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In This Chapter

▶ Getting to know a bit about bitcoin

▶ Understanding how bitcoin benefits us all

▶ Staying safe and stashing your cash

So, bitcoin … you know it’s a new form of money – a digital currency, to be exact – but just how does it work? Sit yourself down comfortably, and we will begin with the basics, the three major aspects of bitcoin:

✔ Origin: How it came to be

✔ Technology: How it works behind the scenes

✔ Currency: Using bitcoins as money

Exploring each of these aspects will help you understand bitcoin (or BTC, as it’s sometimes known) and find out whether and how it can help you. Don’t worry – we will stay top-level for now. Later chapters dig deeper.

Ready? Let’s go.

The Origin of Bitcoin

The most important aspect of bitcoin may be the concept behind it. Bitcoin was created by developer Satoshi Nakamoto. Rather than trying to design a completely new payment method to overthrow the way we all pay for things online, Satoshi saw certain problems with existing payment systems and wanted to address them.

The concept of bitcoin is rather simple to explain: During the financial crisis of 2008, people from all over the world felt its debilitating economic effects. And at the time of this writing (early 2016), many are still feeling the effects in terms of the dwindling value of their fiat currency (the currency approved by a country’s government). As the global financial system teetered on the brink of collapse, many central banks engaged in quantitative easing – or in simple terms, turned on the printing presses. Central banks flooded the markets with liquidity and slashed interest rates to near zero in order to prevent a repeat of the Great Depression of the 1930s. The effect of this was large-scale fluctuations in fiat currencies and what has since been termed currency wars – a race to competitively devalue so that an economy can become more viable simply by its goods and services being cheaper than those of its neighbors and global competitors. The response of central banks around the world was the same as it always has been when these things happen: Governments had to bail out affected banks and they printed extra money, which further devalued the existing money supply.

In bailing out the banks, there was a net transfer of debt to the public purse, thus adding to future taxpayer liabilities. This created a sense of social injustice among some quarters. Aside from that, no one really knows what the long-term effects of quantitative easing will be. Perhaps inflation at some point in the future and a further devaluation of those fiat currencies who engaged in the schemes? What seemed clear is that central bankers, supposedly acting independent of governments, were taking many economies into the unknown and were prepared to devalue their fiat currencies at will just to keep the wheels turning. In doing so, they bailed out the very same institutions and bankers whose reckless behavior had brought about this crisis in the first place. The only other option would have been to let the whole system collapse and be purged, as for instance happened in Iceland. That country defaulted on its debt and endured great economic turmoil in the aftermath of that event.

Therein lies the genesis of bitcoin: a decentralized financial system taken out of the hands of a few elite global decision-makers.

Satoshi Nakamoto decided it was time for a new monetary system, one so different from the current financial infrastructure that you could even call it a disruptive force. Whether or not bitcoin was ever intended to completely replace the financial infrastructure remains unclear, but we do know that multiple banks are looking at the technology that powers bitcoin, because they see its potential and want to adopt this technological power for their own use. They are free to do so, of course, as the core bitcoin technology – known as a blockchain (much more on that in Chapter 7) – was open source from day one for everyone to see. Creating bitcoin as open source meant that anyone was allowed to come up with their own improvements and build platforms on top of it.

Viewed from this angle, bitcoin could be said to have a driving ideology. It is about so much more than just using the associated coin as a payment method. It is about using the underlying technology and discovering its full potential over time. How you decide to use that technology is completely up to you. It can be adapted to fit nearly any financial need you can imagine. All you really need to do is be open to the technology itself. Even though you may not grasp the entire concept from the start, just keep an open mind.

Let’s face it: The intersection of finance and technology is plagued with troubles. All of us have been affected by the banking crises of the 21st century, and quite a few countries are still struggling to recover from that financial fiasco. Bitcoin developer Satoshi Nakamoto was a victim of this mismanagement by central banks and thought long and hard to come up with a proposed solution. The mainstream financial infrastructure is flawed, and a viable alternative is more than welcome. Whether or not that alternative will be bitcoin remains to be seen.

