Have you heard about cryptocurrency and wondered what all the hype was about? If so, it's time for you to start taking cryptocurrencies seriously. Start by learning basics of what they are, how they work, and how to start investing.

Introduction to Cryptocurrency: What Is Bitcoin?

In Investing, Make Extra Money, Technology by Matt Kuhn4 Comments

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For the past few weeks, I’ve been looking much deeper into the enigma known as cryptocurrency. I’ll be honest,  when I first heard about Bitcoin several years ago, I brushed it off as some weird “hacker money” that people gathered as some kind of hobby.

Have you heard about cryptocurrency and wondered what all the hype was about? If so, it's time for you to start taking cryptocurrencies seriously. Start by learning basics of what they are, how they work, and how to start investing.Now, after finally looking for facts rather than making ridiculous assumptions, I’ve come to believe that cryptocurrencies and the technologies behind them will become a major part of our everyday lives in the not too far-off future. Because of this, I feel like anyone interested in personal finance and becoming wealthy should, at a bare minimum, understand the basics of what many are calling the “new asset class”. I’m not saying invest in the stuff, I’m just advising that you educate yourself so you can make the best decisions.

Anyone who has any knowledge of stocks may have some preconceived notions about cryptocurrencies and how they work and how to invest in them. So before we get started, leave those assumptions at the door! 

This post will give you the high level understanding you’ll need to dive deeper into the topic in the future. I’ll mainly be covering Bitcoin, which I feel is a great starting point to understanding the world of cryptocurrencies today. If you have any questions (high level or technical), please leave them in the comments below and I’ll be happy to answer them. 

Now let the story begin…

The Beginning of Cryptocurrency

Before we get ahead of ourselves, you may be tempted to think that cryptocurrency is just “virtual money” – like dollar bills, but in the form of 1’s and 0’s. While true in a sense, most money today is virtual. When you put money into your bank account, calculations are done and then some numbers get moved around in a bank’s database to say that you now have more money (this is extremely simplified, but you get the idea). 

So what makes cryptocurrency special?

For the answer to this question, we’re going to have to start at the beginning. All the way back…to 2009.

Bitcoin – The First Born

They were simpler times. Barack Obama was inaugurated as the first African-American president, the stock market had bottomed out, and One Direction hadn’t even become famous yet!

This also happened to be the birth year of something that would lead to the rise of cryptocurrencies as we know them – Bitcoin.

Bitcoin’s Mysterious Origins

Before getting into what it is, let’s talk about Bitcoin’s very mysterious origin story.

In 2008, someone going by the name “Satoshi Nakamoto” published a paper on a cryptography forum describing the idea of Bitcoin and how it was to be designed. In January of the next year, Nakamoto open-sourced the first version of the Bitcoin software (which means he made it publicly available for free).  

Since it was just a username, there are many theories surrounding who Satoshi really is. All contributions to Bitcoin were made online, and his contributions ended in December of 2010. In 2012, an online profile (P2P Foundation) of his claimed that he was a 37 year old Japanese man living in Japan. However, his communications were all in perfect English.

One individual decided to make a timeline of all his Bitcoin forum posts and figured out that they all stopped between certain hours. Assuming that he was sleeping during those hours, he is assumed to have been living in North or Central America. Many think that “he” is really a “they” and that Nakamoto is really a group of people who came up with the idea for Bitcoin.

Can you feel the intrigue? 

What Is Bitcoin?

The Digital Money

Bitcoins are often described as the first decentralized digital currency. “Decentralized” means that there is no single administration or third-party controlling it. No bank or central government controls the creation or distribution of the money. There is no middleman to go through. With Bitcoin, nobody controls the currency except you.

Think about that for a second. If you want to send money to a friend, you don’t need to do it through PayPal or through your bank. You can send that money directly to your friend. This means 2 things: 1) The transfers are faster, and 2) The transfers are cheaper. 

You may have had to make an Automated Clearing House (ACH) payment before. These are for external transfers – when your bank sends money to another bank or to make a direct deposit or pay a bill. Not all banks charge a fee for ACH payments, but some banks do. These transfers also take several days. If you want a transfer done faster, you’d have to do a wire transfer. Wire transfers get the money sent within hours, but have a higher fee. With PayPal, you have to pay a fee when you collect money for goods or services rendered.

