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5-Minute Beginner’s Guide to Bitcoin

written by: •edited by: Carly Stockwell•updated: 3/27/2014

Anonymous hackers, illegal drug markets, and irate governments — the Bitcoin story has all the elements of a high-tech thriller. To find out more about this mysterious currency, read on.

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    Your 5 Minute Beginner's Guide to Bitcoins Critics denounce Bitcoin as a threat to national security. Proponents believe it will democratize global finance. But despite the intensity of the debate, most of the world doesn’t even understand what Bitcoin is, or how it works.

    You don’t have to be a tech whiz to nerd out over Bitcoin. By cutting through the hype and familiarizing yourself with the opportunities available, you can make an informed decision about whether or not you should invest in this trendy cryptocurrency.

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    What Is Bitcoin?

    Bitcoin is the world’s first decentralized currency. As a peer-to-peer digital payment system, it allows users to exchange money without paying a transaction fee. Unlike other currencies, bitcoins aren’t issued or regulated by governments or banks.

    There’s a strong emphasis on anonymity, which is fitting, given Bitcoin’s mysterious origins. In 2008, a person (or group of people) called Satoshi Nakamoto published a paper on an alternative cryptocurrency that could circumvent all existing financial institutions. In 2009, Nakamoto released the first Bitcoin software.

    Since its launch, Bitcoin has generated a tremendous amount of controversy related to its potential impact on global finance. Bitcoin users can now purchase things in the real world (some legal, others illicit), receive online payments, and speculate on the Bitcoin market itself.

    To understand how the system works, you first need to understand some of the lingo:

    Mining

    Though they can be used for real-world transactions, bitcoins are immaterial. They exist only as software code.

    Bitcoins are produced through a process called “mining." All over the world, powerful computers are solving increasingly complex mathematical problems. (These problems are actually encryption challenges used to secure bitcoins, and by solving them, “miners" are boosting the security of the system.) Each solution automatically generates a random yield of bitcoins, which the miners keep as a reward.

    Like any precious metal, scarcity is what makes bitcoins valuable. But unlike paper currency, there’s a finite number of bitcoins. Once 21 million bitcoins have been generated, that’s it — no more bitcoins. However, each bitcoin can be divided up into smaller subunits, such as millibitcoins (0.001 bitcoin).

    Wallet

    A Bitcoin Wallet is software that allows users to store and exchange currency based on individual digital addresses. To prevent unfair manipulation, every exchange between wallets is 100 percent unique.

    While other currencies might be backed by a commodity (such as gold), bitcoins are backed by an algorithm. Because there’s no centralized regulatory body, there is no fixed value or exchange rate for Bitcoin. When a Bitcoin transaction occurs, the buyer and seller agree on a price based on the going rate for bitcoins elsewhere.

    Voluntary Fees

    Unlike most digital financial transactions, Bitcoin exchanges carry no enforced fees. There are no banks or credit card companies acting as gatekeepers. However, users can choose to pay voluntary fees to sustain the growth of the network and expedite transactions.

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    Roadblocks to Adoption

    With no required fees and no geographic restrictions, you’d think we’d all be paying for our lattes with bitcoins by now. But the concept of immaterial money is difficult for many people to grasp, and when it comes to something as sensitive as personal finance, people won’t trust what they don’t understand.

    It doesn’t help that Bitcoin was featured prominently in the FBI’s shutdown of Silk Road, a hidden online marketplace for illicit drugs. By using Tor (a network that makes Internet users untrackable), Bitcoin users were conducting illegal transactions with complete anonymity.

    And when it comes to criminal activity, Silk Road and its successors are only part of the bigger picture. Theoretically, Bitcoin provides a platform for any crime that involves money, whether it’s laundering, credit card fraud, or tax evasion. Because Bitcoin trading is impossible to regulate currently, some governments have outlawed it.

    It’s easy to understand why institutions would consider the anonymous movement of money a potential threat. But the fear generated by the scandals has eclipsed one of Bitcoin’s most revolutionary potential applications: to alleviate financial crises throughout the developing world.

    Somalia, for example, has no central government. Much of the population lacks access to formal banking, and remittances into the country are subject to a whopping 12 percent service charge on average. As a neutral currency with no centralized issuing authority (or transaction fees), Bitcoin could be a real boon for Somalia’s economy.

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    What Does It Mean for Me?

    If you’re wondering whether you should have started buying up bitcoins a year ago — or whether bitcoins are this decade’s Beanie Babies — it helps to understand the volatility that critics are citing as the currency’s biggest weakness.

    In November 2013, the value of one bitcoin surged to $900, then dropped to $650 in less than 30 minutes. The media said that the bubble had burst, but the rollercoaster continued without bottoming out.

    Without regulation, Bitcoin’s stability is especially vulnerable to unpredictable events. The shutdown of Silk Road caused the Bitcoin market to plummet 20 percent, and the collapse of Mt. Gox (at the time, the world’s foremost Bitcoin trading platform) drove value down by 23 percent.

    Even if you’re willing to accept these risks, you’ll still have a hard time spending your bitcoins. However, the number of businesses that accept bitcoins is growing. Vancouver now has a Bitcoin ATM, and you can even book your journey to space with Virgin Galactic.

    For those of us not hopping aboard Richard Branson’s spaceship, bitcoins may not be quite as practical for, say, buying groceries or paying rent. The average consumer prioritizes convenience and stability over all else, which means most will remain skeptical.

    As with any breakthrough innovation, the road to adoption will be a rocky one for Bitcoin, but it’s already paving the way for other cryptocurrencies. Dogecoin, the currency named after a popular Internet meme, has been used to donate thousands of U.S. dollars to charity. In the future, peer-to-peer money exchanges will likely play a critical role in the global economy.

    If you embrace Bitcoin now, the risk you take as an early adopter might yield rewards in the long run. On the other hand, you can hedge against potential losses by simply waiting to see how this experimental technology evolves.

    Whatever you choose to do, equip yourself with as much unbiased knowledge as possible. When it comes to making decisions, information is the most important form of currency.

    About the Author: Daniel Wesley is the founder of debtconsolidation.com, a website full of information and resources to help get you out of debt.

References

  • How Bitcoins Could Revolutionize Global Payments — Forever http://www.bankinnovation.net/2013/11/how-bitcoins-could-revolutionize-global-payments-forever/
  • CGAP: Bitcoin Not Helping the Poor http://letstalkbitcoin.com/cgap-bitcoin-not-helping-the-poor/#.UzSB_aJ8q3N
  • Bitcoin FAQ https://bitcoin.org/en/faq
  • Bitcoin Values Plummet $500M, Then Recover, After Silk Road Bust http://www.wired.com/wiredenterprise/2013/10/bitcoin-market-drops-600-million-on-silk-road-bust/
  • Bitcoin – A Threat to National Security? http://osintblog.org/2013/05/09/bitcoin-a-threat-to-national-security/
  • Bitcoin surges to all-time high of $900, then drops below $650 in 30 minutes http://www.geekwire.com/2013/bitcoin-surges-alltime-high-800-government-discusses-legitimacy-digital-currency/
  • Bitcoin's Price Plummets As Mt. Gox Goes Dark, With Massive Hack Rumored http://www.forbes.com/sites/andygreenberg/2014/02/25/bitcoins-price-plummets-as-mt-gox-goes-dark-with-massive-hack-rumored/