Bitcoin. It’s one the biggest buzzwords in the financial technology industry right now, but also one of the least understood. With cryptocurrency back in the news again, now’s a better time than ever to delve into the weeds and learn more about how to invest. If you’re standing, sit down, because here’s a breakdown of everything you need to know before buying your first bitcoin — or deciding not to.
Bitcoin Basics: Why People Buy Cryptocurrency
You don’t have to understand bitcoin to realize that banks, businesses, the bold, and the brash are cashing in on cryptocurrency. Just two years ago the price of a bitcoin was $710.09. This morning, the exchange rate for a single bitcoin had grown to about $4,000. It doesn’t take an economics degree to know that the folks who invested in bitcoin a few years ago are now patting themselves on the back — but the good news is, it’s not too late to get in the game.
It may seem hard to believe that a digital currency could be worth thousands of dollars. After all, unlike physical currency like precious metals or printed money, bitcoin is just lines of code. So what makes bitcoin so valuable?
The worth of currency used to be stipulated by precious metals. From 1879 until 1933, for example, Americans could trade the federal government $20.67 for an ounce of gold. For the United States, that all changed at the height of the Great Depression when America faced mounting unemployment rates and spiraling deflation. In 1933, President Franklin D. Roosevelt decided to cut the United States’ ties to gold, effectively allowing the Federal Reserve to pump more money into the economy than the federal government had the gold to back.
The United States now has what is called a “fiat” money system, meaning the dollar’s value is determined by faith, rather than a physical asset. The dollar, for example, is worth far more than the value of the ink and paper that it’s printed on. Bitcoin functions by the same principles. Although the lines of code that make up each bitcoin are worthless in and of themselves, the international market has come to value each bitcoin at thousands of dollars. That’s because bitcoin is scarce and becomes more difficult to obtain over time. Here’s why:
When the bitcoin program was launched on January 3, 2009, bitcoin was produced at a rate of 50 bitcoin every 10 minutes, or 7,200 bitcoin every day. At today’s value, 7,200 bitcoin would be worth just under $50 million, but at the time each bitcoin was worth just a few cents.
According to the bitcoin program, however, the rate that bitcoin is produced cuts in half about every four years. On November 28, 2012, for example, the rate of production changed from 50 to 25 bitcoin every 10 minutes, or 3,600 bitcoin every day. That rate halved again on July 9, 2016 to 12.5 bitcoin every 10 minutes and is expected to halve a fourth time sometime in 2020. At this rate, the total number of bitcoins in circulation will approach a limit of 21 million.
The rate at which bitcoin can be produced cuts in half every four years, meaning that the currency becomes more difficult to obtain over time. In fact, at the time of writing 17.37 million, or 82.70%, of the total bitcoin have already been created. If the demand for bitcoin exceeds the rate at which it can be produced, the price will increase. That means investing in bitcoin now should be a sure fire bet to pay off four years down the road, right? Well, it’s complicated.
If you’re anything like me, chances are your eyes glaze over at cautionary tales, words of wisdom, and long-winded explainers. That’s all fine and well for the real world, but when it comes to buying and selling cryptocurrency, the most valuable investment you can make is time. Cryptocurrencies are wildly unpredictable, even ones as popular as bitcoin. Although bitcoin is worth $4,000 today, it was also worth $19,783.21 on December 17, 2017.
The value of bitcoin is heavily dependent on (a) the faith of investors, (b) the integration of cryptocurrency into current financial institutions, and (c) the public’s willingness to learn and use a new form of currency. Research is key when you’re investing in stocks, but it’s life-saving when you’re investing in cryptocurrency. That’s why we’ve taken the time to explain the technology behind bitcoin before showing you how to buy it. If you feel ready to leave the training wheels behind, you can skip to “Step One: Sign Up for a Bitcoin Wallet.”
How Does Bitcoin Work?
Bitcoin and other cryptocurrencies operate on a technology called “blockchain.” You may have heard of blockchain referred to as a “distributed, decentralized, public ledger,” but the technology is actually easier to understand than that definition sounds. At its most basic level, blockchain is literally a chain of blocks — only not in the traditional sense of those words. When we say the words “block” and “chain” in this context, we are actually talking about digital information (the “block”) stored in an online database (the “chain”). Here’s how it works.
You have all these people, all over the world, who have bitcoin. According to a 2017 study by the Cambridge Centre for Alternative Finance, the number may be as many as 5.9 million. Let’s say one of those 5.9 million people wants to spend one or many of their Bitcoin. This is where blockchain comes in.
