Bitcoin For The Beginner

Every investor knows of Bitcoin (BTC) by now but many do not understand what it is, how it works, or whether it is a good asset to own. The technical aspects of BTC are difficult to understand, however one doesn't need advanced math to know how it works and make an investment decision.
While it was once an internet novelty, major retailers such as Microsoft and Dell are beginning to accept Bitcoin. Even a few small businesses accept the digital currency as payment.

What Is It?

Is it a pyramid scheme? Magic internet money? Something only criminals use for laundering? All these and more are real questions people have asked me about Bitcoin. Some of these people are savvy investors but have no experience with digital currency. Many descriptions of BTC use incomprehensible jargon such as SHA-256 and network difficulty. While it won't hurt to understand these things before buying it isn't necessary.

Bitcoin, in a nutshell, is a decentralized digital asset run on a peer to peer network. Anyone with a computer can participate in this network. There is no central bank or government to issue coins or regulate the network. Bitcoins are stored on a unique address 26-35 characters long that looks like this: 1J8VdQ2HcqXXHE3JiRthy6DMaes4er6DrJ (from the Mozilla Foundation). An address is generated using a secret code and is intended for only a single use. Bitcoins stored on an address can not be accessed without the secret code. Transactions sent from one address to another are computed by the P2P network.

Fractions of a Bitcoin can be spent, otherwise it would be impossible to use it for anything. The smallest fraction of a Bitcoin is 0.00000001, called a Satoshi after the currency's mysterious inventor. One Satoshi is currently worth about 0.00002 USD. This impractically small value isn't really used for anything yet aside from faucet payouts. It only exists so that if Bitcoin becomes extremely valuable one could still send transactions accurate to a penny. Bitcoin can be updated to allow even smaller divisions if such a thing is ever needed.

Providing computer power to the global network is known as mining. This term is used because new coins are generated by the network and given to the miners. Miners are also rewarded with transaction fees. Transactions are computed approximately every 10 minutes. This 10 minute group is called a block and is recorded in a sequential record called the blockchain. The history of any Bitcoin can be traced through the blockchain back to its creation. This is why Bitcoin is considered only semi-anonymous. Personal data is not recorded but BTC addresses used in transactions are recorded.

Block timing isn't exact because the network adapts to computing power. New Bitcoins are rewarded to a single miner every block, not divided between them. Basically the network is presented with a mathematical puzzle. The first computer to solve the puzzle receives newly minted Bitcoins as a reward. The difficulty of the puzzle is adjusted up or down so that no matter how much computing power is available its solution takes 10 minutes on average. A network participant can get lucky and solve the puzzle in 30 seconds, or if nobody finds a solution it could theoretically take 30 hours or more. The goal is 10 minutes but the actual time varies. At first glance this is an odd way to run a network. However it ensures that anyone who wants can participate and still have a chance to receive rewards no matter how many computers are involved. Also the network is stable and predictable with any amount of computing power. In practice small contributors usually join a mining pool. They team up for a better chance to solve the puzzle and split the reward when it is won.

Most people wait 3 blocks or 30 minutes to confirm a transaction. The transaction will appear quickly but will be unconfirmed. In other words if you deposit Bitcoin to the Coinbase exchange or buy a computer from Newegg you will have to wait 30 minutes on average to verify the transfer. This ensures the network didn't make any mistakes calculating the transaction. Unlike other types of payment such as credit cards or Paypal, Bitcoin transactions are irreversible.

Why Is It Worth Anything?

This is the big question for most people. If it doesn't exist in the physical world like gold or oil how can it possibly have any value? Why can’t a computer geek simply make more of them by writing some software? A common answer is "it has value for the same reason any currency has value." However I believe two characteristics bestow value: usefulness and scarcity.

Counterfeit coins will not have any record on the blockchain and thus will be rejected by the network. There is no way to make fake coins without compromising the entire network. The effort required is impractical and unlikely. Instead thieves steal bitcoins through usual methods such as viruses and social engineering.

Bitcoins are scarce: the network produces only 12 per block. The number minted each block halves every four years with the next halving scheduled for 2020. Halving continues until 2140 when the last of the 21 million possible coins are issued. It may seem that coins will be produced for the foreseeable future, however 16.4 million or 78% of all Bitcoins have already been created. Demand far outpaces the creation of new coins. They will only become more scarce in 2020 when 6 are issued every block, in 2024 when 3 are created each block, etc.

Contrary to popular belief Bitcoin is not magic internet money. It offers real innovation over existing currency. Useful features are numerous but most prominent are speed, cost, and safety. Transacting with Bitcoin is much faster than sending a bank transfer or writing a check. Checks need to clear and ACH transfers take days at best. It is also cheaper compared to alternatives like Western Union or bank wires. In fact when sending Bitcoin the sender can raise or lower the transaction fee as they see fit. The network will send transactions with higher fees first so a lower fee will result in a longer confirmation time. The cost is the same whether $1 or $1,000,000 is sent through the network. The savings on international transfers can be significant because the fee is not based on the amount sent.
Bitcoin also offers more safety than other types of payment. You will not have your personal information stolen by using Bitcoin because you don’t have to use any. Credit card companies sell your data to third parties, Bitcoin wallets do not. You will not have a transaction reversed months later like you might with Paypal because transactions are irreversible. You don't have to worry as much about account security because you don't have to rely on the weakest link storing your account data on public servers. And best of all people can use it to store wealth during an economic crises such as the one in Venezuela.

