To begin to understand digital assets and cryptocurrency the best place to start is where it all began and with the most prominent digital asset and cryptocurrency of them all – Bitcoin.
Bitcoin. bitcoin.
First, it's important to understand there is Bitcoin and then there is bitcoin. Bitcoin (with the capital letter) refers to the Bitcoin network. Then there is bitcoin, which refers to the cryptocurrency itself that you're able to buy, sell, and use for sending and receiving in transactions. The symbol for bitcoin is BTC. Many times they are used interchangeably by people, but there is a difference.
Bitcoin is a peer-to-peer consensus network that allows people to send and receive money across the world without a third-party intermediary, middleman, central bank, or government. The concept of the implementation of a cryptocurrency was first described in 1998 by Wei Dai on the cypherpunks mailing list as a new form of money that uses cryptography to control its creation and transactions, rather than a central authority. An actual usable implementation of Wei Dai's idea wouldn't come to fruition until a decade later. That started with the publishing of a whitepaper by Satoshi Nakamoto on October 31, 2008 called Bitcoin: A Peer-to-Peer Electronic Cash System. Bitcoin actually launched in January 2009, and Satoshi stayed on the Bitcoin project until late 2010 when he disappeared without revealing who he was. It's still not known who Satoshi Nakamoto is, or even if Satoshi Nakamoto is a single individual or actually a group of people or even a company.
It's important to note here that Bitcoin is open-source. That means the code that runs the Bitcoin network is available for anyone in the public to see. One advantage to open-source code is that any developer can review the code and inspect it for potential flaws, especially when it comes to security. Another advantage is that other developers can contribute to the project. After Satoshi Nakamoto left the Bitcoin project, it continued to be run by others already involved in the project, and it eventually grew to what it is now.
With Bitcoin, and many other cryptocurrencies, changes to the code are generally voted on by those who mine bitcoin (more on that later). That is one of the biggest and most important features of Bitcoin. Since no one person, or even a small group of people, are able to control or change Bitcoin, it makes it more secure. It would require a vast majority of those currently running the network to adopt any changes in the code, and generally all users would need to adopt the changes for it to continue. Because there is no central authority controlling the Bitcoin network it is considered to be decentralized. As you hear and read more about digital assets and cryptocurrency you'll come across that term often, especially as decentralized finance, or DeFi.
What Does the Bitcoin Network Do?
The software that runs on the Bitcoin network is a decentralized blockchain ledger. For an overview of blockchain and its benefits, read the previous Escient Financial Insights post What is Blockchain and What are the Benefits of Blockchain and Cryptocurrency? The Bitcoin network is made up of thousands of computers that compete to process blocks in the blockchain. Each block is a group of transactions that are being verified and settled, and has an equation to solve. The first miner to solve the equation with the correct matching hash for that block gets to verify and settle the transactions and commit the block to the Bitcoin blockchain ledger. Other miners then confirm the transactions in the block to ensure the security of the network.
With Bitcoin, there is a new block added to the blockchain approximately every 10 minutes. The time fluctuates slightly depending on the number of transactions, network load, and the difficulty the the equation the miners are trying to solve.
Why Do Miners Want to Mine?
Bitcoin mining got its name because those who mine bitcoin receive bitcoin when they solve the equation first, similar to mining gold. Anyone can start mining Bitcoin, and the more miners mining bitcoin the more secure the network becomes because of increased decentralization. If you want to mine bitcoin you simply need to buy the appropriate bitcoin mining hardware, install the software, add your bitcoin wallet address, and then run the software. There are even companies that exist where you can buy the hardware and they run it for you for a fee.
The main reason bitcoin miners mine bitcoin is because the winning miner is rewarded handsomely with bitcoin. Currently, miners receive transaction fees and, most importantly, 6.25 bitcoin for each block. If bitcoin is valued at $40,000, that's more than $250,000. At this time there are approximately 900 new bitcoin mined each day, meaning there's $36 million available for miners every day. You can probably see why bitcoin mining has become a multi-billion dollar industry all its own.
Where Does Bitcoin Get Its Value?
This is the biggest question a lot of people have. For many, the concern is that there's no tangible value to Bitcoin or bitcoin. That concern and confusion is understandable if you don't know how bitcoin works and why it's so special as a monetary system and store of value.
