What Is Bitcoin?

By now, you've heard of bitcoin.

It's one of the most talked about subjects in finance these days… But if you don't understand what it is exactly, you're not alone. And even among the initiated, bitcoin is a polarizing topic.

Bill Gates, the founder of Microsoft, has said that bitcoin is "better than currency."

Some enthusiasts say it will revolutionize everything from banking to government. These proponents believe that the technology behind it will radically transform the economy.

Others are skeptical, warning that bitcoin should be avoided or will eventually become worthless.

In 2016, Jamie Dimon, the CEO of JP Morgan said, "bitcoin the currency is going nowhere." And Charlie Munger, the vice chairman of Berkshire Hathaway, was so put off by the idea of bitcoin that he once called it "rat poison."

It's worth noting that the market has sided with Bill Gates… at least so far.

But what is bitcoin exactly? Is it the currency of the future? Does it even deserve to be called a currency?

Whether you decide that bitcoin is an asset you want to hold… It's important to understand how it works… and why so many people believe it could represent a critical change in the way we think about and use money.

We've put together this introduction to bitcoin to help demystify this new asset, which may be the most fascinating and controversial development in money and finance in generations… if not centuries. We'll also cover an exciting new phase of bitcoin's evolution – what we call "Bitcoin 2.0" – that's just now beginning.

Rummaging through garbage cans for food is a daily activity for some Venezuelans.

Father José Palmar, a Venezuelan Catholic priest, has implored his fellow citizens to separate food from other waste and label their garbage. He hopes this will aid the poverty-stricken as they forage in dumpsters.

The country suffers from widespread shortages of food, medicine, and necessities. It has been in a state of chaos since the bolivar, Venezuela's currency, collapsed.

Venezuela's currency crisis has caused prices to skyrocket for some 30 million people. The annual inflation rate hit 800% in 2015. And the currency continued on a path to worthlessness with the inflation rate soaring past 1,800% in 2017.

Meanwhile, capital controls make it difficult to get money in or out of the country. Converting bolivars to U.S. dollars at "real world" exchange rates must be done on the black market.

At this point, low-denomination bolivar notes are better suited for use as toilet paper than as a medium of exchange.

Venezuela's currency collapse is the best recent example of an economic reality: All government-issued currencies are flawed.

The euro, yen, and dollar – major currencies of developed countries – may be more stable than the bolivar… But they're still faulty. There is perhaps no better proof than the central banks' grand experiment of negative interest rates.

In 2014, the European Central Bank (ECB) introduced negative interest rates to the eurozone currency union. Basically, this means that euro bank deposits cost money instead of paying interest. These negative rates are either borne by commercial banks in Europe or are passed on to savers.

This drastic measure is part of a plan to do "whatever it takes to preserve the euro," as promised by ECB President Mario Draghi in 2012. Of course, it doesn't exactly inspire confidence in the euro when Herculean efforts are needed just to keep the currency from fracturing.

Savers in Japan (if there are any left) face a similar situation. The Bank of Japan (BOJ) introduced negative rates to its banking system in January 2016.

The BOJ has been clear that it is on a mission to debase the yen and produce inflation.

But what about the greenback?

Inflation has ravaged the dollar over time. The U.S. dollar has lost 96% of its purchasing power since 1913, the year the Federal Reserve – the U.S. central bank – came into existence.

In other words, $1 in 1913 would only be worth the equivalent of around $0.04 today.

Even the dollar – the reserve currency of the world – isn't a good long-term store of value.

Also, we can't assume that negative interest rates will only be a problem faced by European or Japanese savers. At a congressional hearing in 2016, Federal Reserve Chair Janet Yellen said she "would not completely rule out the use of negative interest rates" in the future.

All of these deficiencies stem from a currency's reliance on the government. And all major currencies are issued by the government.

