Bitcoin Basics (Part 1): What is It, How Does it Work, and Where Do You Buy It?

Michael QuanContributed, Education, Investment, Making Money, Misc32 Comments

Some links below may be from sponsors. Please see our disclosure for more info.

The Bitcoin buzz has reached a dull roar, and eager investors are clamoring to claim their stake in the cryptocurrency world. There are many different types of cryptocurrency — decentralized digital currencies — but Bitcoin investing is by far the most popular. Despite its newfound fame, many investors still have a lot of questions about this ‘digital gold’.

Keep reading for a beginner’s guide that decrypts some of the mysteries behind cryptocurrencies like Bitcoin.

But before we get to investing speculating, let’s first understand what it is at a high level.

The Investor’s Guide to Bitcoin: What Is Bitcoin?

Before diving into big and somewhat scary-sounding words like ‘blockchain’ or ‘immutable distributed ledger’, let’s review the basics of banking as it works today.

Imagine you are with a friend at the park. Your friend decides to give you a dollar. His only dollar in fact. You both know what type of transaction has taken place here, namely that one person has gained a dollar, and the other has lost a dollar. Nobody else needs to be involved in this transaction because you both know where the dollar is now. You are so excited about having this dollar that you run to the bank to keep it safe.

Now bring it into real life. Pretend that you are a merchant who owns a store. A customer comes in, picks out a product, and pays with a credit card. This is quickly becoming the standard form of payment; in fact, seven out of 10 Americans have one or more credit cards. The retailer’s credit card processor sends a request to your bank, which takes the funds out of your account.

While with your friend at the park, you experienced the actual sensation of holding a dollar bill. With a credit card, no paper money ever changed hands. Already, a lot of our ‘money’ has already been effectively digitized. So how is bitcoin different?

Bitcoin is a virtual currency created in 2009 by a mystery inventor using the alias Satoshi Nakamoto. When you use Bitcoin to pay for something, no banks or financial institutions are involved. It’s a peer-to-peer currency that exists solely in ones and zeros.

Right now, a single Bitcoin is worth an incredible $7989 and change, up from $737 in 2016 just a year ago.

To Unravel Bitcoin, You Have To Understand the Blockchain

Did you know that on any given day, if every person in the United States wanted to withdraw their funds from the bank, there would not be enough physical money to do so? This is because bank branches don’t store all of the money they receive in their vaults. That is why they are able to pay you interest on money in your savings account. The physical money is elsewhere, loaned out to people, the government, or anyone that needs cash and is willing to pay the lenders (the bank) interest. When you put your money into a bank, it’s like Schrodinger’s cash; maybe it’s there, maybe it is elsewhere. Either way, the banks are trusted institutes backed by the FDIC.

But how do the banks keep track of who has how much? Picture a big spreadsheet. Each name has an account number, maybe two, and each account number has a dollar value assigned to it. Now, whenever you withdraw or deposit, this goes onto the ledger and gets saved. This tells the people who work at the bank how much every person has. They have access to change the numbers on this ledger, and an account that allows them to do so. The last time you went to the bank, what happened? A teller likely asked for your member number and account number. You gave that person money, they typed in some numbers, and boom! You’ve turned paper money into pixels.

A Currency with Inherent Trust

The problem becomes, how can you trust that the person behind the counter or some outside force won’t try to change the ledger? How can you be sure they’re not being careless with your money? The sobering fact is between 75% and 80% of all malicious cyber attacks come from inside a business, not outside. And after the Great Recession and the ensuing financial crisis, many people no longer trust big banks. On top of that, identity theft is currently one of the fastest-growing crimes in the country, and it currently represents a $50 billion industry.

As a result, more and more investors are looking for new ways to keep their money safe. This is where the blockchain comes in.

Imagine the spreadsheet described above. Now imagine it has only one column. In each cell of this column is a string of random numbers and letters. Each cell refers to a transaction between two parties (think about your friend giving you a dollar). Now imagine you and everyone else in the world can click on each cell. When you click on it, it will tell you the amount of money sent, the amount received, the time it happened, and the parties involved. Since everybody can see every transaction, nobody can hack it or alter it. So who records the transactions?

