What is Bitcoin and how does it work?
We are seeing an increased number of queries from clients concerning Bitcoin and other cryptocurrencies and, as they are a relatively new concept, we thought it would be useful to provide a short introduction and answer the question ‘what is Bitcoin and how does it work?’
Bitcoin is a digital currency that was started in 2009 as a response to the Global Financial Crisis. To this day, the creator of Bitcoin remains unknown with the initial launch whitepaper written under the pseudonym, Satoshi Nakamoto.
What is the purpose of Bitcoin?
The aim of Bitcoin is to offer a decentralised currency (rather than a store of value, like gold) that is outside of the control of governments; facilitating low-transaction fees, instant international transfers and total anonymity.
How does Bitcoin work?
Bitcoin is a digital token that can be sent and received online and they are identified and secured via public and private keys (a long string of letters and numbers). The public key is like a bank account number that others can use to send bitcoin, whereas the private key is more akin to a PIN and is used to authorise transactions.
The number of Bitcoins will eventually be fixed at 21 million units that are divisible by up to eight decimal places and the smallest unit is known as a Satoshi. At the time of writing, there are in the region of 18 million Bitcoins that have already been released.
The limited number of Bitcoin is where it differs as a currency to Government-backed currencies (like the pound or dollar) as in order to stabilise the price of goods or services, governments release new currency. Bitcoin on the other hand is released according to a schedule and algorithms. As a result of this, if Bitcoin gains mass and international adoption, it could become a threat to existing currencies.
Every Bitcoin transaction is logged namelessly on a publicly available ledger called a blockchain.
What are bitcoin nodes and miners?
Bitcoin operates on a large network of powerful computers that enable instant transactions. The computers on the network are either classified as nodes (a series of computers running the blockchain) or miners.
Bitcoin miners are people or companies whose computers, known as mining rigs, solve complex problems in order to add new blocks to the blockchain. These blocks can then be used to process the transactions on the blockchain in return for newly released Bitcoin (until the 21 million ceiling is reached) or a transaction fee that’s paid in Bitcoin.
This reward for Bitcoin mining is halved every 210,000 blocks and at launch in 2009, the reward for mining each block was 50 new Bitcoins (when they were practically worthless) whereas at the time of writing in 2020 the reward is 6.25 new Bitcoins (when they are worth £14,280 each or £89,250 for 6.25).
How to receive Bitcoin?
Anyone can accept Bitcoin from another person, instantly and anonymously from anywhere in the world. To do this, you need what’s known as a Bitcoin wallet, which is either a physical or digital device that tracks the ownership of your Bitcoin and facilitates transactions. Be aware though that your wallet never actually holds Bitcoins as they always remain on the blockchain, it just acts as a digital record.
How to buy and sell Bitcoin?
Bitcoins are a bit like shares, in that you need an exchange to handle the transaction. Many providers allow users to open an account, transfer a balance in their usual currency and then use this balance to submit buy and sell orders on the exchange. Users can then hold their Bitcoins in the wallet or transfer them to a different wallet, be it software or hardware. Many digital wallets hold the private keys on user’s behalf, which in effect means they don’t actually own the Bitcoin and should the company fail, it will be impossible to get your Bitcoin back.
Is Bitcoin high-risk?
Bitcoin is incredibly risky as it demands a certain level of technical understanding to get up and running and, if the keys are lost (either by an owner or those holding the keys on an owner’s behalf), the Bitcoin will be lost forever and there is no comeback.
There is also a risk of hacking Bitcoin holders, wallet providers or exchanges and in the case of the Mt. Gox exchange, they had to shut down after a hack that lost millions of pounds.
Nonetheless, the recent headline-grabbing gains for Bitcoin has led many investors to see big returns and others have had spectacular losses. For example, in March 2016 a Bitcoin was worth around £300 and just 21 months later, each Bitcoin was worth in excess of £15,500. Furthermore, just a year later in January 2019, each Bitcoin had dropped below £3,000 each. This volatility makes Bitcoin a good candidate for the highest risk – highest return investment on earth.
In addition to this, governments around the world are being very cautious when it comes to Bitcoin, particularly as it is often used for money-laundering, black-market purchasing and a host of other illegal activities. As a result, governments could start restricting or even ban the sale and purchase of Bitcoin, heavily tax it and even require the identities of Bitcoin holders all of which would have an impact on its value and a holder’s ability to access their funds.
Will we ever know who Satoshi Nakamoto is?
It’s unclear whether or not Satoshi is one person or a group of people, however, it’s unlikely that the invention of blockchain technology existed without some form of academic or peer scrutiny. Nonetheless, privacy and security will be a major factor in keeping the identity secret as back in 2009, over 32,000 blocks were mined with a reward of 50 bitcoins each. As a result, a very small number of people would have shared over 1.6m Bitcoins, with a current value approaching £23 billion!
Conclusion
As a new technology and asset class, cryptocurrencies like Bitcoin have an unproven track record and are also subject to high risks unlike any other mainstream investment. You can read more information on the Bitcoin website and read guidance from the Financial Conduct Authority.
Don’t forget, this article offers information about financial planning and investing and should not be taken as personal advice. AV Trinity does not provide advice or recommendations on cryptocurrencies. Remember that investments can go up and down in value, so you could get back less than you put in.