What is bitcoin?
Bitcoin works as a ‘cryptocurrency’ (instead of existing in physical form) and is a decentralised payment network that allows the transfer of money via cryptography. It is secured digital currency that operates outside the mandate of a central authority. It was created in 2009 by the pseudonymous Satoshi Nakamoto, and originally conceived as a method of payment that wouldn’t be subject to government oversight, transaction fees or transfer delay – unlike traditional ‘fiat’ currency. Over the past couple of years bitcoin has gained increasing prominence amongst consumers, governments and financial traders.
Who controls bitcoin?
Instead of being controlled by a central authority, bitcoin’s cash flow and transactions are instead taken care of by the network. People devote computing power to processing and securing bitcoin payments, and in return for doing so can be paid in the form of newly minted bitcoin. As such, no single person or institution can govern where bitcoins are transferred to, or how many bitcoins are in circulation.
The lack of a need for a physical presence means that bitcoins do not actually exist in any individual form – except for a few instances where companies have made ‘physical’ bitcoins. Rather, bitcoin works as a public ‘ledger’, with physical currency being replaced by a constantly updated account of every transaction ever made. That public ledger is referred to as the block chain.
A history of bitcoin currency
Bitcoin is often referred to as a ‘cryptocurrency’, describing its basis in mathematics instead of traditional financial theory. The idea for a cryptocurrency was first proposed by Wei Dai in 1998 on the cypherpunks mailing list, a discussion forum that believed in the use of cryptography to generate social change and increased privacy in communication. It took ten years for the idea of bitcoin to become realised however, this time by Satoshi Nakamoto in another cryptography mailing list.
Satoshi outlined the first specification and proof of concept for bitcoin, but left the project in 2010 while remaining anonymous (it isn’t even known whether Satoshi is a single person or a group of people). Their prominence in creating bitcoin but lasting anonymity has led to plenty of speculation on who Satoshi Nakamoto might be. It has also raised concerns about bitcoin’s legality and legitimacy, all of which have been rebuffed by the bitcoin community. It is estimated that Satoshi may have one million bitcoins in their possession, which at certain points in 2014 would have made them a billionaire.
Bitcoin’s development carried on without Satoshi’s input and by 2013 the currency had reached global prominence.
Alternatives to bitcoin
Bitcoin was the first cryptocurrency, but since its inception hundreds of new competitors and uses for the technology have sprung up. These currencies are referred to as ‘altcoins’, and tend to vary from bitcoin in one or more key aspects:
- Namecoin was the first altcoin. It works in exactly the same way as bitcoin, but is intended to be used as an alternative domain registry system
- Ripple is the largest altcoin by market cap. Ripple’s developers claim that it can process payments in 2-5 seconds, making it much faster than bitcoin
- Litecoin was one of the first attempts to improve on bitcoin; cutting the time it takes to mine a single block, and increasing the total number of coins that can be mined
How bitcoin works
For the majority of users, bitcoin works in a similar way to most digital payment methods like PayPal. Special software for your PC, tablet or phone allows the creation of a bitcoin wallet. You can use your wallet to send money to other users, or make payments on sites that accept the crypto-currency.
Unlike other digital payment methods, though, bitcoin isn’t tied to any traditional (or ‘fiat’) currency. Bitcoin works via a public ledger called the blockchain, which accounts for every bitcoin currently in circulation. Whenever bitcoin is transferred, a record of the transaction is added to the blockchain in the form of a hash: a one-off string of characters that contains details of a series of transactions. Because each hash contains data from both the transaction it is processing and all previous transactions, a fake hash can be spotted extremely easily. That is how bitcoin is kept secure despite information being publicly available.
The process of generating hashes is called ‘mining’ and it is central to how bitcoin works. Miners use powerful computers and specialist software to create a hash that ‘seals off’ a block of bitcoin transactions. As payment for doing so, they are given bitcoins for each hash generated. Those bitcoins are newly minted, so the mining of blocks also governs the supply of new bitcoins.