The important thing to consider is that things generally have value because people agree it's worth what it costs or what they are willing to spend on it. For example, a smart phone costs what it does not just because of the cost to manufacture it, but also because the companies making and selling them have done research to determine what the public is willing to spend on them. They've determined the value the public places on the products. It's the same especially for artwork. A Van Gogh has value because people who want to own a Van Gogh are willing to pay up to a certain amount of money for it. Bitcoin is similar in that regard, except that there is a potential utility of Bitcoin that's being invested, rather than a love of the art or a desire for social status.
Remember that 6.25 bitcoin miners can win for each block? That number changes. When Bitcoin first started, miners received 50 bitcoin for every block. In 2012 that was reduced to 25. In 2016 it was reduced to 12.5, and in 2020 it was reduced again to 6.25. This process is called the Bitcoin Halving. The next halving will be in 2024, at which time miners will then earn 3.125 bitcoin per block.
One important result of the halving is that every time so far that there's been a halving the price of bitcoin has spiked. The price of bitcoin was only $12 before the 2012 halving. The following year it reached $1,000. The price of bitcoin dropped to $670 by the time of the second halving in 2016, but then a year after the halving it was $2,550 and hit an all-time high at the time of $19,700 by the end of 2017. Bitcoin was at $8,787 in May 2020. Several months later it reach a new all-time high of approximately $42,000, followed by additional new all-time highs of approximately $58,000, $61,000, and $69,000 throughout 2021. Although the price of bitcoin is highly volatile, history has shown so far that the halving is typically followed by a significant increase in the price. However, keep in mind that history doesn't always repeat itself and there is no way of knowing what the price of bitcoin will be in the future. It could go up, but it could also go down.
You may be wondering, why is there a halving and why does bitcoin go up in price? That is where the matter of inflation vs. deflation comes in.
Inflation vs. Deflation
Inflation is simply described as the increase in prices of goods due to a decrease in the value of the currency. Inflation is currently the highest it's been in 40 years. This is in large part due to an over-abundant money supply and supply chain issues. The over-abundant money supply is a result of the government printing a lot of money and putting it in circulation over the past couple years. In February 2020, the amount of U.S. currency in circulation was $1.8 trillion. Currently the amount is $2.23 trillion. That's a 23.6% increase in the US currency in circulation in only 2 years. The reason for it was to stabilize the economy and prevent a recession as a result of the COVID-19 pandemic. It worked, but at the same time an extra supply of money in circulation causes the buying power of the currency to decrease. With the supply chain and a number of consumer goods being in short supply, difficult to get, or not available at all, we get increased prices. Add those two factors together and you have the high inflation we're currently experiencing.
This is where deflation comes in. Every 4 years or so the bitcoin mining reward will be cut in half. This will happen until 2140 when the last bitcoin is mined. That means there's a finite amount of bitcoin that will ever exist. That finite amount is 21 million bitcoin. There are almost 19 million bitcoin in circulation right now, so there isn't a whole lot more to be mined.
Where the Value of Bitcoin Comes From
This brings us to a couple ideas for the increase of the value of bitcoin.
Supply and Demand
One of the most basic concepts for economics and the valuing of something is supply and demand. The simple concept is that the value or price of something increases when there is a lower supply than the demand for it, and the value or price decreases with a higher supply than the demand for it. With a limit to the number of bitcoin that will ever exist, the price should increase as the usage and demand increases.
Miners Must Earn Something
If there are no miners then there is no bitcoin. and miners can't be expected to pay the costs of mining without something in return. What they get in return is bitcoin. The bitcoin they receive has to at least cover their mining costs. At this time, that is about $250,000 give or take depending the current price of bitcoin. In 2024, when the bitcoin mining reward is cut in half, miners probably wouldn't continue mining if their compensation drops to about $125,000. To keep their compensation at about the same amount, it is possible that the value of bitcoin could double some time afterwards to bring their compensation back to around the same amount as it is now or at least to an amount that is profitable for them.
Those two concepts are very big and important factors for the potential future value of bitcoin. However, there is no way to know for sure as history doesn't tell us what the future holds for bitcoin. User adoption is important too, as the value of bitcoin is also reliant on its use, as use does create value. Just like any fiat currency, if people are using it then it should have a value.
Breaking Down a Bitcoin
This brings up another unique feature of cryptocurrencies when compared to fiat currency. With the US dollar we can break a dollar down to 100 cents. You can't break it down any further than that since the cent is the smallest unit of currency in the US dollar system. With Bitcoin, you can actually break a single bitcoin into 100 million parts. Each part is called a satoshi, named after Satoshi Nakamoto. You'll also hear or read them referred to as sats for short. There are 100 million satoshis in each bitcoin, so each bitcoin can be broken down to 8 decimal places. For example, if one bitcoin is worth $40,000, then one US dollar ($1.00) is worth 0.00002500 bitcoin or 2500 satoshis (or sats). Bitcoin is actually very flexible in this regard as one satoshi won't equal one dollar until (or unless) the value of bitcoin reaches $100 million, and one satoshi won't equal one cent until (or unless) the value of Bitcoin reaches $1 million.
