What is Bitcoin?

Bitcoin is a digital currency, more popularly known as a cryptocurrency. It exists only on the Internet. Though the name includes the word "coin", there are no actual coins. The gold-colored coins you see commonly associated with Bitcoin are more of an artist's rendition of what a physical Bitcoin might look like.

Bitcoin is becoming more popular – and increasingly mainstream – the higher the price goes. Even people who don't invest in digital currencies track the price of Bitcoin, at least occasionally.
 
But for most people, Bitcoin and everything connected to it is like a foreign language. Not only is it unlike other financial assets, but it must be bought, held, and sold in unique ways.
 
It was developed in 2009 by an anonymous creator as a medium of exchange on the Internet. Bitcoin was to serve as an alternative to sovereign currencies, like the US dollar, the euro and the Japanese yen.
 
The purpose of developing Bitcoin was to facilitate transactions across international borders in a way that would be fast, easy, and anonymous. It was also designed to be a less expensive alternative to traditional bank transactions. Because Bitcoin can be exchanged directly between individuals – such as a merchant and a purchaser – bank fees can be avoided entirely.

Is Bitcoin Money?

Though Bitcoin was initially intended to be a medium of exchange, it's still not clear if it deserves to be considered money, at least in the traditional sense. 

As a cryptocurrency, Bitcoin is not issued by any government, central bank, commercial bank, or other financial institution. That means it doesn't have status as legal tender in any country.
 
At least as of this writing, neither Bitcoin, nor any other cryptocurrency, is accepted by any government agencies for the payment of taxes or other state obligations.
 
Its acceptance in the general economy has also been extremely limited. Though reports continue to come out confirming the acceptance of the crypto by large companies, the list seems to be something of a revolving door. A major company may accept Bitcoin, either temporarily, or on a limited basis.
 
But for everyday purposes, you can't use Bitcoin to make routine purchases at grocery stores, gas stations, movie theaters, hair salons, and other common retail outlets. Nor can you use it to pay your mortgage, utility bills, or insurance premiums.
 
At least at this point in time, Bitcoin's use as money is mostly limited to transactions between individuals who own and use the digital currency.

Is Bitcoin Safe?

Since Bitcoin is neither issued, backed nor regulated by government agencies, central banks, or other financial organizations, there are no guarantees as to the value, integrity, or safety of the currency.
 
Even apart from the absence of the usual government guarantees on traditional sovereign currencies, Bitcoin does have significant risks.
 
Market value risk. The value of Bitcoin is set entirely by the market, and reported by cryptocurrency exchanges. The price can fluctuate by hundreds or thousands of dollars in a single day.
 
The screenshot below provides a chart representation (from Coindesk) of the price swings in Bitcoin between 2013 and 2021.

chart of bitcoin prices between 2013 and 2021

Though the dollar value of Bitcoin has increased dramatically over the past year, you can see from the chart that it's experienced several declines of more than $10,000. This illustrates the price volatility of Bitcoin. If you buy Bitcoin at a peak, it may be worth thousands of dollars less in a few days or weeks.
 
No Federal insurance protection. Money held on deposit with banks in the US is guaranteed by the Federal Deposit Insurance Corporation (FDIC). Similarly, funds held with US-based investment brokers are covered by the Securities Investor Protection Corporation (SIPC) (which protects investors funds from broker failure, though not from declines in market value). 

No equivalent insurance coverage is available for Bitcoin, or any other cryptocurrency.
 
Security risks. As a fully digital currency, Bitcoin is subject to all the threats inherent in Internet-based financial transactions. That includes the risk of fraud, hacking, theft of digital wallets, malware, and system disruptions or breakdowns. 

On an individual level, there's also the possible loss of a digital wallet, as well as the theft of private encryption keys (which are like passwords to access your digital wallet). Though the blockchain does have certain safeguards, no system is ever completely risk-free.
 
And once again, in the absence of any government or industry-sponsored insurance protection, investors can lose their entire investment without any financial recourse.
 
Competition from other cryptocurrencies. Though Bitcoin is the oldest and largest (by market value) cryptocurrency, it's far from the only one. In fact, hundreds of alternative cryptos have come into existence since Bitcoin was developed. Other fast-growing cryptos include Ethereum, XRP, Stellar, and Tether.
 