The reward for solving a block of bitcoin varies over time, and will halve every four years (or 210,000 blocks). For the first four years of bitcoin the blocks were worth 50 bitcoins. Bitcoin’s algorithm is set up to measure the speed at which bitcoins are being mined, and constantly regulate it so that a bitcoin block is mined roughly every 10 minutes. In order to keep mining consistent, bitcoin’s algorithm contains a concept called ‘proof of work’. Bitcoin is set up so that there can never be more than 21 million bitcoins in existence, which means that all possible bitcoins will have been mined by around 2140. Each bitcoin is divisible to eight decimal places, or a hundred-millionth of a bitcoin. This value is referred to as a satoshi, after bitcoin’s creator Satoshi Nakamoto.
Getting started with bitcoin – Ways to acquire bitcoin
There are three ways to acquire bitcoin:
- In the form of a payment
- By buying them off of an exchange or person
- Earning it via mining
Option two will be the way in which most people first acquire some bitcoin. In order to purchase bitcoin from an exchange or individual, a bitcoin wallet is needed.
A wallet is bitcoin’s equivalent of a bank account. Unlike traditional bank accounts though, a wallet is extremely easy to set up and needs no verification. They come in two forms: a software-based wallet that exists on the hard drive of your computer, and an online cloud-based service. There are several ways to fund a bitcoin wallet, but most exchanges and individuals will not accept credit cards or PayPal because it is too open to fraud. Instead, bitcoin ATMs and bank transfers are the most common methods of buying bitcoin.
Trading without a wallet
Alternatively, Spread Betting and CFG brokers offers bitcoin derivatives trading.Trading this way allows you to speculate on bitcoin’s volatility. Bitcoin trading is instead undertaken via spread bets or CFDs and no actual bitcoin is ever traded. You should be aware, however, that there is still the potential to make substantial losses, as well as gains.
Benefits of bitcoin
Bitcoin is a currency that appeals to a variety of different people for hugely differing reasons.
- For its growing base of consumers, it offers a currency that is not controlled by any central bank, and can be spent freely across borders with little regulation or limitation.
- For economists and technology enthusiasts, it represents a hugely significant step towards the digital age.
- For financial traders, it is a new area for investment that brings huge volatility and behaves differently to flat currencies.
- Transaction benefits: For many, the biggest draw to bitcoin is its low cost, high speed and complete freedom when it comes to transactions. Bitcoin is completely global and subject to few laws and restrictions from central or other banking institutions.
So sending money to someone can only take up to ten minutes, the only charge is what is levied by the exchange used, and transactions can be any amount, made at any time and go anywhere. Because of that, the cost of transferring money around the world via bitcoin is usually cheaper and quicker than other methods that can incur fees, impose restrictions and take several days.
Bitcoin is able to offer such speed and low cost because it exists only online, with no central regulator or economy to encumber it. That freedom does come with a downside, however. Bitcoin’s security is still some way from perfect, and with several notable hacks on exchanges anyone keeping large amounts of bitcoin on an exchange is at risk.
As a fledgling currency, many merchants are still reluctant to accept bitcoin. For consumers who are interested in trying cryptocurrencies, that can represent a real problem: even those who want to use bitcoin can find their options extremely limited.
Why invest in bitcoin?
The key reason for bitcoin’s attractiveness to investors is the volatility it has seen in its early years.
In late 2013, investors enthusiastically took to bitcoin as a vehicle for investment. Bitcoin took off in a big way, increasing massively in value from $200 per bitcoin in November 2013 to over $1000 a month later. Since then, bitcoin’s price has seen huge levels of volatility. There are two key reasons for this:
Scarcity of supply
Firstly, bitcoin still has a relatively small number of total coins in circulation. Because of how bitcoin is designed, a certain number of bitcoins are released every ten minutes until the maximum 21 million are in circulation. That point will only be reached in 2140, so volatility is a key feature in bitcoin’s early years.
Secondly, bitcoin is still facing questions surrounding its legitimacy and security. As investors and adopters fear a major government taking decisive action against the currency, any signs that government figures are considering regulation can impact its price.
That volatility can make bitcoin an attractive area for investment, especially in times when other currencies have their movements flattened. However, similar to traditional investment options, with increased volatility of Bitcoins comes increased risks.
How to trade bitcoin
For those financial traders who have decided that bitcoin is a worthwhile investment, two initial paths are possible. One way of investing in bitcoin is similar to that for paying people with it, and the other involves derivatives trading.