Where Will It Go From Here?

Bitcoin is by far the most volatile asset I have ever owned. The short term price is impossible to predict. In July alone the price has swung between $1800 and $2800. These price swings may keep most investors from pulling the trigger. However the long term has significant upside potential.
The market cap of Bitcoin has rocketed from $10 billion to $45 billion in the last 12 months alone, and institutional investors have only just begun to dip their toes in the market. Two ETF applications were recently denied by the SEC. However the insane premium enjoyed by the Bitcoin Investment Trust (GBTC) indicates significant demand for a derivative fund. Each share of GBTC is worth .1 Bitcoin, or approximately $270, but currently trades over $400! They also charge a 2% annual fee, far above what one might expect from an ETF. The largest gold ETF, GLD, charges only .4% by comparison. Bitcoin is so easy to buy that paying almost double for a derivative fund is sheer lunacy. The advantage of a fund is convenience and if an OTC ETF commands this premium there must be significant demand. The SEC is beginning to learn more about digital currencies and will have to deal with Bitcoin eventually. It's only a matter of time until a derivative fund is approved to trade on a major exchange. The killer app that brings Bitcoin to the masses will be investment funds, not flashy software for cell phones.

Are There Any Risks?

Bitcoin is still young and faces many challenges such as regulation, threats to the network, and newer digital currencies. While Japan recently adopted favorable regulation, other places like New York have unfavorable laws. New regulations are impossible to predict and may be enacted any time. For example if China outlawed Bitcoin it would likely have a significant impact on the market. Even laws unrelated to digital currencies might have an effect. The recent change in asset forfeiture by Jeff Sessions means that your money can be seized for mere suspicion. A police officer could confiscate Bitcoins on a traffic stop. After all only a drug dealer would carry thousands of dollars in digital currency. No evidence needs to be found and charges do not need to be filed. Sound a little far fetched? Think again.

Threats to the Bitcoin network also pose a danger. For example the network can be compromised if someone gets 51% or more of total computing power. The current network computing power is 7 million terahash per second, and one terahash is a trillion calculations per second. It would take billions of desktop computers to match the computing power of the network. It would be impossible or at least implausible to get 51% of the power. More likely an attacker would compromise existing network computers.

A few network participants possess staggering resources. Antpool, run by the Chinese company Bitmain, has the most computing power at 23% of the network. Bitmain manufactures dedicated Bitcoin mining computers and could theoretically gain 51% of the network. Bitmain would never compromise the network, but an outside party could try to compromise their Antpool. While a network attack is unlikely, the possibility does exist.

New digital currencies known as alt coins could eventually replace Bitcoin. There are many alt coins available, some of which are superior to Bitcoin. For example Litecoin (LTC) is similar to Bitcoin but blocks only take 2 minutes. Other coins offer total anonymity or better scaling solutions. Despite its disadvantages Bitcoin will remain king because it has name brand recognition. Retailers don't accept alt coins and most people don't know much about them. However alt coins may steal some market share, and as digital currency becomes common Bitcoin could die out if it does not improve. Remember the Walkman? That could be Bitcoin some day.

Just a note, many alt coins (and ICO's) are scams and should be avoided by the novice. Good alt coins exist but their discussion is beyond the scope of this article.

How Do I Get Some?

Bitcoin is easy to get. Popular exchanges such as Coinbase or Kraken accept bank transfers. One can also purchase them in person through websites such as LocalBitcoins where the price is usually higher compared to exchanges. Exchanges are not always safe so most people prefer a software or hardware wallet. Software wallets like Electrum and Mycelium are free and available for major operating systems. Hardware wallets such as Ledger and Trezor offer additional security at a premium cost. No one should pay a significant premium through funds like GBTC because BTC are so easy to buy.

A note for trading on LocalBitcoins: laws vary between jurisdictions so be sure to check your locality. Also when trading in person if the other party mentions the money/BTC will be used for anything illegal and you go ahead with the trade, you are now a criminal. Walk away and do not complete the transaction.

Final Thoughts

Bitcoin, still in its infancy, may be the next evolution of currency. Risks are significant but so is the potential upside. The majority of coins have been minted. As a result price increases directly with each new influx of money. Market cap will expand significantly when institutions join the party. However because significant dangers exist one should only buy what they are willing to lose. The market is incredibly volatile and price will likely fluctuate all over the place. Hold for the long run and ignore short term price swings.

Recent disagreement between miners caused a perception that Bitcoin could fail. Basically the block size needs to increase from 1 MB to accommodate more transactions, but not everyone agrees on the solution. This created a potential network split because large mining pools threatened to use different software to address block size. A compromise was reached and will go into effect next month. This compromise is temporary so expect more wild price swings in the upcoming months.

Investors new to Bitcoin should understand that the sky is always falling. The recent crisis will be followed by many more until the currency reaches adulthood. Don’t buy in to the fear. Instead buy the dips. I have owned Bitcoin for a few years and there has always been some Armageddon or other brewing. Somehow conflicted parties who all stand to benefit find a solution. If the current climate seems too dangerous then one could wait a few months for things to settle down.

Welcome to my Blog

This blog is for random thoughts, musings, and investment ideas. I am a contributor on Seeking Alpha but not all of my ideas are appropriate for that website, so those go here.

I don't have any formal degree however I have been very successful investing my own money. Organizing and writing my ideas is a new challenge that I enjoy.