When you cut out the middleman, you can save time and money. 

Bitcoins are digital units of value, so they can be exchanged for money like the US Dollar or the British Pound, real estate, services, etc. 

The Peer-to-Peer Electronic Cash System 

As you might be able to see from above, Bitcoin describes a cryptocurrency (digital money) and a payment system.

The Bitcoin payment system uses a peer-to-peer network to transfer money. A “peer-to-peer” network means that the nodes on the network can connect to each other directly without having to go through a central entity (like a bank, etc.). Like I said above, it cuts out the middleman. A node is just a computer on a network, and a network is just a group of connected devices that can communicate with each other. The Internet is just one big network of connected devices.

Good so far?

The Bitcoin network does more than just allow for Bitcoins to be sent around without a middleman. It uses cryptography to ensure that fraud can’t happen. 

Cryptography is the encoding of information to make sure that third parties can’t read the information. So instead of “bitcoin,” you could write “nioctib” and hope that nobody understands the message except for your friend who already knows that the key is to spell the word backwards. Obviously Bitcoin’s cryptographic techniques are much more complicated and use some crazy mathematical algorithms, but that’s the general idea.

Since the Bitcoin system makes sure that fraud doesn’t happen, it eliminates the need for a trust-system based off of third parties. This is what allows the system to take out the middlemen. 

The software that Satoshi released in 2009 allowed for nodes (computers) to connect to this Bitcoin network and for transactions to begin.

How Does Bitcoin Work?

The Blockchain

I really believe that blockchain technologies will play a huge part in the future of transactions and automation. And it all started with Bitcoin. 

Blockchain is what allows for Bitcoin’s peer-to-peer electronic cash system I talked about above. Rather than going into the details myself, I’m going to let the CTO of Citi Innovation Lab explain it in one of the clearest and simplest explanations I’ve seen so far (it’ll also help you visualize Bitcoin better in general – trust me, the time you spend watching this is an investment).

Don’t worry if you don’t fully understand the parts about mining, I’ll cover that more below. The main point I want you to understand is the blockchain itself, along with the idea of the ledger:

There are just a few things I’d like to add to the video. The ledger is made up of blocks, which are like “pages” in the ledger. Blocks are files where blockchain data is permanently stored. When a block is “completed” (I’ll talk about how a block is completed in the next section), it is added to the ledger, and ledgers of each node are updated with the latest transactions. This way, everybody on the network has a record of all the transactions which have taken place, helping to prevent fraud. 

Now, even if a hacker is able to change a single node’s ledger, the other nodes know what is right and the compromised ledger can be fixed. So the hacker would have to somehow change the ledgers on the entire Bitcoin network in order to commit fraud – something even the world’s best hackers wouldn’t be able to do.

Although anyone on the blockchain can see all the transactions that have taken place, they won’t see things like your name or other personal information. The blockchain uses addresses to route Bitcoins – just like with mail!

So let’s say that I register with an exchange like Kraken or Coinbase. I’d give them my personal information, and once I’m approved, they would give me a Bitcoin address to use. People could then send me Bitcoin by using my address.

Although there isn’t any personal information recorded in the ledger, people will still be able to see the addresses involved in the transactions and the amounts of money transferred from one entity to another. This isn’t a problem for everyone, but for those who prefer privacy, other cryptocurrencies have been created which integrate ways to stay even more anonymous (Monero, for example). 

Where Bitcoins Come From – Bitcoin Mining

First of all, if you haven’t watched the video above, watch it now because it helps explain mining in context.

With money like the US Dollar, the government decides when to print more money. Since Bitcoin doesn’t have a central bank or an single authority, it uses something called Bitcoin mining to create money. Aside from essentially creating new bitcoins, miners are also the ones who add new transactions to the ledger.

Verifying Transactions

Bitcoin miners (this can be anyone) install special software on their computers and “listen” for transaction messages that are sent across the Bitcoin network. The miners then verify (make sure that senders have enough Bitcoins to send and that the parties are who they say they are) the transactions and store them in a block. The miners are given Bitcoins as a reward and may also be paid via transaction fees

Transaction fees are optional, but miners can choose to verify transactions that offer higher transaction fees, meaning those transactions are verified first.

