What is Bitcoin?
Bitcoin is a type of digital currency or cryptocurrency, a medium of exchange that exists exclusively online. The currency broke into mainstream consciousness in 2017, when its price ran up thousands of dollars over the course of the year. More recently, it soared in 2020 and 2021 as traders saw it as a get-rich-quick way, before plummeting in 2022.
Bitcoin has generated a lot of controversy, from proponents who say it is the future of currency to those who dismiss it as a speculative bubble. Here’s what you need to know about Bitcoin, how it works and some of the downsides.
What is Bitcoin and how does it work?
Bitcoin debuted in 2009, when the software supporting the currency was released. However, its origins are somewhat mysterious, and a person (or perhaps a group) known as Satoshi Nakamoto claims credit for revealing the cryptocurrency.
Bitcoin operates on a decentralized computer network or distributed ledger using blockchain technology, which governs and tracks the currency. Think of the distributed ledger as a huge public record of transactions taking place in the currency. The networked computers verify the transactions, ensure the integrity of the data and ownership of the bitcoins, and they are rewarded with bitcoins for doing so.
This decentralized network is a big part of the appeal of Bitcoin and other cryptocurrencies. Users can transfer money to each other, and the lack of a central bank to manage the currency makes the currency almost autonomous. This autonomy means that the currency can, at least in theory, avoid interference from governments and central banks.
Bitcoin can mostly operate anonymously. Although transactions can be traced to individual users, the person’s name is not immediately linked to the transaction, even if the transaction is processed publicly. However, the authorities have become better at tracking the movements of bitcoins, because the ledger of bitcoin transactions is publicly available.
Where do bitcoins come from?
Bitcoins are created, or “mined,” when computers on the network verify and process transactions in the currency. Some computers called miners are specially equipped with powerful processors that can chew through transactions and earn a portion of a bitcoin. So Bitcoin requires a lot of processing power to maintain the network and a lot of electricity to run these computers.
However, Bitcoins are not created infinitely and the currency is limited to 21 million whole units. Experts expect that the remaining number of bitcoins will be mined around the year 2140. When this happens, miners will be rewarded solely with a fee for processing transactions.
While the number of bitcoins may be limited, each whole bitcoin can be broken down into much smaller units. In practice, bitcoins are divided into fractions of a coin to facilitate payments of very small amounts of real currency. A bitcoin can be officially divided into as many as one hundred million parts, which are called satoshi in honor of the mysterious founder.
Bitcoin is just one type of cryptocurrency, and literally thousands more have been created. Some of the most popular include Ethereum, Solana and XRP.
Users can hold and use bitcoins from a cryptocurrency wallet. A wallet is like a personal location on the distributed ledger that only refers to your currency holdings. When you acquire bitcoins, the wallet provides a unique cryptographic address to the sender. To spend or send bitcoins, you can scan a merchant’s QR code or send money to the public address.
Advantages of Bitcoin
Bitcoin has some advantages as a currency and is popular for many reasons, ranging from the utopian to the capitalist.
1. Decentralized currency management
Through its decentralized network and limited number of coins, Bitcoin promises a kind of utopian version of currency. Proponents say that by getting central banks and governments out of the currency game, the currency will maintain its value better over time. By freeing up these entities, some say Bitcoin is returning power to the people.
2. Anonymous or semi-anonymous transactions
The relative anonymity of Bitcoin is also a big feature for many. Some proponents (such as certain libertarians) like that the government or other authorities cannot easily track who is using the currency. However, such anonymity means that the currency can also be used for criminal activities.
It is worth noting that each transaction is tracked and can be used to reconstruct a given wallet’s expenses. It’s all public, so any device can track spending, which raises additional privacy concerns, although ultimately it’s not clear who owns a given wallet.
3. Difficult or impossible to counterfeit
Bitcoin’s popularity is also due to a completely practical matter. It is difficult to counterfeit, due to the blockchain ledger system that verifies transactions over and over again.
