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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, as traders saw it as a way to get rich quickly, before plummeting massively in 2022.
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 using blockchain technology, 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. However, 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 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. 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.
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.
It’s worth noting that every transaction is tracked and can be used to reconstruct a given wallet’s spending. It’s all public, allowing any entity to track spending, creating further privacy concerns, even if it’s finally not clear who owns a given wallet.
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, though 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.
Just 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 user of electricity, if it were a country as of April 2023. It would rank 70th in terms of its greenhouse gas emissions. Those are huge numbers for a rarely used digital currency.
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, which is valuable when an economy experiences recession. If used throughout an economy, Bitcoin could 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 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 moved 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. Government regulation is coming
Governments have been relatively slow to react to the advent 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 examining how they might regulate cryptocurrency more effectively.
What form the U.S. regulation takes remains unclear, though 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 vital in light of the high-profile blow-up of TerraUSD, a stablecoin cryptocurrency that’s meant to hold a fixed value. The creation of a digital dollar, with the stability of real dollars, may make private cryptocurrencies less attractive.
5. 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.
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 or even a store of value. 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, and it’s a risky investment at best. Still, if you’re looking to get started trading cryptocurrency, here are the key things you need to know.