How to Purchase and Use Bitcoin
There are two main common ways to acquire bitcoin.
Centralized Exchange
The easiest way to purchase bitcoin is to open an account at a centralized exchange such as Gemini, Coinbase, Binance.us, Crypto.com, or others. There you can transfer fiat money such as US dollars from your bank account to your exchange account and then purchase bitcoin. In most cases you can transfer via ACH and buy bitcoin instantly.
To send bitcoin from a centralized exchange to your own bitcoin wallet or to someone else you'll need the bitcoin address to send it to. To get the public bitcoin address, whoever you want to send the bitcoin to selects the receive option in their wallet, which presents a public address and QR code. The address is a long string of alphanumeric characters. Simply copy the address or scan the QR code and send the bitcoin. Here's an example of a Bitcoin address and QR code.
Note that it's imperative that the address you enter is 100% accurate. Even one wrong character will result in sending the bitcoin to the wrong address or to an address that doesn't exist and there is no way of retrieving the bitcoin if that happens.
When you send bitcoin from an exchange to a bitcoin wallet address most exchanges will present you with a confirmation screen where you can verify the recipient's address, the amount of bitcoin, and the fee to send the bitcoin. You may also have to confirm the transaction using a form of two-factor authentication (2FA). Every exchange is different, with different features, rules, and fees, so it's a good idea to compare them.
With many newer Bitcoin wallets the receive address will be different each time you select the receive option in the wallet software. This is unique to Bitcoin. Although the receive address is different each time, the bitcoin that is received will still be part of the master wallet account. The purpose of changing the receive address is to increase privacy for users. The receive address can be reused and will always be part of that master account, but repeated use does reduce privacy.
A Cryptocurrency Wallet
Another way is to have someone send you bitcoin to your own bitcoin wallet. To do this you need to create a wallet. There are different kinds of wallets and many of each kind are available. That topic will be covered in a future Escient Financial Insights post. Once you have your own cryptocurrency wallet you can select the option to receive bitcoin and then essentially follow the same steps as above.
Sending bitcoin from your own wallet works pretty much the same way, except that there is usually a confirmation screen where you confirm the recipient's address, the amount of bitcoin being sent, and the transaction fee. Most Bitcoin wallets allow you to customize the fee, so you could pay a lower fee, but have a longer transaction time, or you can pay a higher fee to settle the transaction quicker. Some wallets will require approving the transaction using private keys on a separate device. This is a security feature of some wallets to protect your wallet from becoming subject to malware or hacking of your computer or mobile device. Again, more on this later in a future Escient Financial Insights post.
The key here is that it's actually pretty easy to transfer bitcoin from one person to another. It's almost as simple as if you were typing in someone's email address or phone number to pay with Apple Pay, PayPal, Venmo, or other similar payment services. The key difference is that the account address is much longer and you have to be extra careful to make sure the address you're sending to is the right one. Also, the transaction will most likely settle in a matter of minutes so the recipient won't have to wait to be able to use the money that was sent to them.
What are the Advantages of Bitcoin?
Payment Freedom
It is possible to send and receive bitcoin anywhere in the world at any time. No bank holidays. No borders. No bureaucracy. Bitcoin allows its users to be in full control of their money. Because it's decentralized there is no authority that can take your money from you.
Transaction Settlement Time
When you pay with a credit card, you might receive authorization right away, but it could take a few days for the transaction to actually be on your credit card account. For merchants, it's the same delay, if not longer, before they can have access to those funds. For checks, it could be even longer. Depending on the amount it could take a week. For an ACH transfer it could take a few days, but some merchants require up to 10 business days. Wire transfers could take a few days as well, even with high fees, especially for international transfers. With Bitcoin, transaction settlement times could take as little as a few seconds (using something like the Lightning Network). Most do take longer, from 10 minutes to a few hours, but the speed at which Bitcoin transactions are able to verify and settle is significantly faster and less expensive than with the traditional banking system.
