Many people ask how bitcoin can be worth anything, when it is just some digital numbers on a computer. Isn't it just one big scam?
Actually the 'money' we normally think of, for example, the British Pound or the US Dollar, is very similar.
What is money?
Most money in the world is held in bank accounts. But think about what a bank account really is... just records of who paid who. Most of these records are digital numbers stored on a computer (like bitcoin).
Maybe we think of money as the coins and notes we hold in our wallets and under the mattress - but coins and notes are little lumps of metal or worthless pieces of paper - they are only of value because other people will exchange them for something.
Even more strangely, shops are happy to hand us their goods when we show them small pieces of plastic with numbers written on them: our credit cards. Or when we wave our smartphones over their phone payment detectors.
The plastic of your credit card might be worth only a few pence, but with it you can spend thousands of pounds. How does that work?
The reality is that we are already in a world where 'money' is really just numbers on a computer or some printed words on scraps of paper, plastic or metal.
This is confirmed by Wikipedia which defines money as 'any item or verifiable record that is generally accepted as payment for goods and services and repayment of debts... with its main functions being a medium of exchange, a unit of account and a store of value'
In simple terms this means whatever we choose as our MONEY just needs to:
- Make it easy to buy and sell goods and services.
- Store the wealth we save by protecting its value.
How can we trust money?
We trust our money (or currency) when we have faith that it won't become worthless.
Currencies become 'worth less' when:
Transactions and balances are recorded incorrectly (through error or fraud).
It's no good if I've saved £10,000 to buy a car, and after I buy that car from one garage, I drive down the road to another garage and I'm able to buy a second £10,000 car because no-one at my bank recorded that my savings were already spent. This means I've just defrauded the second garage owner. If this happens enough, and word spreads, then shopkeepers and garage owners lose trust in the system and they all eventually refuse to accept the currency as payment.
Inflation gets out of control.
When money is 'printed' out of thin air (either by governments, or by criminals forging counterfeit money) this leads to higher inflation - because there's more money to divide up to spend on the limited supply of goods in the shops. Inflation reduces what you can buy with your money, so your savings are worth less than they were - they have been devalued.
There are many examples in history of a currency becoming massively devalued. Two of the worst examples are: Germany, where in 1922 you needed 163 marks to buy a loaf of bread, but in 1923 you would have needed 200,000,000,000 marks to buy a similar loaf (that is not a typing error!). And Zimbabwe, where inflation reached 231,150,889% in 2008.
In the UK, US and recent Europe, our governments and our banking systems have just about been trustworthy enough to avoid large currency devaluation - although we had a severe warning flag in 2008 when the financial system almost collapsed (this was also because of creating money out of thin air: in this case by the banks who lent billions in mortgage money that they shouldn't have).
History tells us we should not be complacent. Asia and Russia had financial crises in the 1990s. Africa had its collapse in the 2000s. And South America continues to have crises, with Venezuela being the country presently in trouble.
Is there a better system?
As history shows, governments, banks and other people can be untrustworthy. So in an ideal world we need to remove the need for trust.
We'd remove the ability to print more money.
We'd ensure that no-one could double spend (like my car example above).
And we'd secure transactions so that they were tamper proof, beyond dispute, and immune from being 'rewritten' at a later date.
Until 2008, there was no solution except to trust in governments and banks to do our book keeping. But then Satoshi Nakamoto published the ground breaking "Bitcoin" white paper which removed the need for trust completely - by using mathematical rules built into computer code.
Not only is bitcoin 'trustless', but at the same time it reduces transaction fees, increases privacy, and stops theft. No-one who has protected their digital key has ever had their bitcoin stolen.
Bitcoin is the first 'scarce' digital resource - it is limited in number and no-one can make more of it when we reach the limit. Only scarce resources protect against inflation. Gold is a scarce resource, which is why most major governments around the world use it to back their currencies (because you can't simply print more gold).
