Unless you’ve been living under a rock, Shirley you’ve heard of Bitcoin. You’ve heard of it, but many people are still confused on what it is, why it has value, etc. If you want a pretty-complete crash course which takes a few hours, check out this course on Udemy (for free).
For what it’s worth, and because this comes up a lot – I wanted to write down my opinions and observations in one place. Some won’t agree, but hopefully some of this information is useful.
If I’ve stated anything incorrect or if I misunderstand something – please leave a comment below or shoot me an e-mail!
What is it?
Bitcoin is a “cryptocurrency”. That means it’s a computer-based form of “money” that is secured using cryptography. It was started anonymously by a person or group called Satoshi Nakamoto. That’s a little disconcerting that a currency was started by an anonymous person or group! If it makes you feel any better, it is open-source – so you could look for problems in the algorithms?
Although some contend, and it does make sense that it may have really been started by DARPA (the evil cousin of the NSA) – which you can imagine what that means for your anonymity! Who knows.
Anyhow, it’s a distributed system (no central “core” or company that controls it) where users can send each other money using public key encryption. When they do, the transaction is hashed, validated, and added to the “blockchain” by “miners” (described below). The blockchain is the master receipt tape, or public ledger of every transaction that has ever been made with Bitcoin. The blockchain is never pruned or destroyed, it lives as long as the currency does!
When the currency was created, some amount of Bitcoins were created. There are now around 13 million Bitcoins, and through a strategy called “mining” (described below), more Bitcoins will be created. There is a maximum number of 21 million Bitcoins that can exist.
The current price as of this writing is ~$280 per Bitcoin. However, you can send or receive in increments as small as 0.00000001 – using milli, micro, nano, etc Bitcoins.
Why does it have value?
Bitcoin is not backed by anything of value, like gold or silver. So, it’s kind of like a fiat currency, but backed by the people’s faith and agreement that it has value.
But wait, why DO people agree that is has value? It’s basically because of of the potential of having an “anonymous” currency like paper money, but the convenience of digital payment, like credit cards. People found value in that and decided to get behind it.
Is it anonymous, like money?
No. It’s partly-anonymous, kind of. Your actual transactions are just between your public key and someone else’s public key. Here’s the catch though. If you ever in your life, make a transaction that can be tracked back to your real name – then ne’er-do-wells, and the NSA could easily go through the block chain and start investigating every single transaction you’ve ever made with that wallet. So, it’s anonymous until the day that you make a transaction that can be tied back to you. Then, it’s far-less private than even a credit card. Nefarious investigators could potentially track every transaction you’ve ever made. Remember, the blockchain lives on forever and your “receipts” of all of your transactions never go away.
So, it’s only anonymous on the surface – but if anyone wanted to press it, your transactions can be found out.
What is Bitcoin mining?
This is the most complicated part of it. As I understand it, random people install software on their computer – or more likely, build specialty machines or buy pre-built hardware which does calculations. These “mining” machines make themselves available on the internet for processing. This is a peer-to-peer network, similar to how torrents work.
Meanwhile when you make a transaction, your software finds a miner and submits your transaction. The miner verifies the transaction, and does a complicated calculation to create a new Bitcoin. The miner is paid some fraction of that new Bitcoin for his/her processing time (<$.25 as of this writing). Once several miners have verified the transaction, it’s considered settled. This is called processing a “block”, and that new transaction (block) is then added to the blockchain.
Mining, by the way, is expensive. Doing a quick calculation with my computer – using the Radeon video card (because it’s better than my CPU for this sort of thing), it would COST me ~$8.20 a month to mine for a month. So at this point, miners MUST invest in expensive, specialized hardware to even break even. More on that below!
The two ways to make money from cryptocurrencies
From what I can tell, there are two fundamental ways to make money from a cryptocurrency. First, is to buy some before it hits big. This is almost impossible to do – especially now when there are a gazillion other cryptocurrency startups. Which one is going to go from $0 to $979 in about 3 months time – like Bitcoin did?
