Cryptocurrencies 101 – Simple Answers to the Questions You’re Too Embarrassed to Ask

Merlin Rothfeld, Investment Strategist and Instructor, Online Trading Academy

Bitcoin and cryptocurrencies in general have made a big splash both in the news and the market over the last several years. So if you’re still scratching your head wondering what exactly a Bitcoin is and why all the fuss, read on as we unlock the mysteries of the Cryptocurrency world.

Bitcoin is the big guy in an entirely new category of digital money called cryptocurrencies. Since it’s the one usually getting all the headlines, we’ll answer some basic questions about bitcoin with answers that can also apply to the broader category of cryptocurrencies.

What is Bitcoin?

Simply put, bitcoin is a cryptocurrency – a digital currency with a perceived value that you can spend, purchase and exchange for goods and services. Cryptocurrencies are not tied to any government or bank. There are no real “coins”, and the only place bitcoin and other cryptocurrencies exists is on the internet. We can’t even quote you the current price of one bitcoin, because it will change by the time you finish reading this paragraph. In mid-December 2017, one bitcoin was worth nearly $20,000. One year later, it was at $3,100!

How Does it Work?

Creating Bitcoins requires specialized computers which are used to perform extremely complicated mathematical computations to create blocks of data. Once the blocks of data are created, they are then added to the bitcoin blockchain. Creating bitcoins and blockchains go hand in hand. It is a process called mining.

While a blockchain may seem like a complex concept, it actually isn’t. A blockchain is simply a ledger, or record of transactions. When you complete a transaction, whether it be with cash, check or credit, that transaction is controlled by the bank, who keeps the ledger. It is a singular, centralized system that the banks control. In contrast, blockchain is decentralized so there’s no middleman, such as a bank. As transactions are completed, they are added to the ledger and the blockchain grows. It is a secure, encrypted system where transactions cannot be controlled, only verified and, once verified added to the chain.

How Does Bitcoin Mining Work?

Mining is the process of solving a block of data. To solve a block of data, a computer or a network of computers runs the bitcoin software in an attempt to be the first one to decipher the blockchain. The reward is the release of a set number of bitcoins. Because of the way bitcoin was created, there are a limited number of 21 million coins.

When Bitcoins first came out it was possible for individuals to mine enough bitcoin to justify the expense of running the rigs, which are machines with specialized chips that do nothing but process the math required to create the blocks. But rigs are large, power-hungry, loud and generate a lot of heat. As bitcoin has exploded, large companies have built huge mining farms with thousands of rigs to reap the rewards. It’s unlikely a home rig or two will generate enough bitcoin to cover the expense of running them.

Cryptocurrency Safety

When you purchase cryptocurrencies, you are given a private key, one that is not stored anywhere, except where you put it. This makes Bitcoin much safer than your bank account. There have been cases of bitcoins being stolen from exchanges, but the chances of having a private key stolen is miniscule, 1 in 1,461,501,637,330,902,918,203,684,832,716,283,019,655,932,542, 946 to be exact!

Pros of Cryptocurrencies?

Decentralized System

With a decentralized system, assets can’t be seized or frozen because they aren’t controlled by a government. Also, because the number of possible Bitcoin is limited to 21 million, governments can’t print more money and devalue your asset.

Can’t Be Counterfeited

It is relatively easy to counterfeit paper money, but that is not the case with Cryptocurrencies because there is a digital record of every transaction.

Limits Fraud

A transaction made via credit card can be cancelled by the purchaser after they receive the product. This leaves the seller minus their merchandise and with no payment. Yes, that’s illegal, but it happens all the time. Once a cryptocurrency transaction is recorded, there is no possibility of cancellation.

Instantaneous Settlements

With Cryptocurrency, you don’t have to wait for a financial institution to clear your transaction. Once money is deposited, it is available to you.

Universal Currency

Everyone who has access to the internet has access to Cryptocurrencies. It could be, and in some cases is, used by countries where inflation is out of control and/or the banking systems are flawed.

Relatively Low Fees

In contrast to the cost of wiring money where fees can run up to 25 percent of the transaction amount, cryptocurrency transactions only cost from a few cents to a few dollars.

How Do you Buy Cryptocurrency?

Cryptocurrencies can be traded, used to make purchases or held as an investment. They can be purchased through an exchange, a cryptocurrency wallet or a Bitcoin ATM. Be aware though, when purchasing from an ATM there may be significant fees charged for the convenience. 

What is a Bitcoin Wallet?

Contrary to its name, cryptocurrencies are not what are actually stored in a cryptocurrency wallet. Instead, it is a place to store your private key. Remember, your private key is called private for a reason and you want to be very careful where it can be accessed from. Be sure to select a reputable Bitcoin wallet! You’ll also want to ensure the wallet you choose supports the type of cryptocurrency you want to purchase. There are desktop and mobile wallets available, but if you choose a mobile wallet, securing your phone is also a must.

You can also store Bitcoin on an exchange which gives you the ability to deal in multiple cryptocurrencies at a time and actively trade them. However, exchanges give you less control of your private key and can be less secure.

Other options for storing Bitcoin include a thumb drive like device called a nano ledger, or simply printing out your keys and securing the paper copy.

How to Spend Bitcoin

You could exchange your bitcoin for the cash equivalent quite easily with Coinbase and other similar sites. Once you click withdraw, the money should appear in your account quickly.

You can only make purchases from companies that accept cryptocurrency as payment, but the number of participating businesses is growing. As an alternative, you could purchase gift cards from gyft.com, for example, and pay for purchases with the gift card.

Risks of Bitcoin

As you’re likely aware, cryptocurrencies are very volatile, with prices skyrocketing and then plummeting in short order.  Unlike standard currencies, cryptocurrencies have experienced wild swings, as you have no doubt been reading about in the news. Bitcoin’s rise has been stratospheric. Just imagine the havoc on the economy if the U.S. dollar was as volatile. 

No Recourse for Lost or Stolen Private Keys

If your private key is stolen, your Bitcoin is gone and there is no recompense.

Possibility of Government Regulation

Initial coin offerings are already banned in China and there is a possibility other Governments could regulate Cryptocurrencies. Afterall, they don’t like missing out on the potential tax revenue that could be generated. However, regulation wouldn’t necessarily be all bad as more companies might be willing to accept them.

Altcoin

Cryptocurrency that isn’t bitcoin is called “altcoin”. There are many altcoin in existence, for example, Ethereum, Litecoin, DASH and Ripple are all major players with high market caps. Smaller altcoin could be scams so, it’s important to do your research before buying into one of the lesser known versions.


DISCLAIMER: This article is written for educational purposes only. By no means do any of its contents recommend, advocate or urge the buying, selling or holding of any financial instrument whatsoever. Trading and Investing involves high levels of risk. The author expresses personal opinions and will not assume any responsibility whatsoever for the actions of the reader. The author may or may not have positions in Financial Instruments discussed in this newsletter. Future results can be dramatically different from the opinions expressed herein. Past performance does not guarantee future results. Reprints allowed for private reading only, for all else, please obtain permission.

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