What is Bitcoin?
After the housing market fell, a digital currency called Bitcoin was introduced into the financial world. Based on innovative technology that was created by a pseudonymous person, Satoshi Nakamoto, Bitcoin promises to lower the transaction fees compared to the traditional payment modes that involve a lot of intermediaries to aid the transaction. This digital currency, also called cryptocurrency, is decentralized, which means it is not controlled by any government.
Bitcoin is unique as it does not exist physically. The balance of Bitcoins is kept on a public ledger that can be accessed by everyone, but the information is not editable. For verification of the information relating to transactions, huge computing power is required. Bitcoin has not yet been declared as a legal tender, and it is not issued or approved by any government or bank. Bitcoin’s popularity was very high from its launch in 2009, and for this reason, hundreds of other cryptocurrencies were launched after it. These are altogether called Altcoins. Today, Bitcoin enjoys the status of the largest cryptocurrency in the world with the highest market cap.
Understanding the Concept Behind Bitcoins
Bitcoin is based on blockchain technology. A collection of nodes (computers) form a network, and each one of them runs a specific code and stores it in Bitcoin’s blockchain. The blockchain is made of several blocks, each of which contains transactional information. All the nodes run on the same blockchain, and they have a list of all the blocks and transactions. The transactions recorded on each of the blocks are in cryptographic symbols. If anyone wants to edit the information on one block, all other blocks in the path need to be edited. Any person who runs a node on the blockchain can see the transactions live. But, to edit or delete a transaction, huge computing power is required. In May 2020, Bitcoin’s blockchain had 47,000 nodes, and to commit a fraudulent activity, all these blocks need to be modified, which is next to impossible. So, no one can cheat the blockchain and the transactions remain secure on the electronic public ledger.
As discussed earlier, Bitcoins have no physical existence and so kept using private and public keys, which are a string of letters and numbers linked through a cryptographic mathematical algorithm. The public key is the address that is disclosed to the world, like a bank account number to which people can send Bitcoins. The private key is like an ATM PIN that is used to approve Bitcoin transactions. The Bitcoins that an individual holds are stored digitally on a wallet that is a digital or a physical device that keeps an account of the Bitcoins held and allows its trading. Here the terms Bitcoin wallet may puzzle the readers as the Bitcoins cannot be stored in the physical or digital wallet, but it is stored decentrally on the blockchain.
How Bitcoin Works
Bitcoin uses the P2P or peer-to-peer method to promote instant payments. The Bitcoin transactions are facilitated by companies and independent individuals who comprise the nodes or miners. Miners process the blockchain transactions and get rewarded with new Bitcoins and also transaction fees. New Bitcoins that miners get are released now also but at a periodic declining percentage to achieve a total number of 21 million Bitcoins. Considering the numbers of Bitcoins mined till July 2020, there are another 3 million bitcoins left to be mined. For a centralized currency, the governments release new ones according to the financial parameters and maintain stable prices. But for decentralized cryptocurrencies, the release rate is pre-decided as per the algorithm of the blockchain.
Presently, Bitcoins are held or transacted on a public ledger maintained electronically and called a blockchain. The process by which bitcoins are released in the blockchain is called bitcoin mining and the individuals who do this task are miners. Miners have to solve computationally difficult puzzles to find a new block and then add it to the blockchain. Each record in the network needs to be verified before the new block is added, and the lucky miner is rewarded with a few bitcoins. The reward is also getting reduced by half for every 210,000 blocks. In 2009, the reward was 50 new bitcoins and in May 2020, the reward came down to 6.25 bitcoins. The miner chooses the hardware necessary for mining with utmost care considering factors like high yield rate, price of the hardware, etc. Application-Specific Integrated Circuits or ASIC and ones using a higher configuration processor like Graphic Processing Units (GPUs) are costly but yield more rewards.
A bitcoin can be divided into eight decimal places or 100 millionths and the smallest unit is named Satoshi after the creator. Now, the participating miners may decide to make bitcoin divisible into smaller parts.
History of Bitcoin Began
The domain name Bitcoin was registered on August 18, 2008, but the identity of the person behind it is still a secret. On October 31, 2008, an individual or group called Satoshi Nakamoto published a whitepaper explaining the operations of Bitcoins. The first Bitcoin blocked was mined on January 3, 2009, and this block is called the genesis block.
Bitcoins As Mode of Payment
Bitcoin has the potential to be used as a payment mode by sellers. A shopkeeper or an online website selling certain merchandise may opt for this transaction mode. The transactions can be done by using hardware terminals or wallet addresses using touch screen applications or QR codes. It is an easy and secure mode of payment and can be added by an online merchant as a payment mode with Credit/Debit Cards, PayPal, etc.
Employment in Bitcoins
Self-employed people can get payment by getting employed in Bitcoins. The person can add this as a payment mode by sharing the wallet address and get paid for the services they offer. Bitwage, BitGigs, Cryptogrind, Jobs4Bitcoins, Coinality, etc., are some companies that help individuals to work in Bitcoins.
Many financial experts who promote Bitcoin believe that it can facilitate a new international system of transactions that will be secure, fast, and low-cost. Bitcoin and other cryptocurrencies are decentralized, which means it is not controlled or regulated by any government or central bank. But, Bitcoins can be exchanged for other traditional currencies like the dollar. So, traders interested in currencies also trade them for the digital currency, Bitcoin. Also, Altcoins can be an alternative to any national Fiat currency and commodity like gold.
