Cryptocurrency reached a peak in 2021. Bitcoin once again notched an all-time high valuation, surpassing $65,000 (earlier in the year, it had dipped below $30,000). And this year bitcoin — and cryptocurrency in general — penetrated deeply into financial services as well as the culture, gaining an expanding foothold in popular art, commerce and other corners of the mainstream.
If you’re looking for a primer on bitcoin and cryptocurrencies, you’re in the right place. We’ll take a look at the basics — what bitcoin is, where it comes from and how to buy it — as well as a range of other topics including valuation, legality and its practical applications.
But first: A quick backstory
Bitcoin was invented in 2009 by a person (or group) who called himself Satoshi Nakamoto. His stated goal was to create “a new electronic cash system” that was “completely decentralized with no server or central authority.” After cultivating the concept and technology, in 2011, Nakamoto turned over the source code and domains to others in the bitcoin community, and subsequently vanished. (Check out the New Yorker’s great profile of Nakamoto from 2011.)
What is bitcoin?
Simply put, bitcoin is a digital currency. No bills to print or coins to mint. It’s decentralized — there’s no government, institution (like a bank) or other authority that controls it. Owners are anonymous; instead of using names, tax IDs or social security numbers, bitcoin connects buyers and sellers through encryption keys. And it isn’t issued from the top down like traditional currency; rather, bitcoin is “mined” by powerful computers connected to the internet.
How does one ‘mine’ bitcoin?
A person (or group, or company) mines bitcoin by doing a combination of advanced math and record-keeping. Here’s how it works. When someone sends a bitcoin to someone else, the network records that transaction, and all the other transactions made over a certain period of time, in a “block.” Computers running special software — the “miners” — inscribe these transactions in a gigantic digital ledger. These blocks are known, collectively, as the “blockchain,”of all the transactions that have ever been made.
Using specialized software and increasingly powerful (and energy-intensive) hardware, miners convert these blocks into sequences of code, known as a “hash.” This is more dramatic than it sounds; producing a hash requires serious computational power, and thousands of miners compete simultaneously to do it. It’s like a multitude of chefs feverishly racing to prepare a new, extremely complicated dish — and only the first one to serve up a perfect version of it ends up getting paid.
When a new hash is generated, it’s placed at the end of the blockchain, which is then publicly updated and propagated. For their trouble, the miner currently gets 12.5 bitcoins, which, in February 2018, was worth roughly $100,000. Note that the amount of awarded bitcoins decreases over time.
What determines the value of a bitcoin?
Ultimately, the value of a bitcoin is determined by what people will pay for it. In this way, there’s a similarity to how stocks are priced.
The protocol established by Satoshi Nakamoto dictates that only 21 million bitcoins can ever be mined — almost 19 million have been mined so far — so there is a limited supply, like with gold and other precious metals, but no real intrinsic value. (There are numerous mathematical and economic theories about why Nakamoto chose the number 21 million.) This makes bitcoin different from stocks, which usually have some relationship to a company’s actual or potential earnings.
Without a government or central authority at the helm controlling supply, “value” is totally open to interpretation. This process of “price discovery,” the primary driver of volatility in bitcoin’s price, also invites speculation (don’t mortgage your house to buy bitcoin) and manipulation (hence the well-documented talk of tulips and bubbles).
Bitcoin has made Satoshi Nakamoto a billionaire many times over, at least on paper. It’s minted plenty of millionaires among the technological pioneers, investors and early bitcoin miners. The Winklevoss twins, who parlayed a $65 million Facebook payout into a venture capital fund that made early investments in bitcoin, are now well-known billionaires, according to Fortune.
How do I buy bitcoin?
If you’re willing to assume the risk associated with owning bitcoin, there is an increasing number of digital currency exchanges like Coinbase and FTX where you can buy, sell and store bitcoins.
Getting started is as minimally complicated as setting up a Paypal account. With Coinbase, for example, you can use your bank (or Paypal account) to make a deposit into a virtual wallet, of which there are many to choose from. Once your account is funded, which usually takes a few days, you can then exchange traditional currency for bitcoin.
Speaking of Paypal, a number of established money services now offer in-app bitcoin purchasing, which makes it quick and easy for beginners to get their toes wet. It’s also worth noting that some platforms charge considerably higher fees to make certain transactions, which can end up eroding your investment if you do a lot of trading. So you should read the terms carefully before buying to make sure you understand the limitations of service.
What can I do with bitcoin?
While there are some places where you can spend bitcoin, many people just hang on to them, like you would with other long-term investments. The price volatility of bitcoin makes it difficult to transact day-to-day purchases.
Is all of this legal?
Short, qualified answer: Yes, for now, as long as — like any currency — you don’t do illegal things with it. For instance, bitcoin was the sole currency accepted on Silk Road, the Dark Web marketplace for drugs and other illicit goods and services.
Since then, bitcoin has largely evaded regulation and law enforcement in the US, although it’s under increased scrutiny as it attracts the mainstream attention of institutional investors. Though it’s legal to buy and sell bitcoin, many aspects of the industry, such as tax concerns for investors, still occupy a gray area that could be vulnerable to future regulation and/or law enforcement action.
What are the risks?
Legal and regulatory hazards aside, as both an investment and currency, bitcoin is very risky. When you wake up in the morning, you know pretty precisely how much a dollar can buy. The financial value of a bitcoin, however, is highly erratic and may swing widely from day to day and even hour to hour.
It’s very difficult, though not impossible, for bitcoin transactions to be traced back to individuals. Though they’re secured, they’re also obscured through the use of public and private encryption keys. This pseudonymity can be appealing, especially with companies and marketers increasingly tracking our every purchase, but it also comes with drawbacks. You can never be certain who is selling you bitcoin or buying them from you. Opportunities for money laundering abound.
Theft is also a risk, and there are limited avenues for pursuing refunds, challenging a transaction or recovering such losses. Once a transaction hits the blockchain, it’s final.
OK, so what about — wait, there are more risks?
Because bitcoin is still relatively new decentralized technology, there is plenty of murkiness and many unknowns. Even the technical rules for mining are still evolving and up for debate.
The IRS views bitcoins as property, not currency, and there are tax implications. In 2017, a federal judge ruled that Coinbase must surrender records to the IRS on transactions of $20,000 or more. Coinbase’s regulation troubles have continued into this year, with the SEC blocking a new lending product Coinbase planned to release in September 2021.
Then there’s the fundamental question of whether you should trust a particular exchange. The federal rules surrounding cryptocurrency exchanges are still being hashed out, and exchanges have been hacked as recently as late 2021.
Are there other cryptocurrencies?
Yes. There are thousands, with more sprouting up every day. Aside from bitcoin, which is the real progenitor of them all, other well-known alternative currencies include ether, sol and ada.