Given that the cryptocurrency phenomenon has only existed for a little over a dozen years, future dominance in the space is both fluid and unpredictable. Though Bitcoin may be the dominant digital currency today, it could be unseated by either an existing crypto or by one yet to be developed.
 
Prohibition by governments. Over the past century, government-issued currencies have become a monopoly as a medium of exchange. Since the power of government rests on that monopoly, Bitcoin and other cryptocurrencies may represent unwelcome competition.
 
A prohibition by a major country or group of countries, like the United States, China, or the European Union, could crash the crypto party. Banning of cryptocurrencies in general, or Bitcoin in particular, could spell the end of that currency.

What is Blockchain?

Blockchain is the system in which cryptocurrencies operate. It's called a chain, because it represents a sequence of both registration and distribution of currencies within its network. Unlike traditional banking systems, it's not controlled by any participating entities, but rather by the participants themselves. However, the blockchain does record transactions of digital currencies.
 
The blockchain functions as a public ledger, recording all transactions, and serving as a control function that provides the integrity of the network. This is how Bitcoin and other cryptocurrencies are able to function without a central processing system, like a banking system.
 
At its essence, the blockchain enables participating individuals to transact between one another without going through a third party. This is the quality the blockchain provides that both increases the speed and decreases the cost of transactions. 

For example, where a transaction that goes through a bank may be delayed for a day or more, a transaction on the blockchain will be almost instantaneous.

Bitcoin Mining

This is the name given to the process that brings Bitcoin into existence. Based on the original design of Bitcoin, there is potential to "mine" – or create—up to 21 million Bitcoin. There are currently 18.7 million Bitcoin in existence, with 2.3 million yet to be mined into creation.
 
That limit doesn't mean Bitcoin mining will end any time soon. Miners increase the supply of Bitcoin by earning Bitcoin as compensation for their work. Since miners are the keepers of the blockchain, they're required to group and broadcast transactions into "blocks" and linking the various blocks together.
 
To be a Bitcoin miner requires a computer with an unusual amount of computing power. This is because specific hardware is required to facilitate the process.
 
But as the number of Bitcoin mined into existence grows, the compensation miners receive for their work declines. Because of that reduction, it's estimated Bitcoin mining will continue for at least another 100 years.

How to Buy Bitcoin

You can't buy and sell Bitcoin through a bank or through most brokerage firms. It must be purchased through specific sources that deal in cryptocurrencies.
 
Specifically, Bitcoin is bought and sold through cryptocurrency exchanges. These function much like stock exchanges, though they specialize in cryptocurrencies. You'll be able to buy, sell, and often store Bitcoin through or on an exchange.
 
Examples of cryptocurrency exchanges include Binance, Coinbase, or Coindesk. But as the popularity of cryptocurrency has grown, particularly as an investment, a small number of investment brokers also offer the ability to buy and sell digital currencies. Examples include Robinhood, Webull, and SoFi Active Invest.
 
To open an account, you'll need to link a bank account to the exchange or broker, to transfer money to make purchases. You'll also need a digital wallet to hold your Bitcoin. There are four different types:
 
Online. These are cloud based and can be accessed from your computer. They're not as secure as other wallet types, because your private key is stored online.

Mobile. These wallets are held on your mobile device, which can enable you to use Bitcoin when making payments at merchants that accept Bitcoin for payment.

Desktop. This is a digital wallet that's installed on your computer. They're generally safer than other wallet types because they will also store your private key on your computer, rather than online.

Hardware. These can include an external storage medium, like a thumb drive. They can be connected to your computer only when you're about to make a transaction with your Bitcoin. This type of wallet also does not require storing your personal key online. And perhaps best of all, the media can be used with multiple devices, since it's portable.

History of Bitcoin

Bitcoin was launched in 2009 by a person going by the name of Satoshi Nakamoto. At its initial launch, it was valued at approximately $1.
 
Bitcoin was designed to be a medium of exchange, but action on that front was highly limited. Instead, it's since functioned primarily as an investment speculation. As such, the value of Bitcoin has fluctuated dramatically, but mostly to the upside.
 