Similar to other assets, Bitcoin may also be traded. It may be bought at a lower price and sold at a high for gains. Bitcoins may be purchased from a cryptocurrency exchange or mined or can be owned in many other ways.
The Internal Revenue Service (IRS), in March 2014, stated the provisions of taxation of Bitcoins and other digital currencies. It stated that all Altcoins would be classified as property for taxation purposes and not as currency. The sale of bitcoins from the wallet or the usage of bitcoins to pay for any goods or services will be treated as a transaction that attracts a tax. The gains or losses from the portion of bitcoins held in the wallet as capital will attract capital gains tax, while the bitcoins held in inventory will be treated as normal gains or losses.
Risk of Bitcoin Investments
Bitcoins were not originally created as an asset, and no shares or equity were issued. When the prices of bitcoins suddenly increased in May 2011 and November 2013, speculative traders became interested in cryptocurrency trading. Many people buy bitcoins as an investment and not with the idea to transact.
The investments in Bitcoins have a certain fundamental risk because of their digital nature and absence of a fixed value. The Consumer Financial Protection Bureau (CFPB), the Financial Industry Regulatory Authority (FINRA), the Securities and Exchange Commission (SEC), and other regulatory authorities have, from time to time, issued advisories to alert the traders about the risks involved.
Chief Executive Officer of the Digital Currency Group, a company that invests in Bitcoin and other blockchain companies, states that Altcoins are the highest-gain, highest-risk investment. Cryptocurrencies are based on a new concept and involve highly complicated blockchain technology. But with the passage of time, Bitcoins and other cryptocurrencies are evolving daily.
Bitcoin Regulatory Risk
Bitcoins are an alternative to government-issued currency and may be utilized for money laundering, tax evasion, black market transactions, or other illegal activities. For all these reasons, the governments may ban, restrict, or regulate transactions of Bitcoin. Some regulatory bodies like the New York State Department of Financial Services have, in 2015, regulated all transactions in Bitcoins. The regulations require that companies working with the purchase, sell, transfer of bitcoins to keep a record of the identity of customers. The companies need to appoint a compliance officer and also maintain certain capital reserves. Also, all the transactions equal to or more than $10,000 must be recorded and then reported to the regulator. Some other organizations are in the process of issuing some regulations. According to cryptocurrency giants, a set of uniform regulations will increase longevity and improve the liquidity and universality of bitcoins.
Security Risks of Bitcoins
The majority of the owners of Bitcoins have not acquired this digital currency through mining. Actually, they buy and sell Bitcoins and other cryptos on several popular exchanges that are fully electronic. Because of this digital nature of the exchanges, hackers can transfer the bitcoins if they can access the owner’s device (computer) and steal the private keys. Owners can prevent this hacking by choosing a paper wallet or by disconnecting the computer from the internet. Hackers can also target the electronic exchanges and access thousands of accounts and wallets with stored bitcoins. In such a hacking attack, during 2014, millions of dollars worth of bitcoins were stolen from MT. Gox, a Japanese Bitcoin exchange.
There is no chance of getting the bitcoins refunded in case of theft. This is because Bitcoins are decentralized and immutable, and once the hacker carries out the transaction, it is impossible to reverse. There is no intermediary like in the case of debit or credit card, and so no appeal can be made.
Most of the investments that are controlled and regulated by the government are insured. For example, the Federal Deposit Insurance Corporation (FDIC) insures the regular bank accounts and Securities Investor Protection Corporation insures some other investments. As the Bitcoin exchanges or Bitcoins are decentralized, they are not insured by any government agency. Also, presently no regulations exist that will force the exchanges so that they ensure the clients’ digital currency. In an attempt to secure the clients’ funds from fraud, popular cryptocurrency trading platform SFOX promised to cover the investors’ Bitcoin holdings with FDIC insurance.
Risk of Bitcoin Fraud by Operators
As the Bitcoin transactions are under encryption and private keys are required to verify the transactions, some fraudsters may sell fake bitcoins. The action was taken against an operator who was selling false bitcoins by SEC in the year 2013. There have been many cases of price manipulation of bitcoins by scamsters.
Values of Bitcoins are volatile and may fluctuate due to high volume selling or buying. Some price fluctuations are news-driven also. During the year 2013, in a single trading session, the prices of Bitcoins fell by 61% and the single-day price drop was bigger in 2014 when it was recorded as 80%. At that time, some industry experts expressed concern that the Bitcoin bubble may have burst and the digital currencies may be worthless in the near future. But the prices again rose to touch an ATH in 2017, and again in 2018, silencing the critics.
Though there are many cryptocurrencies in the market now, Bitcoin leads them as the most popular crypto. The price movements of Bitcoins impacts the prices of all other cryptos.
Tax Risks of Bitcoins
At present, Bitcoins are not eligible to be included in retirement accounts or as a tax-saving investment. Therefore, there are no ways to get a tax-relief on the gains made from bitcoin trading.
Bitcoin forking means splitting the blockchain into different directions, and each fork has its own rules. Forking happens when there are any disagreements between the miners and developers of the blockchain. The splitting may result in a hard fork, in which the new digital currency shares its transaction history with Bitcoin till a split point. On this split point, a new token or currency is created. Bitcoin SV (created in November 2017), Bitcoin Cash (created in August 2017), and Bitcoin Gold (created in October 2017) were results of a hard fork.
The second type of splitting results in a soft fork. In this case, the protocols are compatible with the original blockchain. The soft forks increase the size of the blockchain.