitcoin For?
The main advantage of bitcoin is that it allows sending money over the internet without any trusted 3rd party. This enables all kinds of things that are impossible with traditional bank transfers or services like PayPal.
Of course, not everyone is interested in bitcoin to liberate the world from financial oppression. Many bitcoiners are simply in it to make money.
Bitcoin is traded online 24 hours a day, 7 days a week, and traders worldwide try to apply that age-old, simple sounding formula— buy low, sell high— to turn a profit. Since bitcoin can be sent and received without any government approval, soon after it went online, bitcoin became the foundation of the world’s first truly global financial market.
One of the most popular early uses of bitcoin was on so-called “dark marketplaces,” which resulted in many people associating bitcoin with criminals. For the first time ever, it was possible to buy drugs, guns, and other illicit goods online. Some view a silver lining to all this, since you can read reviews on the quality of the drugs, which could help to reduce overdose deaths from bad drugs.
Many people appreciate bitcoin for the ability to send cheap, uncomplicated transfers across international borders. Millions of people travel from low income countries to work abroad, and support family members back home. Conventional transfers cost about 7% of the total sent, which amounts to over $50 billion USD in fees every year.
When you consider that many of these transfers are headed for some of the poorest people in the world, it means billions of dollars literally coming out of their pockets. Since bitcoin’s fees are usually much lower, many people favor it for their money transfers.
Since bitcoin can be sent over the internet anonymously, hackers increasingly favor it from ransomware attacks. In these attacks, a computer virus is implanted in a computer or a computer network. It propagates through the whole system, and once it has taken over, it locks down the system and displays a message demanding a ransom in bitcoin or another cryptocurrency.
The victims then have to decide whether to pay the money or lose their entire file system. For large companies, their data may be worth millions, so whether or not to pay the ransom is a simple economic decision.
It’s certainly not pretty, and it is forcing companies around the world to take cybersecurity more seriously, but in any case, ransomware results in growing demand for bitcoin.
There are other use cases for bitcoin— for example, some have experimented with microtransactions, because it’s possible to send tiny amounts of money. This can be applied to many online business models. For example, when you want to buy a single article or image without subscribing to a service or handing over your credit card information.
Store of Wealth/Speculative Investment
But the single most common reason people use bitcoin these days is as a store of wealth. Since it is independent from the financial system and has limited supply, many believe that bitcoin will be resistant to financial crisis and will increase in value in the future, making it an ideal store of wealth, just like gold. But as the price of gold goes up, people can go out and mine more gold in more difficult to reach places, which keeps the price down. With bitcoin, no matter how high the price goes, the supply stays the same.
For this reason, the bitcoin price has periodically rocketed up. In 2011, bitcoin shot up to $31.91, before crashing down to around $10. Then, in 2013, the price rallied again, this time topping $220, only to drop down to $70. Later that year, the price broke $1000 for the first time, crashing down to $360 some months later.
Finally, towards the end of 2017, bitcoin shocked the world by reaching $20,000— and of course then crashed as low as $3,500 within a year. Are you beginning to see a pattern?
So for many people, the choice between keeping savings in dollars or bitcoins is the choice between a stable currency that loses value, or a very volatile currency that increases in value.
How Can I Get Bitcoin?
There are 4 main methods for acquiring bitcoin— mining, buying from an exchange, buying P2P, or trading goods and services.
Mining sounds very exciting at first, but if you think it means “free money,” you’ll be sorely disappointed. Most successful mining operations are in industrial scale facilities and have dedicated staff and security. Of course, some people mine as a hobby, and if you are interested in computers and programming you might enjoy it. But realistically, you probably won’t make any money.
For this reason, most people obtain bitcoin by buying it.
Buying from an Exchange
The most common way to acquire bitcoin is through a brokerage or exchange. The most well known exchange in the United States is Coinbase. Coinbase is very easy to use, and recommended for anyone buying crypto for the first time. Gemini is a popular alternative.
