You’ve probably heard of Bitcoin, which was the very first “crypto” currency. Cryptocurrency is digital money that is securely issued and managed using cryptography. There are no bills or coins — it exists only electronically, like money in your Venmo or PayPal account.
Bitcoin is the most popular, but there are hundreds of cryptocurrencies (Ethereum, Ripple, Stellar Lumens, Litecoin). Make sure you understand how they work before you invest in any of them.
Reasons for Using Cryptocurrency
You want to keep your financial record more private. Traditional banking requires you to open an account and share the details of your finances with the bank. With Bitcoin, transactions are processed through a peer-to-peer payment network. So, if Person A transfers money to Person B, a record of that transaction will be visible on a public decentralized ledger (called the blockchain), eliminating the need for verification from a third party (such as a bank).
Cryptocurrency transactions are tracked, but the details are pseudo-anonymous. There is public proof that the transaction took place, but the details of who made the transaction are not necessarily tied to a physical identity.
You want an alternative to traditional banks. Bitcoin is not attached to any government, country or central bank. It is an independent global currency with no president or CEO — it’s a “leaderless democracy” of people around the world who maintain the system. Other cryptocurrencies provide different benefits than Bitcoin but are more likely to have issuing authorities. For example, Ethereum was issued by the Ethereum Foundation.
You want to invest in the next big thing and make a fortune. If this is your motivation, make sure you seek financial advice from a professional. Bitcoin’s value has increased from just 6 cents in 2010 to a peak of more than $19,000 in 2017 (and back down in 2018), so it has seen a lot of volatility. For those looking to build wealth for the long run, cryptocurrencies should be considered as one part of a balanced investment strategy.
According to Mark Pesce, host of “The Next Billion Seconds” podcast, which recently did a miniseries called “Cryptonomics,” “Any investment in cryptocurrencies should follow the ‘Buffet Rule’ — If you don’t understand it, don’t invest in it. Do your research, learn and the opportunities will come.”
History of Bitcoin
In 2008, a mysterious author named Satoshi Nakamoto published a whitepaper entitled 'Bitcoin: A Peer-to-Peer Electronic Cash System.' Bitcoin was then released as open-source code in January 2009.
Bitcoin is a digital currency that:
- Is exchanged between individuals without a third-party financial institution.
- Uses a network of connected computers around the world to keep a record — or ledger — of transactions and prevent double-spending.
- Broadcasts this ledger in a transparent but pseudo-anonymous way, so that anyone can verify accuracy, but certain personal transaction details remain private.
- Releases new Bitcoins into the marketplace in a slow and programmatically defined way through “mining.”
- Has a limited and finite supply.
What Does the “Crypto” in Cryptocurrency Mean?
The “crypto” refers to cryptography, which used to be the making and cracking of codes. However, in today’s electronic world, cryptocurrency provides secure financial communication through encryption and complex mathematical algorithms, used to conceal the details of financial transactions, while maintaining a reliable record.
Reliable Transactions Without Banks
Usually, a currency is regulated by its country’s central bank. For example, in the U.S., the Federal Reserve raises and lowers federal interest rates and the Treasury prints cash and coins. But Bitcoin has no central bank to do these things.
Instead, Bitcoin uses computer software that connects users all around the world over the internet to construct its ledger. Every time a Bitcoin is exchanged from one person or entity to another, the ledger is updated across the entire network. Everyone running the free software is given the same vote on upgrades and nobody can force monetary changes upon the people running the software.
According to Chris Kline, COO of Bitcoin IRA, a company that combines cryptocurrencies with individual retirement accounts, “For too long, consumers relied solely on third-party institutions to verify financial transactions, and, as we saw in the 2008 financial crisis, that backfired tremendously. Cryptocurrency is the necessary market advancement for people seeking a more financially transparent future.”
The database used to keep track of all Bitcoin transactions is called blockchain. As new transactions occur, computers on the network complete mathematical equations to verify the validity of these transactions. Valid blocks of transactions are added to the public database (blockchain).
The goal of blockchain is to allow digital information to be recorded and distributed, but not edited. Simplified, blockchain is really just a big record-keeping ledger, showing who paid what to whom and when they paid it. Instead of a financial institution maintaining this accounting record, the network of computers running the software all around the world checks the entries and comes to virtual consensus. The power to maintain the system is decentralized so that, as long as there are computers running the software, the ledger continues.
Mining shares many of the same principles as real-world mining, except, instead of using manpower and machinery to take a substance like gold from the earth, Bitcoin miners use computer power to verify pending transactions entered on the public ledger. This process enforces chronological order in the blockchain and protects the neutrality of the network, so no group or individual can control or modify the information. In exchange for verifying transactions and, miners are awarded Bitcoin.
