Not only is Bitcoin (BTC) the first cryptocurrency, but it’s also the best known of the more than 19,000 cryptocurrencies in existence today. Financial media eagerly covers each new dramatic high and stomach-churning decline, making Bitcoin an inescapable part of the landscape.
While the wild volatility might produce great headlines, it hardly makes Bitcoin the best choice for novice investors or people looking for a stable store of value. Understanding the ins and outs can be tricky—let’s take a closer look at how Bitcoin works.
What Is Bitcoin?
Bitcoin is a decentralized digital currency that you can buy, sell and exchange directly, without an intermediary like a bank. Bitcoin’s creator, Satoshi Nakamoto, originally described the need for “an electronic payment system based on cryptographic proof instead of trust.”
Every Bitcoin transaction that’s ever been made exists on a public ledger accessible to everyone, making transactions hard to reverse and difficult to fake. That’s by design: Core to their decentralized nature, Bitcoins aren’t backed by the government or any issuing institution, and there’s nothing to guarantee their value besides the proof baked in the heart of the system.
“The reason why it’s worth money is simply that we, as people, decided it has value—same as gold,” says Anton Mozgovoy, co-founder & CEO of digital financial service company Holyheld.
Since its public launch in 2009, Bitcoin has risen dramatically in value. Although it once sold for under $150 per coin, as of June 8, 1 BTC equals around $30,200. Because its supply is limited to 21 million coins, many expect its price to only keep rising as time goes on, especially as more large institutional investors begin treating it as a sort of digital gold to hedge against market volatility and inflation. Currently, there are more than 19 million coins in circulation.
How does bitcoin work?
Bitcoin is built on a distributed digital record called a blockchain. As the name suggests, blockchain is a linked body of data, composed of units called blocks that contain information about each transaction, including the date and time of each transaction, total price, buyer and seller, and a unique identification code for each exchange. Entries are combined in chronological order, forming a digital chain of blocks
"Once a block is added to the blockchain, it becomes accessible to anyone willing to see it, acting as a public ledger of cryptocurrency transactions," said Stacey Harris, a consultant at Pelican, a network of cryptocurrency ATMs.
Blockchain is decentralized, which means it is not controlled by any single organization. "It's like a Google Doc that anyone can work on," says Buchi Okoro, CEO and co-founder of African cryptocurrency exchange Quidax. "No one owns it, but anyone who has a link can contribute to it. And as different people update it, your copy updates as well."
While the idea that anyone can edit the blockchain may seem risky, it actually makes Bitcoin trustworthy and secure. For a transaction block to be added to the Bitcoin blockchain, it must be verified by a majority of Bitcoin holders, and the unique codes used to identify users' wallets and transactions must conform to the correct encryption pattern.
These codes are long, random numbers, which makes them incredibly difficult to fraudulently generate. The level of statistical randomness in the blockchain verification code, which is required for every transaction, greatly reduces the risk that anyone could make a fraudulent bitcoin transaction.
How does bitcoin mining work?
Bitcoin mining is the process of adding new transactions to the Bitcoin blockchain. It's a tough job. Those who choose to mine bitcoins use proof-of-work, putting computers in a race to solve mathematical puzzles that verify transactions.
To entice miners to continue racing to solve the puzzle and support the overall system, the Bitcoin code rewards miners with 6.25 BTC for each new block. BTC amounts to approximately $190,000.
"This is how new coins are created," and recent transactions are added to the blockchain, Okoro said.
In the early days it was possible for the average person to mine Bitcoin, but this is no longer the case. Bitcoin code has been written over time to make solving its puzzles more challenging, requiring more computing resources. Today, Bitcoin mining requires access to powerful computers and large amounts of cheap electricity to be successful.
Bitcoin mining pays less than before, which makes it more difficult to recoup the increasing computational and electrical costs.
"In 2009, when this technology first came out, every time you got a stamp, you got a lot more bitcoins than today," said Flory Marquez, co-founder of BlockFi, a crypto asset management company. "There are more transactions [now, so] the amount you pay for each stamp is less and less." By the year 2140, it is estimated that all bitcoins will have entered circulation, meaning that mining will not release any new coins, and miners may have to rely on transaction fees instead.
How to use Bitcoin
In the United States, people commonly use Bitcoin as an alternative investment, which helps diversify a portfolio in addition to stocks and bonds. You can use Bitcoin to make purchases, but there are some vendors that accept real crypto.