However, governments are beginning to lose their absolute control over money…

You see, bitcoin has no central authority. The government doesn't issue it or control it. A mysterious computer programmer designed bitcoin to be decentralized, much like the Internet.

Bitcoin isn't a fad… It's a new form of money.

Since money is the lifeblood of an economy, this is a huge development. And to fully appreciate bitcoin's significance, we have to fully understand how modern money came to be.

The Progression of Money

Money has gone through several major transformations throughout history.

Of course, gold and silver have served as money for thousands of years.

The first official coins made out of precious metals appeared around 600 B.C. in Lydia (part of present-day Turkey). King Alyattes had coins minted that were made of electrum, an alloy of gold and silver.

On the front of the coin was a roaring lion's head, which was the symbol of Lydian kings. On the back was the impression left by the hammer that pounded the electrum into the die that shaped its face.

These coins, which have come to be known as "Lydian Lions," performed the three main functions of money:

1. Medium of exchange

   Without some form of money, goods would need to be bartered for other goods. Or if there was no payment, the buyer and seller would need to keep track of the debts incurred. Since the coins were a widely accepted form of payment, they facilitated transactions.

2. Unit of account

   The markings on the coin signified a specific value, so they provided a common measure of different types of goods. Each coin might have bought 10 sheep, but only five oxen. Therefore, an ox was twice as valuable as a sheep. Also, the coins wouldn't need to be weighed and verified before each transaction like unstandardized pieces of gold or silver.

3. Store of value

   A sheep herder could store a coin until he needed to buy more sheep. Of course, he would have to be confident that the coins wouldn't lose their purchasing power in the meantime.

For more than 1,000 years, coins were adopted as forms of money around the world. But coins can be inconvenient… They're bulky and hard to carry in large quantities.

In the 7th century A.D., the Chinese began to use paper bills. This allowed wealthy Chinese to leave their cache of iron coins with a trustworthy person in exchange for a piece of paper that recorded how much they had deposited.

Then, around the 10th century, authorities of the Song Dynasty began issuing official "Jiaozi," the oldest government-issued paper currency.

Paper money came to America in the late 17th century. The Massachusetts Bay Colony issued America's first paper money in 1690. The Continental Congress – the governing body of the 13 colonies – began issuing paper money in 1775. And in 1792, the U.S. Congress created the dollar as the country's standard currency.

Then, as the Great Depression unfolded, the prices of goods and services collapsed. In 1933, the U.S. abandoned its commitment to buy or sell gold at a fixed dollar price. This allowed the Federal Reserve to "print" money to stimulate the economy.

In 1971, President Richard Nixon closed the gold window. After that, not even foreign governments could redeem their dollars for gold. The surprise move severed the final link between the U.S. dollar and gold. At that point, the dollar became a fiat currency – backed by nothing but the "full faith and credit" of the U.S. government.

Today, the monetary system is based solely on trust. The Fed, which controls the base monetary supply, must be trusted not to debase the currency. The financial crisis in 2008 and 2009 revealed the problems with this system of trust.

With the banking system on the verge of collapse, the Fed resorted to emergency stimulus measures. In October 2008, the Fed initiated quantitative easing – basically printing money – to avoid a repeat of the Great Depression.

There was nothing to stop the Fed from increasing the base money supply, either. The dollar was no longer backed by anything, so it could be printed out of thin air.

During the monetary mayhem of the financial crisis, a radically different form of money emerged. It wasn't conceived by a king or a committee of bankers… but a computer programmer.

The Birth of Digital Gold

In August 2008, someone anonymously registered the bitcoin.org domain name. That was the first known appearance of the word "bitcoin."

Then, in October 2008, a coder going by the name of Satoshi Nakamoto published a white paper describing the basics of bitcoin.

Satoshi said that he had been writing the computer code for a year and a half. And in January 2009, bitcoin was born.

Satoshi claimed to be a 33-year-old man from Japan… But his true identity remains a mystery. It could even be a group of people.