When Satoshi Nakamoto came up with the idea of bitcoin, one key factor was destined to play a major role: decentralization. Decentralization means we are all part of the bitcoin ecosystem, and we all contribute to it in our own ways. Rather than relying on a government, bank, or middleman, bitcoin belongs to everyone, in a system called peer-to-peer, and we all make up the bitcoin network. Without individual users, there is no bitcoin. The more people embrace bitcoin, the better it works. Bitcoin needs an ever-expanding community who actively use bitcoin as a payment method, either by buying goods and services with bitcoins or offering goods and services in exchange for bitcoins.

Due to the digital currency’s free market spirit, anyone in the world can set up their own business and accept bitcoin payments in a matter of minutes. Plus, existing business owners can offer bitcoin as an alternative payment method, with the potential to expand their customer base on a global scale. It’s easy to do your bit(coin) and get involved.

Getting Technical

As you’d expect with a peer-to-peer payment system, the technology powering bitcoin digital currency is a force to be reckoned with. A lot of focus is being put on making bitcoin’s blockchain technology a powerful tool in the financial sector. That’s only to be expected, because most of the focus regarding bitcoin revolves around the currency aspect.

Bitcoin’s technology offers unprecedented technological options and abilities only dreamt of a few years ago. And a great deal of potential remains hidden below the surface for the time being, as some of the world’s brightest minds try to grasp the potential implications of integrating bitcoin technology into our daily lives. There is more discussion about this in Chapter 3.

Bitcoin technology has been underestimated in the past, and to be honest, it has a bit of a checkered history. Several platforms have been created in order to make bitcoin more accessible and usable, but that has not always lead to a happy ending – especially when it comes to security. New tools like bitcoin represent a learning curve for everyone. Bitcoin is only slowly starting to mature in that regard.

The potential of bitcoin technology has attracted many interested parties from all aspects of life. The frontrunners are people in the financial sector, who are intrigued by the open ledger aspect of bitcoin technology. Open ledger means anyone in the world can see every financial transaction on the network take place in real time. Even though that idea might seem a bit scary, open ledger in a system allowing us to track multiple things would be beneficial. None of these implementations have to be related to finance per se, but there are plenty of options worth exploring in that sector.

When it comes to accepting bitcoin payments, there’s a lot of room left to explore. Although integrating a bitcoin payment option onto your website just takes a few minutes, in-store payments are a slightly different manner. However, multiple payment processors will gladly help you convert your bitcoin transactions to local currency. To make that deal even better, you receive payments to your bank account the very next business day, rather than waiting up to a week for credit card payments to clear through the banking network. And the fees for accepting bitcoin as a payment solution are likely to be low as well.

Bitcoin as Currency

Whenever we talk to people about bitcoin, one of the first things they mention is the current bitcoin price. At the time of writing, the price hovers around $300 per bitcoin.

Bitcoin had nearly no value until 2011 and only then started climbing the charts slowly. However, in 2013 bitcoin saw a peak price of well above $1,100, which some attributed to market manipulation by a trading bot on the largest bitcoin exchange at that time.

The bitcoin price is determined by its users under the free market principle of supply and demand. And although the bitcoin supply is limited to 21 million “coins” in total – to be reached by 2140 – no huge demand exists for this digital currency just yet. As bitcoin matures further over the next few years, that story might change.

Why 21 million? Nobody knows. Some believe it’s because it’s a mathematical equation that brings us to the amount of coins available until the year 2140 with rewards being halved every four years.

Keep in mind that bitcoin is a payment method that can be used online and in the real world as well. However, that does not make bitcoin a currency, because it lacks certain aspects of the “ground rules” that determine whether a payment method is a currency or not. But according to most experts around the world, bitcoin is to be considered a digital currency in its truest form. As we try to wrap our hands around this new currency technology, who is to say whether or not that term is correct? What we can say is that bitcoin is a valid payment method for many goods and services, and that is what makes its digital aspect so much fun to explore.

By being a decentralized payment method (meaning no government or official entity controls it), bitcoin lets anyone in the world accept a digital currency payment from anyone else in the world. Bitcoin is the same digital currency across borders, no matter what the country’s physical currency, and can be converted into nearly any local currency on request. With no transaction fees to speak of, and being able to receive your payments the next business day, what’s not to like? On top of that, mobile payments are on the rise, so bitcoin is an excellent alternative mobile payment method to take your customer base to the next level, at very little cost.