Major companies accepting Bitcoin include Microsoft, PayPal, and Whole Foods, to name a few. You may also find that some small local retailers or certain websites take Bitcoin, but you'll have to do some digging.
You can also use a service that allows you to connect a debit card to your crypto account, meaning you can use bitcoins like you use a credit card. This usually involves a financial provider instantly converting your bitcoins into dollars.
In other countries—especially those with less stable currencies—people sometimes use cryptocurrencies instead of their own currencies.
Bitcoin provides an opportunity for people to store value without relying on a currency backed by a government. This gives people an option to hedge against a bad scenario. You can already see people in countries like Venezuela, Argentina and Zimbabwe (high debt countries) where Bitcoin is gaining a lot of traction.
When you use Bitcoin in the US as a currency, not an investment, you need to be aware of certain tax implications.
How to buy bitcoins
Most people buy Bitcoins through cryptocurrency exchanges. Exchanges allow you to buy, sell and hold cryptocurrencies. Setting up an account is similar to opening a brokerage account — you'll need to verify your identity and provide some funding source, such as a bank account or debit card.
Major exchanges include Coinbase, Kraken, and Gemini. You can buy Bitcoins from online brokers like Robinhood.
No matter where you buy your bitcoin, you need a bitcoin wallet to store it. It can be called "hot wallet" or "cold wallet".
A hot wallet (also called an online wallet) is held by an exchange or provider in the cloud. Online wallet providers include Exodus, Electrum, and Mycelium. A cold wallet (or mobile wallet) is an offline device used to store bitcoins and is not connected to the internet. Some mobile wallet options include Treasure and Ledger.
A few important notes about buying bitcoins: Although bitcoins are expensive, you can buy fractional bitcoins from some sellers. You should also look at fees, which are usually a small percentage of your crypto transaction amount but can add up on small-dollar purchases. Finally, Bitcoin purchases are not as instant as other equity purchases. Since miners must verify Bitcoin transactions, it may take at least 10 to 20 minutes for you to see your Bitcoin purchases in your account.
How to Invest in Bitcoin
Like a stock, you can buy and hold Bitcoin as an investment. You can now do this in a special retirement account called a Bitcoin IRA.
Regardless of where you choose to hold your bitcoin, people's philosophies on how to invest it vary: some buy and hold long-term, some sell after the price rises, and others bet on its price falling. Bitcoin price has experienced large price swings over time, reaching as high as $5,165 and $28,990 in 2020 alone.
"I think in some places, people can use bitcoin to pay for things, but the truth is it's an asset that looks like it's going to appreciate relatively quickly for some time," Marquez said. "So why would you sell something that's going to be worth a lot more next year than it is today? Most people holding it are long-term investors."
Customers can invest in Bitcoin mutual funds by buying shares of Grayscale Bitcoin Trust (GBTC). However, the minimum investment required is $50,000. That means the majority of Americans can't afford it. In Canada, however, Bitcoin investing is becoming more accessible. In February 2021, the Objective Bitcoin ETF (BTCC) began trading as the world's first Bitcoin ETF, and the Ontario Securities Commission also approved the Evolve Bitcoin ETF (EBIT). American investors looking for exposure to bitcoin or bitcoin-like stocks can consider blockchain ETFs that invest in cryptocurrency technology.
An important note: While crypto-based funds can add diversification to crypto holdings and reduce risk somewhat, they still carry a substantial amount of risk and charge much higher fees than broad-based index funds with a history of steady returns. Investors looking to grow wealth steadily can opt for index-based mutual and exchange-traded funds (ETFs).
Should You Buy Bitcoin?
Many financial experts support their clients’ desire to buy cryptocurrency, but they don’t recommend it unless clients express interest. “The biggest concern for us is if someone wants to invest in crypto and the investment they choose doesn’t do well, and then all of a sudden they can’t send their kids to college,” says Ian Harvey, a certified financial planner (CFP) in New York City. “Then it wasn’t worth the risk.”
The speculative nature of cryptocurrency leads some planners to recommend it for clients’ “side” investments. “Some call it a Vegas account,” says Scott Hammel, a CFP in Dallas. “Let’s keep this away from our real long-term perspective. Make sure it doesn’t become too large a portion of your portfolio.”
Bitcoin is like a single stock, and advisors wouldn’t recommend putting a sizable part of your portfolio into any one company. At most, planners suggest putting no more than 1% to 10% into Bitcoin if you’re passionate about it. “If it was one stock, you would never allocate any significant portion of your portfolio to it,” Hammel says.
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