What Exactly Is Bitcoin, and How Does It Work?
Bitcoin is a decentralized cryptocurrency that was created to be “a peer-to-peer electronic cash system” by Satoshi Nakamoto back in 2009. Nakamoto (whose actual identity is unknown) launched Bitcoin with a white paper explaining the concept, and a website, Bitcoin.org, which allowed users to download the Bitcoin mining software used to run the network. But even these two sentences probably has us out over our skis a bit. So, let’s review some underlying cryptocurrency concepts first.
Bitcoin is a decentralized digital currency, which means that it is not backed by any government or nation. In contrast, the US dollar is backed by the US treasury, which makes it a fiat currency. Cryptocurrency is secured by cryptography, exceptionally complex encryption, which makes a true cryptocurrency virtually impossible to hack or counterfeit. A cryptocurrency’s value is driven by its utility, its scarcity, and the trust the market places in it, not unlike other currencies. Bitcoin, the world’s largest cryptocurrency by market capitalization, was developed in the aftermath of the great financial crisis of 2007/2008. It was in many ways a response to the wildly unpopular bailout of financial institutions like Goldman Sachs, Citigroup and JP Morgan, who caused the financial crisis by underwriting and securitizing unqualified home loans (for more on that, see April’s Adding Value). The digital coins owned and utilized on cryptocurrency networks have their activity recorded and shared on a distributed ledger, or blockchain, which is stored on and backed up by nodes throughout the network. This is in contrast to traditional banking, where transactions are private, stored on a central computer, and subject to the whims of the institution.
From the day Bitcoin was launched (January 3, 2009), anyone interested could download the opensource Bitcoin software for free. This software is used to purchase Bitcoin, verify transactions, audit the distributed ledger, mine for new Bitcoin, and award Bitcoin for proof of work. Proof of work is a peer-to-peer review process that verifies, and makes permanent qualified transactions and successful mining activity. All verified activity is added to the blockchain, Bitcoin’s decentralized database. The blockchain manages the storage, validation, authorization, movement of data, and documentation of all transactions within the life of each Bitcoin. It’s a continuous and chronological system of individual, verified blocks that cannot be broken, restructured, or revised once verified. Each block contains roughly one megabyte of transaction information recorded in unique hashes which is openly available to the entire network and linked to the blockchain through hashed data. For example, each block header contains the hash of the current block, the hash of the previous block, the timestamp of when it was created, and the hash that was used to create it (the nonce).
Is Bitcoin really a currency?
Bitcoin is a fully functioning currency. Although the news coverage surrounding Bitcoin is usually focused on wild volatility and Bitcoin millionaires, Bitcoin is accepted as payment by thousands of businesses across the globe, including AT&T, Sotheby’s, Microsoft, Burger King and PayPal. The big holdout at present is Amazon, but that it likely a matter of when, not if they will begin accepting Bitcoin payments. Another big difference between Bitcoin and other currencies is scarcity. This feature is by design as a deflationary measure. Bitcoin was built on the premise that the total number of Bitcoins that could be created is exactly 21 million, and that each one can be split evenly into 100 million smaller units, called Satoshi, to facilitate daily use. While Bitcoin is not backed or regulated by any government, it is accepted as a currency by the majority of nations across the globe, with the two notable holdouts being China and Russia.
Is Bitcoin an alternative investment?
Yes to that was well. Because the production of Bitcoin is set at 21 million coins, scarcity is built in. And unlike fiat currencies, Bitcoin’s trading value is not negatively impacted by inflation or deficit spending, which nations often employ in times of conflict, calamity or in support of policy initiatives. Bitcoin has in many ways responded to such events similarly to gold, which tends to see its value increase during times of uncertainty. Running counter to these factors, is that cryptocurrency networks are operating in the uncharted waters of a new frontier. Because they are untethered to any national economies, they are also unsecured and unregulated, which has led to extreme volatility – the 52-week price range for Bitcoin as of this writing is $9,916 - $64,863. And if the whole Bitcoin network collapsed tomorrow, there would be no SIPC to repay customer claims. Of course, it’s worth noting that if a security failure or accounting irregularity popped up for one of our favorite blue chips, their share price could drop precipitously as well. Just ask anyone who held a position in Lehman Brothers in 2007.
When it comes to taxation, Bitcoin holdings are treated like real estate by the IRS. If you buy and hold, you do not have to check the virtual currency box on your tax return. But if you sell a position, exchange it for another cryptocurrency, or use it to make a purchase, you do. In this sense, it’s like an equity position. Bitcoin gains are taxed as capital gains, and follow the same rules in terms of whether they are viewed as short-term, held under one year, or long-term, held over one year.
For any specific questions regarding cryptocurrency tax liability, speak with a trusted tax professional. This article is not intended to be tax advice and is for informational purposes only.
How do you buy Bitcoin?
Bitcoin, like most other cryptocurrencies, is widely available for purchase through a number of different platforms. You could buy Bitcoin directly on bitcoin.org, through an exchange like Coinbase, at a Bitcoin ATM, or you could gain exposure through an investment product like Grayscale Bitcoin Trust.
A more labor-intensive method to acquire Bitcoin is mining. To create new Bitcoins, a miner uses a specialized mining rig to create and test 64-character sequences (hashes) to try and find one that is less than or equal to the defined condition, which would mine the block. If other miners review the proof of work and verify the activity, they will begin mining the next block in the blockchain. At that point, the miner would be rewarded with 6.25 newly minted Bitcoins (see mining reward section →). Mining is an extremely competitive and expensive endeavor, requiring high powered rigs using enormous amounts of energy to generate and test hashes fast enough to compete with other miners. Only one block can mined at a time, that means miners and teams from across the globe are testing trillions of hashes per second, racing to solve the same block.
Mining Reward Structure
Every time 210,000 blocks have been mined, or roughly every four years, the Bitcoin reward is halved.
2009 - 2012 ..............50 Bitcoins
2012 – 2016 ..............25 Bitcoins
2016 - 2020 ..............12.5 Bitcoins
2020 – 2024 ..............6.25 Bitcoins
The rate at which blocks are mined is managed by the core Bitcoin software using the difficulty of hash complexity to maintain a rate of roughly 1 block every 10 minutes.
Oh yeah, there’s definitely risk
Bitcoin is a currency that’s also an alternative investment asset and a hedge against inflation. And like all investments, there is inherent risk. So far, the decentralized structure of Bitcoin’s network has encouraged a peerless level of security, but that doesn’t mean it's impervious to getting hacked. There’s also the risk of human error. All transactions involving cryptocurrency require you to use unique credentials (public and private keys) to send or receive coins. Because cryptocurrency networks are decentralized, if you lose your keys, there is no support network to retrieve them. Likewise, if you left your keys written down on a post-it note, anyone who found it could spend the Bitcoin linked to it or move your assets to a new virtual wallet. Another risk is the possibility that a bad actor could accumulate 51% of the Bitcoin available, introduce new protocols to benefit themselves, and unravel the entire system. Of course, it should go without saying that there is risk. If there was no risk, there could be no upside.
If you’d like to discuss how Bitcoin could fit into your portfolio, contact one of our fiduciary advisers. We’d be happy to discuss it with you, at no cost or obligation.
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