Choose Your Own Fees
There is no fee to receive bitcoin, and many wallets let you control how large a fee to pay when spending. Higher fees can encourage faster confirmation of your transactions. Fees are unrelated to the amount transferred, so it's possible to send 100,000 bitcoins for the same fee it costs to send 1 bitcoin. Additionally, merchant processors exist to assist merchants in processing transactions, converting bitcoins to fiat currency and depositing funds directly into merchants' bank accounts daily. As these services are based on Bitcoin, they can be offered for much lower fees than with other payment services.
Fewer Risks for Merchants
Bitcoin transactions are secure, irreversible, and do not contain customers’ sensitive or personal information. This protects merchants from losses caused by fraud or fraudulent chargebacks. Merchants can easily expand to new markets where either credit cards are not available or fraud rates are unacceptably high. The net results are lower fees, larger markets, and fewer administrative costs.
Security and Control
Bitcoin users are in full control of their transactions; it is impossible for merchants to force unwanted or unnoticed charges as can happen with other payment methods. Bitcoin payments can be made without personal information tied to the transaction. This offers strong protection against identity theft. Bitcoin users can also protect their money with backup and encryption. Further, a bitcoin wallet cannot be brute-force hacked, or at least none have been hacked yet. For more details on this, read the previous Escient Financial Insights post About Those Objections to Cryptocurrency You May Have Heard….
Transparent and Neutral
All information concerning the Bitcoin money supply itself is readily available on the block chain for anybody to verify and use in real-time. No individual or organization can control or manipulate the Bitcoin protocol because it is cryptographically secure. This allows the core of Bitcoin to be trusted for being completely neutral, transparent, and predictable.
What are the Disadvantages of Bitcoin?
Everything that has advantages also has disadvantages, and it's important to be aware of them so you can weigh the pros and cons for yourself. Here are some of the most prominent disadvantages for Bitcoin.
Acceptance
Many people are still unaware of Bitcoin or are not using it yet. More businesses are beginning to accept Bitcoin because they want the advantages of doing so, but the list remains small and still needs to grow in order to benefit from network effects.
Volatility
The total value of bitcoins in circulation and the number of businesses using Bitcoin are still very small compared to what they could be. Therefore, relatively small events, trades, or business activities can significantly affect the price. In theory, this volatility will decrease as Bitcoin markets and the technology matures. This is a new asset class and a for of currency at the same time, so it's difficult to imagine and know how it will play out.
Ongoing Development
Bitcoin software is still in active development, and may always be. New tools, features, and services are being developed to make Bitcoin more secure and accessible to the masses. Some of these are still not ready for everyone. Most exchanges and markets for bitcoin are new and lack full regulation, and may offer no insurance. In general, Bitcoin is still in the process of maturing.
Not Completely Anonymous
Bitcoin is designed to allow its users to send and receive payments with an acceptable level of privacy as well as any other form of money. However, Bitcoin is not anonymous and cannot offer the same level of privacy as cash. The use of Bitcoin leaves extensive public records. Various mechanisms exist to protect users' privacy, but it is possible to track transactions and accounts. This is a disadvantage for some, but could also be seen as an advantage as it does help make Bitcoin less enticing to bad actors who would use it for fraud or criminal activity.
Some concerns have been raised that private transactions could be used for illegal purposes with Bitcoin. However, it is worth noting that Bitcoin will undoubtedly be subjected to similar regulations that are already in place inside existing financial systems. Bitcoin cannot be more anonymous than cash and it is not likely to prevent criminal investigations from being conducted. Additionally, Bitcoin is also designed to prevent a large range of financial crimes.
Should You Purchase or Invest in Bitcoin?
There is potential for Bitcoin to increase in value. However, Bitcoin does have a high amount of volatility and does have risk. Each individual should research Bitcoin on their own and weigh the pros and cons when deciding whether or not to purchase bitcoin or invest in some. Escient Financial does offer advice on digital assets and cryptocurrency, so if you would like assistance in making the decision, feel free to...
This content is developed from sources believed to be providing accurate information. The information in this material is not intended as investment, tax, or legal advice. It may not be used for the purpose of avoiding any federal tax penalties. Please consult legal or tax professionals for specific information regarding your individual situation. The opinions expressed and material provided are for general information, and should not be considered a solicitation for the purchase or sale of any security. Digital assets and cryptocurrencies are highly volatile and could present an increased risk to an investors portfolio. The future of digital assets and cryptocurrencies is uncertain and highly speculative and should be considered only by investors willing and able to take on the risk and potentially endure substantial loss. Nothing in this content is to be considered advice to purchase or invest in digital assets or cryptocurrencies.
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