What Is Bitcoin, and How Does It Work?
It exceeded $19,000 in December of that year and then lost approximately 50 per cent during the first part of 2018.
But Bitcoin's history is much more extensive and isn't limited to headlines about its price fluctuation. It incorporates technology, currency, mathematics, economics and social dynamics. It's multifaceted, highly technical and continues to evolve very fast. But because it's completely digital and doesn't correspond to any existing fiat currency, it may be hard to understand for new users. This guide intends to clarify some fundamental concepts and answer basic questions about Bitcoin.
But First, a Quick Story
Bitcoin was invented in 2009 by a person (or group) called Satoshi Nakamoto. Its declared objective was to create "a new electronic cash system" that was "completely decentralised without a server or central authority". However, after cultivating the concept and technology, in 2011, Nakamoto handed over the source code and domains to other Bitcoin community members and disappeared.
What Is Bitcoin?
Bitcoin is a digital currency. It's a complex concept, not simply an assigned value of money stored in a digital account, such as your bank account or line of credit. Moreover, Bitcoin doesn't have a corresponding physical element, such as coins or paper bills.
How Does Bitcoin Differ from Traditional Currencies?
Bitcoin can be used to pay electronically if both parties wish to do so. In that sense, it's equal to dollars, euros or yen, which are also traded digitally.
But it differs from digital fiat currencies in a few important ways:
The most important Bitcoin feature is that its system is decentralised. No institution controls the Bitcoin network. Instead, it's maintained by a group of voluntary coders and managed by an open network of specialised computers distributed worldwide, attracting individuals and groups uncomfortable with banks or government institutions' control over their money.
Bitcoin solves the "double spending problem" of electronic currencies (in which digital assets can easily be copied and reused) through an ingenious combination of cryptography and economic incentives. Banks fulfil this function with electronic fiat currencies, allowing them to control the traditional system. With Bitcoin, the integrity of transactions is maintained through a distributed and open network that no one owns.
2. Limited Supply
Fiat currencies, such as the dollar, euro, yen, etc., have an unlimited supply. Central banks can have the volume they want and try to manipulate the value of one currency in relation to others. Currency owners (especially people with little alternative) pay the cost.
With Bitcoin, on the other hand, the supply is tightly controlled by the underlying algorithm. As a result, a small number of new BTCs is created every hour and will continue to be made at a decreasing rate until the maximum of 21 million is reached. This makes Bitcoin more attractive as an asset because, in theory, if demand grows and supply remains the same, the value will increase.
Although the senders of traditional electronic payments are usually identified (for verification purposes and to comply with anti-money laundering legislation, among other things), Bitcoin users theoretically operate in semi-anonymity. Since there's no central "validator", and users don't need to identify themselves when sending BTC to another user. When a transaction request is sent, the protocol verifies all previous transactions to confirm that the sender has the necessary amount of Bitcoins and the authority to send them. The system doesn't need to know your identity.
In practice, each user is identified by the address of their "wallet" (or electronic wallet). Transactions can, with some effort, be traced in this way. In addition, the police have developed methods to identify users if necessary.
The law requires that most exchanges perform identity checks on their clients before they're allowed to buy or sell Bitcoins, which facilitates another way of tracking their use. In addition, as the network is transparent, the progress of a particular transaction is visible to all.
This makes Bitcoin a tough currency for criminals, terrorists or money launderers.
Bitcoin transactions can't be reversed, unlike electronic ones with fiat money.
This is because no central regulator can say, "OK, the money has to be returned". If a transaction is registered in the network and more than an hour has passed, it's impossible to modify it.
While this point may disturb some, this means that you can't alter any transaction in the Bitcoin network.
The smallest unit of a Bitcoin is called a satoshi. It's one one-hundred-millionth of a BTC (0.00000001). At today's prices, that's about one-hundredth of a cent. This could facilitate microtransactions that traditional electronic money doesn't allow.
How Are Bitcoin Transactions Monitored?
Bitcoin uses an elementary data log file called a blockchain. Each blockchain is unique to each user and their personal Bitcoin wallet. All Bitcoin transactions are recorded and made available in a public ledger, which helps guarantee their authenticity and prevent fraud. This process helps avoid duplicate transactions and people copying BTC.
While each BTC records the digital address of each wallet it touches, the Bitcoin system DOESN'T record the names of people who own wallets. In practical terms, this means that each transaction is digitally confirmed but completely anonymous simultaneously.