Create Money By Solving Complex Math Problems

While verifying transactions, the miners are also trying to guess a key (a certain combination of letters and numbers) which will unlock the protected block (through their mining software). This requires some complex math, and once the mining software guesses the correct key, the miner who unlocked the block is given new Bitcoins as a reward.

The block is then considered “complete,” and the miner can add the block to the blockchain – which is really just a chain of every completed block. The blockchain contains every transaction ever completed on the Bitcoin network. All the nodes on the network then update their own ledgers, and this keeps the whole network in sync and secure.

The difficulty of the math problems needed to unlock a block change in relation to how fast the problems are being solved. If it’s too fast, meaning too many Bitcoins are being given out too quickly, the math problems become harder. 

As you’ve probably guessed, there are so many miners today that it’s hard for any individual to solve the math problems. Because of this, the idea of pooled mining was introduced. Pooled mining is when a bunch of miners combine their compute-power to solve the math problems. When a problem is solved, the Bitcoin reward is divided between each of the miners.

Getting Some Hands-On Experience

If you’d like to try mining yourself, I’d start with NiceHash, since it’s pretty easy to get started with. You’ll need a Bitcoin address, which you can get one with any wallet. I’ll talk about wallets a little further down.

Today, mining software will use your computer’s GPU (graphics card) rather than your CPU because the GPU is better at performing the math required. This means that it would definitely help to have a strong GPU, but it doesn’t hurt to try. Just make sure the price of the electricity you’re using to mine isn’t higher than how many Bitcoins you’re making through mining. GPU’s are faster, but they use more electricity. There are actually chips you can buy that are optimized specifically for Bitcoin mining.

Laptops typically aren’t recommended for mining because they just don’t have the processing power needed, but it’s fun to just mess around with it, even if you don’t make any Bitcoins.

Bitcoin Limit

There is actually a Bitcoin limit of 21 million Bitcoins. The Bitcoin protocol (rules that define how Bitcoin should work) says that the number of Bitcoins given out as a reward for mining Bitcoins should be halved around every 4 years (for ever 210,000 blocks mined and added to the ledger). This means that in around 2140, there will be no new Bitcoins.

At this point, what would keep miners mining so that transactions can be processed? This would be transaction fees. I can only assume that transaction fees would pretty much be guaranteed in 2140 so that transactions continue to be verified (assuming that Bitcoin is still around then!). 

What Makes Bitcoin So Great?

We’ve already discussed a few reasons why Bitcoin has gained the popularity it has:

  • Cuts out the middleman, making transactions faster and cheaper
  • Completely removes idea of trust-based system
  • Public ledger, cryptography used, and verification of transactions make Bitcoin very secure

One thing that may or may not be considered a benefit, is that transactions are not reversible. Once a transaction has been made, there’s no way to go back. Since there’s no central authority, there’s no one to help you with fraud if it were to occur (although this would be an event which could derail Bitcoin forever). 

Bitcoin is also much more than a simple-transfer-money service. Think of your phone for a second. It has many applications. When you think of a phone’s main purpose, you probably think of calling people, but you know it can do much more than this. When you think of Bitcoin, you probably think of “money,” but money is just one of Bitcoin’s possible applications.

The Bitcoin system can and has been built and expanded upon (one way this has been done is through sidechains). Since the code is open-sourced, anyone can contribute to it. Companies have been built on top of Bitcoin’s blockchain. For example, one company has created a money-lending service through Bitcoin. Other companies have taken Bitcoin and built their own cryptocurrencies off of it, leading to many of the cryptocurrencies we have today.

Bitcoin has and will also be used more in automation. For example, due to Bitcoin’s security mechanisms, a drone can deliver a package and be 100% sure that it delivered it to the right person. It can also be sure that the package was paid for!

The possibilities are truly endless.

Recap and Examples

I think this video does a good job of putting where we’re at right now into a visual format. It also goes a little deeper into the security aspect of Bitcoin (for those of you who are a little more techy):

What’s the Difference Between Bitcoin and Other Cryptocurrencies?