Computers. A highly complicated algorithm is run on individual computers all over the world, which verifies how many “dollars” are sent when they are sent, and where they are going. You can even own one of these computers and run a program to help confirm transactions from all over the world. The more computers running the program, the safer the system gets. The more confirmations, the less likely anyone is lying. After enough computers confirm that a transaction is true, it goes into the ledger that everyone can see. This also makes it impossible to hack. But wait, why would people use their computers to do this? Don’t they have to pay for electricity to run the computer?

Bitcoin – A Finite Digital Resource

If you run a computer or are mining Bitcoin, you are rewarded with a small amount of Bitcoin for confirming these transactions. This is the only way new Bitcoins enter the system, and there are a finite number of Bitcoins. Unlike paper money, there is no way you could simply print more Bitcoin for yourself. The way it works is based on mathematics and programming. If you are a programmer, you can look at all of the code that powers Bitcoin here.

It’s an open-source code, which means that just like the ledger, everyone can see it, nobody owns the rights to it, and it is verifiable every step of the way. In a world where 58% of businesses are concerned about cyber attacks, a data storage system that cannot be hacked could change everything.

So there you have it, the blockchain. An immutable, unhackable, and globally distributed ledger.

In fact, the blockchain has been so successful that healthcare organizations are investigating its potential uses for medical records.

How To Buy Bitcoin?

Back in the earliest days of Bitcoin, it was quite difficult to buy Bitcoin, but today it is as simple as anything else. First, you make an account with Coinbase. This might take some time because to comply with financial regulations they need a picture of you and your driver’s license or some sort of state ID. This is standard procedure for any investment institution. Just follow the prompts on the website to finish creating your account.

Once your account is confirmed, you will get an email letting you know. Then, you can link a bank account, or you can use a credit card like you would on Amazon or some other online marketplace. There is a 4% fee for credit card transactions and a 1.5% for bank transfers, but credit cards are absolutely instant. Overall though, the act of buying Bitcoin is shockingly easy. There are also a number of “digital wallets” where Bitcoins can be stored.

Of course, this beginner’s guide to investing in Bitcoin is just a brief overview. There’s obviously a lot more to explore. In the next article, we will discuss how to keep your Bitcoin secure, other methods of trading in cryptocurrency, and the crazy upside potential of investing in Bitcoin.

*Update – I’ve started up an account at BlockFi which actually pays me interest on my crypto balance up to 8.6%! 

Final Thoughts

I do believe digital currencies are the future.  However, I haven’t pulled the trigger myself to “invest” in Bitcoin.

It doesn’t make it a bad investment, but I don’t have enough information yet to make an educated decision.

The values continue to fluctuate rapidly day-to-day, so instead of chasing money (i.e. speculating), I’m going to put my emotions aside for now and learn more.  It’ll be interesting to see how this pans out from here!

(BTW, if I were to speculate, I’d come up with a theory and do my best to “test” it.  I’d put up real money, but just a tiny amount relatively, so I could get in the game, but be 100% okay if it vanished tomorrow.)

Readers, what are your thoughts on Bitcoin, or other digital currencies? Will it disappear or gain wide acceptance? If so, when?

Michael Quan
Follow me

32 Comments on “Bitcoin Basics (Part 1): What is It, How Does it Work, and Where Do You Buy It?”

  1. This article certainly aged well, Michael. The stock market was actually considered speculation as recently as the 1950s. Some people, to this day, still consider the stock market as a giant wild speculation casino. I believe in the long term nature of cryptocurrencies and digital assets and I bet this is just the beginning and the start of something great.

    I don’t think it is speculation in the least 😉 the technology that went behind creating a digital currency like such is just on another level.

    1. You might try to flip it around and look at it from the other angle. Let’s speculate on our fiat currencies as a thought experiment:

      I would speculate that they (central bankers) will keep debasing the currency — it’s the only release valve they have left.
      I would speculate that the odds of that happening are approximately 100% 😉

      Bitcoin is no longer the speculative asset. If you start to measure your costs/wealth in Bitcoin, you’ll quickly see that literally everything is getting repriced in a sound money, and everything around you starts getting cheaper!

