Bitcoin is a type of digital currency or cryptocurrency, a medium of exchange that exists solely online. The currency broke into mainstream consciousness in 2017 as its price climbed dramatically over the year. More recently, after plummeting significantly in 2022, the crypto soared in late 2023 and early 2024 with the impending approval of Bitcoin ETFs.
Bitcoin has generated much controversy, from proponents who see it as the future of finance to those who dismiss 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 was introduced in 2009 when the software supporting the currency was released. Its origins are somewhat mysterious, however, with an individual (or perhaps group) known as Satoshi Nakamoto credited with 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 vast public record of transactions occurring in the currency. The networked computers verify the transactions, ensuring the integrity of the data and the ownership of bitcoins, and are rewarded with bitcoins for doing so, although the rewards diminish over time.
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 it nearly autonomous. This autonomy means that the currency, theoretically, can avoid the interference of governments and central banks.
Bitcoin can function relatively anonymously. While transactions may be traceable to certain users, the individual’s name is not immediately tied to the transaction, even though the transaction is processed publicly. However, authorities have become better at tracking the movements of bitcoins because the record 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. Thus, Bitcoin requires a lot of processing power to maintain the network and a lot of electricity to run those computers.
Bitcoins aren’t created indefinitely, however, and the currency is limited to 21 million whole units. Experts anticipate the remaining bitcoins to be mined out around the year 2140. After this, miners will be rewarded only with a fee for processing transactions.
Although the number of bitcoins may be limited, each whole bitcoin can be split into many smaller units. In practice, bitcoins are divided into parts of a coin to facilitate payments of very small amounts of real money. A bitcoin can be formally divided into as many as 100,000,000 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 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 receive 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 funds to its public address.
Advantages of Bitcoin
Bitcoin has several advantages as a currency and is popular for many reasons, ranging from the idealistic to the capitalist:
- Decentralized monetary management: Through its decentralized network and fixed number of coins, Bitcoin promises a kind of utopian version of currency. Proponents say that by removing central banks and governments from the currency game, the currency will maintain its value better over time. By cutting out these entities, some say that Bitcoin returns power to the people.
- Anonymous or semi-anonymous transactions: The relative anonymity of Bitcoin is also a huge draw for many. Some proponents (like certain libertarians) appreciate 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 illicit activities.
It’s worth noting that each transaction is tracked and can be used to reconstruct a given wallet’s spending. It’s all public, allowing any entity to track spending, which raises further security concerns, even if it’s ultimately unclear who owns a given wallet.
- Hard or impossible to counterfeit: Bitcoin’s popularity is also due to an entirely practical matter. It’s difficult to counterfeit, thanks to the blockchain ledger system that verifies transactions repeatedly.
- Surging popularity: Bitcoin is also popular because the hype surrounding the cryptocurrency has made it a trendy trading vehicle. Since 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 have driven the price of bitcoins much higher over the past decade, though it continues to fluctuate significantly.
Image credit: barrons
Disadvantages of Bitcoin
Bitcoin suffers from several significant drawbacks that are inherent in its design, notably its limit on the number of coins in circulation and its general volatility:
- Bitcoin is an energy hog: Large computer miners require a lot of energy to operate. Generating the electricity is expensive and pollutes the environment, for what some critics 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, if Bitcoin were a country, it would rank as the 27th highest user of electricity as of April 2023. It would rank 70th in terms of its greenhouse gas emissions. These are enormous figures for a rarely used digital currency.
- The number of coins is limited: By its very nature, the number of coins is limited, and that poses a serious problem for using Bitcoin as a currency. Essentially, this limit does not allow the money supply to be increased, which is necessary when an economy experiences a recession. If used throughout an economy, Bitcoin could cause catastrophic deflationary spirals, which were more common when economies ran on the gold standard. In fact, this concern is a key reason why the gold standard was eliminated.
A problematic situation arises when consumers and others hoard money during tough economic times. When money doesn’t flow, it slows the economy. Without a central authority, such as a bank to stimulate the economy or offer credit, the economy could move into a deflationary spiral. Thus, consumers don’t spend because goods will be cheaper tomorrow, exacerbating the situation.
With a fixed number of units, Bitcoin does not provide the flexibility needed to manage a system-wide currency.
- An unstable currency is impractical: Imagine going to a restaurant where the prices went up or down throughout the day, sometimes by 10% or more. If this sounds like an unattractive prospect, it’s exactly what makes Bitcoin practically useless as a currency. While volatility makes Bitcoin appealing for traders, it renders it almost useless 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 money.
- Government regulation is coming: Governments have been relatively slow to react to the advent of cryptocurrency, but many have now awakened and are beginning to figure out how to regulate it. Some countries, like China, have outright banned it, while others are considering doing so. Still others, like the United States, are examining how they might more effectively regulate cryptocurrency.
The form that U.S. regulation takes remains unclear, but President Joe Biden has asked the federal government to study 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 essential considering the high-profile collapse of TerraUSD, a stablecoin cryptocurrency that was designed to hold a fixed value. The creation of a digital dollar, with the stability of real dollars, might make private cryptocurrencies less attractive.
- Every transaction is reportable to the IRS: The laws surrounding cryptocurrency are challenging for consumers, making it tough to use.
The IRS now requires you to declare on your annual tax return if you’ve had transactions in a cryptocurrency in the current fiscal year. Moreover, if you sell crypto assets or buy something with one, you could create a tax liability. So you’ll need to keep clear records of your exchange costs if you’re using the digital currency, lest you run afoul of the law and add to a tax bill.
Here is the full overview of what you need to know about cryptocurrency taxes.
Bottom Line
While Bitcoin is an intriguing experiment, it has significant drawbacks that make it difficult to achieve the stated mission of being a medium of exchange or even a store of value. Indeed, one of the world’s greatest investors, Warren Buffett, has referred to the currency as “probably rat poison squared” and has said that it’s not the kind of thing he considers an investment. Add on the fact that states could potentially shut down the currency, and it’s a risky investment at best. However, if you’re looking to start trading cryptocurrency, here are the key things you need to know.
By Andrej Kovacevic
Updated on 14th July 2024