But not only is bitcoin more scarce than gold (because gold has no limit on how much can be mined), it has the huge advantage that it can be sent across the internet, which gold cannot. This allows easy cross-border payments, and potentially allows everyone in the world to transact with anyone else in the world without banks (who, you may have noticed, make it there mission to add as many costly middle layers and delays as they can when you make international payments).
And while we're comparing it to gold, bitcoin is divisible. If you have a gold coin worth £1,000, how are you going to buy a loaf of bread with it? Shave some gold off? But bitcoin can be spent in as small units as you like. If you have one bitcoin worth £10,000, you can still buy a loaf because you just pay 0.0001 bitcoin for it.
What is bitcoin and how does it work?
For practical purposes bitcoin is quite simple compared to our current banking system. Only three concepts are required to use the entire payments system: private keys, public bitcoin addresses, and wallets.
Bitcoin has no concept of people. There are only public bitcoin addresses which contain bitcoin balances. And to spend those balances you need the private key linked to the public bitcoin address.
So a bitcoin address is just like a traditional bank account, but instead of an account name, sort code, account number, ISIN, SWIFT code, and all those other silly details we need in the existing bank system, any bitcoin account in the world is described by just its one public bitcoin address.
A public bitcoin address is a set of between 26-35 characters and looks like this: 1GHD1ikdnhJtxf2fweSPnig36cEjtT41w9.
Anyone who knows the public bitcoin address can send bitcoin money into it, which increases the balance.
In the bitcoin world we don't know who owns what bitcoin address. It's very simple. The 'owner' of a bitcoin address is the person who knows the private key.
The private key is everything.
Anyone with the private key has access to your money. So private keys should never be given to anyone, ever.
If you lose your public bitcoin address, you can easily recreate it from the private key. But other people can never recreate the private key from your public address.
A private key is 64 characters and looks like this: KyU3Lev756h1TwYkF88NX5YSG9W xsYwJwvbsNeNYrx51d9xvA5vY.
By the way, those numbers in italics above are a real private key and its bitcoin address... but don't get too excited, because I don't have any bitcoin in it :-)
A bitcoin wallet is simply a collection of the public bitcoin addresses you own (and their private keys) - similar to carrying the cards of many different bank accounts in a normal leather wallet.
Wallets can be:
- Paper wallets. Literally all you need is to write down the public bitcoin address and the private key, and that's a wallet, that anyone can send bitcoin to, and only you can spend from.
- Software wallets. These are able to monitor the balances in your bitcoin addresses, and sign transactions so that you can make payments from your wallet to other people over the internet.
- Hardware wallets. These look a little like USB memory sticks and do the same as software wallets. But they are generally more secure because they can protect your wallet with PIN numbers, and you can disconnect them from the computer and lock them away.
Another beautiful thing about bitcoin... your entire worth is represented by your private keys, so backing up your account is as simple as writing down your private key in several places or having copies of your wallet on several USB sticks. To make life easier, many wallets allow you to back up the wallet with twelve random words (the 'seed') instead of the 64 characters of gobbledeegook.
There Are No Banks
There are no banks (so there is no risk of the bank going bust and you losing money - as happened to me in 2008). The bitcoin network is thousands of computers spread across the world, all holding every transaction and balance that's ever taken place, so there is no single point of failure. And never any dispute about which bitcoin address holds how much bitcoin.
How do transactions work?
Say you've sold me something, and want me to pay you 0.05 bitcoin. This is how it happens.
You tell me your public bitcoin address, e.g. A5mPL4hxh6iSQzictcsRVqRXcycab1GgS
I use my bitcoin wallet software (free and available for computers and smartphones) to create the transaction:
- Send 0.05 bitcoin from my address 1GHD1ikdnhJtxf2fweSPnig36cEjtT41w9 to your address A5mPL4hxh6iSQzictcsRVqRXcycab1GgS.
My wallet software (digitally) signs the transaction with my private key, then sends the signed transaction to the bitcoin network.
