Bitcoin: understand what they are and how they work

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What is Bitcoin?

Bitcoin was the first of what have become known as “cryptocurencies”.

These are forms of digital money that use encryption to secure transactions and control the creation of new units.

The plan was to make a form of currency not controlled by governments or businesses, that you could trade globally with no cost and without having to reveal your identity.

The popularity of Bitcoin has spawned many copycats – sometimes called “altcoins”.

To make things more confusing, there are also “second generation” virtual currencies like Ethereum and Bitcoin Cash.

So they’re not like the coins in my purse or wallet?

No. They are essentially a line of numbered “code” – instructions used in computer programming.

However, once purchased they can be exchanged for some goods and services, like normal money.

Created by a mysterious developer who uses the pseudonym Satoshi Nakamoto, Bitcoins exploded on to the financial scene in 2013, following enormous increases in their value.

In the original Bitcoin white paper, Nakamoto describes his creation as a “peer-to-peer version of electronic cash”, allowing “online payments to be sent directly from one party to another without going through a financial institution”.

Even though Bitcoin hit a record high of about $19,200 for each coin on December 17, the cofounder of the Bitcoin.com website said that “Bitcoin is right now the riskiest investment you can make … as soon as people realise how it works, they will start to sell”.

Here are some of the things you should consider before you jump on the bandwagon.

Description…. Bitcoin

  • Cryptocurrency: Bitcoin is a digital form of money that you can use to pay for some transactions online. It is the most popular of the so-called “cryptocurrencies”.

  • As with “real” currencies (like the US dollar), you can own one, 10, or millions of Bitcoins. Unlike real currencies, cryptocurrencies only exist online and are not backed by any government or central bank.
  • Cryptocurrencies depend on complex computer software to verify, validate and secure transactions between people exchanging this virtual money online.
  • The software running Bitcoin was first released in 2009, together with the website, Bitcoin.org, by a programmer self-identified as Satoshi Nakamoto. He announced Bitcoin as “a Peer-to-Peer Electronic Cash System”.
  • Regulation. In March 2014, the IRS, the US government agency responsible for tax collection, stated that all virtual currencies, including Bitcoins, would be taxed as property rather than currency. 
  • South Korea is reportedly also looking to tax the money made from trading in cryptocurrencies. The government will also ban minors from opening accounts on virtual coin exchanges, and propose a bill to allow only eligible exchanges to operate.

How does it work?

  • Blockchain: The financial system to validate Bitcoin transactions is known as the Blockchain, and depends on a decentralised network of computers connected over the internet.
  • Like peer-to-peer (P2P) networks where unidentified people upload and download music and films, the blockchain depends on a growing community of people and institutions online.
  • Those peers run the Bitcoin software to verify Bitcoin transactions, independent of any bank or treasury.
  • Every time people exchange Bitcoins online, the whole network gets updated with the new information, creating new “blocks”, i.e. long chains of data for computers to solve.
  • Mining farms: Like printing new bank notes, new Bitcoins are created by solving “blocks” of mathematical equations that are created each time Bitcoins are exchanged online.
  • Even though the Bitcoin software can crunch all those equations automatically, it requires a lot of computing power to do so.
  • This automatic process is known as “mining” and requires a lot of computing power. For this, large data centres, known as “mining farms”, have been set up. Many of the largest farms are located in Russia and China.
  • Blockchain.info counts 16 million Bitcoins in circulation, while there can only be up to 21 million Bitcoins. This limit is set in the Bitcoin algorithm.

How to mine

Mining is a tricky process that involves solving a complex maths problem that takes both time and computing power. The more powerful your computer (and thus, the quicker you can crunch the numbers) means a more difficult problem.

Custom-built Bitcoin mining hardware and software is now available, allowing miners to find Bitcoins even faster.

Each miner also solves a dual function as they process and secure transactions on the block chain. But the more miners that join, the harder it becomes to find Bitcoins.

What is a Bitcoin miner?

A Bitcoin miner can be anyone that simply does it for fun right up to someone with the latest equipment who is attempting to mine for profit.

Bitcoin miners also join into pools that split the workload and gives each of them a share of the profits.

Where can you buy it?

  • Costs more than gold. At December’s peak rates, one Bitcoin costs as much as $18,000. For this much, you could also buy 300 grams of gold, at current rates.
  • In 2010, you could buy one Bitcoin for less than $0.10. Back then, it would take 10,000 Bitcoins to buy two pizzas.
  • Bitcoin exchanges. Bitcoins can be purchased, or sold, through exchange operators dedicated to cryptocurrencies, as well as traditional operators such as Chicago-based CME and Switzerland-based Swissquote, among others.
  • In those public exchanges, Bitcoin is traded under the XBT and BTC symbols. BCH stands for Bitcoin Cash, which is a “hard fork”, or a new variation, of the original Bitcoin algorithm.
  • CME’s Bitcoin Reference Rate (BCC) is a spot price index used by CME, and is based on the daily Bitcoin price on specialised exchanges such as Bitstamp, GDAX, itBit and Kraken.

