One of the luckiest moves you could have made this year would have been to buy bitcoin in the middle of January, when one unit of the blockchain-based cryptocurrency was less than $1,000. Bitcoin’s price has since increased ten-fold and, as of Thursday, passed the $16,000 mark for the first time.
Bitcoin’s frenzied price ascent has generated attention and FOMO, particularly since even earlier investors in the eight-year-old currency have turned hundreds of dollars into millions and — in the case of Cameron and Tyler Winklevoss — millions of dollars from a Facebook payout into reportedly more than $1 billion.
Of course, hindsight is 20-20, and there is certainly no guarantee bitcoin’s price will continue to rise. In fact, while some believers say bitcoin will be essential in the future global economy, others warn of a dense thicket of risks, including scams and theft, regulation and the chance that bitcoin falls out of favor and a different cryptocurrency is eventually widely adopted instead. These are just a few among the many reasons why nobody should spend money on bitcoin that they cannot afford to lose — completely.
Yet, caveats and cautions aside, it is clear bitcoin cannot be ignored. Previously a little-discussed side project of tech industry types — known by many as a vehicle for money laundering — bitcoin has become one of the biggest financial stories of the year: Bloomberg recently named bitcoin’s high, volatile price as one of the top reasons to be concerned about 2018.
Why are analysts so worried? What are the alternatives to bitcoin? And how does blockchain work, exactly? Here are answers to some of your biggest bitcoin and cryptocurrency questions.
1. What is bitcoin, exactly?
Created in 2009, bitcoin is a decentralized, global, peer-to-peer cryptocurrency. It is a medium of exchange just like other digital money, except instead of a central authority like a bank or government mediating transactions, all payments are instead verified and recorded using cryptography — specifically through a distributed public ledger or record called a blockchain.
In plain English, computers around the world are working together every day to authenticate bitcoin transactions, agreeing upon which payments are legitimate and in what order any buying and selling took place.
The term “bitcoin” first appeared on the web in a paper called “Bitcoin: A Peer-to-Peer Electronic Cash System,” authored by the mysterious and possibly pseudonymous Satoshi Nakamoto. The paper sketched out the basic premise about how a decentralized currency might work, using autonomous software to capture and store transactions in the blockchain.
Bitcoin believers point out many advantages to the digital coin, including its relative anonymity, the ease of moving it internationally and its independence from a central authority. In theory, the process of buying and selling bitcoin is transparent, relatively frictionless (and thus low in transaction costs) and difficult to hack.
Yet, while bitcoin and the use of the blockchain are revolutionary in many ways, in practice, bitcoin transactions still leave much to be desired, as they consume a lot of electricity, come with plenty of vulnerabilities and risks, and still process slowly relative to those of other digital payments.
2. What is blockchain and how does it relate to bitcoin?
If bitcoins are like digital “dollars,” then blockchain is the digital monetary system where those dollars live — and move to and from individuals’ bitcoin wallets. The blockchain is a record of transactions that is copied onto each and every computer in the bitcoin network.
Each bitcoin owner receives a unique digital key that is used to verify ownership of their bitcoin, and when you try to send someone money, these transactions are stored alongside your key in the blockchain, and then verified through “mining,” which involves cryptographic hash functions that help keep the process secure (at least for now). This video helps explain the process.
Even if you’re skeptical of bitcoin itself, the ability to use blockchain in this way to engage in trustworthy transactions — without the use of banks or any kind of middleman — is seen by proponents as a game-changer, and is arguably what makes bitcoin such an interesting development in the first place. Many big banks, from Wells Fargo to JPMorgan, have started launching blockchain initiatives — and a few even own patents. Even central banks are looking at blockchain: Hello, Fedcoin?
But the possibilities that blockchain opens up go far beyond the financial world, or in spaces like insurance and payments processing: Medical recordkeeping, energy metering, personal identification and even voting could be revolutionized by blockchain applications.
3. Should I buy bitcoin?
Unless your financial house is in pristine order, you should probably pump the brakes. Do you have debt or lack an emergency savings account? Have you been saving enough for retirement? Depending on your answers, it could be dangerous and foolish to divert your valuable cash away into the speculative bet that is bitcoin. After all, most people don’t have money they truly feel comfortable losing completely, which means they need to be far more careful in the way they calculate risk and reward.
Bitcoin changes value from day to day, making it wildly unsuitable as a place to park your cash as you would in a savings account. Buying bitcoin is a lot more like buying a lottery ticket than a tested investable asset.
The safest approach, if you’re determined to buy bitcoin, is to only do so with “fun money,” aka money that you’d be using for fun after maxing out on all the boring but crucial stuff, like debt payments, your personal savings, and your retirement account. Even then, you’d be best served using money that you “find” in your fun budget: that $20 you would have spent on a cab after a night out, but that you instead saved by taking public transit, for example.