What we know is that Satoshi developed an elegant solution to the problem of trust with traditional currencies.

Bitcoin is purely digital. It's just zeros and ones (known as "bits") on a computer network… hence the name bit-coin.

That's not as radical a departure from today's currency as it sounds. Economists estimate that only about 8% of fiat currency exists in physical form (coins and bills). So most of our dollars already exist in electronic form.

When your employer direct deposits your paycheck... or you swipe a debit card to pay for groceries... no physical bills exchange hands. But that's where the similarities between digital dollars and bitcoin end…

At its heart, bitcoin is a computer protocol – a set of rules in computer code that control how the system works. The Internet has its own protocol that governs how data and information is transferred. Instead of data, the bitcoin protocol is basically a means of transferring value… something that it's exceptionally good at.

You can quickly and easily transfer bitcoin from one "address" to another. And it doesn't matter where in the world the sender or recipient is: bitcoin knows no borders. (Technically, you don't "send" bitcoin from one place to another, as we'll explain later.)

Bitcoin exists entirely outside of the traditional banking system. It doesn't rely on commercial banks to manage accounts or verify transactions. As a result, there are no middlemen, such as Wells Fargo or Visa.

Bitcoin is transferred via a peer-to-peer network, which doesn't have a central computer server or authority.

Unlike dollars, bitcoins aren't a central bank's liability (or "IOU"). bitcoin shares this characteristic with gold, which isn't a liability of the central bank either.

But bitcoin is far more easily transferred than gold…

In 2013, the Bundesbank – Germany's central bank – announced that it planned to hold half of its gold reserves in its own vaults in Frankfurt, Germany.

The only problem was that much of its gold was held at the New York Fed and in Paris, France. So the Bundesbank had to conduct an arduous, phased transportation of 674 tonnes of gold. (That's the weight equivalent of more than 300 Ford Explorer SUVs.)

The operation cost $9 million and took about four years to complete. Bitcoin, on the other hand, can be transferred to anyone – anywhere in the world – securely, cheaply, and almost instantaneously.

It's electronic and more easily transferrable than gold, but isn't a liability of any central bank. So you can think of bitcoin as "digital gold."

It is like a digital commodity that – like the Lydian Lions – serves the three main functions of money:

1. Medium of exchange

Although far from universal today, more and more mainstream businesses are accepting bitcoin as payment.

The retailer Overstock.com accepts bitcoin… so do Microsoft's Windows and Xbox online stores. And you can pay for DISH Network's satellite television service with bitcoins.

In April 2017, the Japanese government officially recognized bitcoin as a legal payment method and currency. And in September 2017, apartments in two residential towers in Dubai became the first major real estate development in the world to be priced in bitcoin.

Granted, bitcoin isn't an ideal medium of exchange because its price is so volatile. In November 2017, bitcoin declined from more than $7,800 to about $5,600, only to recover and surge past $18,000 before the end of the year.

Again, this is why we view bitcoin as more of a digital commodity, or digital asset, than a digital currency. (Currencies are forms of money, but not all money is necessarily a currency.)

Over time, if bitcoin's volatility moderates and more merchants accept it as payment, it will better serve as a medium of exchange.

2. Unit of account

Bitcoin is fungible: One bitcoin is equivalent to any other.

Bitcoin is also extremely divisible. A bitcoin can be divided into 100 million units (each unit is known as a "satoshi").

Because of its standardization and divisibility, we can easily measure the value of goods and services in bitcoin.

3. Store of value

Bitcoin is designed to become more valuable over the long term because of its limited supply.

With the dollar, the total amount of circulation is up to the whims of the central bankers. Bitcoin, on the other hand, has a predetermined supply. It doesn't suffer from the inflation problems of traditional currencies. So it can be a long-term store of value… like gold.

Gold is scarce. Miners continue to extract more, but the total supply is limited by nature. The Earth's crust only holds so much gold.