If the network of users running the Bitcoin software accepts the proposal and adds the transactions to the blockchain, the miner gets paid in Bitcoin and receives any transaction fees that users choose to include. (Users include a transaction fee to have their transactions prioritized.)
A new block of Bitcoin data is verified by the worldwide network and added to the chain every 10 minutes, updating the ledger with an official timestamp and releasing more currency into the marketplace.
A real commodity like gold takes time and effort to extract, which makes the end product more valuable. Bitcoin mining is designed to mimic this and release new Bitcoins at a fixed and predictable rate. If more computers start mining, the system self-regulates by making the math problem harder to solve, requiring more effort, which helps the network maintain its average of a new block every 10 minutes.
The maximum number of Bitcoins that can ever be created is 21 million. Every four years, the 10-minute reward for mining Bitcoin gets cut in half. It’s currently 12.5 Bitcoin every 10 minutes. In May of 2020, that rate will be reduced to 6.25 Bitcoin every 10 minutes. At the current rate, it’s estimated the last Bitcoin will be mined around the year 2140.
Geiger explains that “The predictable issuance schedule and maximum of 21 million Bitcoin means that Bitcoin has no inflation.”
(Mostly) Private Transactions
Individual Bitcoin transactions use unique keys, so they aren’t exactly anonymous, but they’re concealed behind long, complex numerical passwords.
Because there’s no account to open, no credit checks, fees or terms to accept — anyone can own cryptocurrency. This offers an alternative for anyone who can’t get access to traditional banking or those who don’t trust large financial institutions.
Cyber identity thieves often request payment in Bitcoin, and secret websites where drugs and weapons are sold also use cryptocurrency. However, regulators, especially in the United States, increasingly are monitoring cryptocurrency exchanges so many criminals have been caught as a result of using Bitcoin.
How to Use Cryptocurrency
Cryptocurrency and its underlying blockchain technology can be used for various functions from retailer point of sale currency, to smart contracts to investment assets. Anyone can buy Bitcoin and other cryptocurrencies. You can trade on exchanges (Coinbase, Kraken, Bitstamp) or earn cryptocurrencies playing video games or performing tasks online. Before buying, research the company for complaints and customer reviews. Fraud and hacking are real risks with cryptocurrency because, like cash, once it’s gone, it’s gone.
One Bitcoin is broken up into 100 million Satoshis. Look online for the current exchange rate between Satoshis and U.S. dollars (USD). In late 2018, you could get between 15,000 and 19,000 Satoshis per dollar.
You make Bitcoin purchases by scanning a QR code using an app. Cryptocurrency is accepted as payment by many small companies and even some large retailers, including Overstock.com and Expedia.
Also, you can invest in cryptocurrency as an asset and track it the same way you would traditional stocks or bonds.
Phil Geiger of Mycelium, a Bitcoin wallet application for Android, says, “The safest way to increase your wealth using cryptocurrency is to convert small amounts of dollars into Bitcoin and to hold it for longer than two years.”
Wallets are secured using cryptography, which means you are responsible for storing your own unique access keys to your cryptocurrencies. You have a public key, which is like your address, so people know where to send you cryptocurrency. Then there are individual unique keys for each currency unit, which are like your passwords, unique and private to you.
Cryptocurrencies let you turn your phone into a bank by downloading a wallet application that only you control. The benefit of this is that you are given ultimate control of your money. Nobody can confiscate or censor transactions. But this also means you are solely responsible for keeping your money safe. If your phone is stolen and you don’t have a back-up written down, your funds are gone forever.
Some people choose “hot” digital wallets, which are offered by most exchanges and are stored online. Other people prefer “cold” storage options like detachable drives or even paper copies so that digital keys are kept offline and are therefore protected from hackers. Experts warn against opening a “hot” digital wallet on the same site where you bought your cryptocurrency because of lack of privacy and increased vulnerability to hacking.
The Future of Cryptocurrency
The identity of Bitcoin’s mysterious creator, Satoshi Nakamoto, is still unknown. Some speculate that Nakamoto is a group of people. Regardless of who he, she or they are, they have changed the financial system forever.
You may not be able to use cryptocurrency for everything just yet, but at the rate that technology is changing, it’s likely that cryptocurrency will play some role in the future of payments.
“Now is the perfect time for those who are curious to get involved with cryptocurrency,” says Kline. “As regulatory uncertainty in the space continues to be resolved, mainstream adoption continues to increase and, in my opinion, the market is about to grow.”
Before investing in Bitcoin or anything else, build your knowledge of risk and reward with SAM’s free Money Basics Investing course.
[Any reference to a specific company, commercial product, process or service does not constitute or imply an endorsement or recommendation by the National Endowment for Financial Education.]
Ver este artículo en espanol: Aspectos básicos del bitcoin