What Is Bitcoin?

By Matthew Frankel Markets Fool.com

Bitcoin is an unregulated virtual currency designed to eliminate the "middleman" from financial transactions and enable direct, anonymous transactions between users. Bitcoin has several advantages over most other currencies, such as small transaction costs, a public record of transaction amounts and times, and the anonymity of users' personal information. However, there are some downsides to bitcoin as well.

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Image source: Getty Images.

What is bitcoin?

Bitcoin was created in 2009 by a programmer or group of programmers using the pseudonym Satoshi Nakamoto. Several people have since claimed to be the creator, but none have been conclusively proven. Bitcoin was designed to be a decentralized currency, intended to eliminate the "middleman" from financial transactions. Payments are sent peer-to-peer from the payee to the recipient, with no transaction fees and no need to exchange any personal information.

The currency is completely virtual and is self-sufficient -- i.e., it's not controlled by any central authority. New bitcoins are created through a process called "mining." Through mining, sophisticated computing equipment solves complex mathematical problems, and the reward is a newly created block of bitcoins.

In the early days of bitcoin, everyday computers had sufficient power to mine for blocks of coins online. As the competition for the newly created blocks intensified over time, more and more sophisticated mining hardware was developed. For example, miners can be as simple as these small devices that can plug into any computer's USB ports.

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Image Source: Flickr user Mirko Tobias Schafer.

Or, they can be complex collections of advanced computing devices working together, like this "mining farm."

Image Source: Flickr user Marko Ahtisaari.

There are several readily available software programs that allow users to either mine for bitcoins on their own or join "mining pools," which essentially allow participants to combine the power of their mining hardware and then share any blocks of coins that they receive.

However, it's important to realize that the supply of bitcoins is not unlimited. The production rates for the next hundred years or so have been predetermined, and will decrease over time (currently, 12.5 bitcoins are released in each block, which occurs approximately every 10 minutes). There will be a maximum of 21 million bitcoins created in total, with final production occurring around the year 2140. This prevents things like inflation and dilution from impacting the inherent value of each bitcoin; unlike most currencies around the world, bitcoin has a specific limit on how much can be created.

Each bitcoin can be broken into fractional units, with up to eight decimal places of precision. For example, if one bitcoin is worth $1,000, and you need to pay for a $20 item, then you would send 0.02 bitcoins (abbreviated BTC). The term millibitcoin, or mBTC, is used to represent 0.001 (one one-thousandth) of a full bitcoin.

To be perfectly clear, there is no such thing as a physical bitcoin, despite the abundance of pictures like this one:

Image source: Getty Images.

Every finalized bitcoin transaction is kept on a massive public online ledger known as the "blockchain." This contains information such as the time and amount of each transaction, but it does not contain any personal information.

How to store and spend bitcoins

People who wishes to hold and spend bitcoins must create a bitcoin "wallet," which stores the information needed to complete bitcoin transactions. The bitcoins themselves remain a part of the blockchain, but your wallet contains the information necessary to access and use your own bitcoins. There are several software providers of bitcoin wallets, and with a little research, you can find one that's best for you.

Bitcoin isn't universally accepted yet, but over the past several years, the list of businesses that accept bitcoin has grown. Just to name a few, the current list includes Overstock.com, Microsoft, Expedia, Newegg.com, Home Depot, DISH Network, and Intuit. Many small businesses accept bitcoin payments as well.

Of course, with the anonymity of bitcoin comes the potential for it to be used for illegal activities, such as gambling or buying drugs or weapons. This was a bigger problem in the earlier years of bitcoin than it is now, but it still exists to some degree.

While bitcoins are still used for illicit activities, common legitimate uses of bitcoin include paying for internet services like web hosting and advertising. There are also several popular online stores set up for the specific purpose of allowing people to shop with bitcoins, and mainstream retailers are increasingly accepting the virtual currency.

Another common use of bitcoin is for low-cost money transfers, particularly to foreign countries. The average cost of a bitcoin transfer is about $0.04, and it takes just over nine minutes to complete, making it appealing for people who need to send money overseas.

Advantages of bitcoin

Bitcoin is popular for a reason, as it has several advantages over traditional currencies that many people find attractive. Just to name some of the biggest reasons to use bitcoin instead of say, U.S. dollars:

  • Bitcoin transactions have few or no fees. This makes them appealing for merchants -- instead of paying a credit card processing fee of, say, 2% of a sale, a merchant can pay a minuscule fee by accepting a bitcoin payment.
  • All information is transparent. Details of every financial transaction involving Bitcoin are available on a public "ledger" known as the blockchain, for everyone to see. While personal information is not visible, you can see what amount was transferred, and what bitcoin address it was sent to. This makes it easy to verify transactions, and makes it impossible for bitcoin to be manipulated by any person, organization, or government.
  • As alluded to in the previous point, Bitcoin is anonymous. Transaction amounts and times are public, but no identifying information is. While this has been used for negative purposes such as buying illicit items (search online for "Silk Road" for an example), it can also be an advantage for everyday consumers.

Disadvantages of bitcoin

Every currency has its flaws (yes, even the U.S. dollar), and since bitcoin is so new, it has some unique drawbacks that people should be aware of before getting involved:

  • Bitcoin can be a highly volatile currency, which is one of its biggest disadvantages. In fact, on the day I wrote this article (Jan. 5, 2017), bitcoin hit a multiyear high of $1,153.02, then plunged 23% to an intraday low of $887.47, and then finally rebounded to just under $974 as I write. The value of a bitcoin has risen 400% over the past 16 months alone. Price swings like these are unheard of with most traditional currencies, but they're not rare with Bitcoin.
  • While many retailers accept bitcoin, it's nowhere near universally accepted. Several proponents have "lived off of bitcoins" for certain periods of time, but it's not practical for the average person to rely completely on bitcoin as their only currency.
  • Bitcoin wallets can be lost. While I'm not sure that this risk is any greater than that of losing an actual wallet containing paper money, there are other risks such as hacking, viruses, and simply forgetting your passcode to a bitcoin wallet. Entire bitcoin exchanges have been hacked, costing bitcoin owners millions of dollars. While there are safeguards to protect against most permanent losses, and the security features available to bitcoin users are continuously evolving, there's still a very real risk.

The bottom line on bitcoin

While bitcoin certainly has some advantages over traditional currencies, it's important to be aware that virtual currencies are still in their infancy, and as such, they're bound to have some growing pains along the way. At this point, however, the long-term viability of bitcoin as a universally recognized currency remains to be seen.

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Teresa Kersten is an employee of LinkedIn and is a member of The Motley Fool's Board of Directors; LinkedIn is owned by Microsoft. Matthew Frankel has no position in any stocks mentioned. The Motley Fool owns shares of and recommends Intuit. The Motley Fool recommends Home Depot. The Motley Fool has a disclosure policy.