Do You Really Know What Bitcoin Is? A Guide for the Confused

Maybe it was those stories you heard — Lamborghinis and second mortgages, fortunes made and lost off of something you didn’t even really know existed until six months ago. Maybe it’s those eye-popping charts you keep seeing, the ones that go $5,800 per unit to $19,000 per unit in just one month … and the other ones that go in the opposite direction in just one week. Maybe all of your friends are constantly watching their phones, tracking their own investments, celebrating their newfound riches, freaking out about their sudden, sharp losses, and you just hate feeling left out. However you heard about it, it is now clear that this is at least something you should know about — whether to invest, or just to inform your Schadenfreude. The problem is, well, what … is a bitcoin, exactly? Secretly, you know you don’t understand the thing, even though you may pretend to. Isn’t it mostly for buying drugs? Where would I even buy one? Why would I want to? And isn’t it already too late to be asking these questions, let alone actually investing in it?

All right. Seriously. Remind me what a bitcoin is?
A bitcoin is one unit of an anonymous digital currency called, yes, bitcoin.

Hang on: “anonymous … digital … currency”?
That’s what it was built to be, at least — a theoretically untraceable and unhackable version of PayPal, more or less. But so many people got so excited about buying into the system that a market developed around buying and selling it — with bitcoin becoming less important as a currency than as a commodity, like gold. You can still buy things in bitcoin (like you can with gold, sort of), but many more people are now using it as an investment vehicle.

So bitcoin is a currency and a commodity?
Something like that. Fundamentally, bitcoin is a secure system for storing and exchanging money anonymously on the internet. In some contexts, it works like untraceable money (for, say, buying drugs on the dark net); in others, it works like a safety-deposit box without a bank (like when it’s used to store money away from the prying eyes of governments); in still others, it’s a tradable financial asset like a stock or bond (you could use bitcoin to become a millionaire). But each of these metaphors has limitations, too. Unlike most currencies, bitcoin is not supervised or endorsed by any government; it has incredible price volatility, which makes transactions complicated and undermines the safety-deposit-box approach; and, unlike the stock market, where valuations are based at least theoretically on expectations of future company value, there is no “fundamental” basis of speculative value for bitcoin.

Wait: Is bitcoin … real?
No, but then again, neither is the dollar.

But the dollar is backed by the U.S. government.
Who needs a central government when you’ve got an unhackable, unfoolable currency?

I’m already lost. Why would anyone buy a bitcoin?
For the same reason you’d buy anything: Because you think a bitcoin is worth something. And there are a few different reasons to think it is. Maybe what’s valuable to you is bitcoin’s anonymity: A lot of people really like operating anonymously on the internet. Plus, if you want to move your money out of an economically or politically unstable country without being hit with taxes or currency controls, converting your fortune to bitcoin might help. Or maybe what’s valuable to you is bitcoin’s whole philosophy — you believe it will someday be widely adopted as a day-to-day currency, and you want to buy in early. But those are the reasons people originally got into bitcoin — the true-believer stage. Now people are getting in because they think they can make money — the investment stage. In that case, what’s valuable is, well, the fact that everyone else is buying bitcoin and you think its price will keep rising.

I mean, will its price keep rising?
That depends. Unlike most regular currencies, whose purchasing power declines over time, bitcoin was designed to be deflationary: There are a limited number of total bitcoins, and new ones are added to the market slowly. What drives the price up is if more and more people show up hoping to buy the existing coins, thereby bidding up their value. But that’s a big if — if bitcoins never reach widespread adoption, or if they’re too difficult to convert into more usable cash, their value will go down.

This seems pretty risky.
Well, yeah. And even setting aside the long-term case for bitcoin, in the short and medium term the currency is terrifyingly volatile. On paper, 2017 was very good to bitcoin — this time last year, one bitcoin was worth about $900; it’s now worth about 15 times that — but also very stressful to bitcoin investors. Within one week in December, Bitcoin hit a high above $19,000, dropped to as low as $10,400, and then climbed back up above $15,000 24 hours later.

Who would create something like this? And, honestly, why?
For years, hacker-types have been trying to create a digital currency that can be used reliably without the need for a government or central bank. (Because, you know, Big Brother and all of that.) In 2008, a pseudonymous programmer called Satoshi Nakamoto apparently solved the problem with bitcoin, a system that seemed to secure financial transactions outside the authority of a central bank. It distributed the task of verifying transactions across a whole network of computers.