So, although people can't easily see their identity, they can see the history of their Bitcoin wallet. This is good since a public history adds transparency and security and prevents people from using BTC for dubious or illegal purposes.
How Does Bitcoin Work?
Compare it to Torrent, the P2P network you definitely never used to download lots of music in the early 2000s. In this case, though, instead of moving files from one place to another, the Bitcoin network generates and verifies that the blocks of information are expressed as a virtual currency.
Bitcoin and its many derivatives are known as cryptocurrencies. The system uses cryptography (extremely advanced cryptography called blockchain) to generate new currencies and verify those transferred from one user to another. Cryptographic sequences serve to:
- Make transactions virtually impossible to counterfeit
- Make banks or wallets of currencies easily transferable as data
- Authenticate a transfer of Bitcoin value from one person to another.
Before a Bitcoin can be spent, it must be generated by the system or mined. While a fiat currency needs to be minted or printed by a government, the mining aspect of Bitcoin is designed to make the system self-sufficient. People mine BTC by providing processing power from their computers to the distributed network, which generates new data blocks that contain the distributed global record of all transactions.
The coding and decoding process for these blocks requires vast processing power. The user who successfully generates a new block (or, more accurately, the user whose system generated the random number that the system accepts as a new block) is rewarded with some BTCs or a portion of the transaction fees.
In this way, moving BTCs from one user to another creates the demand for more processing power donated to the network on an equal footing, generating new Bitcoins that can then be spent. It's a system of self-replication that generates wealth ... or at least generates cryptographic representations of value that correspond to wealth.
What Is Bitcoin Mining?
Bitcoin mining refers to the process through which new BTCs are created due to the computers that help maintain the network. The computers involved in Bitcoin mining are in a kind of computational race to process the new transactions that enter the network. The winner, usually the person with the fastest computers, receives a portion of new BTCs. There's usually a new winner every 10 minutes. We have already mentioned that there'll be a total number of up to 21 million BTCs worldwide. After reaching this number, no new coins will be created, and it's expected to happen in 2140. So far, around 16 million BTCs have been distributed. Each existing coin was created through this method and was initially granted to a computer that helped maintain these records. Anyone can set up their PC to extract Bitcoin, but these days only people with specialised hardware manage to win the race.
Is It Worth Investing in Bitcoin Mining?
The Bitcoin mining industry has grown at a rapid pace. Something that at one time could be done with a typical home PC is now only done profitably in specialised data centres. These are warehouses full of computers called ASICs created solely for mining Bitcoin. Today it costs millions of dollars to even start a profitable mining operation.
What Can I Do with My Bitcoins?
Once you have BTCs, these behave like physical gold coins: They have value and trade as if they were gold nuggets in your pocket. You can use Bitcoin as an investment, buying the cryptocurrency to obtain a profit from the price fluctuation. You can also see it simply as a new way to spend money; the number of places is growing daily.
What Makes Bitcoins Valuable?
Let's look at gold as an example of a coin. There's a limited amount of gold on earth. As new gold is extracted, less is left, making it harder and more expensive to find and extract. The same is true with Bitcoin. There are only 21 million BTCs, and, as time passes, they become more and more difficult to extract.
Bitcoin has no official price. Instead, it's established according to what people are willing to pay.
The price is usually shown as the cost of an entire Bitcoin. However, exchanges will allow you to buy any amount, and you can buy less than one BTC. The Libertex price index is a good resource for viewing Bitcoin prices in real-time.
When Is The Right Moment to Buy?
As in any market, nothing is certain. Throughout its history, Bitcoin has generally increased its value quickly, followed by a slow and steady decline until it stabilises. Use tools such as the Libertex price index to analyse charts and understand the history of Bitcoin's price.
Bitcoin is global and isn't affected by any country's stability or financial situation. For example, speculation about the devaluation of the Chinese yuan has caused greater demand from China, which has also raised the rate in exchanges based in the United States and Europe. Global chaos is generally considered beneficial for the price of Bitcoin since it's apolitical and beyond any government's control or influence. When thinking about how the economy and politics will affect the price of Bitcoin, it's important to think globally and not only about what is happening in a single country.
Bitcoin Pros and Cons
Strong Points of Bitcoin
However, that doesn't mean that Bitcoin doesn't have its place in the future. Let's talk about some advantages and disadvantages of Bitcoin with respect to traditional currency.