Trading bitcoin via an exchange
Those wishing to purchase actual bitcoin will need a wallet for starters, followed by some bitcoin to fund it with. The most common method of buying bitcoin is from an exchange, in return for some fiat currency. Rarely though, will an exchange accept credit card or PayPal payments.
Choosing between bitcoin exchanges is a matter of weighing up different features, with security and legitimacy the two key concerns.
Once you have chosen an exchange, a trading strategy is needed. Most traders will either buy and sell bitcoin on a daily basis, or hold onto bitcoin on the grounds that its price will increase in the long term.
Trading bitcoin via derivatives
Shorting bitcoin is tougher than shorting more traditional currencies, mainly because most bitcoin exchanges are not as tailored to investments as forex exchanges. The difficulty in making complex bitcoin trades – as well as the need for a specific wallet, lack of credit card or PayPal funding, and scarcity of currency – means that bitcoin does not have the same liquidity in trading as other currencies.
Those traders wishing to speculate on bitcoin’s volatility can turn to bitcoin derivatives. These products do not involve holding any actual bitcoin. They work by allowing you to open contracts and make bets on what bitcoin will be worth after a period of time, or what direction bitcoin’s value is moving in. Spread bets, CFD trades, binaries and other products allow a variety of ways to invest in bitcoin while avoiding some of its limitations and risks.
Bitcoin is attractive to traders because of its extreme volatility, but volatility brings with it great risk. Bitcoin can lose or gain huge amounts in short spaces of time, so anyone aiming to be involved in bitcoin trading needs to be aware that losses can come large and fast.
Bitcoin spread betting
Spread betting enables you to bet on whether bitcoin will move up or down. The greater the price movement that bitcoin makes, the greater the profit (or loss) when the spread bet is closed.
Just like when spread betting on other assets, traders who bet on bitcoin never actually own any cryptocurrency. As such, many of the potential difficulties and risks associated with bitcoin are negated when spread betting:
- There is no need for a bitcoin wallet to be obtained
- Spread bettors do not need to trade via an exchange, which means that the security problems associated with exchanges are not a factor
- In the UK, that also means that the tax implications associated with trading bitcoin do not come into play; spread betting is classed as gambling, and as such does not incur a tax on profits
- If a trader believes that bitcoin is about to lose value, they can short the crypto currency by ‘selling’; most bitcoin exchanges do not allow you to short but spread betting allows you the chance to make a profit (or loss, if bitcoin moves upwards) in a bear market. However, spread betting bitcoin also comes with significant risks, and losses can exceed deposits on trades.
Bitcoin CFD trading
Like spread betting, CFD trading offers an opportunity for you to speculate on bitcoin’s price fluctuations without any actual crypto-currency trading hands. It has many similarities to other bitcoin derivatives, but also some key differences that you need to be aware of.
When a bitcoin CFD (or contract for difference) is traded, an agreement is made to exchange the difference in value of bitcoin from the time when the contract begins and the time when it is closed. As with any CFD trade, the underlying asset – in this case bitcoin itself – is not traded, but dictates how much is gained (or lost) from the trade when it is closed.
While a CFD does stipulate that the difference in value of bitcoin from when the contract is opened to when it is closed must be paid, it does not usually expire naturally. Instead, if you wish to close your bitcoin CFD, simply place a trade of the same value in the opposite direction.
- Bitcoin CFDs have many of the same advantages as bitcoin spread bets.
- Traders dealing in CFDs do not need to open an account with a bitcoin exchange, or obtain a bitcoin wallet; the difficulties and risks associated with both services are thus negated
- CFD trades can be opened as either long, indicating that the trader believes bitcoin will increase in price, or short if the trader believes that bitcoin’s value will fall
Bitcoin spread bets and CFDs – the risks
Bitcoin CFD trading losses can run indefinitely. Most CFDs and spread bets are also leveraged and bought on margin, which means that you are exposed to the full value of the contract for a fraction of its total cost.
Bitcoin is much more volatile than traditional ‘fiat’ currencies, thanks in large part to the relative scarcity of bitcoin and lack of a central bank’s guiding hand. A leveraged position on a currency that has been known to drop over $200 overnight – as it did back in December 2013 – can be a very risky proposition indeed.