That was Satoshi’s big innovation?
Yes: to secure transactions without the oversight of the government. If you send bitcoin to someone, your transaction is added to a record of every transaction across the entire network, from the very first bitcoin onward — essentially, a long bank ledger that everyone in the bitcoin network has a copy of. This record is called the “blockchain,” and, thanks to some neat cryptographic work, it is nearly impossible to forge, fool, or tamper with. Which all makes cryptocurrency look, suddenly, like a safe way to conduct business.

Okay. So where does a bitcoin come from, if there’s no government and no mint?
At all hours of the day, all over the network, computers (called miners) race to package recent transactions on the network into an unfakeable unit (called a block) of the blockchain. Blocks are created every ten minutes or so; this is the authenticating process, sort of like when a credit-card company verifies you have available funds. Essentially, miners are doing the work of encrypting transactions. For what reward? The first miner to create a verified block — one that follows the cryptographic rules laid out by Satoshi Nakamoto — is rewarded with a certain number of bitcoins.

Could I mine my own?
Yes, theoretically, but unless you live next to a power plant and own an airplane hangar’s worth of computers, it’s probably impossible. Creating a block requires a lot of computing power — in part to ensure that it would be too energy-intensive and expensive to sabotage the blockchain with false transactions, and in part to keep bitcoin scarce. And while that works great for bitcoin, it’s less impressive for the rest of the world: One hotly disputed estimate holds that bitcoin mining currently uses as much energy as all of Denmark. You’re probably better off just buying from someone who already owns some, on one of many exchanges.

Before, you said “crypto-currency” — don’t you just mean bitcoin?
Actually, no. With Satoshi’s blessing, bitcoin’s basic decentralized, anonymous structure was pretty quickly adopted and used by other digital currencies, which tend to get lumped together into the cool-sounding grouping “crypto,” as in, “My yoga instructor made millions in crypto.”

Where else might a yoga instructor invest?
The most famous cryptocurrency besides bitcoin might be Ether, which is intended less as a currency than as a platform for decentralized, algorithmically executed “smart contracts” — but is still traded like a currency. Then there’s Litecoin, which attempts to be bitcoin’s more efficient cousin. And if you feel like those cryptocurrencies are lacking a certain je ne sais quoi — like, say, a cute mascot — you might invest in Dogecoin, a Shiba Inu–themed coin started as a joke in 2013 that now has a market capitalization of over $700 million.

So how do I buy bitcoin?
If an ATM seems ridiculous, go to the app store and download the bitcoin-trading app Coinbase. It’s the favorite for newcomers looking to pocket their first bitcoin; it has a clean interface and a polite, patient tone escorting you along “the easiest on-ramp to the bitcoin world.” Sign up, connect your bank account or debit card, and scroll to the bottom of the page, where a button beckons: buy bitcoin now. Debit- and credit-card users can front up to $750, the weekly purchase limit.

Can I trust Coinbase?
You can trust Coinbase as much as you can trust anything in the cryptocurrency trading space, which is … not much. In December, Coinbase announced it would investigate its employees for “insider trading” — but good luck regulating “insider trading” among cryptocurrencies.

Now that I’ve bought my bitcoins, where … are they? Can I even ask that?
Bitcoins are, obviously, not physical, so it’s not like they’re filling up a vault or someone’s mattress. Basically, bitcoins reside at “addresses” — long strings of letters and numbers — and the blockchain (which, remember, is distributed in full across the network) says how many bitcoins are at each address. In order to move bitcoins from one address to another — to pay someone, say — you need to use your address’s corresponding private key, which is a lengthy, complicated password you’re given when you open a new address using your choice of software. Don’t forget it! You might end up like Mark Frauenfelder, who wrote in Wired about resorting to a hypnotherapist to remember how to access an address where he’d stored $30,000 worth of bitcoins.

How can I check my bitcoin account? I mean, I guess, my address?
Most people use a “wallet,” a piece of software or hardware that makes it easy to keep track of your bitcoin. One of the most popular software wallets is Exodus, which offers “normal people” access to cryptopia. You can transfer bitcoin from your Coinbase account to your Exodus wallet easily, though know that while cryptos held behind your Exodus fortress are much more secure than those stored in internet-based Coinbase, savvy hackers still break in on a regular basis. If you’re feeling especially paranoid, reduce your chances of getting hacked with a “cold wallet,” hardware that stores crypto offline, such as Trezor and Ledger Nano S. You insert it into a USB port, move your bitcoin from your Coinbase address to the address provided with the new cold wallet, and unplug it from your computer.