These exchanges link to your bank account, so you can buy and sell bitcoin via ACH direct debits. There are many exchanges out there, but be sure to use a reputable exchange, as less established exchanges have been known to lose or steal user funds.
There are a number of services like LocalBitcoins and Paxful that link individual buyers with each other, called P2P (or person to person) exchanges. These usually work with escrow services, where bitcoins are held by a neutral party until the seller receives the cash. Once the seller receives the cash, they then release the funds to the buyer, which provides some protection for the seller.
Many people prefer this method because it has more anonymity. Many people believe the value of bitcoin could eventually exceed $100,000 or even $1,000,000 USD, and they prefer to stay private, fearing that the government or kidnappers could come after them in the future if anyone knows that they have a big stash of bitcoin.
These methods are generally more convenient, with numerous payment options including PayPal, bank transfers, cash in person, or even Amazon gift cards. On the downside, rates tend to be a bit more expensive than the big exchanges.
Trading Goods or Services
There are some bitcoin freelance sites, where you can work for bitcoin. There are also a number of annoying websites that allow you to earn tiny amounts of bitcoin in exchange for clicking ads or filling out surveys. Some services allow you to earn cash back in bitcoin for buying things on certain websites.
And if you can get in the right place at the right time and hold up a sign that the bitcoin community likes with your bitcoin address on it, then you might be able to get some donations, like this guy, who held up a sign reading “buy bitcoin” at a televised Federal Reserve meeting. He received over 6 bitcoin in donations from hundreds of appreciative bitcoiners, which would be worth around $60,000 today.
The "Bitcoin IRA" has also grown in popularity in recent years. Many gold IRA specialists now also offer cryptocurrencies to their clients. You can rollover or transfer some retirement funds into cryptocurrencies. These self-directed IRAs are a unique way of diversifying retirement savings into bitcoin, while also enjoying the tax benefits of an IRA.
How Do I Use Bitcoin?
The main thing you need to know about to use bitcoin is wallets. A bitcoin wallet is just a set of both a public and a private key where you can store bitcoin. We’ll go over the most common types of wallet here, because after you buy your bitcoin, your wallet is the most important part of using bitcoin.
This is the original, and most basic form of wallet. You can generate a wallet on a website like bitaddress.org, and it consists only of a private key (don’t share!) and a public key (okay to share). It looks like this:
The QR codes allow you to easily scan your address, or to send the bitcoin to another address. But to do that, you’ll need some kind of wallet software.
TIP: For extra security, you can copy the website and run it offline by following this guide.
There are two main types of software wallets— mobile wallets and desktop wallets. A mobile wallet is usually on a smartphone, while a desktop wallet is an application on a PC or laptop.
Wallet software enables you to use your private key to sign transactions, so you can send bitcoin to other addresses.
This type of wallet is more convenient than a paper wallet, because you can spend your bitcoin directly by just inputting an address and clicking “send.” The drawback is that since they are connected to the internet, it is possible for a hacker to steal your funds.
For this reason, many people use this type of wallet more for day to day expenses, while they keep their main bitcoin savings in a more secure wallet, like a paper wallet or a hardware wallet. One of the most popular mobile wallets is Mycellium. Coinbase and blockchain.com also offer popular mobile wallets.
A hardware wallet is a device that connects to a computer, usually via a USB port, and can sign transactions. Many hardware wallets are built so that the private key is physically insulated from the internet, and have additional security features that make it VERY difficult, if not impossible, for any hackers to access the funds.
While they represent a good balance between the convenience of software wallets, and the security of paper wallets, hardware wallets are the most expensive wallet option, usually ranging anywhere between $50-200 USD, depending on how many features you want.
TIP: Be sure to buy from the manufacturer. Second hand wallets could be tampered with to steal your bitcoin!
A brain wallet is more or less like a paper wallet, except in your brain. Bitcoin addresses and private keys are quite difficult to memorize, as they are just strings numbers and upper and lower case letters, so most brain wallets take the form of an easy to remember phrase which is then run through an algorithm to generate the wallet.