Bitcoin's supply is limited by computer code. The bitcoin protocol controls how many bitcoins will ever be in existence.

Currently, around 17 million bitcoins are circulating. Ultimately, there will be 21 million bitcoins. These may sound like large numbers, but they're not.

Credit Suisse estimates the number of millionaires in the world (in U.S. dollars) to be more than 32 million. So not every millionaire could own one… There aren't enough to go around.

Bitcoin's portability and scarcity are perhaps its greatest strengths. Because of its special qualities, bitcoin could represent an evolution in money… just like the Lydian Lion coin and the Jiaozi paper money.

However, bitcoin aims to break up the government monopoly on money that has progressed ever since the first Lydian Lion was minted.

Before you continue reading, keep in mind that it's not necessary to understand the technical aspects of bitcoin to grasp its basic concept. You can simply create a digital wallet and start obtaining and sending bitcoin.

You don't need to understand the complexities to use it… just like you don't need to know everything that goes on behind the scenes with the banks and payment-processing network when you swipe your credit card.

However, we believe everyone should have at least a basic understanding of the technology behind bitcoin. And as an investor, this knowledge is invaluable.

At this point, we're going to get a little more technical and take you deeper into…

The Science of Cryptography

How often do you log in to your bank's website to check your account balance? Or when was the last time you entered your credit-card information and billing address into a website to buy something online?

If you're like us, you do this all the time and don't think twice about it.

Thankfully, your sensitive data are secure because of modern cryptography – the study of sending and receiving secret information.

Web browsers and Internet protocols help us create digital secrets automatically when we send private information from our computers and smartphones. Similar cryptographic technology is used by the bitcoin network. Bitcoin is known as a crypto-currency because cryptography plays a crucial role in making bitcoin secure.

To help show you how, let's consider the following scenario… You walk into a coffee shop that happens to accept bitcoin as a form of payment.

You order a large coffee, which costs $4 (or 0.0008 bitcoins).

At the counter, you take out your smartphone and open your bitcoin wallet. You scan a QR code (a two-dimensional barcode) posted next to the cash register. It looks like this…

You then enter 0.0008 bitcoins as payment and press "send." You just used bitcoin as a medium of exchange.

You transferred value directly to the merchant. No bank accounts were involved. Also, because you didn't use a credit card, the merchant didn't have to pay an interchange fee to the card-issuing bank or a payment-processing fee to Visa.

The merchant and you had never met each other before. And yet, he was comfortable giving you his bitcoin address. He also knew that the bitcoin you were "sending" him wasn't double-spent somewhere else.

Bitcoin completely removes the need for trust between you and the coffee shop merchant and allowed you to transfer value directly.

Let's examine how bitcoin did this…

The digital wallet on your phone (or computer) is just a few computer files that hold your digital "keys." There are private and public keys. These key pairs are how bitcoin ownership is determined.

There might be many key pairs in your wallet, but we'll simplify to just one pair here.

The private key is a long, random number. It proves ownership of bitcoin and must be kept a secret.

The private key and its corresponding public key are related. Apply some fancy math to the private key, and you're left with the public key.

The coffee shop merchant has his own set of keys. But he gave you his bitcoin address (in the form of a QR code). bitcoin addresses are created with the help of cryptographic hash functions.

A hash function takes an input and applies some calculations to produce an output (known as a "hash").

A hash can be thought of as a digital "fingerprint" of the input. No two people should have the same fingerprint. Likewise, no two inputs should have the same hash.

Here's an example of a hash:

B4056DF6691F8DC72E56302DDAD345D65FEAD3EAD9299609A826E2344EB63AA4

All hashes from a particular hash function are the same length. The input could be a single letter or the entire novel Moby Dick and their outputs would be the same length as the string above.

Also, it's impossible to take a hash and work backwards to figure out the input. This is why the coffee-store owner could give you his bitcoin address, which is the hash of the public key.

