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What is Bitcoin & How Does It Work?

January 29, 2019 · 3 minute read

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What is Bitcoin & How Does It Work?

To understand Bitcoin, there are a few other definitions to clarify first, including that of digital currency .

This type of currency does not have a physical form, so it can’t be seen or touched, but theoretically, it can be used in the same ways as traditional money, including buying and selling goods and services. Digital currency can be used around the globe, as long as parties accept this type of payment, being exchanged among digital wallets.

Cryptocurrency is a type of digital currency, one that’s based on cryptography, using complex mathematical principles to create and analyze algorithms. Bitcoin is the most widely recognized form of cryptocurrency, but it isn’t the only option.

Bitcoin uses blockchain technology and a decentralized ledger to operate. In hypothetical terms, blockchain is like a spreadsheet duplicated across networks of computers with the technology creating the ability for people to regularly update the spreadsheet with transactions.

Records are public and easily verified, creating a sense of openness. Bitcoin has no primary regulating authority—and no centralized version of its record exists. Regulators are increasingly getting involved, but the regulatory structure is currently nowhere near the same degree as those imposed on securities or banking products.

What Exactly is a Bitcoin?

In short, bitcoin are pieces of complicated computer code with a fluctuating, market driven dollar value. They are created by computers and use significant amounts of energy (more about energy usage later!) in their creation.

A bitcoin is not tied to any particular bank or regulatory agency, with users identified by a wallet ID number , rather than by a name.

Bitcoin was the first major cryptocurrency created, appearing in January 2009. Its creation has been credited to a developer named Satoshi Nakamoto, although it’s possible that multiple people participated in its development under the umbrella of this name. You can find speculation about his true identity if you dig a little. Whoever Nakamoto really was, he disappeared, leaving his fortune in bitcoin behind.

Although the blockchain and its associated online ledger are publicly available, people can store their bitcoin on their own hardware, a storage system called “cold storage .”

This provides a layer of protection from theft, in contrast to “hot storage ,” a system where the cryptocurrency is stored in the cloud and faces a bigger risk of being stolen.

However, if someone stores his or her bitcoin on personal hardware and no longer has access to that hardware, he or she permanently loses access to bitcoin owned. One estimate suggests that $30 billion in bitcoin have already been lost in that manner. To prevent this loss, savvy people involved in bitcoin transactions back up their online wallet .dat file every time they send or receive bitcoin and safely store this duplicate file.

It’s important to note that, yes, bitcoin is currently the most popular form of blockchain-network currency—but, because cryptocurrency is either unregulated or banned around the globe (with Iceland being a unique exception), new forms of it could appear at any time. Or, other frequently-used types, including Bitcoin Cash, Litecoin, Ethereum, EOS, and Ripple, could someday increase in popularity and surpass bitcoin usage.

Some countries still consider this currency to be illegal ; specifically, those countries are Morocco, Bolivia, Ecuador, China, and Nepal. (P.S. Bitcoin is legal in the U.S.) Laws surrounding Bitcoin usage continue to evolve, with governments often debating questions, such as whether bitcoin should:

•  be accepted as legal tender currency

•  be taxable

•  have their trading regulated

•  have their mining regulated

“Laws and regulations relating to Bitcoin and other cryptocurrencies,” reads , “can change several times a year as financial institutions adapt to the market and government opinion shifts.”

“If planning a trip overseas, it’s highly recommended to research the target country’s Bitcoin policies beforehand via an official government website. This is especially important if traveling for business.”

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Online Retailers Using Bitcoin

Some retailers accept bitcoin as payment for their goods and services. As of November 2018, at least 15 major retailers do so, with Overstock.com being the first to do so, starting in January, 2014.

Since June 2014, Expedia.com has accepted bitcoin payments when customers want to book hotel rooms (but not yet for their other services), while eGifter.com allows people to purchase gift cards, including for retailers that don’t directly accept bitcoin.

When someone makes a purchase, then the relevant amount of bitcoin is sent from his or her online wallet to the seller’s wallet. There are typically fees involved in bitcoin transactions, but they are currently quite small, with no ongoing fees as you might experience with banks. Fees involved are paid to:

•  servers that support bitcoin networks, which will probably involve a few cents every time you make a transaction

•  online exchanges necessary to convert bitcoin into traditional cash

•  mining pools joined; people often join bitcoin groups, and these pools will typically charge, say, a 1% fee or ask for donations from members

So, although bitcoin transactions are not free, they can be significantly less costly than traditional money transfer fees. Be aware that no kind of depositor insurance (like FDIC coverage) is available for someone’s bitcoin savings, and it is not backed by any precious metals, or SIPC insurance.

Bitcoin Investors

Some people keep the bitcoin they accumulate, seeing it as an investment. The value of bitcoin fluctuates daily, and you can check Coindesk or a similar site to check current values.

Right now, there are about $2 billion of bitcoin in existence (which is about 16.3 million bitcoin in current circulation); when the total value hits the 21 million coin mark, no more will be created. This is estimated to happen in 2040.

Bitcoin Mining

A crucial element in understanding bitcoin is the mining process. A “miner” is a person who includes his or her computer in the bitcoin network, with these computers serving as ledger sites for bitcoin transactions. In exchange for their work, miners earn bitcoin.