Once the transaction has been confirmed, every one of the approximately ten thousand computers (known as 'nodes') on the bitcoin network records the new balance in my public bitcoin address and your public bitcoin address - the nodes' job is to always know the up-to-date balances on every public bitcoin address that has every existed - that way they can verify that future transactions are valid and that no bitcoin address is spending more than it owns.
My wallet software connects to a node and obtains my new balance, which has now reduced by 0.05 bitcoin. Likewise your wallet software updates your bitcoin address with the balance, which has increased by 0.05.
Our transaction is complete, and you are free to go crazy and spend your 0.05 bitcoin.
That process would be exactly the same if the transaction was for 0.000001 bitcoin, or for 10,000,000 bitcoin. And the fee would also be the same (currently the equivalent of a few pennies or cents, paid in bitcoin to the miners on the network who confirm your transaction).
If you didn't already have a wallet and were impatient to do the transaction right now, you could create a public bitcoin address and your private key in less than a minute by going to a site like bitaddress.org.
That sure is easier than opening a bank account in the old world.
As long as you keep your private key safe, you could hold £10 billion without fear of it being stolen. You could travel abroad to anywhere in the world, and if you wanted to spend it, all you need is an internet connection and the private key.
What goes on behind the scenes to validate and confirm the transaction on the bitcoin network is complex (it's an article in its own right), but understanding it is not required to use bitcoin.
Suffice to say... the rules written into bitcoin's code ensure that no-one can double spend their bitcoin, that the transaction becomes irreversible once confirmed, and that it is not worth the while of rogue or criminal actors to put fraudulent transactions into the system (because it would cost them an unspeakably large amount of money to do so). This whole process is called 'bitcoin mining'. It has nothing to do with mining in the traditional sense. It is actually about using massive computing power to solve a mathematical problem.
But who sets the rules?
The 'rules' are actually the bitcoin core code which can be found here - anyone can download it, check it, and become a miner (hint: don't bother - unless you have vast computers and access to cheap electricity).
Is Bitcoin worth owning?
To cut to the chase, when you look at the perfect features you'd ask for if you were designing a money from scratch, bitcoin meets almost all of them, and is the best money invented so far. For that reason it has the possibility of taking over from gold as the world's safe haven that underlies other currencies, and perhaps becoming the world's next reserve currency in place of the US Dollar.
Since its creation in 2009, it has survived some severe storms already. It was initially used by the black market, so had regulators and security forces after it; bitcoin exchanges have been hacked; China tried to ban it; Western governments are wary of it (because it is out of their control); and thousands of other crypto-currencies (like Ethereum, Bitcoin Cash, Litecoin, BAT and Dash) have been launched to compete.
And yet, after all this, bitcoin is stronger and still growing, now with a current value of around $182 billion. It is firmly in the mainstream with the world's biggest futures exchange in Chicago trading it, and the SEC and FSA (in the US and UK respectively) considering requests to authorise bitcoin funds that could be used in people's retirement plans.
And it is taking more and more market share from its competitor crypto-currencies.
Bitcoin runs on the most powerful computer network that has ever existed, hundreds of times more powerful than all of Google's servers combined.
Sorry, I can't resist some figures here: it currently performs around 70 quintillion (that's 70,000,000,000,000,000,000) crypto calculations per second to keep bitcoin secure - that is also the reason why other crypto currencies are unlikely to be able to compete.
Perhaps a huge investment opportunity?
I wrote an article on Bitcoin in late 2017, and I am proud to say I called the high of the 'bitcoin bubble' within a few days of its highest ever price. My children multiplied their pocket money many times. In that article I contradict some of what I am writing here. But I also said that I didn't know much about bitcoin - I just wrote that article because I know a bubble blow-off when I see one.
Since then I have learned a lot more about bitcoin. I've read the original white paper and absorbed many writings and lectures from the experts. The more I learn, the more I like.
I'm confident bitcoin is here to stay. More than that... I believe bitcoin is a force for good and safety in a financial system that may collapse. It has huge potential benefits, not just as a payments and savings system, but also from the transparency it brings. Every transaction, ever, is recorded and available for everyone to see - this would stop much political malfeasance and corruption around the world. It may even stop wars because governments would lose their ability to print the money to fund them.