Just by knowing his bitcoin address, you wouldn't have been able to figure out what his public key was. And even if you knew his public key, it would still have been impossible for you to figure out his corresponding private key.

The coffee-shop merchant can safely display his bitcoin address in public. And public keys can be broadcast… which you did whether you knew it or not.

You see, to pay for that coffee, you had to prove that you had possession of your private key. But you had to do that without showing the private key to anyone.

In the background, you created a digital "signature" with your private key. Every bitcoin transaction needs a valid signature, which is unique to each transaction. So if you bought a cup of coffee yesterday from this same coffee shop, your signatures on the two transactions would still be different.

Today, you broadcasted the signature for this transaction and your public key to the bitcoin network.

Because your public and your private keys are mathematically related, the bitcoin network can validate this signature without seeing your private key. In other words, the network can verify the private key that corresponds with your public key was used to create this signature.

This example shows how cryptography keeps private keys confidential, while making verified transactions possible.

This leads us to the next big question… How does the bitcoin network know that you have enough bitcoin in your wallet to pay for this coffee? After all, to transfer the 0.0008 bitcoin to the merchant, you first must have obtained it.

This is how the blockchain comes into play.

The Money Ledger

Bitcoin is money. And its blockchain is the ledger that keeps track of who owns this money.

The blockchain is basically a database. It stores data about every single bitcoin transaction.

The bitcoin blockchain began on January 3, 2009, when Satoshi's computer established the "genesis block."

The blocks are groups of transaction data. Each block is organized like a ledger, or record book. Let's take a look at some hypothetical transaction data.

This particular block contains data about your coffee purchase.

Instead of names, like Alice or Bob, the actual ledger shows bitcoin addresses. Everyone can see the block data. But since it only records bitcoin addresses, it offers a degree of anonymity.

A bitcoin payment is just a credit to one user and a debit from another. This is why you don't really "send" bitcoins. Your 0.0008 bitcoin was just transferred from your address to the coffee shop's address.

In this ledger, you can also see the unique signatures needed to verify the transactions.

Since the blockchain data is visible, bitcoin users can agree on its accuracy. In other words, we can trust the blockchain instead of having to trust other bitcoin users.

But that means we have to be confident that the blockchain can't be changed…

The blocks have a "header," which includes a timestamp of the time and date for the block.

The header contains a compact summary – created using hash functions – of the transactions within that block. So if a malicious hacker were to try to change the amount you paid for the coffee from 0.0008 to 8 bitcoins, the transaction data in block 79 would no longer match its header.

Each block header also has a hash of the previous block's header. Therefore, there's data from the previous block inside of each block. This is how the headers link, or chain, the blocks together… hence the name "blockchain."

The linking mechanism makes the blockchain immutable… No one can alter it.

Changing any part of the transaction data within a block would change that block's header. Then, that header would no longer sync with the next header.

Essentially, the blockchain is a trustworthy accounting system.

Since the blockchain contains every bitcoin transactions since the genesis block, we can tally all of the bitcoin credits and debits and determine how many bitcoins each address has. This is how the network could verify that you had enough bitcoins to pay for that cup of coffee.

Besides immutability, decentralization is another crucial security feature of the blockchain.

The Distributed Ledger

A centralized database exists in a single location. There is one copy on a computer or server that users can access.

If the server fails, the entire network is shut down. Also, if the data on the server are compromised, then all of the users will see faulty data.

A distributed database, on the other hand, has no single point of failure. Many copies of the database exist. And these copies can be used to verify each other's accuracy.

Bitcoin is distributed. Not even governments can shut down bitcoin because of its global, distributed structure. (What governments can do is control the exchanges that help you turn your fiat currency into bitcoin.)

The bitcoin network consists of around 10,000 computers running the protocol around the world. If some of these "nodes" fail, the bitcoin network continues to function. Also, thousands of copies of the blockchain exist, which helps ensure the integrity of the data.