More specifically, as “work,” miners compete for bitcoin by attempting to solve challenging math problems. These problems are so complex that, rather than trying to directly solve them, the miners use high-speed computers to create a multitude of guesses, playing the odds that one of their responses will be correct and they will win bitcoin cryptocurrency. These problems are known as “proof-of-work” problems, which is the name of those that take intensive computer resources to solve them.

Each of these problems, explains LifeWire.com , has a “set of possible 64-digit solutions.” A computer, running day and night, may solve a problem in an average of two to three days, although it can definitely take longer. With only one computer involved, the miner may only earn 50 to 75 cents per day; when you subtract the electricity costs involved, it isn’t a money maker, at all.

But, miners who run, say, 500 computers per day can net up to $500 daily. So, to be profitable, a miner must invest significantly in computer hardware and/or collaborate with a miners group to exponentially boost the power of hardware. “This prohibitive hardware requirement,” the article concludes, “is one of the biggest security measures that deters people from trying to manipulate the bitcoin system.”

Bitcoin Abuses

LifeWire.com lists three forms of bitcoin abuse. They include:

•  Confirmation time delays: Because it takes several seconds or minutes for transactions to be confirmed across the numerous “swarm of computers” involved, a person who uses super-fast clicking can actually spend the same bitcoin more than once, paying different people out of the same coin. This abuse is ultimately caught and corrected but, if the sellers whose transactions get negated have already sent out goods, they lose both the money and the products.

•  Pool organizations taking too much of a share: Miners organize into groups/pools and divide up the bitcoin that are successfully mined. People who organize the pools can take more than they should out of the shared prizes.

•  Online exchanges can be poorly managed: People who exchange bitcoin for cash on behalf of miners can be dishonest. They can be incompetent. Yes, this can happen at more traditional banking organizations too, but conventional banks have FDIC insurance, while bitcoin exchanges are not.

The anonymity of bitcoin operations can seem dicey as well, although because the history of each bitcoin wallet is public and transparent, this helps to mitigate the ability of miners with ill intent to use the system for illegal purposes.

Here’s something else to consider. Once you conduct a bitcoin transaction, the result is final. If, for example, you use a credit card to purchase something, there are legal means to obtain redress if you’re not satisfied. With bitcoin, there isn’t. Final is final.

Power Challenges

The process of mining bitcoin uses up a significant amount of electricity, so much so that a Newsweek article warns that “Bitcoin Mining on Track to Consume All of the World’s Energy by 2020.” Already, the article reads, the electricity required to manage bitcoin mining is thought to exceed the energy consumption of 159 different countries.

And, as each transaction occurs, it needs to be added to and confirmed on the online ledger. As increasing numbers of people and computers become part of this blockchain network, mathematical equations involved will continue to become increasingly more complex—which will likely further boost the demand for more energy.

An article in the Washington Post puts this energy usage into context, sharing how the bitcoin network generates 14 million trillion possible hashes (meaning, potential solutions to the mathematical problems) every single second.

Even if every single participant employed the world’s most efficient computer hardware (which they definitely don’t), this would still involve at least 1.2 billion watts (gigawatts) of instantaneous power, comparable to what’s generated by one of the nuclear reactors located in the United States.

CCN.com offers a different perspective on energy usage involved, noting how every single bitcoin network transaction uses up enough energy to power an average home in the Netherlands.

A Note About Iceland

Numerous bitcoin networks are located in Iceland, a country with cheap renewable energy because of the volcanoes located there and because the frigid Arctic winds can cool computer server rooms. Cheaper energy costs mean that bitcoin miners can further increase their profits.

Iceland is also the first (and, as of the time of writing this post, the only) country to regulate cryptocurrency use, effective September 2018. Bitcoin networks must now register with the country’s Financial Supervisory Authority, with this legislation created to combat terrorist activities and money laundering.

Cryptocurrency can be a useful tool for people involved in these illegal activities; because people use wallet ID numbers rather than real names for transactions, this provides anonymity.

Another concern of Icelandic officials focuses on the volatile nature of cryptocurrency, with a 2018 report by The Icelandic Data Center Industry noting that the combination of power consumption issues and speculative nature of crypto trading pose a huge risk factor for their vulnerable local markets.

Bitcoin for the Modern Investor

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SoFi Invest®
The information provided is not meant to provide investment or financial advice. Investment decisions should be based on an individual’s specific financial needs, goals and risk profile. SoFi can’t guarantee future financial performance. Advisory services offered through SoFi Wealth, LLC. SoFi Securities, LLC, member FINRA / SIPC . SoFi Invest refers to the three investment and trading platforms operated by Social Finance, Inc. and its affiliates (described below). Individual customer accounts may be subject to the terms applicable to one or more of the platforms below.
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Crypto: Bitcoin and other cryptocurrencies aren’t endorsed or guaranteed by any government, are volatile, and involve a high degree of risk. Consumer protection and securities laws don’t regulate cryptocurrencies to the same degree as traditional brokerage and investment products. Research and knowledge are essential prerequisites before engaging with any cryptocurrency. US regulators, including FINRA , the SEC , and the CFPB , have issued public advisories concerning digital asset risk. Cryptocurrency purchases should not be made with funds drawn from financial products including student loans, personal loans, mortgage refinancing, savings, retirement funds or traditional investments. Limitations apply to trading certain crypto assets and may not be available to residents of all states.
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