Bitcoin 101

Bitcoin has been all over the news lately, from insane price increases (from less than $1,000 in January to more than $16,000 now), to whether it’s a bubble, and its use as the ransom currency of choice by hackers. The news coverage of Bitcoin can be as dizzying as its price, as this chart of Google search traffic about Bitcoin this year shows.

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So, what is Bitcoin? How does it work? And why should you care?

What is Bitcoin?

Bitcoin is a cryptocurrency.

A cryptocurrency is an entirely new form of money. In all of human history there have really been two types of money. Commodity money uses tangible items (shells, beads, gemstones, precious metals, and other physical items) as money, and fiat money is paper or coins issued by a government (like the US Dollar).

These currencies are used as a means of exchange, a store of value, and a unit of account (the three purposes of money). Here are some examples:

  • A herder giving a merchant 3 shells in exchange for a goat is using commodity money as a means of exchange.
  • A king keeping a vault full of gold is using commodity money as a store of value, because gold is more suited for this purpose since it’s more durable than other commodities that might decay over time.
  • A business with $1,000,000 US Dollars in revenue this year is using fiat money as a unit of account.

Cryptocurrencies like Bitcoin aren’t commodity money, because they’re electronic rather than physical. And they aren’t fiat money, because they’re not issued or controlled by any government. Instead, Bitcoin & others are called cryptocurrencies because the trust & value of the currency is protected by all the transactions being stored in encrypted ledgers replicated across thousands of computer systems. This is called the blockchain.

What is the Blockchain?

Blockchain is the method of storage for cryptocurrencies. Picture it like a giant Excel spreadsheet with two important differences.

First, it’s encrypted. This means transactions written in a blockchain ledger can’t be undone, a little like the mosquito trapped in a block of amber in Jurassic Park. Each block of encrypted transactions written to the Bitcoin ledger then have more encrypted transactions stored after them, just like all the layers of amber that protected & preserved the mosquito.

And, the Bitcoin ledger is distributed. There’s not just one copy of this ledger, there are thousands of copies on computer systems all around the world, all being compared to one another at all times to ensure they stay in sync. So if anyone tries to hack or overwrite previous transactions on one copy of the ledger, the system will block that from happening because it recognizes these transactions don’t line up with all the other valid copies of the ledger. It’s not a totally foolproof system, but by it’s design it has some real security advantages over financial systems with a single point of control (like traditional banking records that are stored & controlled by a single entity).

Are there other Cryptocurrencies?

Yes, and the number is growing all the time. Bitcoin was one of the first cryptocurrencies, and it’s the most well known. Two other cryptocurrencies, Ethereum and Litecoin, are also very well known and are growing in usage & awareness. And there are hundreds or thousands of other cryptocurrencies with huge differences in valuation & adoption. Currently there are 17 cryptocurrencies that have a market value of more than $1 billion. Here are the top ten:

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How do I Buy & Use Cryptocurrencies?

The easiest way to buy a cryptocurrency is using an online exchange like Coinbase, GDAX, or Binance. Coinbase is the easiest point of entry with the simplest user interface, but it has the highest fees. GDAX is owned by Coinbase and charges lower fees, but like Coinbase it only offers three currencies (Bitcoin, Ethereum, and Litecoin). Binance has dozens of currencies, but it’s the least user friendly.

You can start in Coinbase or GDAX by adding money to your account through your bank account, wire transfer, or credit/debit card. You can only add value to Binance through an existing cryptocurrency; for example, adding US Dollars to your Coinbase account, buying some Ethereum there, transferring some or all of that Ethereum to your Binance wallet, then using the Ethereum in your Binance wallet to buy other currencies like IOTA or Ripple.

Even though many cryptocurrencies now have values in the hundreds or thousands of dollars per coin, you can buy a fractional piece of coin for a very small investment. For example, right now $20 will buy 0.00132251 Bitcoin (since 1 BTC is currently valued at around $16,000), or $20 will buy 0.04073461 Ethereum (since 1 ETH is currently valued at around $490). And, other up & coming cryptocurrencies have much lower valuations, like IOTA ($4.45) or Lumens ($0.13).

Using cryptocurrencies is a different story, and going back to the three purposes of money is helpful in thinking about this. Cryptocurrencies aren’t a good substitute for other currency right now as a means of exchange or a unit of account due to their volatility. Imagine telling an employee a year ago you’d pay them 1 Bitcoin per week in salary. Last year that 1 Bitcoin would cost you $900 to provide their salary, but now it would cost you $16,000 to provide their weekly salary. So, the current practical use is really limited to a store of value, and like all volatile investments (like dot com stocks in the 90s or some real estate in the mid 2000s) it will swing wildly in valuation, so it’s not the right place to store your entire savings or retirement account.

What Else Should I Know?

I’ve been studying Bitcoin, other cryptocurrencies, and the blockchain pretty heavily for the last month and I still feel like I can barely talk intelligently about it. If you’re interested in learning more, just ask and I’ll be happy to share what I know as one way of repaying the others who’ve done the same for me.

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