Let's say a node received your coffee transaction. It's a valid transaction that the node hadn't seen before, so it passed the information on to other nodes. In turn, those nodes sent the transaction on to even more nodes. Within seconds, virtually the entire network had received your transaction data.

However, the transaction doesn't become part of the blockchain until it's included in a block and attached to the chain by a process called "mining."

Specialized nodes (called "miners") take the next group of unverified transactions and bundle them into a block. They verify the transactions and then race to solve a math problem involving the block data and a hash function.

The only way to solve these math problems is to guess and check to see if the answer is right. The miners plug in the block data, along with a random number (called a "nonce"), until they find a nonce that produces the desired hash.

The first computer that solves the math problem receives newly created bitcoin. This bitcoin reward (which is now 12.5 bitcoins) is the incentive for the miners to use their computers and processing power to validate transactions on the bitcoin network.

The competition to solve the math problem is a "proof of work" system. The miner that comes up with the solution to the problem first has proven that it has done a lot of work to come up with the right input.

The other miners then check that the math problem has been solved correctly and that the header of this block and the previous one match up. Once everything is verified, they add the block to their blockchains.

Now that you're familiar with what a blockchain is, you'll be able to see through the hype.

Every time you hear that blockchain technology will revolutionize our way of life, think to yourself… A blockchain is just a ledger. It may be a special type of distributed ledger that serves as the basis for a new type of money. Nonetheless, a blockchain is just a shared record book.

A big benefit of this distributed system is that verification comes from the consensus of many nodes. The network has agreed that the transactions in a block that is being added to the blockchain are all valid.

It would be hard to hijack this network. A malicious group would need to control more than 50% of the processing power of the bitcoin network to corrupt the blockchain. That's an unlikely scenario, given the size of the network.

Computing Power

IBM's Watson computer famously won the television trivia show Jeopardy! in 2011. At the time, the supercomputer could perform 80 trillion operations per second (with decimal numbers). And since then, the computing platform has been repeatedly upgraded.

Watson has helped companies solve complex problems and cut costs. Watson has even helped doctors diagnose cancer.

Indeed, Watson is versatile. But it would be nearly useless for bitcoin mining…

Most bitcoin miners use specialized computer systems with hardware that's specifically designed to perform hash functions – and nothing else. The more hashes these mining "rigs" can perform per second, the better the chances they'll solve bitcoin's proof-of-work math problem first… and win their owner some bitcoin.

The "hash rate" measures how fast miners can compute hash functions. The hash rate for the entire bitcoin network is more than 7 million terahashes (trillions of hashes) per second. That's 7,000,000,000,000,000,000, an outrageously large number.

Prior to 2016, the hash rate hadn't exceeded 1 million terahashes. So, the aggregate computing power of the bitcoin network is growing exponentially.

With the bitcoin network growing more powerful, you might assume that blocks are being mined faster. But that's not the case. Miners still add a block to the blockchain every 10 minutes, on average.

The reason that it continues to take about 10 minutes to mine a block is because the difficulty of the proof-of-work math problem is adjusted dynamically. If miners are consistently adding blocks faster than 10 minutes, then the math problem gets harder.

The difficulty target is a crucial aspect of the bitcoin protocol. Without it, miners could mine blocks in rapid succession and be rewarded lots of bitcoin. The amount of bitcoin in circulation would mushroom, depressing the price of existing bitcoins. In other words, it would be hyperinflationary – not unlike what has happened with the Venezuelan bolivar.

In fact, the hyperinflation in Venezuela has caused some people to turn to bitcoin mining.

Many bitcoin critics contend that mining is a massive waste of energy. However, most mining occurs in countries where electricity is in surplus and very cheap.

For example, Iceland is a major bitcoin mining hub because of its plentiful geothermal power sources, which have zero carbon emissions.

curated by Glen Brink, InvestmentMarketingTips.com