Bitcoin is a type of digital currency or cryptocurrency, a medium of exchange that exists exclusively online. The currency burst into mainstream consciousness in 2017, as its price soared into the thousands of dollars during the year. More recently, it has skyrocketed in 2020 and 2021, further stoking the fever over cryptocurrency and the potential to get rich quick.
Bitcoin has created a lot of controversy, from supporters saying it’s the future of the currency to those decrying it as a speculative bubble. Here’s what you need to know about Bitcoin, how it works, and some of its downsides.
What is Bitcoin and how does it work?
Bitcoin got its start in 2009, when the software behind the currency was released. Its origins are a bit of a mystery, however, and one person (or perhaps a group) known as Satoshi Nakamoto takes credit for unveiling the cryptocurrency.
Bitcoin operates on a decentralized computer network or distributed ledger called a blockchain, which manages and tracks the currency. Think of the distributed ledger as a huge public record of transactions made in the currency. Networked computers verify transactions, ensuring data integrity and bitcoin ownership, and they are rewarded with bitcoins for doing so.
This decentralized network is a large part of the attractiveness of Bitcoin and other cryptocurrencies. Users can transfer money between themselves, and the lack of a central bank to manage the currency makes the currency almost self-sufficient. This autonomy means that money, at least theoretically, can avoid interference from governments and central banks.
Bitcoin can operate mostly anonymously. Although transactions may be traceable to certain users, the person’s name is not immediately linked to the transaction, even if the transaction is processed publicly.
Where do bitcoins come from?
Bitcoin is created or “mined” when computers on the network verify and process transactions in currency. Some computers called miners are specially equipped with high-powered processors that can chew up transactions and earn a portion of a bitcoin. So Bitcoin requires a lot of processing power to maintain the grid and a lot of electricity to run these computers.
However, bitcoins are not created endlessly and the currency is limited to 21 million whole units, although the software can be modified to allow more. In the absence of such a change, experts expect the remaining amount of bitcoin to be mined around the year 2140. When this happens, miners will be rewarded only with a fee for processing transactions.
Although the number of bitcoins may be limited, each entire bitcoin can be broken down into much smaller units. In practice, bitcoins are divided into fractions of a coin to facilitate payments of very small amounts of real currency. A bitcoin can be officially divided into one hundred million parts, called satoshi in honor of the mysterious founder.
Bitcoin is just one type of cryptocurrency, and literally thousands more have been created. Some of the most popular include Ethereum, Litecoin, and Ripple. Social media specialist Facebook also announced plans to create a cryptocurrency called Libra, but he has had difficulty launching digital currency so far.
Users can hold and spend bitcoin from a cryptocurrency wallet. A wallet is like a personalized location on the distributed ledger that only references your foreign currency holdings. When you acquire bitcoin, your wallet provides a unique crypto address to the sender. To spend or send bitcoin, you can scan a retailer’s QR code or direct money to their public address.
Advantages of Bitcoin
Bitcoin has certain advantages as a currency and is popular for a number of reasons, ranging from utopian to capitalistic.
1. Decentralized currency management
Thanks to its decentralized network and its limited number of coins, Bitcoin promises a kind of utopian version of the currency. Proponents say that by pulling central banks and governments out of the currency game, the currency will better maintain its value over time. By clearing these entities, some say that Bitcoin is giving power back to the people.
2. Anonymous or semi-anonymous transactions
The relative anonymity of Bitcoin is also a huge characteristic for many. Some supporters (such as some libertarians) like that the government or other authorities cannot easily keep track of who is using the currency. However, such anonymity means that the currency can also be used for criminal activities.
3. Difficult or impossible to counterfeit
However, the popularity of Bitcoin is also due to an entirely practical matter. It’s hard to fake, because of the blockchain ledger system that verifies transactions over and over again.
4. Growing popularity
Bitcoin is also popular because the hype around cryptocurrency has made it a fashionable trading vehicle. Because the value of the currency fluctuates so much, traders can step in and make (or lose) money. This hype and the perceived limited nature of coins has driven the price of bitcoin up over the past decade, and it continues to fluctuate significantly.
Disadvantages of Bitcoin
Bitcoin suffers from a few significant drawbacks intrinsic to its design, including its limitation in the number of coins in circulation and its general volatility.
1. Bitcoin is a big energy user
Large computer miners require a lot of energy to operate. Generating electricity is expensive and pollutes the environment, because what some critics say is a monetary project with little feasibility.
A July 2019 study in the tech journal Joule showed that mining produced enough carbon emissions to rank it among a small country (roughly the levels of Jordan and Sri Lanka). A May 2021 Harvard Business Review article indicates that Bitcoin’s electricity consumption accounts for around 0.55% of global production, in line with a small country like Malaysia or Sweden.
2. The number of pieces is limited
By its very nature, the number of coins is limited, which poses a serious problem when using Bitcoin as a currency. This is because this limit does not increase the money supply, exposing an economy to destructive deflationary spirals, which were more typical when economies operated on the gold standard. In fact, this concern is one of the main reasons the gold standard was phased out.
A difficult situation arises when consumers and others accumulate foreign currency during difficult economic times. When the money doesn’t flow, it slows down the economy. Without a central authority such as a bank to boost the economy or provide credit, the economy could enter a deflationary spiral. Thus, consumers do not spend because the products will be cheaper tomorrow, creating a destructive spiral.
With a fixed number of units, bitcoin does not provide the flexibility to manage a system-wide currency.
3. A volatile currency is useless
Imagine going to a restaurant where prices go up or down every day, sometimes by 10% or more. If that sounds like an unappealing prospect, that’s exactly what makes Bitcoin virtually useless as a currency. While volatility makes Bitcoin attractive to traders, it makes it almost worthless as a medium of exchange.
Consumers need to know what a currency can buy when making spending decisions. If they expect money to rise – or even soar – they have little incentive to use it as money.
4. All transactions must be declared to the IRS
The laws surrounding cryptocurrency are onerous for consumers, making it difficult to use.
The IRS now requires you to report on your annual tax return if you made a transaction in cryptocurrency during the current tax year. And if you sell crypto assets or transact with one, you could create a tax liability. So you will need to keep clear records of your buying and selling prices if you use digital currency, for fear of breaking the law and accumulating a tax bill.
Here is the full recap on what you need to know about cryptocurrency taxes.
At the end of the line
While Bitcoin is an interesting experience, it has serious drawbacks that make it difficult to achieve the stated mission of being a medium of exchange. In fact, one of the world’s largest investors, Warren Buffett, called the currency “probably squared rat poison”And said it was not the kind of thing he considered an investment. Add to the fact that governments could potentially close the currency at will, and it’s a risky investment at best.