With other public recorders of information, like the Securities Exchange Commission (SEC), Wikipedia, or your local library, there’s someone in charge of vetting new data entries. With blockchain, however, that job is left up to a network of computers. These networks often consist of thousands (or in the case of Bitcoin, about 5 million) computers spread across the globe. When you go to make a purchase using bitcoin, that network of computers rushes to check that your transaction happened in the way you said it did. They confirm the details of the purchase, including the transaction’s time, dollar amount, and participants.
When consumers make purchases using the U.S. dollar, banks and credit card companies verify the accuracy of those transactions. Bitcoin performs this same function without these institutions using a system called “hashing.” When one person pays another for goods using bitcoin, computers on the bitcoin blockchain rush to check that your transaction is accurate. In order to add new transactions to the blockchain, a computer must solve a complex mathematical problem, called a “hash.”
Solving a hash takes computers, and even supercomputers, an average of 10 minutes. During that time, computers also check the accuracy of new transactions on the bitcoin blockchain. If a computer is the first to solve a hash, they store newly-made transactions as a block on the blockchain, at which point they become unalterable.
How is Bitcoin Created?
When computers successfully add a block to the blockchain, they are rewarded with cryptocurrency. Earlier we discussed how the amount of bitcoin produced every 10 minutes cuts in half every four years. At the time of writing, computers receive 12.5 bitcoin, or approximately $60,600 USD, for each block that they add to the blockchain.
If the tune of sixty grand sounds enticing, be warned that the process of adding blocks to the blockchain, what the cryptocurrency world calls “mining,” is not easy. In fact, the odds of solving one of these problems on the Bitcoin network are about one in seven trillion (12 zeros). To put that number in perspective, the odds of winning the jackpot lottery are one in 13 million. To solve complex math problems at those odds, computers must run programs that cost them significant amounts of power, energy, and money.
Similar to winning the lottery, solving hashes essentially comes down to chance — but there are ways to increase your odds of winning in both contests. With bitcoin, arriving at the right answer before another miner has almost everything to do with how fast your computer can produce hashes. Just a decade ago, bitcoin mining could be performed competitively on normal desktop computers.
Over time, however, miners realized that graphics cards commonly used for video games were more effective at mining than desktops and graphics processing units (GPU) came to dominate the game. In 2013, bitcoin miners began to use computers designed specifically for mining cryptocurrency as efficiently as possible, called Application-Specific Integrated Circuits (ASIC). These can run from $500 to the tens of thousands.
Today, bitcoin mining is so competitive that it can only be done profitably with the most up-to-date ASICs. When using desktop computers, GPUs, or older models of ASICs, the cost of energy consumption actually exceeds the revenue generated. Even with the newest unit at your disposal, one computer is rarely enough to compete with what miners call "mining pools."
A mining pool is a group of miners who combine their computing power and split the mined bitcoin between participants. A disproportionately large number of blocks are mined by pools rather than by individual miners. In July 2017, mining pools and companies represented roughly 80% to 90% of the computing power on the bitcoin network.
In the real world, the power from the millions of computers mining on the bitcoin network is close to what Denmark consumes annually. All of that energy costs money and according to a recent study from research company Elite Fixtures, the cost of mining a single bitcoin varies drastically by location, from just $531 to a staggering $26,170. Based on average utility costs in the United States, that figure is closer to $4,758.
What Do I Need to Buy Bitcoin?
1. Digital Wallet: In order to conduct transactions on the bitcoin network, participants need to run a program called a “wallet.” Bitcoin are not technically “coins,” so it only seems right that a bitcoin wallet would not actually be a wallet. Instead of leather, wallets are made up of two unique and distinct cryptographic keys: a public key and a private key. The public key is the location where transactions are deposited to and withdrawn from. This is also the key that appears on the blockchain ledger as a user’s digital signature, not unlike a username on a social media newsfeed. The private key is the password required to buy, sell, and trade the bitcoin in a wallet.
2. Personal Documents: The U.S. Securities and Exchange Commission requires users to verify their identities when registering for digital wallets as part of its Anti-Money Laundering Policy. In order to buy and sell bitcoin, you will need to verify your identity using several personal documents including your driver’s license and social security number.
3. Secure Internet Connection: If you choose to trade bitcoin online, use discretion about when and where you access your digital wallet. Trading bitcoin on an insecure or public wifi network is not recommended and may make you more susceptible to attacks from hackers.
4. Bank Account, Debit Card, or Credit Card: When you exchange USD or another currency for bitcoin, you will need funds to make those transactions. Bitcoin wallets can connect directly to your bank account, debit card, or credit card.