Some wallets would replace letters with symbols for added security. For example; “A$k n0t what bitc0in can d0 f0r y0u— a$k what you can do for bitc0in” In this phrase, the letter “O” is replaced with a zero, and the letter “S” is replaced with a dollar sign, making an easy to remember phrase that is VERY difficult to crack. You can generate brain wallet addresses with a program like this one.
Of course, brain wallets are not the most convenient, and an additional disadvantage is that if something happens to the person who is carrying the brain wallet, their bitcoin could be lost and become inaccessible to their heirs. This has already happened, when the CEO of a cryptocurrency exchange died without leaving his family or employees with the keys to millions worth of bitcoin.
This is one reason why people use “multi-signature wallets.”
A multi-signature wallet basically means that more than one key is required to sign a transaction. This makes it possible for multiple people to share ownership of a wallet. For example, there could be 3 keys total, with 2 keys required to sign a transaction, or 5 keys with 3 required to withdraw money from the address. This way, if one person loses their key, the other in the group can still access the money.
This also provides higher security against thieves and hackers, and is commonly used for large bitcoin holdings.
Risks of Investing in Bitcoin
Many people have already gotten rich from bitcoin, and many more expect to do the same in the future. This is part of why people perceive bitcoin as being “scammy.” The more people buy bitcoin, the higher the price goes, so many people try to convince others to buy in order to increase the value of their own holdings.
This has some similarity to a pyramid scheme, but unlike a pyramid scheme, bitcoin offers a real, functional product with major utility— an alternative to the global financial and banking system. As long as bitcoin holds any value at all, it will continue to be useful, and as long as it is useful, it is likely that its value will continue to grow as more people use it.
However, there are some common risks cited with owning bitcoin.
At present, all the supercomputers on earth working for millions of years could not crack a single bitcoin wallet by brute force. However, there are some fears that if technology improves exponentially, computers could be developed that are vastly more powerful than what we have now. If that were to happen, the encryption algorithms that secure bitcoin could become obsolete.
Of course, bitcoin proponents have already developed quantum resistant algorithms that could be added to the bitcoin protocol in such an event, but no one knows what an arms race like that might look like.
A Superior Coin
Many coins have tried to make a name for themselves by claiming to be the “bitcoin killer,” with features that are superior to bitcoin’s. Eventually bitcoin could go the way of Yahoo or AOL as the “Google” of digital currencies emerges.
Bitcoin believers argue that bitcoin is the most robust and proven digital currency out there, and also the one with the best security, since it has the most computing power backing it. They argue that it is more akin to TCP/IP, the communication protocol of the early internet, which has remained unchanged since the early days of the internet, and still forms the foundation of the world wide web.
They also argue that bitcoin’s lack of features is intentional, and that higher performance currencies are less reliable. They further argue that any killer features that could be added to another coin could be added to bitcoin as well. Nonetheless, there is still fierce and ongoing debate about what makes an ideal cryptocurrency. Only time will tell which approach comes out on top, but for now bitcoin remains the clear leader.
No one knows exactly what bitcoin’s future will look like. But it was developed in response to what many believed to be irresponsible money printing by central banks, and with COVID-19, the problem has only gotten worse. So for the foreseeable future, it seems that the underlying causes that drive people to use bitcoin will not be going anywhere.
If all of this seems like a lot to swallow, don’t worry. Many regard bitcoin as a paradigm shift, kind of like when we realized that the earth revolves around the sun, rather than the sun revolving around the earth. When we become very deeply entrenched in a certain way of thinking or doing things, we can’t just change our minds and our lives overnight. These things take time.
The best way to understand bitcoin is to get a small amount and use it. Send it back and forth between friends or family, try using a block explorer to view details on your transactions, and you will start to get a feel for it. Who knows, when you start tasting that financial freedom, you might just like it!