While it traded in the hundreds of dollars for the first few years, it began a steep increase in 2017, peaking at over $13,000 at the end of the year. It declined through the end of 2019, then began another major advance, reaching over $50,000. 

You can check the current price here

Who is Satoshi Nakamoto?

This is a pseudonym for the person who created Bitcoin. Though it's often presumed this name represents an individual, it may also be a group of founders. No information has ever been provided as to the actual name of the person or people who created Bitcoin, nor has any individual or group been presented as the digital currency's founder.
 
Though there's speculation as to who the founder is, that information has never been revealed.

Ask an Expert
All of our content is verified for accuracy by Mark Herman, CFP and our team of certified financial experts. We pride ourselves on quality, research, and transparency, and we value your feedback. Below you'll find answers to some of the most common reader questions about Bitcoin.

Is Bitcoin a Good Investment?

Given that Bitcoin has no intrinsic value, doesn't generate any type of cash flow, and isn't backed by any major financial institutions or government, it should be considered more of a speculation than an investment.
 
Another important consideration is the role of Bitcoin in your portfolio, as it doesn't neatly fit into any of the traditional asset classes such as stocks, bonds, or as a cash substitute. Thus, it may be difficult to integrate as part of a balanced portfolio if you own a significant amount of Bitcoin and your goal is diversification. 

Can You Really get Free Bitcoins?

Some businesses are offering free Bitcoins for opening a new account. The number of businesses offering free Bitcoin and the qualifications required to get it change on a regular basis.
 

What will Bitcoin be Worth in 2030?

Since the value of this digital currency is determined entirely by market forces, predicting any future value isn't remotely possible. It could go to $1 million or more, based on its price performance in the last few years. But it could just as easily go back down to a few dollars, or even to zero if it's replaced by other cryptos or banned by one or more major governments.

Can I Convert Bitcoin to Cash?

The easiest way to convert Bitcoin to cash is through the cryptocurrency exchange where you buy and sell it (or store it). If the account is connected to your bank account, you should be able to sell Bitcoin and move the cash to your bank.
 
Another method is PayPal. If you have a PayPal account, you can buy, sell and store Bitcoin there. And with a PayPal debit card, you'll be able to make purchases from your Bitcoin holdings. It's not clear if they'll allow you to access your Bitcoin by using your PayPal debit card to withdraw cash at ATMs.
 
In addition, there are now more than 28,000 Bitcoin ATMs in the US. You'll be able to withdraw cash against your Bitcoin using debit cards issued by the platforms where you hold your digital currency.

Can Bitcoin be Trusted?

It's important to understand that investing in any cryptocurrency has you leaving the security of the traditional financial system. After all, detachment from the mainstream financial system is largely what cryptos are all about. It's one of the major initial attractions.
 
But all the risks discussed in this article are real. And we can probably add that there is risk common in participating in any new or relatively new financial venture, like digital currencies. You'll need to decide if you're willing to accept those risks as part of a price to be paid for owning Bitcoin.
 
You can mitigate some of those risks by the way you invest in Bitcoin. For example, using a hardware digital wallet will generally provide you with the safest way to invest and store Bitcoin. You'll also need to take care to protect your digital wallet private key, just as you would with the account number for a bank or investment account. Then, as is recommended with any type of investing, it's important to diversify by holding other assets.
 
Because of the high risks associated with Bitcoin and cryptos in general, only a small amount of your financial holdings should be held in digital currencies.

Are There Tax Considerations for Buying and Selling Bitcoin?

Yes, and the IRS has recently started asking for cryptocurrency transaction information on tax returns to capture any taxes due. Bitcoin is treated as a type of property, for which you will incur a capital gain or loss when you sell depending on your cost basis or fair market value when you acquired the asset. 

As with any capital gain, if you hold the asset for less than a year it is considered short-term and taxed as income, whereas assets held for longer than one year are taxed at more favorable capital gains rates.  

Mark Herman has been helping friends with financial questions since serving as an Army helicopter pilot. Since then, he’s gained valuable experience in the corporate world before moving on to become a Certified Financial Planner™.

If you have a question about Bitcoin, then please ask Mark.

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