Bitcoin as a currency tool

For bitcoin to be widely thought of as a currency, it needs to be used more and more. As you might imagine, it’s hard enough to convince merchants to accept bitcoin as a brand new currency, but it is even harder to convince consumers to get involved with digital currency.

The advantages for the merchants are crystal clear: Bitcoin cuts down on fees and other costs. But if no one visiting your store is using bitcoin as a payment method, there is no benefit in accepting it either. So it’s up to the consumer to set the wheels in motion.

To make bitcoin a more convenient currency tool, you can turn to familiar-looking plastic:

✔ Prepaid bitcoin cards

✔ Bitcoin debit cards

These plastic cards can be topped up with bitcoin – or linked to an existing bitcoin wallet (for more on wallets, see Chapter 5) – allowing you to spend digital currency wherever major credit cards are accepted. The merchant still pays the same fees as with regular card transactions and still receives funds in local currency.

Bitcoin is still some way from being a mainstream payment method; retailers need to be convinced to accept bitcoin. We think the time has come to start convincing the everyday consumer to leave the cash and cards at home and pay with bitcoin using their mobile device. That will not happen overnight, so until then, bitcoin users must be patient (while reveling in the thought that they’re ahead of the game).

Bitcoin and retailers

As a forward-thinking retailer, you should be ready and prepared to accept bitcoin payments for your online or brick-and-mortar shop. Accepting bitcoin payments doesn’t require you to deploy additional hardware, as it peacefully coexists next to your existing payment infrastructure. You do need an Internet connection however, but most retailers already have that.

Here are some of the main advantages of accepting bitcoin:

✔ Accepting bitcoin payments is subject to very low transaction fees – a welcome change from the 3 to 5 percent per transaction you lose when accepting any type of card transaction.

✔ Bitcoin payments can be converted to a local currency of your choice, and funds are deposited to your bank account the very next business day. If you’re using a good payment processor, they will charge you only a small margin to convert the bitcoin to your local currency. Compare that to card transactions, where you have to wait up to a week or so before you receive the money – minus the 3 to 5 percent transaction fee plus an additional fee for any currency conversions – and bitcoin is the clear winner across the board.

✔ Bitcoin is a global currency. It works the same in every country around the world. Everywhere you go, the bitcoin symbol is the same.

✔ Bitcoin value is calculated to the eighth digit after the decimal point (the hundred millionth), unlike cash, which is only broken down to hundredths, or cents. For example, trading in U.S. dollars allows you to charge $11.99. Bitcoin would allow a charge of 11.98765432 BTC. Although this may not seem to be of significance now, should the value of BTC exponentially increase in the coming years, those additional decimal places will be very useful for accurate pricing in the future.

✔ Accepting bitcoin payments lets you expand your potential customer base on a global scale, as there is no need to offer a plethora of local currencies when offering bitcoin will suffice.

✔ Bitcoin-to-bitcoin means it keeps its value during the transaction and it is later on converted to a currency of your choice.

Bitcoin and consumers

As a consumer, the advantages of using bitcoin are pretty straightforward. First of all, you no longer need to use cash to pay for goods or services at a bricks-and-mortar location. Cash is clunky to use, and it fills up your wallet with banknotes and your pockets with coins so quickly that you just want to spend it faster to get rid of it (or is that just me?). Plus, the ever-present – if slight – chance exists that you may be carrying counterfeit money without even knowing it. Should you ever be in that situation while trying to pay for something, you will not be having a fun afternoon, we can tell you that much.

Bitcoin is also a viable alternative to paying for goods and services with your bank account or bank/credit/debit card, for the following reasons:

✔ Rather than relying on the services provided by a centralized service such as a bank, bitcoin lets you make any payment to anyone at any time, regardless of business hours, weekends, and holidays.

✔ When you make an online payment, it is processed immediately.

✔ Bitcoin is a borderless digital currency, operating in the same manner in Europe as it does in North America, Africa, Asia, Latin America, and Australia. Anyone in the world can use bitcoin to pay for anything else in the world, albeit you might have to jump through some hoops in order to get there.

✔ Many efforts are underway to push bitcoin’s acceptance by merchants, combined with new and improving alternative ways to spend bitcoin conveniently (such as the previously mentioned debit cards).