And even if you are totally financially secure, and would just be using your “fun” money you’d be fine losing, there’s still an argument that — even if putting a little cash into cryptocurrency is smart — you might not want to put all of it into bitcoin specifically.
That’s because there are actually lots of other cryptocurrencies out there. While these carry more risk simply due to the fact that fewer people know about, test, and own them compared to bitcoin, they could offer some key advantages. Here’s a peek at some alternatives:
4. What are popular cryptocurrencies other than bitcoin?
Bitcoin’s success has inspired lots of copycats. At the moment, CoinMarketCap currently tracks the price of no fewer than 1,300 different cryptocurrencies, many of them trading for fractions of a cent. Some of them are pretty ridiculous-sounding, like Tattoocoin, Golfcoin, and PokeCoin.
That said, there’s a good argument that at least some of bitcoin’s competitors are onto something. Indeed, many early adopters think bitcoin is outmoded, pointing to rising transaction costs, slow speeds, privacy concerns, looming regulation and other inefficiencies as signs that bitcoin itself will be disrupted.
At the moment, the largest digital currencies beyond bitcoin include B2B-friendly Ripple, fast and (relatively) lightweight Litecoin, fork-coin Bitcoin Cash, and Ethereum-traded ether, known less as a rival to bitcoin than as a sister technology that enables smart contracts and distributed applications.
Meanwhile companies like IBM are throwing weight behind Lumens, a blockchain-based currency that facilitates exchange across borders, and artists like Mariah Carey are letting fans pay for merchandise with Monero, a privacy-focused alternative cryptocurrency.
Also getting lots of attention right now is a new digital currency called IOTA, which added some $3 billion to its value after the foundation behind it had inked deals with tech heavy-hitters like Samsung and Microsoft, CNBC reported. IOTA’s creators say it improves on bitcoin by swapping the blockchain for the “Tangle, a new blockless distributed ledger which is scalable, lightweight and for the first time ever makes it possible to transfer value without any fees” — but IOTA has some detractors, including critics in the Ethereum community.
Still, while many of these so-called altcoins may have advantages over bitcoin on paper, bitcoin is the clear frontrunner among cryptocurrencies, with the strongest network effect at the moment — meaning that its value keeps increasing as more people jump on the bandwagon. (Of course, this means that if the bubble bursts and people hop off, the price could go diving.)
This is all to say, the choice currency of the future might one of these altcoins — or simply just bitcoin — or it might be a cryptocurrency or alternate payment system nobody has ever even heard of today.
5. How do I buy bitcoin? Should I buy it or mine it?
If you’re feeling confident that you can afford to lose a few bucks, the most straightforward way to invest in bitcoin is to buy it. The easiest way is usually to go through an exchange like popular (but hardly infallible) San Francisco-based Coinbase. Only four exchanges have been granted a license to buy and sell bitcoin by New York’s Department of Financial Services, according to CNBC.
The other three exchanges are Circle, Ripple, and BitFlyer, which is the largest exchange in the world and based in Japan. These exchanges will all allow you to transfer your local currency into a digital currency like Bitcoin, usually for a small transaction fee.
You can buy fractions of a bitcoin, meaning that you don’t actually need to have $16,000 — or whatever the current going rate for a bitcoin is when you buy it — in order to get in on the action. But, because the large exchanges have often become the target of hackers in the past, it’s recommended to transfer any bitcoin you buy into storage you control yourself — known as a bitcoin wallet — which come in both hardware and software forms.
Another way to get bitcoin? If you help maintain the blockchain, you can “mine” bitcoin electronically by helping to verify the transactions for a bounty; though at this point, this process requires having special equipment, some degree of technical skill, and a lot of computer processing power. That is because, as more and more people continue trading bitcoin, the computing costs have also risen: Processing one bitcoin transaction now uses about as much power as American homes do in a week, according to one estimate.
So proceed with caution. Your electricity bill could get very ugly, and top-of-the line bitcoin mining equipment can run you thousands of dollars, according to Coindesk.
6. What is the price of bitcoin today?
The price of bitcoin right now is more than $16,700, extremely historically high for the digital currency. But you can easily buy fractions of a coin, meaning that the actual barrier of entry for investing in digital currencies is low, relative to stocks and bonds.
Many bitcoin exchanges, like Coinbase, typically have you designate a purchase amount using your local currency.
For Coinbase, the minimum is 1.00 in your local currency.
7. Who are the people buying bitcoin now?
Bitcoin has come a long way from its early origins as the currency-of-choice for cybercriminals, but it’s also got a long way to go before it can be truly considered mainstream. The fact that it is decentralized and makes it easier to elude authorities has made digital currencies a popular tool for soliciting donations among neo-Nazis, for example.
The people using bitcoin also tend to be younger and male: Close to 97% of the people engaging with the bitcoin community online identify as male, according to Coin Dance, which compiles statistics about the digital currency industry. A large majority of the people also tend to be between the ages of 25 and 44. Some critics have argued that bitcoin ownership’s homogeneity is another sign that it’s an asset bubble.
