Ifyou have even a passing interest in the world of finance, then you will have noticed by what’s going on with Bitcoin right now.
Since the start of 2021, the price has been going up and down like a child on playground see-saw.
On January 3rd this year, I decided to buy some Bitcoin. I had no idea how to do it at the time, nor did I know that it would be the day that the price climbed to a record high of $34,000 for a Bitcoin. Little did I realise it would continue climbing to $40,000 over the coming week, or drop 25% again thereafter.
I simply wanted to buy a small holding as a means of learning the process — the ‘How’ of Bitcoin investing.
It turned out to be remarkably easy and I’ve shared my findings in this article.
My first week as a Bitcoin investor yielded some useful lessons, mainly around the psychology of it - I've shared those lessons here.
Of course, there’s way more to know and understand. I started out with questions about what it is and how it works — some might say I was careless to invest before having the answers to these?
I’ve since set out to educate myself and close the gaps in my knowledge. It’s a process that will continue in the coming months. Through a series of articles, books and podcasts I’ve come up with what I think are the fundamentals.
I’ve shared my sources throughout, and my definitions and descriptions are provided in my own words and in as simple terms as I can muster. They may not be entirely factually correct but they’re based on my understanding and I think they’re broadly accurate.
It’s not a comprehensive summary of everything you need to know about Bitcoin and crypto. It’s just the answers to the biggest questions I’ve had so far.
Use it as you see fit and be sure to do your own research as well.
Bitcoin tends to be used synonymously with the term cryptocurrency. The mechanics of ‘How’ to buy Bitcoin generally seem to apply to other cryptocurrencies and I’ve used the same process above to buy a tiny holding of Ethereum too.
This piece is specific to Bitcoin — the largest and most well known of the cryptocurrencies.
What is Bitcoin?
I picture a Bitcoin as a virtual gold coin. It exists digitally, and has a value relative to other currencies. It’s traded against other these (in much the same way as you can buy US Dollars in exchange for GB Pounds). Instead of the coins existing physically, they exist within blockchain technology (described below).
A good analogy, provided by journalist Nathan Popper who came up in many different podcasts on the subject including this one, is that Bitcoin works much like PayPal and its network of users. Each person who has a PayPal account can send and receive money to other users in the same way that each holder of a Bitcoin wallet can send and receive money to each other. In PayPal, currencies exist virtually too.
What is Blockchain?
Blockchain is the technology underpinning Bitcoin. The best analogy I’ve encountered is to picture a fly trapped in a block of amber (you’ve seen the movie Jurassic Park, right?). The fly at the centre of the amber is the coin itself. Around the fly, layers of amber are built up over time, locking in the history of the fly.
In blockchain, each transaction for the individual coin is recorded as a new layer of amber, and appended to the blockchain in encrypted code. As such, the blockchain records the entire transaction history of each coin and grows over time.
Where is it?
Bitcoin uses distributed computing and is effectively stored in networked computers all over the world. It’s important to understand that each of the network nodes (each computer storing Bitcoin) effectively holds a full copy of the Bitcoin ledger. This is a full record of the transactions for each Bitcoin and is currently growing as Bitcoins are bought and sold, sent and received. These nodes and their respective copies of the ledger synchronise with each other and remain updated with each transaction.
This effectively validates the ownership and existence of each Bitcoin and ensures that the whole system is consistent and maintains its integrity.
It’s also what gives Bitcoin the unique property that no single person or organisation owns or controls the system. It’s a co-operative, self-governing and unregulated structure.
No central bank owns it. No government owns it. The ‘system’ can’t be changed without consensus from all Bitcoin owners.
What gives it value?
Bitcoin is currently being ‘mined’ which is the process of creating the coins. They are created by the computers at the nodes, their value arising from the computer processing power required to bring them into existence on the network. I’m still a little sketchy on the detail behind mining, but the point is that there is a recognised process that brings them into existence just as gold bars are created out of the ore that is mined. They cannot simply be plucked from thin air any more than gold can be created by alchemists. Each has a process for bringing them into existence.
Unlike traditional modern currencies, Bitcoin will forever be subject to a finite supply — there will only ever be a maximum of 21 million of them. Currently around 19 million of these have been mined. It’s estimated that the full complement of Bitcoin will have been mined by the year 2140 but this is of course an estimate.
The fact that there are only ever going to be 21million is key, and is built into the computing protocol and the design of Bitcoin. It has implications for a number of things:
- Bitcoins that have been stored on hardware wallets that have been lost or destroyed inadvertently will not be replaced or recreated. The supply is finite.
- Once all 21 million have been mined, there won’t be any more created. This isn’t the case for traditional money which governments and central banks print more of when they want to end a recession or simply need more money (for example to issue stimulus cheques in a pandemic). Such measures (quantitative easing) solve a short term problem for governments, but devalue the currency and reduce its purchasing power and the value of savings. You can read all you need to know about the importance of purchasing power in this excellent story.
The main source of value in Bitcoin is the consensus and acceptance of it as a store of value, which after many years in existence (it came about in 2009) seems to have been reached. Mainstream investors (like Paul Tudor-Jones) and companies like Square and MicroStrategy are investing in it. PayPal will now allow payments in Bitcoin too.
In this podcast, Michael Saylor, co-founder of MicroStrategy gives a really good synopsis of what Bitcoin is and how it works. He also shares why his company are investing their reserves in Bitcoin rather than holding it in cash.