"Negativity towards bitcoin is inversely proportional to knowledge of bitcoin."
I am a very conservative investor, and I would call owning bitcoin a speculative bet - something I wouldn't normally do. However I personally believe this is the best investment opportunity of our lifetime and that is why I wanted to write this article.
You may have heard that bitcoin is extremely volatile and goes up and down by 50% a month. This has been true.
That doesn't sound much like a 'safe' place for savings. But the thing is, this is what happens to all assets when people are unsure how to price them. Gold went through massive swings in the 1970s. Assets are incredibly volatile while people argue about how valuable they are, but while they are being volatile assets, as long as they are gaining more adoption, they also go up a LOT.
Once an asset has general acceptance, the volatility reduces. But by then the price has 'been discovered' and so most of the investment opportunity has already gone. As in almost every financial investment, risk is what creates the biggest rewards, and once the risk has gone, the potential rewards have too.
Make no mistake - bitcoin is highly risky - it could drop most of its value.
But on the flip side, the reward could be 10X, 100X or 1000X your initial investment, especially as it gains trust and other currencies start to lose theirs (remember all that money printing and the $ trillions of government debt).
That is why this has the potential to be the investment opportunity of a generation. The maximum you can lose is 1X what you put in. But you could make 100X that.
There can only ever be 21 million bitcoins and there are already nearly 18 million in existence (that's built in to its code). This set limit makes bitcoin scarcer than any financial asset that has ever come before it. If bitcoin becomes the world's reserve currency, all of the world's wealth will be measured in bitcoin, everyone will want to hold their savings in bitcoin, and each bitcoin will likely be worth many $ millions. Even if that doesn't happen, it will be used by more and more people around the world to move their money to safety from collapsing or corrupt governments, because all they need is an internet connection - again, more demand and limited supply will make it worth much more than it is now.
What are the risks?
The big picture risks (and my very summarised responses to them) are:
- There is a concerted international pushback on the amount of energy the bitcoin network uses.
- This issue is the one that most grates me (from an ethical and climate change point of view rather than a security one). After studying bitcoin deeply, I think most of the system is almost perfect, but I hate the amount of energy it uses. I strongly considered not publishing this article when I saw these metrics - the bitcoin network uses as much electricity as the whole country of Austria (and 0.33% of the world's electricity). Unfortunately this energy usage is fundamental to how the bitcoin mining process stays secure from bad actors (for instance rogue states like North Korea or powerful bitcoin mining consortiums in China), so using energy and using bitcoin are currently inseparable. I hope and believe that the bitcoin community will eventually find a method of securing their transactions that does not cost so much energy. There are many talented scientists and mathematicians thinking about this, but no-one has yet found a satisfactory way of replacing the current system.
- A very large holder of bitcoin (for example, the inventor Satoshi Nakamoto) decides to sell all their holdings.
- This risk is the same as for those people holding Facebook shares. What if Mark Zuckerberg decides to sell all his holdings in one go? That doesn't put everyone off holding FB shares. Anyway, there is no incentive for holders like that to sell while they see so much potential ahead.
- A '51% Attack' in which one rogue party takes over more than 50% of the computing power of all bitcoin miners.
- This would mean they could prevent new transactions from confirming but they wouldn't be able to create unlimited bitcoins or reverse other people's transactions. So the reality is that the rewards don't justify the expense.
- Quantum computing comes of age and is so powerful that it can unravel the private keys that keep bitcoin wallets secure.
- This is still years away, and bitcoin could strengthen or change its cryptographic code in response.
- There is a major software bug.
- There have already been two problems in the bitcoin code base, neither causing any damage, but both acting as learning experiences to strengthen the network going forward. The worst was in 2013, known as The Chain Fork.
- Governments outlaw its ownership.
- China has already tried to ban bitcoin exchanges. The exchanges just moved to Japan. And ironically, most bitcoin miners are currently based in China, because China subsidises its electricity!