      If you haven’t yet had a chance to read Jeff Booth’s book The Price of Tomorrow, I would highly recommend it. The TL;DR: we are watching a slow moving train crash as Technology (an exponentially deflationary input) is heading right for Central Bank printing who are trying to milk Inflation out of the global economy. “Two Men Enter, One Man Leaves” – Mad Max Beyond Thunderdome

      These things tend to unravel gradually then suddenly. So try not to get caught flat-footed as the unwind can be vicious. Speaking of which, here’s another great series of reads on that very topic:
      https://unchained-capital.com/blog/category/gradually-then-suddenly/

  2. A good video resource on using BitRefill:
    https://www.youtube.com/watch?v=B1Kk3GYLMXA

    He’s got an entire series on Buy/Sell/Spend — he’s based on Canada, so some of the content is Canada-specific but a lot of it translates to most of the world.
    https://www.youtube.com/playlist?list=PLxdf8G0kzsUU_1rj1Ppb8_jJ0najdB-z0

    Worth subscribing for all kinds of good Bitcoin educational resources. There are a lot of scammers out there (especially on YouTube!), but this guy is legit.

    Paxful is another resource I forgot to mention to trade Bitcoin for just about any imaginable gift card under the sun. It’s very popular in parts of Africa for topping up pre-paid phone cards and such.

      1. For smaller purchases, you’re probably better off using Bitcoin through the 2nd layer of the stack — called Lightning Network. Think of it in a similar way to how the Internet protocols are built in stacks: TCP/IP, with IP as the base layer protocol, and TCP as a layer on top of that.

        Lightning is built on top of the Bitcoin protocol for — lightning fast payment throughput.

        [Side tangent: people are now even working on and have working prototypes of STREAMING money (i.e. Bitcoin) through the Lightning network. The first version is Adam Curry (the inventor of podcasts) has a podcast player where you pay fractions of a penny for only the content you consume. So if you get value (and keep listening) you keep streaming bitcoin to the creator. Stop listening, your payment stream stops. Value for value. More on that here if you’re interested: https://podcastindex.org/ ]

        But back to your original question…

        You can buy just about anything from Amazon to air fair. Probably the easiest way is to buy gift cards using your bitcoin through sites like: https://www.bitrefill.com/ or my favorite is the https://foldapp.com/ which has a Bitcoin-back program (like cash-back) but you earn Bitcoin back instead.

        There are also vendors who prefer Bitcoin (since it is a better store of value than cash). One of the leading Bitcoin Point Of Sale software developers has a list of merchants here: https://directory.btcpayserver.org/

        Final point… (I am not a tax-advisor) but spending & selling Bitcoin is a taxable event in the US and will incur short-term or long-term capital gains taxes. So, a BETTER option is to use your Bitcoin as the most pristine form of collateral, and take out a loan against it so you can avoid the tax hit. A couple reputable companies for that are: https://unchained-capital.com/ and https://www.blockfi.com/ you put your BTC up as collateral and then you can get a USD loan for up to 50% of the value of the BTC.

        Happy to answer any other questions!

        P.S. The next 4-year bitcoin cycle (known as halvings when the new-mining reward issuance gets cut in half by the protocol) just started in May, and so that’s why were are new beginning a new bull-run in the price. (less supply + equal or greater demand = price goes up!) so selling right now would not be wise IMO. 2021 is going to see crazy price movement to the upside!

  3. I know that I’m a bit behind in all this cryptocurrency and I want to be a part of it. One of the things that does interest me is bitcoin. Now as you did mention, there is only so much bitcoin to go around so it does make sense as to why the value of it exponentially increased so much. Now I’ll just have to do some more research and then make a decision of what I want to purchase.

  4. I don’t know enough about crypto currencies to invest. I am sure there is a lot of money to be made but I will stick with what I know, slow, boring, dividend payers.

    1. it’s prudent to be cautious before investing in an emerging technology. As we know it’s good to have a diversified portfolio. However, a brand new global asset classes don’t come around all that often! 😉 Especially one that is HIGHLY uncorrelated to other investment vehicles. If you want a good hedge against a lot of the uncertainty in the world these days, I can’t think of a better option! 🙂 I started with < 1% of portfolio in crypto and have dollar-averaged in and now about 25% of my portfolio is crypto.

  5. I just purchased some Bitcoin, Ether, Bitcoin Cash, Dash, and Ripple. Much like investing in an index fund I think it makes the most sense to buy a basket of the larger and more serious cryptocurrencies. I am taking some risk on this because i think it is going to be a significant technological change for our entire world that will not soon be dismissed or lose its value. Mark Cuban, Bill Gates, and many others believe blockchain technology is the wave of the future for currency and so I want to have exposure to it. Keep in mind that many exchanges like Kraken.com offer sell stop orders and with the new futures contracts you will have multiple ways to manage your risk.