It may sound flakey to declare that Bitcoin has value because people agree and accept that it does — but this is the case for modern money today too and has been the case throughout time, when shells, rocks and beads were used as a means of tribes trading and exchanging notional value. Banknotes are merely bits of paper (or plastic) that have been issued by governments who tell us they have worth which we all accept. An online bank balance is simply a string of numbers that we all agree equates to an amount of value that represents purchasing power.
Once upon a time banknotes could be exchanged for a corresponding amount of gold but this isn’t the case and hasn’t been since the early 20th Century in many developed countries.
As such, all financial assets only really have value because we all agree they do. The same is true for Bitcoin.
To learn more about this, if you read one book on Bitcoin (that will educate you in the fundamentals of money and economics too), make it 'The Bitcoin Standard' which I’m currently devouring on audio.
Photo by Jingming Pan on UnsplashIsn’t it risky as an investment?
All investments are risky and can go down as well as up. Shares in a company can be lost if it goes bust. Savings in a bank are devalued in terms of purchasing power when governments print more money, or when the banks go bust. Gold bars can be stolen.
It seems to me that many of the scare stories stem from those who’ve chosen to ‘bet the farm’ on Bitcoin and suffered big losses when they were expecting massive gains; From those who treated it as a get rich quick scheme and were surprised when it lost instead of gained.
Bitcoin’s price is pretty volatile and goes wildly up and down. In 2003 it was at nearly $20,000 and dropped to a little more than $3,000. It’s fluctuations like this that make it possible for well-timed investments to pay massive returns, and poorly timed ones to lose significant amounts of money.
You may get your fingers burned if you try and buy and sell in the short term to capitalise on gains and catch the market in decline. For my part, I’m simply trying to accumulate Bitcoin as an asset in the hope that in the long term it will appreciate in value enough that I can sell and make a decent profit.
The internet is full of speculation of course (probably hopeful speculation by small-time investors like me) — but this article from Reuters points out that JP Morgan tip it to reach $146,000 and Citigroup are even more bullish forecasting a value of $300,000 per Bitcoin. Such predictions could be very long term (2030 or later?) but reflect that once all coins are mined, the only fluctuations in value will be down to trading and supply and demand. The coins will be worth what someone is willing to pay for them.
As a store of value when more widely used traditional currencies like the US Dollar and GBP have been further devalued by governments printing more, Bitcoin may become ever more desirable.
In the meantime, the guiding principle seems to be that you should only invest what you can afford to lose in Bitcoin and that’s certainly what I’m doing.
What about it getting lost or stolen?
There are high profile stories of people losing Bitcoin after losing the hardware wallet it was stored on, while some have lost the password to it.
Some have lost Bitcoin when they left money on a crypto-exchange that was hacked. Some have bought Bitcoin through dubious or fraudulent intermediaries and websites that turned out to be hoaxes.
Bitcoin is unregulated and investments in it aren’t protected by financial regulators. That may be considered a drawback to some.
There are examples of best practices that can be followed though to minimise your risk, such as using a hardware wallet to effectively store your coins offline — and not losing it or forgetting its password. The same is true though for other assets and currencies — you wouldn’t leave a wallet full of cash on a park bench, or a gold bar on your doorstep either, right? Conventional banks are also subject to hacks, ransomware and other means by which existing currencies can be lost.
Can you spend it?
Bitcoin was originally conceived in part as a means of making anonymous online purchases. Inevitably, this was initially appealing to those looking to make illicit or illegal purchases via the dark web. To some extent I guess that this is still part of what makes Bitcoin popular as a spendable currency.
Bitcoin can be used as a payment mechanism with ease though, and as mentioned PayPal now accept Bitcoin payments as do many large and small businesses.
The sense of paying for goods and services in Bitcoin is somewhat questionable however. Currencies by definition tend to have an accepted basic value — we may all agree that a can of Coca-Cola costs $1 for example.
With the value of Bitcoin relative to other currencies fluctuating as wildly as it does, trading in a fraction of your Bitcoin today might mean you pay $1 for your drink, but that $1 worth of Bitcoin could subsequently increase in value to $30, $300 or more (or less) in the relatively near term, meaning that you overpay or lose notional future value.
This excellent, if somewhat alarmist story describes the many reasons why Bitcoin has become more of an asset than a currency in recent years.
In short, you can spend your Bitcoin but it’s probably ill-advised to do unless you want to forsake potential future gains in value for the sake of anonymity.
Next Steps
There’s still so much I have to learn about Bitcoin and cryptocurrencies. The above may help you in reaching the same level of understanding that I have, and I hope it’s useful. I’m also willing to correct inaccuracies if there are any — I’ve no intention of misleading anyone.
Bitcoin isn’t the answer to everyone’s financial problems, nor is it a get-rich-quick scheme or a scam dreamed up by those more clever than the rest of us. It is simply what it is — potentially the evolution of the concept of money, and certainly of technology. It has potential for making many more people wealthy than it has already, but there could also be many who lose everything if they are flippant or careless in how they approach it.
I will be growing my holding of Bitcoin a little at a time, and only with funds that I could stand to lose if something went badly wrong. I view it as a speculation on something that could one day increase radically in value. I’d rather have a share of potential gains, than be sat in 10 or 20 years regretting my inaction whether that hesitance had been borne out of cynicism, excessive caution or ignorance.
If you’re similarly minded, I invite you to get involved and make a small investment too (but only one you can afford to lose if it all goes pop)!
Note: This article is for informational purposes only. It should not be considered Financial or Legal Advice. Consult a financial professional before making any major financial decisions.