More detailed discussion of the risks is available on the internet if you are interested in doing your own research.
How can I buy bitcoin?
Before you can own and send/spend bitcoin, of course you need to buy some. This must be done using a bitcoin exchange, such as Kraken (for those buying using US Dollars or Euros) or Coinfloor (for those buying using British Pounds). You will have to sign up to the exchange, provide some evidence of your identity (as most banks now ask you to do, to prevent money laundering), and then send them cash. Once your account has cash in it, you can then trade your cash for bitcoin.
Bitcoin has never been stolen from anyone that kept their private key safe.
But it has been stolen from exchanges.
Exchanges have learned from this and most are generally much better now because they keep the private keys in 'cold storage', i.e. off the internet, so they can't be hacked.
But the point is this: bitcoin is designed so that the owner of the bitcoin is the banker - they should own the private key, and no-one else. You are likely to look after your key better than an exchange. So best practice is to have your own bitcoin wallet and to send your newly purchased bitcoin from the exchange to your own wallet as soon as you buy it.
You need to keep that private key safe!
That means, as a default, do not trust downloadable wallets for your computer or phone (or websites that create paper wallets as per my examples above).
Unless you are technically adept enough to verify that well regarded open source wallet software has not been modified before you download it, I recommend you buy a hardware wallet, particularly if you are holding significant quantities of bitcoin. Hardware wallets are secure and relatively easy to use, and can also be backed up in case of loss or breakage.
I'll repeat this. You need to keep that private key safe!
If you lose your private key, you've lost your bitcoin money. Forever. Irretrievably.
You should back your wallet up - by writing the private keys (or word seeds) down on paper, or creating copies of your wallet files from your software or hardware wallets.
The tricky balance is to have your wallet/keys backed up in multiple places, but in a secure enough way that no-one else can find them. Keeping your private keys unencrypted on your normal computer or phone is a bad idea, because your computer may get hacked or pick up a malicious virus.
Putting It All Together
Bitcoin is an almost perfect store of value. It is digital (so never degrades), can't be confiscated by governments (or anyone), scarce (more can't be printed like countries' currencies, so it keeps its value), easy to transact with anyone in the world (for any amount), allows anyone to bank (with no permission required from banks or governments), keeps undisputable and irreversible transactions, can't be counterfeited, and is anonymous.
It is likely to become a lot more valuable as it gains even more acceptance.
This article showed how you can use bitcoin as money to transact.
There's nothing to stop you having a play with bitcoin - that's the best way to learn about it. With very little risk (i.e. you can just try it with a few pounds/dollars worth of bitcoin) you could:
- Create a paper wallet with bitaddress.org or download a free software wallet like electrum (it's not the easiest to use, but it is open source and one of the most secure).
- Open an account at a bitcoin exchange like Kraken or Coinfloor, and buy your first bitcoin. You don't have to buy a whole bitcoin - you can buy a tiny fraction of one.
- 'Withdraw' your bitcoin from the exchange to your wallet's public bitcoin address - that way it's up to you to keep the private key safe.
- You are now the proud owner of bitcoin. You can check by going to a site like BitRef to check that you really did receive those bitcoin from the exchange.
- One of the beauties of bitcoin is you can send incredibly small amounts, right down to a hundred millionth of a bitcoin (this is known an one 'satoshi'). And the transaction fees are very small. So you can experiment by creating another bitcoin address and sending yourself some of your own bitcoin.
- When you're more confident you could buy some more in the hope of making a huge return.
- If it turns out the whole world is not moving to bitcoin and this article is completely flawed, you can get your pounds or dollars back again by sending your bitcoin back to the bitcoin exchange and exchanging it back to your currency.
For The Record
I believe bitcoin will continue to be an incredible investment opportunity. I'll lay my neck on the line so that, in a few years, I can be smug, or you can laugh at me...
As I write this article on 27th August 2019, one bitcoin is worth £8,260, or $10,155, or €9,153 or 6.2645oz of gold.