8. What are the advantages of using bitcoin vs. USD?
Right now, bitcoin isn’t super practical for actually buying things. Every once in a while, a retailer or construction company will put out a press release saying they accept bitcoin, but there’s little evidence that many people are actually taking them up on it. Over the last year, the value of bitcoin has climbed too quickly for people to be comfortable spending it. If your $10 could be worth $20 tomorrow, it’s hard to know when might be a good time to spend it.
But that all could change if more and more big institutions continue to start investing in bitcoin: The more people investing in a particular asset, the less the price will fluctuate on the decisions or comments of a single person.
As more and more major Wall Street players begin giving bitcoin access to their clients, then the price would stop bouncing around so much, making it easier to use — in theory.
9. What is an ICO?
ICO stands for “initial coin offering.” It’s analogous to an initial price offering, which is where companies sell “shares” in the company to raise money and expand. But with an ICO, instead of selling small shares of your company to investors, you issue them a new digital currency that will become valuable once the company in question takes off — again, in theory. Because ICOs create an incredibly attractive playbook for scammers, several jurisdictions from China to South Korea have banned the practice.
10. Could my bitcoin get hacked?
Very possibly. Bitcoin exchanges have often been the target of hacks over the years. In 2014, the then-largest bitcoin exchange Mt. Gox was hacked to the tune of some $500 million. Coinbase has one of the best reputations for avoiding hacks, as Fortune reported, but several of its customers have been robbed by thieves who are able to get their hands on users’ personal information.
To protect your bitcoin earnings, Bitcoin.org recommends using a mix of online and offline storage, encrypting your wallet so that it is password protected, and keeping all of your software up to date.
Yet there are also other risks to think about besides being hacked. Bitcoin is often the subject of regulatory crackdowns: Most recently, the United Kingdom and the European Union announced that they were planning to introduce a series of new rules meant to address fears that bitcoin is being used for tax evasion and money laundering. There’s more detail below, but you’ll want to make sure you are paying taxes on relevant gains if you own a lot of bitcoin.
Bitcoin is also subject to existential threats: Some crypto experts fear that the rise of quantum computing may some day give rise to computers capable of forging bitcoin transactions, essentially rendering the blockchain worthless, though Forbes noted this era is likely around a decade away at least.
Yet another issue to be concerned about? As big Wall Street institutions like the Chicago Mercantile Exchange get into the business of tracking bitcoin, there will soon be institutions making bets that bitcoin will fail, something that is difficult to do now. Already, Nasdaq and CBOE are joining CME Group in launching bitcoin futures trading in coming weeks and months, giving investors a way to bet on the price direction of the cryptocurrency, whether that’s up — or down.
11. Are there less risky ways to invest money than bitcoin?
There are lots of ways to invest your cash without taking on nearly so much risk as buying digital currencies. Government-backed bonds, for example, are backed by the full faith of the government that issues them. Investing in the stock market carries plenty of risk, too, but the financial services industry has also invented numerous ways to make it less risky for retirement savers. Mutual funds, index funds, and diversified exchange-traded funds are all essentially ways to invest in the stock market without putting all your eggs in one basket. Diversified vehicles like ETFs don’t yet exist in the world of cryptocurrency.
There has been a good deal of talk about setting up a product that would let you invest in lots of different digital currencies at once, but these initiatives have run afoul of regulators. On the flip side, it’s very easy to buy even a small fraction of a digital currency — which is much more difficult to do with stocks — meaning that it’s theoretically much cheaper to invest $100 in lots of different cryptocurrencies than it would be to invest that amount in a similar number of stocks.
12. I’ve made a ton of money on bitcoin. What should I do now?
Congrats! When you’re rolling the dice, it’s never a bad idea to take some of your chips off the table when you’re up. With bitcoin continuing to hit all-time highs, lots of bitcoin investors have started to cash out, selling some of their bitcoin in the spirit of quitting while ahead.
That said, these profit-takers seem to be in a minority: Two-thirds of bitcoin investors say they are employing a “buy and hold” strategy because they think the price is going to continue rising to an average of nearly $200,000 per coin, according to one survey.
Of course, a number of influential experts think that bitcoin is in a speculative bubble, and that its price is bound to fall back to earth — or even zero —eventually. These skeptics include billionaire investor Warren Buffett, Nobel-winning economist Robert Shiller, and J.P. Morgan CEO Jamie Dimon.
Just remember, whether you make your bitcoin earnings through short-term trading or because you’re in it for the long haul, no matter how encrypted your digital wallet is, the IRS still gets its cut.
If you do decide to cash in your bitcoin winnings — by either selling them, or exchanging them for goods and services — you’ll need to pay capital gains tax. Here’s how to figure out what you owe.
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Dec. 7, 2017, 4:30 p.m. Eastern: This story has been updated.