Bitcoin is the world's most popular cryptocurrency. It doesn't exist in coins or banknotes — it's digital money.
Well, that's an over-simplification. The world has long had the ability to transfer funds without having to hand over hard currency — wire transfers, credit cards, PayPal. But Bitcoin aims to be its own currency — not a means to transfer dollars, pounds, euros, or yen, but its own thing. It's designed to be decentralised — no one entity, government or otherwise, has control over it. This is a huge part of the currency's appeal — it's seen as an ideal, futuristic, Global Currency.
It's got its own symbol: ₿. And the plural of Bitcoin is "Bitcoin", and it's always capitalised. This is how to avoid pissing off its fans.
And its fans are many and varied. That's why we've got this Useful Note — to tell you a little bit about this hot topic and how it works, so that you can understand the people constantly going on about it in ways you can't comprehend. As Bitcoin is technically an investment vehicle, we aren't going to tell you how to spend your money — if you want to get into Bitcoin, better read this FAQ from the Bitcoin website.
In truly understanding Bitcoin, it's important to separate the technological aspects of it from the economic aspects. There are more or less two totally different ways of thinking about it — as a thought experiment in using cryptography to make currency, and as a currency outside the control of any central bank. So, let's address the technological aspects first:
- There's no "physical" Bitcoin. A transaction in Bitcoin is a message that is broadcast into the Bitcoin network, being a public record of who sent how much to whom. Each transaction is attached to a "hash", which is like an electronic signature. The Bitcoin network is a "peer-to-peer" system, meaning that each individual piece of the network works together to verify the transaction; there's no central authority that does all the work.
- Bitcoin users are only identified by their individual accounts, known as "wallets". All transactions are between wallet addresses only. Part of the process of verifying each transaction is making sure which accounts are involved, how much was transferred, and that each account has the correct amount at the end of the transaction.
- All Bitcoin transactions are compiled into a public ledger called the "blockchain". Anyone has access to the "blockchain" and can verify a transaction if they want.
- Individual Bitcoin users donate their computing power to the project. They work on the individual "blocks", a bundle of transactions released every ten minutes, in a process known as "mining". The user's computer, known as a "node", verifies the transactions in the block. They do this by looking for a nonce that when hashed together with the block's signature hash produces a result lower than "target difficulty". In other words, they're looking for a way to make it easy for the Bitcoin network to verify each individual transaction, but at the same time extremely difficult to generate an arbitrary value that would pretend that a transaction has been verified. This is known as "proof of work".
- When a Bitcoin user shows "proof of work", they get Bitcoin as a reward for allowing the Bitcoin network to use their computer to verify a few transactions. This is how new coins are added into circulation. For every block verified, the miner gets ₿6.25 as of May 12, 2020. However, the rate is halved every four years; it's scheduled to drop to ₿3.125 around May 2024.
- Once the blockchain is verified, it cannot be changed without redoing the work — the "proof of work" process makes it difficult to guess or reverse-engineer the process. Of course, if you tell computer nerds that something is unbreakable, they will try their hardest to break it. The crackers quickly developed means to try and fake the "proof of work" (e.g. with customised chips). For this reason, the "target difficulty" is periodically adjusted, meaning that the Bitcoin network will demand a more complicated "proof of work" to prevent the increasingly sophisticated attackers from cracking it. As long as the attackers are kept out and the nodes who verify the blocks are honest, the system remains stable. The adjustment of the "target difficulty" is also a way of ensuring that transactions can actually be released every ten minutes.
This all makes it quite interesting for the computing nerds — a way to verify transactions without a central authority whom you have to trust implicitly. But a lot of non-computing nerds latched on to Bitcoin for other reasons:
- The decentralised nature of Bitcoin means there is no government or central bank in control of the project. Bitcoin appeals tremendously to people who are inclined to distrust the government on principle. The idea is that there is no single entity who can knock over the whole system just because. There also aren't any middlemen like banks or credit card companies to take a cut of the transactions.
- It can serve as a true Global Currency. Anyone, anywhere around the world, can handle transactions in Bitcoin, mine Bitcoin, and earn Bitcoin. It would eliminate all the problems of foreign exchange.
- It's completely anonymous. While every transaction is a public record, the participants are only identified by their wallets, which are in turn identifiable only as a random string of characters.
- It's stupid valuable. By early 2021, the exchange rate hit $50,000 per Bitcoin.
- It's full of Techno Babble and makes people feel like they're on the cutting edge.
The people behind Bitcoin are probably a little in Column A, a little in Column B. It's not that easy to determine, though, because we don't actually know who created it. Nominally, the original Bitcoin whitepaper is credited to a character known as "Satoshi Nakamoto", but it's strongly believed that this is a pseudonym, and could possibly refer to multiple researchers.