- Anonymity and privacy
Bitcoin purchases between individual users are completely private: Two people can exchange BTCs or fractions of coins between wallets simply by exchanging HASH functions, without names, e-mail addresses or any other information. And because the P2P network uses a new HASH function for each transaction, it's more or less impossible to link simultaneous purchases to a single user. The nature of the encrypted P2P network also protects it from the outside: Nobody can see your purchases or personal receipts without having access to your wallet.
- No transaction fees (for now)
Conventional purchases that aren't cash include transaction fees: Pay with a Visa credit card, and Visa will charge the merchant a few cents to verify the transaction. And, of course, that cost forms higher prices for goods and services.
At the moment, there are no mandatory transaction fees for Bitcoin. Individual users and merchants can send their purchases to the network equally and simply wait for them to be verified in the next block. However, this process can take time (and it takes more time the more the network is used). Then, to speed up transactions, many merchants and users add a transaction fee to increase the priority in the block, rewarding users in the P2P network for completing the verification process more quickly.
As the global supply of BTCs reaches its limit of 21 million coins, transaction fees will become the main method for miners to earn. At this point, presumably, most transactions will include a small fee simply as a function of completing the purchase quickly.
- No central government authority or taxes
Because Bitcoin isn't recognised as an official currency by any country, buying, selling and using BTC to pay for goods and services aren't regulated. Therefore, anything you buy with BTCs isn't subject to a standard sales tax or any other tax that is typically applied to that item or service. This can be a great economic advantage if you are rich enough to do a lot of business exclusively in Bitcoin.
Without being subject to most currency laws, Bitcoin is effectively a barter system. Imagine your current supply of BTCs as a gigantic pile of potatoes: If you exchange ten thousand potatoes for a new TV, the government won't request a sales tax in the form of eight hundred potatoes. It simply isn't equipped to handle transactions not made in its own currency.
However, you should remember that any conventional income you receive from transactions in Bitcoin will be treated in the usual way. So, if you transfer BTCs worth $10,000 to your bank account through a Bitcoin market, you'll have to declare them as income in your tax forms.
In addition, trading Bitcoin doesn't override other standard requirements for taxation: Even if you buy a new car with BTC from a private seller, you'll still have to register that car with the government and pay taxes based on its market value.
Weak Points of Bitcoin
So, if Bitcoin is so good, why doesn't everyone use it? Well, it has some drawbacks too, especially at present.
- Possible government interference
Every time something new challenges the status quo, the government gets involved to ensure that things remain as they're supposed to be.
- No monetary sovereignty
Perhaps the biggest weakness of Bitcoin is that it's not a "recognised" sovereign currency. It's not backed by the full faith of any governing body. While this could be seen as a strength, using Bitcoin as a fiduciary currency is supported only by other Bitcoin users' perceived value, making it highly vulnerable to destabilisation. In short, if one day a large number of merchants who accept BTC as a form of payment stop doing so, its value will drop drastically.
The current high price of Bitcoin is a function of both the relative scarcity of BTCs and their popularity as a means of investment and wealth generation. Therefore, if confidence in the Bitcoin market is suddenly and drastically reduced, for example, if a major government declares its use illegal or a major trading platform is attacked and loses all of its stored value, the currency price will fall, and investors will lose huge amounts of money.
- Lack of guarantees
The Bitcoin network doesn't have built-in protection mechanisms for accidental loss or theft. For example, if you lose the hard drive where your Bitcoin wallet file is stored (think of a "hack" or an error in a unit without a backup copy), the BTCs held in that wallet are lost forever. Interestingly, this is an aspect that further aggravates the limited supply of Bitcoins.
In addition, if the file in your wallet is stolen or compromised and the thief spends the BTCs contained in it before the legitimate owner, the double-spending protection mechanism integrated into the network means that the legitimate owner has no alternative. Unlike if, for example, your credit card is stolen, you can call the bank and block the card. Bitcoin doesn't have that authority. The Bitcoin network only knows that the BTCs in the committed wallet file are valid and process them accordingly.
- Limited concurrent transactions
The Bitcoin block system requires the connection and confirmation of the P2P network to be verified. Because each block contains a limited record of transactions and an upper limit to the number of new transactions that can be written, there is a limit on how many people can buy and sell with the system at any given time.