By definition, all cryptocurrencies are digital currencies that use cryptography for security. They are also decentralized, so no single entity should be able to control or manipulate the currency. By nature, cryptocurrencies are very volatile. In a single day, the price-to-dollar value of Bitcoin can change dramatically.

Any cryptocurrency that is not Bitcoin is referred to as an altcoin. After Bitcoin was created, other entrepreneurs and developers decided that Bitcoin could be improved upon and expanded on the idea of Bitcoin by creating separate cryptocurrencies (“cryptos”). This is why I based this intro post on Bitcoin – most altcoins are based off of Bitcoin, so they use many of the same concepts like blockchains and mining.

In general, the main differences between Bitcoin and other cryptos lie in the main purpose. Here are some popular altcoins and what they were built for (for a list of all cryptos, check out coinmarketcap.com):

  • Ethereum: Enables smart contracts to be created. Made with the intention of having apps built on its own blockchain.
  • Litecoin: Very similar to Bitcoin, but allows for faster transaction verifications.
  • Ripple: Built specifically for larger, international transactions, such as those banks participate in.
  • Monero: Built to increase privacy and to allow for untraceable transactions.

Each currency can be used in different places as well. Bitcoin is becoming more accepted globally as a valid form of payment, whereas other altcoins can only be used for specific applications. For example, Steem is an altcoin distributed within a social media platform, which cannot be traded for currency like the US dollar, but can be traded for Bitcoin (which can then be traded for dollars).

Investing In Bitcoin

The great question – should you invest in Bitcoin?

Looking at the facts, I wouldn’t seriously invest in Bitcoin yet. With the stock market, we have centuries worth of data to base decisions on. With cryptocurrencies, we have a maximum of 8 years.

Have people become millionaires investing in cryptos? Yes. Is it likely to happen to you or I? Probably not. Beware of FOMO (Fear of Missing Out). You may see others making money with cryptocurrencies and want to jump in yourself. Make sure that you never jump into any kind of investment without having a good understanding about what makes it go up and down. It could take months to do the research, but it’s worth it if it prevents you from doing something stupid.

Along with this, the market is very volatile, which can be nerve-racking for experienced and non-experienced investors alike.

That said, I don’t think it’s bad to invest for fun if you have the funds. My wife has agreed to let me have some “fun money” based on the cryptocurrencies I think will do the best over the next couple of years. It’s not much, but it helps me feel like I have some skin in the game.

Remember – always do research on your investment before putting money into anything! 

Setting Up An Account

If you’re thinking about playing around with cryptos, I would apply for an account with a cryptocurrency exchange as soon as possible, because it takes forever to get approved. I applied about 3 weeks ago and I’m still waiting to get fully approved (there are different tiers you apply for – the higher the tier, the more money you can invest, but the longer it takes to get approved).

Two popular ones are Kraken and Coinbase. I actually went with Kraken because the day I tried to set up my account, Coinbase’s site was down. I’m sure it was a fluke, but I want to make sure my exchange is reliable. 

You’ll have to apply for at least tier 2 if you want to buy Bitcoin with dollars.

Getting Yourself a Wallet

Almost any crypto post you find will tell you not to keep your money on the exchange, but to keep it in a “wallet.” Their reasoning is that if the exchange gets hacked, all your money is gone. 

A wallet is a piece of software that stores special “keys” (a string of numbers and letters) that allows you to send and receive money on a particular blockchain. The wallet itself doesn’t store your money – your wallet stores the key you need to access your money on the blockchain.

There are 5 types of wallets:

  • Desktop wallet: You install this on a single computer and can only access the wallet on that computer. 
  • Online wallet (“cloud” wallet): It’s like accessing your Google Drive – you can do it from any computer.
  • Mobile wallet: Download an app so your wallet is on your phone
  • Hardware wallet:  Stores your private keys on a hardware device like a USB. Important to use for high amounts of cryptocurrency. This would generally be the most secure option.
  • Paper wallet: You can just print your private keys on a piece of paper. It’s pretty safe, but easy to lose.

The wallet you choose really depends on if you’ll need to access your wallet from multiple locations, if security is a main concern of yours, etc. I’d say that hardware wallets are probably the most secure, so it would be a good option if you’re having a hard time deciding. 

