What is Bitcoin?

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Bitcoin is one kind of digital currency or cryptocurrency, a medium of exchange that exists exclusively online. The currency broke into mainstream consciousness in 2017, as its price ran up thousands of dollars over the course of the year. More recently, it skyrocketed in 2020 and 2021, stoking even more fever about the cryptocurrency and the potential to get rich quickly.

Bitcoin has created much controversy, from proponents who say it’s the future of currency to those who decry it as a speculative bubble. Here’s what you need to know about Bitcoin, how it works and some of its drawbacks.

What is Bitcoin and how does it work?

Bitcoin debuted in 2009, when the software underpinning the currency was released. Its origins are a bit mysterious, however, and a person (or perhaps group) known as Satoshi Nakamoto claims the credit for unveiling the cryptocurrency.

Bitcoin operates on a decentralized computer network or distributed ledger called a blockchain, which manages and tracks the currency. Think of the distributed ledger like a huge public record of transactions taking place in the currency. The networked computers verify the transactions, ensuring the integrity of the data and the ownership of bitcoins, and they’re rewarded with bitcoins for doing so.

This decentralized network is a huge 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, at least theoretically, can avoid the interference of governments and central banks.

Bitcoin can operate mostly anonymously. While transactions might be traceable to certain users, the person’s name is not immediately tied to the transaction, even if the transaction is processed publicly.

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 outfitted with high-powered processors that can chew through transactions and earn a part of a bitcoin. So Bitcoin requires a lot of processing power to maintain the network and a lot of electricity to run those computers.

Bitcoins aren’t created infinitely, however, and the currency is limited to 21 million whole units, although the software could be changed to allow for more. In the absence of such a change, experts expect the remaining number of bitcoins to be mined out around the year 2140. When this occurs, miners will be rewarded solely with a fee for processing transactions.

While the number of bitcoins may be limited, each whole bitcoin can be split 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, Litecoin and Ripple. Social media maven Facebook has also announced plans for a cryptocurrency called Libra, but it’s run into some difficulties launching the digital currency so far.

Users can hold and spend bitcoins from a cryptocurrency wallet. A wallet is like a personalized location on the distributed ledger that refers to only your currency holdings. When you acquire bitcoins, your wallet provides a unique cryptographic address to the sender. To spend or send bitcoins, you might scan a retailer’s QR code or direct money to its public address.

Advantages of Bitcoin

Bitcoin has some advantages as a currency and is popular for many reasons, ranging from the utopian to the capitalistic.

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 extricating these entities, some say that Bitcoin returns power to the people.

2. Anonymous or semi-anonymous transactions

The relative anonymity of Bitcoin is also a huge feature for many. Some proponents (such as  certain libertarians) like that the government or other authorities cannot easily track who uses the currency. However, such anonymity means that the currency can also be used for criminal activities.

3. Hard or impossible to counterfeit

Bitcoin’s popularity is also due to an entirely practical matter, though. It’s tough to counterfeit, because of the blockchain ledger system that verifies transactions over and over.

4. Surging 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 limited nature of coins has driven the price of bitcoins much higher over the last decade, and it continues to fluctuate significantly.

Disadvantages of Bitcoin

Bitcoin suffers from some significant drawbacks that are intrinsic to its design, notably its limit on the number of coins in circulation and its general volatility.

1. Bitcoin is an energy hog

Big computer miners require a lot of energy to operate. Producing the electricity is expensive and pollutes the environment, for what some detractors say is a currency project with little feasibility.

A July 2019 study in technology journal Joule showed that mining produced enough carbon emissions to rank it with a small country (around the levels of Jordan and Sri Lanka). A May 2021 article in Harvard Business Review states that Bitcoin’s electricity consumption is about 0.55 percent of global production, in line with a small country such as Malaysia or Sweden.

2. The number of coins is limited

By its very nature, the number of coins is limited, and that poses a serious problem on using Bitcoin as a currency. In effect, this limit does not allow the money supply to be increased, exposing an economy to 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 the economy. Without a central authority such as a bank to stoke the economy or offer credit, the economy could move into 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 doesn’t provide the flexibility needed to manage a system-wide currency.

3. A volatile currency is useless

Imagine going to a restaurant where the prices changed up or down every day, sometimes by 10 percent or more. If this sounds like an unattractive prospect, then it’s exactly what makes Bitcoin virtually useless as a currency. While volatility makes Bitcoin attractive for traders, it renders it all but worthless as a medium of exchange.

Consumers need to know what a currency can buy when they make spending decisions. If they expect the currency to rise – or even skyrocket – there’s little incentive for them to use it as currency.

4. Any transaction is reportable to the IRS

The laws surrounding cryptocurrency are onerous for consumers, making it tough to use.

The IRS now requires you to declare on your annual tax return if you’ve had any transaction in a cryptocurrency in the current tax year. And if you sell crypto assets or make a transaction with one, you could create a tax liability. So you’ll need to keep clear records of your buy and sell prices if you’re using the digital currency, lest you run afoul of the law and run up a tax bill.

Here’s the full rundown on what you need to know about cryptocurrency taxes.

Bottom line

While Bitcoin is an interesting experiment, it has serious drawbacks that make it difficult to achieve the stated mission of being a medium of exchange. In fact, one of the world’s greatest investors, Warren Buffett, has called the currency “probably rat poison squared” and has said that it’s not the kind of thing he considers an investment. Add on the fact that governments could potentially shut down the currency at will, and it’s a risky investment at best.

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Written by
James Royal
Senior investing and wealth management reporter
Bankrate senior reporter James F. Royal, Ph.D., covers investing and wealth management. His work has been cited by CNBC, the Washington Post, The New York Times and more.
Edited by
Senior wealth editor