How safe an investment is Bitcoin?

Investing in Bitcoin would mean investing in the complex algorithms on which it is based, and on the future of the peer-to-peer network that operates it.

Al Jazeera has looked at the terms and conditions that an investor in Bitcoin would have to accept to buy Bitcoin from a Swiss-based exchange operator. Here are some of the risks that you would be accepting as an investor in Bitcoin:

  • Price volatility. The value of cryptocurrencies may change significantly even in a single day, which would mean a capital loss of your investment.
  • For example, last week the price of Bitcoin fell by 26 percent. If you had bought a Bitcoin on December 19, you would have paid $18,936 for each coin. But if you wanted to sell it on December 23, buyers on the market were not willing to pay more than $14,048 – a loss of $4,888 for each coin.
  • In 2013, the price of Bitcoins had fallen by 61 percent in a single day. On April 10 the exchange for Bitcoin had fallen from $266 to $140 for each coin.
  • Cryptocurrencies lack the historical track record of other currencies or commodities, such as gold, that could guide whether current levels of volatility are typical or atypical.
  • Hacking risk. On December 19, a South Korean cryptocurrency exchange said it would file for bankruptcy after it was hacked for the second time this year.
  • Over 70 million dollars’ worth of Bitcoins has reportedly been lost by several cryptocurrency exchanges and miners, highlighting concerns about the security of such currencies.
  • “Hard fork” splits. Since the value and support for the currency depend entirely on the community using it, disagreement between the stakeholders may result in the splitting of the network to support new competing cryptocurrencies, known as “hard fork”.
  • For example, Bitcoin Cash (BTC) is a hard fork from the original Bitcoin. Effectively, BTC is now a different cryptocurrency from the original Bitcoin, prompting stakeholders to sell their “old” Bitcoins and invest in this new one.
  • The cofounder of the Bitcoin.com website, Emil Oldenburg, reportedly “sold all my Bitcoins recently and switched to Bitcoin cash”.
  • Early stage technology. With advances in technology, cryptocurrencies are likely to undergo significant changes in the future. How the existing cryptocurrencies will cope, or benefit, from those changes is to be determined.
  • There is also the risk of alternative technologies that could supersede existing cryptocurrencies and make them obsolete.

Where you can use it
  • Online stores that accept Bitcoin. In 2014, Overstock became the first major online retailer to accept Bitcoin payments. Monoprix and Newegg also accept Bitcoin online payments.
  • For travel. Latvian airlines AirBaltic and Air Lituanica accept Bitcoin payments for some of their flights.
  • California-based online travel booking website CheapAir.com claims to have completed more than $1.5m in Bitcoin sales on flights, hotel bookings and Amtrak railway bookings.

The future of cryptocurrencies

Second-generation cryptocurrencies include altcoins with more advanced functions, that harness the computing power of the blockchain.

An example is Ethereum – the blockchain can execute “smart contracts”.

These are pieces of computer code that can interact with other coded contracts and perform work – for instance moving money around and making decisions.

The DAO platform that was hacked is written into the Ethereum blockchain and can autonomously operate without humans to control the organisation.

To decide what investments the DAO makes, its members vote on which proposed contacts will be included in the blockchain.

This could be the start of an autonomous financial future dictated by machines rather than humans.

Why have there been so many warnings about Bitcoin?

Partly because of fears that investors will lose a packet.

Firstly, Bitcoin has no central bank that stands behind it and isn’t regulated by any state.

Secondly, experts reckon the bubble could burst.

Earlier this year Ethereum – the second biggest cryptocurrency after Bitcoin – saw its value collapse from $317 a coin to $0.1 a coin in a day. It bounced back, and is now trading at $473 a coin, but the lesson is there.

Some have labelled Bitcoins what traders call a “fool’s asset”. Unlike investing in a house that can be rented out or a company that makes profits, the only way to make money from them is to find a “greater fool” than you who’ll pay an even higher price than you will.

Legendary investor Warren Buffett says of Bitcoin: “Stay away from it. It’s a mirage, basically.”

Finance expert Martin Lewis said: “Bitcoin is a highly speculative investment. Putting money in it is a form of gambling.”

Why else are people worried?

Because it is being exploited by criminals and hackers.

The fact that transactions are untraceable makes it a dream come true for drug dealers and money laundering, and it is the currency of choice for cyber criminals.

It is telling that online crooks who launched the massive WannaCry ransomware attack earlier this year, which crippled part of the NHS and as well as businesses in 150 countries, demanded Bitcoin payments for organisations to regain access o their systems.

The ill gotten gains can be transferred across borders and withdraw in any currency or spent them on the dark web – a collection of hard to find websites where it is impossible to track the user.

The Treasury this month announced a crackdown on Bitcoin to tackle money laundering and tax dodging.

Under the plans, online platforms where Bitcoins are traded will be required to vet customers and report suspicious activity.

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