4. Increasing popularity
Bitcoin is also popular because the hype surrounding the cryptocurrency has made it a trendy trading vehicle. Because the value of the currency fluctuates so much, traders can jump in and make (or lose) money. This hype and the perceived finite nature of coins have driven the price of bitcoins much higher over the past decade, although it continues to fluctuate significantly.
Disadvantages of Bitcoin
Bitcoin suffers from some significant drawbacks inherent to its design, notably the limit on the number of coins in circulation and its general volatility.
1. Bitcoin is an energy hog
Large computer miners require a lot of energy to operate. Producing the electricity is expensive and pollutes the environment, for what some critics say is a currency project with little feasibility.
How much electricity does Bitcoin use and how much greenhouse gas does it emit? According to the Cambridge Bitcoin Electricity Consumption Index, Bitcoin would rank as the 27th highest consumer of electricity, if it were a country as of April 2023. It would rank 70th in terms of greenhouse gas emissions. Those are huge numbers for a rarely used digital currency.
2. The number of coins is limited
By itself, the number of coins is limited, and that poses a serious problem when using Bitcoin as a currency. In fact, this limit does not allow the money supply to increase, which is valuable when an economy is experiencing recession. If used throughout an economy, Bitcoin can create destructive deflationary spirals, which were more typical when economies ran on the gold standard. In fact, this concern is a key reason why the gold standard was eliminated.
A challenging situation arises when consumers and others hoard currency during tough economic times. When money doesn’t flow, it slows down the economy. Without a central authority such as a bank to stimulate the economy or provide credit, the economy can enter a deflationary spiral. So consumers don’t spend because goods will be cheaper tomorrow, creating a destructive spiral.
With a fixed number of units, Bitcoin does not provide the flexibility needed to manage a system-wide currency.
3. A volatile currency is useless
Imagine going to a restaurant where the prices went up or down every day, sometimes by 10 percent or more. If this sounds like an unattractive prospect, it is exactly what makes Bitcoin virtually useless as a currency. While volatility makes Bitcoin attractive to traders, it makes it all but worthless as a medium of exchange.
Consumers need to know what a currency can buy when making spending decisions. If they expect the currency to rise – or even skyrocket – there is little incentive for them to use it as currency.
4. Public regulation is coming
Governments have been relatively slow to react to the rise of cryptocurrency, but many have now woken up and are beginning to study how to regulate it. Some countries, such as China, have banned it outright, while others are considering doing so. Still others, such as the United States, are investigating how to regulate cryptocurrency more effectively.
What form the US regulation will take remains unclear, although President Joe Biden has tasked the federal government with studying cryptocurrencies, the risks to financial stability and national security, the environmental impact and even the creation of a digital dollar.
The move to a clear regulatory framework is important in light of the high-profile explosion of TerraUSD, a stable coin cryptocurrency intended to have a fixed value. The creation of a digital dollar, with the stability of real dollars, could make private cryptocurrencies less attractive.
5. Every transaction must be reported to the IRS
The laws surrounding cryptocurrency are burdensome for consumers, making it difficult to use.
The IRS now requires you to state on your annual tax return whether you have had transactions in a cryptocurrency in the current tax year. And if you sell crypto-assets or make a transaction with one, you may create a tax liability. So you need to keep track of your buying and selling prices if you use the digital currency, so as not to run afoul of the law and get a tax bill.
Here is a complete overview of what you need to know about cryptocurrency taxes.
The bottom line
While Bitcoin is an interesting experiment, it has serious drawbacks that make it difficult to achieve its stated mission of being a medium of exchange or even a store of value. In fact, one of the world’s biggest investors, Warren Buffett, has called the currency “probably rat poison squared” and has said it’s not the kind of thing he considers an investment. Add in the fact that governments could potentially shut down the currency, and it’s a risky investment at best.