However, actually implementing Bitcoin as a currency has not been very smooth. There are a number of problems that have been uncovered:
- Governments (mostly) don't like it. Because of the total anonymity, Bitcoin is highly popular for off-the-books or totally illegal transactions. It can also be used to circumvent currency controls. Bitcoin users run a real risk of governments intervening to shut the project down. And because there's no physical asset to take away from the users, there isn't any real protection from this. In most countries, Bitcoin is tolerated and not outright illegal, but its true legal status is uncertain, to say the least. Bitcoin proponents claim conspiracy, but more likely it's Old Media Playing Catch-Up. This is starting to change, as El Salvador voted in June 2021 to make Bitcoin legal tender alongside the US dollar effective that Septemberthough even then, the exchange rate between Bitcoin and the dollar will be set by the market.
- People don't really trust it. Most governments do not accept Bitcoin or other cryptocurrency as payment — including for taxes. Many Bitcoin enthusiasts are trying to convince them otherwise, and in some states you actually can pay your taxes in Bitcoin — but the final number is denominated in the local currency. Merchants also don't really trust it, even if they technically accept it as payment; prices are usually quoted in the local currency, and the Bitcoin is exchanged for the local currency at the spot rate. Those guys don't want to hang on to their Bitcoin; they just want to use the Bitcoin network to make the transaction happen.
- Depending on your jurisdiction's tax laws, Bitcoin can be considered taxable. They do have value, in the sense that they can be exchanged for real currency. You can buy Bitcoin, wait for it to appreciate, and then sell it for a profit — as you can for a foreign currency or a stock. But most tax authorities have special rules for stocks, currency, and other financial instruments. They'd probably see Bitcoin as a commodity like gold, rather than a real currency. Again, depending on the jurisdiction, you'd probably have taxable income if you sell it at a profit — which could mean you have a taxable transaction every time you buy something with Bitcoin. If you try to avoid this by styling yourself as a "Bitcoin dealer" like a stockbroker, you might have to go "mark to market" and pay tax on the amount of money you make every year, regardless of whether or not you actually sold it.
- Bitcoin is highly volatile — one minute, it may be worth a dollar, and the next, it may be worth a cent. "Real" currencies with government backing benefit from government intervention — they can manipulate the money supply to keep the rate stable, and also block nefarious transactions attempting to manipulate the currency from outside. No such luck with Bitcoin. Even regular trading exacerbates Bitcoin's volatility; like any currency, the price is set by what people are willing to pay for it on the open market, and while most transactions in dollars are done by banks and other financial institutions, most Bitcoin trading is done by individuals or small organisations. That's a big reason why prices are still quoted in "real" currency.
- Bitcoin is not really anonymous. Sure, you're only known by your wallet address, which is a random string of characters that can't be traced to you. At least not by itself — hacking also relies a lot on Social Engineering, so it's still possible to connect you to your wallet address by tricking you into revealing it. And once that happens, every transaction in Bitcoin you've ever made from that wallet is now definitively traced to you. People have tried to work around this, but most of these methods (e.g. using the Tor network or a "Bitcoin mixer"note ) are not good for Bitcoin's reputation because they make you look like you're doing something illegal.
- Bitcoin can be lost forever. If you lose the password to your wallet file, there's no way to get the Bitcoin inside. Billions of dollars' worth of Bitcoin have already been lost because of forgotten or lost passwords. In a few cases, Bitcoin were lost because the owner died or disappeared and never told anyone the password to their wallet file. This is exactly what happened to "Satoshi Nakamoto" — he's believed to control over 5% of all Bitcoins that will ever be mined, but he hasn't been heard from since 2010.note It also adds to Bitcoin's volatility — if a large amount of Bitcoin once thought lost suddenly reappears, that will have a big inflationary effect on it.
- Without any centralised authority, Bitcoin users have no recourse in case of fraud or malfeasance. There's no proof of ownership that the police or government will accept. There's no physical underlying asset. There are no chargebacks or complaint forms. Bitcoin exchanges are not guaranteed or capable of error correction; banks and stock exchanges can roll back an erroneous or fraudulent transaction, but not Bitcoin.
- A venture this big without a centralised authority will naturally develop a centralised authority. This creates a problem of trust — if any group of people forms a cartel representing more than 50% of the mining power in the entire blockchain, they can "outvote" the rest of the world and suddenly take over the verification process unilaterally — and not necessarily correctly. In other cases, groups form out of convenience to facilitate Bitcoin transactions, but these entities are unregulated and unprepared. For several years, the biggest Bitcoin exchange was a website called Mt. Gox, which was formerly a Magic: The Gathering online card exchange — they were in over their heads and went bankrupt, and all the Bitcoin stored on the exchange was either wiped out or stolen by hackers.
- Bitcoin attracts... the wrong kind of people. Obviously, there are people who use its anonymity to trade in illegal things on the Internet — drugs, sex, malware. But there are also very credulous people who are drawn to Bitcoin, with a shaky understanding of economics and a "fear of missing out", and many of these people are particularly susceptible to financial fraud like Ponzi schemes. Bitcoin has been accused of being a "pump-and-dump" — it has no value in itself, but the early investors hype it up to later investors and then sell at the height of the bubble, while the later investors can't replicate the process themselves. It certainly doesn't help that, as stated, there's no recourse for fraud victims. Nor does it help that it's explicitly easier to mine Bitcoin for early investors than it is for later ones.