5. Bitcoin Exchange: After you’ve set up your wallet with a payment method, you'll need a place to actually buy bitcoin. Users can buy bitcoin and other cryptocurrencies from online marketplaces called “exchanges,” similar to the platforms that traders use to buy stock. Exchanges connect you directly to the bitcoin marketplace, where you can exchange traditional currencies for bitcoin.
Before You Buy: Is Bitcoin Anonymous?
Anyone can view a history of transactions made on the blockchain, even you. But while transactions are publicly recorded on the blockchain, identifying user information is not. When reviewing the transaction history of your bank account, for example, you’ll notice that the names of vendors are included on your bank statement. On the bitcoin blockchain, however, only a user’s public key appears next to a transaction — making transactions confidential but not anonymous.
This is an important distinction. International researchers and the Federal Bureau of Investigation have claimed time and again that they can track transactions made on the blockchain to user’s other online accounts, including their digital wallet. That’s a direct result of that Anti-Money Laundering Policy we mentioned earlier.
Step One: Sign Up for a Bitcoin Wallet
If you’ve made it through the winding road of explanations leading up to this point, congratulations! You may very well be ready to buy your first (fraction of a) bitcoin. The last thing you’ll need before you’re out the door is a place to store them.
When it comes to choosing a bitcoin wallet, you have options, but the Louis Vuitton and Gucci of the cryptocurrency world right now are “software” and “hardware” wallets. Software wallets are mobile applications that connect with your traditional bank account. These wallets allow for quick and easy access to bitcoin, but the drawback is they put your money in the hands of a third-party company. Although the leading software wallets are trustworthy, popular third-party companies have collapsed, or been hacked, in the past. Much like you wouldn’t store thousands of dollars in your mattress, users with larger sums of bitcoin should consider storing their money more securely.
Coinbase is the most popular software wallet available in the United States, in part because it has a website, mobile application, and stores 98 percent of customer currencies offline for added security. For beginners, Coinbase is the best and easiest place to start because it is connected directly to a bitcoin exchange, which simplifies the buying and selling process. Blockchain.info is another popular wallet connected to the bitcoin exchange, but the wallet is not supported by a mobile application. Users can also download mobile-only wallets such as Bitcoin Wallet for Android or Blockchain Bitcoin Wallet for iOS.
Hardware wallets are a little more old-school but tend to be considered more secure because they are kept offline. These wallets store a user’s private key on a physical hardware device similar to a flash drive, which prevents hackers from accessing a user’s private key through an internet connection.
Step Two: Connect a Bank Account
In order to purchase bitcoin, you need to connect your wallet to a bank account, debit card, or credit card. Although these payment methods all perform the same function — exchanging traditional currency for bitcoin — they each carry their own set of fees.
Transactions made using a bank account can take 4-5 days to process on Coinbase, but are generally recommended for first-time investors. By linking a bank account to your wallet, you can buy and sell bitcoin and deposit that money directly into your account. Bank accounts are generally recommended if you are dealing with larger sums of money. At the time of writing, bank accounts allow users to spend as much as $11,250 per week.
Debit and credit cards, on the other hand, allow you to buy bitcoin almost instantly. The drawback is that on Coinbase and other popular exchanges, debit cards can only be used to purchase crypto — and even then, only in smaller amounts. Users cannot sell bitcoin or deposit money into their bank account when their wallet is connected to a debit card.
Step Three: Choose a Bitcoin Exchange
Bitcoin exchanges are online marketplaces where you can trade bitcoin for traditional currencies, say BTC for USD. Just like when you go to make a purchase online, you have options. There’s eBay, Amazon, Etsy, and Alibaba — to say nothing of the millions of private retailers who use these websites to sell their product. The same is true of buying bitcoin. Even if two exchanges trade the same cryptocurrency, it is likely that they each offer slightly different services. Exchanges can vary in reputation, reliability, security, processing fees, exchange rates, and cryptocurrencies available for trading. Before settling down with an exchange, date around. Here are our top five recommendations for where to start.
Best for Beginners: Coinbase
Coinbase is the most popular and respected digital currency exchange in the United States. Although Coinbase only trades in five cryptocurrencies — Bitcoin, Bitcoin Cash, Ethereum, Litecoin, and Ethereum Classic — the exchange offers a way to securely buy and store cryptocurrency in one location. Coinbase charges a one percent fee for U.S. transactions from a bank account or Coinbase USD wallet. Purchases made using a credit or debit card are charged a 2.49 percent fee. Plus, Coinbase secures cash balances up to $250,000 in the event of theft or breach in online storage.