Traders therefore need to ensure that risk management is set up on every trade. Bitcoin Spread Betting and Bitcoin CFD Brokers offers a number of ways to manage your risk. ‘Guaranteed stops’ (an optional feature that comes at a price) can cap your maximum risk if bitcoin’s value suddenly drops (or leaps) against an open position. Price alerts warn traders when a target is breached. Seminars and guides offer a comprehensive view of how to trade with as little risk as possible.
Spread bet bitcoin – example
For this example, bitcoin is currently trading at $250 per XBT. Because bitcoin spread bets are leveraged (and a $1 bet per point is equal to buying 100 XBT), it shows as 25000
John believes that the price of bitcoin is about to fall, so he decides to place a spread bet
Spread Betting Broker is offering bitcoin at a bid/offer spread of 24850/25150: at these prices, John can ‘buy’ at the offer price of 25150, or ‘sell’ at the bid price of 24850
John chooses to ‘sell’ $1 per point at 24850.
A US senator speaks out against bitcoin calling for a ban, and the crypto-currency falls 1000 points (or $10) to a market price of 24000; Let’s say Spread Betting Broker now offers a price of 23850/24150
John decides to close her position by ‘buying’ at the offer price of 24150, 700 points below her selling price of 24850
In this example, John would have made $700 from her spread bet ($1000 on the correct call, minus the $300 spread). Had the market moved 1000 points in the other direction, he would have lost $1,300: $1,000 on the incorrect call and $300 on the spread.
Bitcoin CFD example
Daquan thinks that bitcoin is going to improve from its current valuation of $200; it shows as 20000, because CFDs are leveraged and buying a single contract is equal to buying 100 bitcoins
Daquan decides to speculate on his belief via a CFD
CFD Broker is offering bitcoin long at 20150, or short at 19850; this is represented as 19850/20150
Believing that bitcoin is set to improve, Daquan buys a single contract at 20150
A major retailer announces that it will begin accepting bitcoin, and its value increases 500 points to $205 (or 20500); CFD Broker now offers bitcoin at 20350/20650
Daquan decides to take his profits, selling at the bid price of 20350; this is 200 points above the initial offer price of 20150
In this instance, Daquan would’ve made $200 profit from his CFD. If he had shorted bitcoin instead of going long, he would have lost $800.
How is bitcoin used in business?
A number of businesses already accept bitcoin as a form of payment, though they are still very much in the minority. They include:
- Virgin Galactic
Of course, these big names have the infrastructure to cater for the cryptocurrency. But given the regulatory question marks and the volatility of the market, it’s little surprise that bitcoin integration hasn’t yet become more commonplace.
As a foundation for technology
Many companies are looking past the currency itself and towards the decentralised ledger at the heart of bitcoin.
Blockchain technology has already seen the rise of an array of new business models, including those surrounding global payment, web development and data security. Plus, there are a number of funds looking to invest in blockchain-based projects, bringing cryptocurrency firmly into the eye-line of financial hubs worldwide.
What is a bitcoin fork?
A fork occurs when one blockchain splits into two, creating two separate records of data. It is up to the network of bitcoin miners to agree which one of these to continue using, and which should be discarded.
Forks are the result of a misalignment of the community’s mining programs, and enable the blockchain to undergo essential software updates. The two main types are soft forks and hard forks.
The upgraded blockchain is now responsible for validating all transactions (blocks), but the existing blockchain will still recognise and record these transactions. Keep in mind that this only works one way: the upgraded blockchain will not recognise any blocks mined via programs using the existing blockchain.
The upgraded blockchain is now responsible for validating all transactions, but the existing blockchain no longer recognises these blocks as valid, nor records them. This means all users of outdated programs must update to access the upgraded blockchain.
Generally, forking is resolved with little to no disruption. But differences of opinion in how a cryptocurrency should scale or function have proven insurmountable in the past. The most high-profile example of this is bitcoin cash, which came about when bitcoin hardforked and divided bitcoin miners along with it. This ultimately resulted in two distinct cryptocurrencies, bitcoin and bitcoin cash, albeit ones with the same transactional history up until July 2017.