- Bitcoin doesn't scale well. The blockchain is a record of every Bitcoin transaction ever made. That makes it a very big file, which is difficult to store and grow even with all the decentralised computers working on it. A member of the public looking to verify the blockchain may have to wait several hours for a result, and that number will just get bigger over time.
- Bitcoin is inherently deflationary. Because "proof of work" gets more difficult over time, Bitcoin is designed with a cap — only 21 million Bitcoin will ever exist. Every four years, the amount of Bitcoin you get for mining is halved.note This creates scarcity, which drives up the price of Bitcoin relative to "real" currency. But "real" currency is designed to be inflationary. The reason for this is that if you know your money is going to decrease in value soon, you'll spend it right away, knowing you can get more for it today. And that gets money flowing into the economy and stimulates it. If everyone is sitting on their currency waiting for it to appreciate, they're not spending it, and the economy dries up — which is not good.
- Bitcoin is an investment. If you want to make a decent amount from mining, it takes a lot of real-world money. And it gets more expensive over time, because the "proof of work" gets more difficult over time. You've got to pay for not just the hardware, but also the electricity. Some unscrupulous miners have instead taken to installing malware on other people's computers to make them do the mining and put them on the hook for the electric bill.
- Bitcoin creates hardware scarcity. Miners tend to require specialised processors, US$500 graphics cards, and even more expensive ASIC boards. All that is difficult to procure and uses up the planet's rare earth minerals. It also pisses off people like video gamers, who are starting to have serious trouble procuring graphics cards because the Bitcoin miners are hoarding them; it's bad enough that graphics cards manufacturers are starting to design them to prevent them from being used for mining.
- Bitcoin is an environmental disaster. Miners are using a lot of electricity, which isn't necessarily generated cleanly. Bitcoin mining takes up more electricity per year than many entire countries, and because the "proof of work" gets more difficult over time, it requires more processing power, which means more electricity. Bitcoin miners tend to look for sources of cheap electricity. In some cases, that's in poor foreign countries without much incentive to make clean energy. In other cases, they muscle in on a community's electrical grid and drive up the price of electricity for people with nothing to do with Bitcoin.note The aforementioned El Salvador, with abundant geothermal capacity, is now marketing itself as a home for environmentally friendly mining.
Bitcoin's success has led to a number of imitators. While Bitcoin itself is essentially synonymous with cryptocurrency, many of the others have noticed some of the issues with Bitcoin and tried to resolve them:
- Litecoin is essentially a way to make the Bitcoin algorithm nimbler. Its transactions are processed every 2.5 minutes, four times faster than Bitcoin. Its proof-of-work algorithm, called "scrypt", is designed to make it harder to build ASICs that accelerate the work. Its expected cap is 84 million coins. It's much more in the "thought experiment" realm of things, designed to have a much lower transaction volume than Bitcoin so that people can observe the effects of a virtual currency without the strain of supporting an actual economy.
- Ether, the native cryptocurrency of the Ethereum platform, is the second most popular cryptocurrency after Bitcoin. It works a lot like Bitcoin, but it has a bunch of interesting new features, including "smart contracts" — think of these as separate wallet files where the funds are explicitly tied to a contractual obligation, and the transfer happens automatically if the obligation is met. It's a big platform for "initial coin offerings" — i.e. you can start your own cryptocurrency and offer it to people on the Ethereum platform. It's also one of the main platforms to get into the "non-fungible token" or NFT craze. It's got no supply cap, and transactions are verified every 12 seconds. Unfortunately, the Ethereum network is very susceptible to "the wrong kind of people" manipulating the contracts, to the point that a single contract led to hackers stealing $50 million worth of Ether in one go. The Ethereum Foundation has announced that it will change from demanding "proof of work" to "proof of stake" sometime in 2021. When implemented, validators will have to put up a stake of 32 Ether to participate in the validation process. (Small investors can join a validator pool.) Validators are chosen at random to create new blocks, and check and confirm blocks they don't create; they get rewards for doing so (and lose their stake if they create or validate malicious blocks). This will greatly reduce Ethereum's environmental impact, since validators don't have to use significant computing power.
- Dogecoin started as a joke — a reference to the "doge" meme. But it somehow became one of the most popular cryptocurrencies in its own right. It's effectively a clone of Litecoin, but it's actually more economically robust, because it started with 100 billion coins and adds 5 billion every year afterward — making it slightly inflationary, the way a "real" currency is. Mostly, though, it's used for tipping on websites like Reddit and Twitch. In keeping with the meme, everything is in Comic Sans.
- Chia is designed to combat Bitcoin's environmental impact. Instead of demanding "proof of work", it uses "proof of space and time" — it's not using the peer-to-peer network for verification, but rather for storage. It runs on what's essentially a weighted lottery system; the more data you can store, the higher the chances of you "winning" the stake in verifying the blockchain. While it does solve the energy consumption problem, it creates other problems in its users buying up high-capacity storage drives.