Some words of wisdom – remember to always back up your wallet. If you lose your phone or get your computer stolen, your keys could be gone for forever. Make sure you keep the wallet software updated. And wallets only support certain types of cryptos, so make sure your wallet supports the cryptocurrency(s) that you want to invest in.

Final Words

The invention of the Internet revolutionized the way we communicate. I believe that a similar change could happen with cryptocurrencies and the technologies they’re based on, with regard to how we transfer value. It’s a bold statement, but one that grows truer each day.

I hope this was helpful for you! If anyone is interested in cryptocurrencies or you have questions on anything in the post, let me know in the comments below and I’ll do more posts on the subject.

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Comments

  1. This is a great post!!! I have struggled with people asking why I don’t invest in bitcoin and I always say b/c I don’t fully understand it. After reading this I no longer have that excuse 🙂

    1. Author

      Thanks, that means a lot!! Haha sorry to take that from you, I should add some kind of disclaimer or something at the beginning 🙂 Hopefully I’ve given you some other excuses though!

  2. Love this! I have been thinking about cryptocurrencies myself for a while now, but find it super difficult to understand. I haven’t finished reading this since I’m at work, but I’m definitely coming back for this one (and the accompanying video!).

    My question is, are cryptocurrencies really unhackable? I suppose a central bank isn’t unhackable either, but I did hear something about ether being “hacked” last year…

    My main struggle is understanding how the cryptocurrency manifests in every day life. As in…how do I pay for something with it? Or what does it mean to lend money with bitcoin? How does bitcoin that’s mined actually get circulated? (Though I’ve never questioned how new printed money gets circulated exactly) It also confuses me that there can be more than one form of currency circulating in general!

    I have a LOT of research to do before investing in it, but the FOMO is real. My boyfriend has been hot on the research trail of ether and is dying to jump in, but I feel it’s just another hot get rich quick investment at the moment (at least not knowing anything about it)

    Hilariously, Coinbase’s office is very close to where I work…perhaps I can glean something there?

    1. Author

      Hi Jing, sorry it’s been awhile – I took a little break from the blogging world to handle some personal issues. But I’m back!

      Great questions! As a cyber security enthusiast, I don’t think anything is truly unhackable. At least not until the human component is taken out. It’s interesting because the week after you posted this, it was reported that Bithumb (a big Ethereum and Bitcoin exchange) was “hacked”. However, it wasn’t the company’s network, the hack was done on an employee’s computer and then information from that hack was used to try and steal money from user’s crypto-wallets.

      Ethereum itself split into two different cryptocurrencies last year because of a hack on the DAO (https://en.wikipedia.org/wiki/Ethereum#The_DAO_hard_fork). The DAO was a decentralized organization built on top of the Ethereum blockchain. Its code was hacked and millions of dollars were stolen. Anyways, I think that the blockchains themselves are fairly safe. It’s the exchanges, wallets, and organizations built around the blockchains that aren’t completely safe.

      That’s why a lot of people recommend keeping your money on a hardware wallet, especially if you have a lot of money invested. You can protect that yourself rather than trusting an exchange.

      Cryptocurrencies only have value because people say they do. Just like with paper money, people trade it for other things because everyone believes it’s worth something. I can send you US dollars via an app or something and then it gets put into your bank account. With Bitcoin, I would just send Bitcoin to your blockchain “address” (basically your virtual wallet) in order to send you money. I’m not too sure about the lending though. And just like how new currency is circulated around our economy through spending, it’s the same thing with mined Bitcoin. The miners get new Bitcoin, and then many of the miners will sell their Bitcoin, causing it to circulate.

      I hope this helps! I’m still in the learning phase myself, but if you have any more questions, feel free to ask! Haha the FOMO is definitely real. It’s hard not to feel that way when you hear everyone saying you should buy [insert hot new crypto here] since it will only skyrocket in the coming years. But you’re smart for keeping a cool head and doing the research first.

      Oh wow! Could be a fun place to stop by. Although I probably wouldn’t ask if you should start investing. I have a feeling I know what their answer would be… 🙂

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