What if I don’t want to bother with any of that?
If you have an IRA or 401(k) account with brokers such as Charles Schwab, TD Ameritrade, Fidelity, or E-Trade, you can gain exposure to crypto’s price volatility without owning a single shard of crypto by buying shares in the Bitcoin Investment Trust (symbol: GBTC), managed by Grayscale Investments, an investment management firm that deals exclusively in crypto. For the rough equivalent of one bitcoin’s worth of exposure, buy ten shares.

How can I keep from getting scammed, hacked, or ripped off?
Some very smart people might tell you that the best way to avoid a crypto scam is to invest your money elsewhere, like in a diverse portfolio of low-fee stock-market index funds, say. But who wants to listen to them? The best way to avoid a scam, properly speaking, is to keep your money in the best-known cryptocurrencies (like bitcoin) and use the biggest exchanges (like Coinbase) — but that’s not a guarantee you won’t lose your money if the market crashes. Otherwise, make sure you do your research on what you’re investing in, especially by reading any announcements and white papers for ICOs.

Wait, what’s an ICO?
An ICO is either a hip, sexy new way for entrepreneurs to bypass VCs and raise money from the people, or it’s the biggest opportunity for internet scammers in years. Maybe it’s both! ICO stands for “initial coin offering,” and at its core, it’s a fund-raising drive, almost like a Kickstarter. People financially back a project — usually a business, like a cloud-storage network called Filecoin — by buying “tokens” (essentially in-house cryptocurrency) that can generally be exchanged for the goods that will eventually be offered by the project. In the case of Filecoin, for example, you can exchange your filecoins for storage — or you can sell them on a cryptocurrency exchange, like you might bitcoin. (This has been compared to raising money for an airline by selling frequent-flier miles.) If that sounds financially risky — and legally dubious — that’s because it is. A number of ICOs are scams, such as the Diamond Reserve Club, which falsely claimed to be backed by real diamonds. Participants are increasingly getting calls from the SEC, which began filing ICO fraud charges this year.

Whoa, my bitcoin went up 20 percent. How can I cash out?
Had enough of the roller coaster, huh? If you want to cash a small amount — three figures, say — in an exchange like Coinbase, it’s easy to use the app to sell and cash out to an attached bank or PayPal account. (It may take a few days to clear.) But for all its secrecy and anonymity, bitcoin is not really a take-the-money-and-run kind of investment. In the four figures and above, you’re likely to start running up against weekly transaction limits, established by exchanges to keep the markets relatively stable. If you’re looking to dump actual bitcoin millions all at once, your only option might be a site like LocalBitcoins, which helps connect buyers with sellers IRL. (Bring a bodyguard.) Well: That, or buy a lot of drugs on the dark net.

I probably should have asked this before, but are cryptocurrencies … legal?
In the U.S., yes: Buying, selling, trading, and holding cryptocurrencies is legal in G7 countries, provided you pay your taxes. To track the evolving legal landscape, go to bitlegal.io.

I have to pay taxes on my computer money?
Cryptocurrencies are assets, according to the IRS and SEC. Crypto is neither a foreign nor domestic currency, no matter how you use it (in America, at least). Come tax season, your bitcoin earnings will be subject to taxation. In its 2014 notice, the IRS confirmed that underreporting or failure to report cryptocurrency-derived gains would be subject to penalties. So every time you use crypto, you might trigger a gain or a loss.

But … it’s a bubble, isn’t it?
On some level, bubble is a confusing term for bitcoin: If there is no fundamental value to compare the price to, who’s to say it’s too high? But, no, yeah, it’s probably a bubble. I mean, did you see what happened in December?

Is this the kind of thing that’s going to blow up the real economy?
If the bubble explodes, the U.S. economy as a whole is probably okay — not enough people have put money into cryptocurrency markets for a crash to make a huge dent. But some bitcoin skeptics have warned that new futures markets might eventually introduce systemic risks, and it’s not exactly comforting to see CNBC headlines like “People Are Taking Out Mortgages to Buy Bitcoin, Says Securities Regulator.”

So … should I buy bitcoin or not?
In the spirit of Satoshi Nakamoto, here’s an algorithm: Rate your appetite for risk on a scale of zero (lily-livered) to five (iron-stomached). Rate your FOMO on a scale of zero (comatose) to five (desperate to belong). Multiply those two numbers together, and then multiply the product by your salary, minus the amount of debt you’re in. Divide that figure by 10,000, and invest that much money in bitcoin. So you make $75,000, have a low tolerance for risk (one), but a high fear of missing out (five)? Invest $37.50 and not a penny more. You never know!