Figuring Out How Bitcoin Works

Bitcoin is changing the way people think about money by planting a seed of doubt in people’s minds – in a positive and thought-provoking way. Mind you, given the financial crises over the past decade, it’s understandable that some people are trying to come up with new and creative solutions for a better economy. Bitcoin, with its transparency and decentralization, may prove to be a powerful tool in achieving that goal.

One thing bitcoin does is bypass the current financial system and could therefore potentially provide services to unbanked and underbanked nations all around the world. Whereas most people in the Western world find it normal to have a bank account, the story is quite different elsewhere. Some countries in Africa, for example, have an unbanked population of anywhere from 50 to 90 percent. Do these people have less right to open and own a bank account than Americans or Europeans do? Absolutely not, but doing so may come with rules so strict as to be unobtainable for many citizens.

For a while now, society has been evolving toward a cashless ecosystem: More and more people use bank and credit cards to pay for goods and services both online and offline, for example. Mobile payments – paying for stuff with your phone – are now on the rise, which may become a threat to card transactions. Bitcoin has been available on mobile device for years now.

We’re slowly starting to grasp the concept of blockchain technology’s potential and future uses: A blockchain (see Chapter 7) can do pretty much anything; you just have to find the right parts of the puzzles and fit them together.

Here are some examples of what bitcoin technology is capable of (see Chapter 3 for more on these):

✔ Taking on the remittance market (transfers of funds between two parties) and coming out on top in every aspect.

✔ Sending money from one end of the world to the other end in only a few seconds.

✔ Converting money to any local currency you desire.

✔ Overriding the need for a bank account, making bitcoin an incredibly powerful tool in unbanked and underbanked regions of the world.

What if you live in an unbanked region and have no reliable access to the Internet? There’s a solution for that as well: Some services allow you to send text messages to any mobile phone number in the world in exchange for bitcoin or a few other digital currencies. Once again, bitcoin proves itself a very powerful tool in underbanked and unbanked regions of the world.

Perhaps the most impressive showcasing of what bitcoin can do is the bitcoin network itself. All transactions are logged and monitored in real time, giving users unprecedented access to financial data from all corners of the world. Furthermore, the blockchain lets you track payments’ origins and destinations, even as money is on the move in real time. Such valuable insight will hopefully be adopted in the current financial infrastructure, even though there may be a period of adjustment while that takes place.

Using Bitcoin Anonymously

One of the biggest misconceptions surrounding bitcoin is whether or not digital currency is truly anonymous. The simple answer to that question is “no, not entirely.” But a certain level of anonymity is tied to using bitcoin and digital currency in general. Whether you can label that as “anonymous enough” is a personal opinion.

Whenever you use bitcoin to move funds around, you can essentially hide your identity behind a bitcoin wallet address (Chapter 5 talks more about wallets). These wallet addresses are a complex string of numbers and letters (both lower- and uppercase) and provide no insight into who you are or where you’re located. In that regard, bitcoin offers a certain level of protection you won’t find in most other payment methods.

But that is also as far as the anonymity goes, because bitcoin wallet addresses are part of a public ledger – the blockchain – which tracks any incoming and outgoing transfers to and from any address at any given time. For example, if we were to send you 0.01 BTC right now, anyone in the world could see the transfer from wallet address A to wallet address B. No one would know whom those addresses belong to, but the transaction itself would be in plain sight.

Once someone knows your public wallet address, they can monitor it at the www.blockchain.info website at any time. In doing so, not only will they see current transactions, but blockchain.info will also display a list of all previous transactions associated with your bitcoin address. As a result, if someone knows your public wallet address, there is no real anonymity when it comes to using bitcoin, as all of your financial transactions are publicly visible.

This story changes a bit whenever bitcoin exchanges are involved (Chapter 2 talks more about exchanges). Anyone can see a transfer from your bitcoin wallet to the wallet address of the exchange, as these are publicly listed in most cases. However, if you sell your bitcoin, it becomes a lot harder to track where those coins went to. In that regard, there is a small sense of anonymity, but once again, it depends on your personal opinion as to how secure this is.

Introducing third-party anonymity

Ways to stay anonymous when using bitcoin do exist, though none of these methods is very user-friendly at this time. Generally speaking, those who are interested in anonymity may have something to hide. It could be that they are seeking to avoid paying taxes or that they are purchasing illegal goods or services in their jurisdiction. Using services such as an online wallet, you can “mix up” coins and extract them from a completely different address, without the addresses being linked together in any way. This technology is developing even as we type. But using such services involves a few risks, and if your coins are lost in the process, there is no way to get them back. Don’t worry too much about losing your coins though – we explain more on how to manage them and your wallet in Chapter 5.