      1. One more tip for you and readers of the blog. You can avoid the fees from Coinbase buy going through their exchange instead (called GDAX). There’s a simple how-to video on the process here: https://www.youtube.com/watch?v=lcCIjIAqM-4

        It should make sense for most people that have purchased traditional assets from a broker.

  6. I keep a small amount of money where I use to speculate on things such as this. While most of my portfolio is in index funds, sometimes you feel the urge to try and hit a homerun. The Bitcoin proponents keep saying if you had invest just a hundred dollars years ago….you’d be a millionaire! Haha. Thanks for the primer on bitcoin…it’s a little complicated but you did a good job explaining it.

    1. I know, it’s strange how psychology messes with your head! I could have… If only… Haha.

      It think it’s fine (and fun) to have a little money to speculate with. I already have some money in a private equity investment, so who knows if that pans out. I shoulda got some bitcoin instead! 😉

        1. You can currently get exposure to this new asset class via GBTC (see: https://finance.yahoo.com/quote/GBTC/ ). That’s the easiest way if you are familiar with the “traditional markets” and don’t want to learn how to buy BTC directly off of an exchange. Be aware however that crypto-exchanges operate 24-7-365. There are no “trading-hours” for global assets! If you hold BTC directly you can enter/exit positions whenever you want. If you instead hold GBTC you are limited to changing your position during Wall St. trading hours.

          Also, the CME will soon (probably by end of the year) offer Futures contracts on Bitcoin. Details here:
          http://www.cmegroup.com/trading/equity-index/us-index/bitcoin_contractSpecs_futures.html

        2. I’ll probably touch on it more when it closes out, but I essentially purchased some secondary shares of the Honest Company a while back. It’s ~$8000 if I remember correctly and will only pay out when there is a liquidity event… i.e. IPO or buyout.

  7. Michael,

    Long time. Hope all is well for you and the family. This is really funny. I have read how people who mined bitcoin early on and forgot about their accounts have now woken up to tens if not hundreds of thousands of dollars. I think Bitcoin is the new gold market until it isn’t. I think many of the dollars that would have ended up in gold have ended up in Bitcoin which is part of the run up. It is like virtual Gold but much lighter as it doesn’t way anything and has no properties. Maybe one day they can fill the cavities in your teeth with Bitcoin? All joking aside I am curious to see where it goes and what happens when it pops for the first time. I have a feeling we will here the horror stories about how Bitcoin ruined people and that they couldn’t buy or unload fast enough. It will need to be well regulated like the Stock market before it is a stable currency. I think once Bitcoin is more widely accepted means of payment is when we will really understand its value. It is very intriguing but also a HUUUUUGE gamble. Exciting times we live in. I hope to be telling stories to my grandchildren about I remember when Bitcoin was invented. We might refer to it as betacoin and then again we might be having our social security checks in it one day. No one knows but I will enjoy watching how this plays out.

    1. Hey Randy, nice to hear from you. It’ll be interesting to see how they try to regulate it. And, you’re right, it needs to be more stable in order to become a viable means of currency.

      Man, I should have used my gaming rig to mine some bitcoin in the early days!

      Have a great Thanksgiving with the fam. 🙂

  8. I’ve put a little money into the cryptocurrency market. If things keep going well, it will improve my financial situation. If it goes poof, I won’t have lost too much money since I “invested” what I could afford to lose.

    Thanks for sharing, this is a great article and resource for crypto noobies

    1. That’s great, Erik! That’s a very smart strategy, and potentially something I may do once I figure out more of the nuances. Good luck.

  9. “So, instead of chasing money (i.e. gambling), I’m going to put my emotions aside for now and learn more.”

    I think that’s a good decision. I’m with you on this. I’ve heard people rave about Bitcoin and how much money they have made from it. But I don’t believe in chasing speculation and making quick bucks. Maybe I just need to be more adventurous >_<

    1. Yeah, it’s a personal decision for sure. I do know people who are making a decent chunk of change from it currently, but my risk aversion is a bit too high these days. 🙂

Leave a Reply

This site uses Akismet to reduce spam. Learn how your comment data is processed.