Best for On the Go: Square Cash
The Square Cash app is a leader in peer-to-peer money transfers, right alongside PayPal-owned Venmo. The Cash app comes from Square, the company that makes those mobile credit card readers. Square is a huge financial technology company that includes many other services — one of which is trading bitcoin. The Cash App allows users to buy and sell bitcoin without processing fees. Unlike most online exchanges, the Cash App stores your bitcoin in your Square Cash Account, rather than a separate digital wallet. If you’re worried about security, however, you can send the bitcoin in your Square Cash Account to another wallet of your choosing. Square limits purchases at $10,000 per week, but there is no limit to what you can sell.
Best for Bitcoin on a Budget: Robinhood
Robinhood launched in 2013 as a fee-free stock brokerage. In February 2018, the company expanded into the bitcoin and ethereum markets, along with market data for another 15 currencies, allowing users to trade cryptocurrency without a fee. As is the case with Square, Robinhood stores bitcoin in the same Robinhood account that is used for stocks. Robinhood is mobile first and just recently added a Web version, so it is best for people comfortable managing money from their phone or tablet. The drawback of trading bitcoin on Robinhood is that the application is only available in 27 states at the time of writing.
Best for Big Spenders: Coinbase Pro (Formerly GDAX)
If you feel comfortable trading on Coinbase and want to step up your trading volume, you may be ready to switch from Coinbase to Coinbase Pro. Formerly known as Coinbase Global Digital Asset Exchange (GDAX), the trading platform uses interfaces similar to Bloomberg terminals and active stock, commodity, and option trading platforms. Coinbase Pro offers options to make market orders, limit orders, and stop orders in addition to traditional buying and selling. Instead of trading exclusively from USD to cryptocurrency, Coinbase Pro allows users to trade between cryptocurrencies, say between Ethereum and Bitcoin. Coinbase Pro charges fees ranging from 0.10 percent to 0.30 percent based on your trading volume. Most people trade less than $10 million per month and will fall into the 0.30 percent tier. If you want to try Coinbase but with much higher volume, this platform is the way to go.
Best for Branching Out: Binance
Binance may be your best bet if you’re looking to diversify your cryptocurrency portfolio. The online exchange supports multiple currencies and even more digital currencies, including Bitcoin, Ethereum, Ethereum Classic, Litecoin, Ripple, Bitcoin Cash, and many fledgling cryptocurrencies you may not have heard of. Many exchanges that trade this many cryptocurrencies charge higher fees, but Binance charges a flat rate of 0.1 percent for trades. While this is platform offers a huge range of currencies at a low cost, there are some bugs reported with the Android mobile app and some users have reported delays withdrawing certain currencies.
Best for Buying in Cash: Peer-to-Peer
If you have a wallet, but it isn’t connected to a bank account, debit, or credit card, you can buy bitcoin using cash through a peer-to-peer exchange. Unlike typical bitcoin wallets, peer-to-peer exchanges work similarly to Craigslist for cryptocurrency, allowing buyers and sellers in the same areas find each other and meet up to trade bitcoins for cash. With peer-to-peer exchanges, it’s important to remember that you are trading high-value currency with strangers you have never met before. If you choose to trade bitcoin in this way, we recommend that you meet buyers and sellers in a public place with high visibility.
Your bitcoin exchange and bitcoin wallet do not need to be the same. While most exchanges offer wallets for their users, security is not their primary business. If you do choose to use a wallet offered by an exchange other than Coinbase, we do not recommend that you use that exchange's wallet to store bitcoins in large amounts or for long periods of time. Instead, make your transaction and transfer your bitcoin to a more secure wallet.
Step Four: Place Your Order
One exchange, three steps, and four thousand words later, you’re now ready to buy your first bitcoin. It’s important to keep in mind that although one bitcoin costs several thousand dollars, bitcoin can be divided up to eight decimal points. That means you can buy 1 bitcoin for about $4,000, 0.1 bitcoin for $400, or even 0.00000001 bitcoin for $.00004 if it suits your budget.
Investing in cryptocurrencies and Initial Coin Offerings ("ICOs") is highly risky and speculative, and this article is not a recommendation by Investopedia or the writer to invest in cryptocurrencies or ICOs. Since each individual's situation is unique, a qualified professional should always be consulted before making any financial decisions. Investopedia makes no representations or warranties as to the accuracy or timeliness of the information contained herein. As of the date this article was written, the author owns no cryptocurrencies.