Always do your own research before using any external service and ask yourself whether or not anonymizing your BTC balance is really that important to you or not.

One of the biggest issues concerning external services is the fact you are relying on a third-party to anonymize your coins. Bitcoin and digital currency were created to remove any middleman from the equation and put the users in control of their funds at all times. Trusting a third party with your money essentially goes against bitcoin’s core values. Plus, using an anonymity service for bitcoin raises suspicion of money laundering. Considering that you are already semi-anonymous by only exposing your public bitcoin address, taking things one step further could raise suspicions around your possible intentions. Chapter 5 covers more on how to manage your funds and the most appropriate ways to do this.

Protecting privacy

When it comes to protecting your privacy, the story is similar.

There are ways to protect your privacy when using bitcoin to move funds around, but these require some effort and planning:

✔ You can generate a new address for every individual transaction.

✔ You can avoid posting your public bitcoin wallet address in a public place.

Generating a new wallet

When receiving funds from another user, you can opt to give them a brand new, freshly generated wallet address, which cannot be directly linked to any existing addresses you already own. This type of throwaway address lets users isolate transactions from one another, which is the primary precaution you can take to protect your privacy.

However, depending on how you store your funds – which type of bitcoin client you are using and which operating system you’re using it on – you may also be able to generate change addresses. For example, if you install the Bitcoin Core client on your computer or laptop, you can create a new change address every time you send funds to someone else.

A change address occurs whenever you have a certain amount of bitcoin in your wallet balance and are sending less than that total amount to another user. Let’s say you have 3 bitcoin and need to spend 0.25 bitcoin. You need to receive the “change” – 2.75 bitcoin in this case – in your wallet. The Bitcoin Core client (as well as a few other desktop clients) allows you to have this “change” sent to a newly generated address. In doing so, there is no direct link between your original address and the new address, even though you can trace back the steps by looking at the blockchain itself.

Keeping your wallet address secret

Another way to protect your privacy – to a certain extent – is by not posting your public bitcoin wallet address in a public place. Using the address on your website, blog, social media, or on a forum is not a good idea if you want privacy. Once someone stumbles across your wallet address and can somehow tie it to you personally, there is no way to restore privacy other than by using one of the aforementioned methods.

Demonstrating fungibility

The main problem with bitcoin is its fungibility, or more correctly, lack thereof. Fungibility has nothing to do with mushrooms, by the way. It’s just a fancy term for goods being interchangeable or capable of being substituted … and that suits bitcoin.

Most governments in the world will stick to their own, controllable system of issuing fiat currency. Local currencies are centralized and issued by a central bank. If they need more money, the central bank can simply issue more money by turning on the printing presses or engaging in quantitative easing as it’s been termed. Thus, either by order of the government or by acting as an independent authority – a central bank may boost liquidity in the economy by carrying out quantitative easing. With bitcoin, this is not the case, as there is a fixed liquidity cap of 21 million coins. Thus, the cap of 21 million coins essentially means that bitcoin is not fungible as other fiat currencies are.

Trusting the Idea of Bitcoin

One of the biggest hurdles to overcome whenever a new technology comes knocking on your door is whether or not you should put your trust in it. In the case of bitcoin, that trust has to work on both sides. Even though you as the user are always in control of your own finances, you still have to trust the rest of the bitcoin network to not drop off the face of the earth tomorrow.

The chances of bitcoin disappearing are so slim that it isn’t something you should worry about. However, if there is one thing that life has taught most of us, it is that there are no certainties in life. Luckily for everyone involved, the bitcoin network consists of many individual users, as well as bitcoin nodes, which are put in place to keep the network running at all times. We explain more about nodes and their role in Chapter 6.

This brings us to the concept about bitcoin that people have the most difficulty with in terms of trust: decentralization. As mentioned, bitcoin is a decentralized digital currency, which means there is no central point of failure that would cause the bitcoin network to not recover. Every individual user is an integral part of the bitcoin ecosystem, so it would take a nearly impossible amount of collaboration in order to shut down everyone at the same time.