As more and more sellers and individuals use Bitcoin to do business, the number of transactions per second increases, the P2P network becomes congested, and some operations without transaction fees take hours to complete. While conventional payment systems such as credit cards can expand their connections and processing power to speed up transactions, Bitcoin's P2P nature doesn't allow it to be compared with the global financial system.
However, the previous weaknesses aren't that significant if you exchange BTC. As a merchant, you're not the owner of Bitcoins, you don't make payments with them, but you get a reward for a successful investment. So, what is the difference between buying and selling Bitcoins?
What is Buying Bitcoins?
When you buy or sell cryptocurrencies, you buy the asset itself. To buy Bitcoin, you need to download a wallet. The Bitcoin wallet looks a bit like the online banking software most traditional commercial banks use for their customers.
Once you have a Bitcoin wallet, use a traditional payment method, such as a credit card, bank transfer or debit card, to buy BTCs on a Bitcoin exchange platform. Then, they are transferred to your wallet. The most important part of any wallet is to keep your passwords (a string of characters) safe. If you lose them, you lose access to the BTCs stored there. Once you have Bitcoins in your wallet, you can make payments or exchanges.
- You own BTCs.
- You can use them to pay for various products and services.
- You need to put all the value of the purchase.
- You have limits for maximum deposits.
- You must pay the deposit and/or withdrawal fees.
- Your wallet password is exposed to hacker attacks, and you can lose your entire investment.
What Is Bitcoin Trading?
You can sell and buy Bitcoins not only with fiat money, such as dollars or euros but also by exchanging Bitcoin for other cryptocurrencies, generating profits due to the difference in your costs. This is a way to get involved in the world of cryptocurrencies without having to undermine them.
Margin and Multiplier in Cryptocurrencies
In margin trading, you'll borrow buying and selling power in exchange for a portion of your funds being reallocated (the margin). This margin will only be accessible again after an operation in which you return the capital that you borrowed.
- You can use the multiplier*, so you only have to put a fraction of the total size of your position in advance.
- You won't have to pay income tax.
- You start operating immediately, without the need for an account in a cryptocurrency platform for buying and selling.
- You mustn't pay deposit or withdrawal fees.
- You can start demo operations and not open a real account.
- You don't own BTC.
- You can't use Bitcoins to pay for goods or services.
- You can easily invest too much and too quickly using a multiplier.*
*Multiplier negotiation allows you to negotiate an amount you don't have. Crypto trading services usually offer this feature.
Cryptocurrency CFDs (Contracts for Difference)
Libertex offers BitcoinCFDs that allow you to trade cryptocurrencies without owning them. Crypto CFDs are contracts between buyers and sellers in which sellers pay buyers the difference between the current value of the encryption assets and their value when the contract expires. Please remember that while trading can be worth it for some people, it always comes at a risk.
What Is Bitcoin Cash?
In August of 2017, the Bitcoin community had a disagreement over the rules governing the mining process, specifically about what constitutes the appropriate size (in megabytes) of a block. After the inability to reach a consensus, two sides were formed. On the one hand, the Bitcoin traditionalists and the group that cheered bigger blocks, on the other. Finally, the members of the second side separated to create the Bitcoin Cash.
Although they share a common digital ancestor, each has its own blockchain with slightly different protocols. (For what it's worth, BTC miners are running on 1MB blocks, Bitcoin Cash uses 8MB blocks). The bifurcation is expected to happen again in the future.
Are There Any Other Cryptos?
To sum up, we can say that Bitcoin and cryptocurrencies are among the most attractive trade assets. On the other hand, as we can see, investing in Bitcoin involves risks of all kinds, from the volatility issue to the probability of being scammed.
Most people trade cryptocurrencies through cryptocurrency exchange platforms; however, there is another option with which one can speculate on price movements. This can be done by using contracts for difference or CFDs. When you have a contract, you do not actually own the underlying asset; instead, you have the right to receive the difference between an asset's current value and its future value. If your prediction about the underlying asset's value is incorrect and the difference is negative, you'll have to cover that loss.
Libertex lets you work with CFD right now and is completely free on the demo account, giving you the option to practise your skills and if you feel ready to start trading CFDs Bitcoin on a real account!
We also offer you free lessons on how to trade CFDs. But please note that trading CFDs with leverage can be risky and can lead to losing all of your invested capital.
Disclaimer: The information in this article is not intended to be and does not constitute investment advice or any other form of advice or recommendation of any sort offered or endorsed by Libertex. Past performance does not guarantee future results.
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