The other way seems to be from “mining”, as described above. The issue is that as the blockchain gets longer, the calculations take longer, so each passing month, you will make less and less money. In the case of Bitcoin, it’s almost no longer profitable and everyone is bailing on Bitcoin mining. More on that in minute!
So, while the currency is still new, the blockchain will be smaller and it should be fairly profitable to do mining.
Achilles Heel #1: The cost of mining hitting critical mass
Which leads me to my first of a few conclusions. If you buy $1000 in hardware to do mining, and it returns $100 the first month, the next month it might be $96, and the month after, $92, etc – because the blockchain is getting longer and more difficult to hash.
There is a concept built into the process called “halving” where, as the calculations get more difficult, the miners will be paid more. However, the blockchain-length, and electricity costs seems to be out-pacing that rule.
So, mining when the currency is new can be lucrative – but there comes a point where it literally costs more to hash, then it returns. Bitcoin, in my opinion, is heading towards that very quickly (perhaps in the next 1-3 years?). Meanwhile, only 13 of the 21 million bitcoins have been mined. What happens when it’s too expensive to mine?
Practically, I think it means that it will start taking a long time for your transaction to be validated, which will annoy users – and at some point, enough people will pull out and the currency will collapse.
Achilles Heel #2: It’s not anonymous
As described above, it’s not really anonymous. As soon as you make a transaction that can be tied to your real name, ALL of your previous transactions can now be correlated and investigated because the blockchain of ALL transactions never goes away. By the way, this concept is called an “identity anchor”.
This is significant because A) a lot of people don’t understand this and B) this currency primarily has value BECAUSE people think it’s “completely anonymous”.
Achilles Heel #3: It’s not safe from theft (like FDIC)
You have 4 choices where to store your wallet:
- On your hard drive (using Windows/Mac/Linux software)
- On a portable USB or thumb drive (using your desktop app)
- On your phone with an app
- On a website (see here)
Each of these is fraught with peril! For your hard drive – hard drives can fail, and computers can be stolen. If you don’t have a solid backup, you’ve lost your money, permanently. If you lose or have your USB drive stolen, again, your money is gone. If you store your wallet on your phone and you drop it – or someone steals it, they may not be able to “steal” your money, but to you – the money is still gone.
Lastly, and probably worst – is storing your wallet on a website. This gives you the greatest convenience – but also turns the e-wallet websites into huge hacking targets. Remember back in 2011, the biggest Bitcoin currency exchange around, Mt.Gox had an enormous breach – and ultimately got sued, went bankrupt, and shutdown. Would you feel safe holding your life-savings with websites like this?
I mention the FDIC – if you are in the United States, all money you put into a bank is automatically insured up to $100,000. With cryptocurrencies, as of now, they are very much like dollars in your wallet – if you lose your wallet, your money is gone! And there is not great place to store your wallet.
When Bitcoin first came out, I thought for sure that it would be shut down immediately. There are several laws about creating a competing currency. For example, in the 18 U.S. Code § 486 – Uttering coins of gold, silver or other metal:
Whoever, except as authorized by law, makes or utters or passes, or attempts to utter or pass, any coins of gold or silver or other metal, or alloys of metals, intended for use as current money, whether in the resemblance of coins of the United States or of foreign countries, or of original design, shall be fined under this title  or imprisoned not more than five years, or both.
The fact that Bitcoin survived, is very suspicious to me. The Federal Reserve and the U.S. Treasury don’t take lightly this sort of thing – so the fact that they are OK with a competing currency, makes me lend a little credence to the DARPA story! I mean, what better law enforcement tool could you have but a digital currency that “people who like anonymity” will use?
Anyhow, Bitcoin is one of those truly innovative ideas. Although it’s not perfect, it is a pretty unique idea. I don’t know if Bitcoin or any of the other MANY cryptocurrencies will survive. My best guess is that someone will address some of the problems, and maybe there will be a Version 2.0 of the idea?
Meanwhile, I hope some of this helps.