What is Bitcoin and how does it work? – Forbes Advisor Canada

Not only is Bitcoin the first cryptocurrency, but it is also the most well-known of the more than 5,000 cryptocurrencies in existence today. The financial media eagerly covers every new dramatic high and stomach-churning low, making Bitcoin an inescapable part of the landscape.

While the wild volatility may make for good headlines, it hardly makes Bitcoin the best choice for beginners or people looking for a stable store of value. It can be difficult to understand the ins and outs – let’s take a closer look at how Bitcoin works.

What is Bitcoin?

Bitcoin is a decentralized digital currency that you can buy, sell and exchange directly, without an intermediary such as a bank. Bitcoin’s creator, Satoshi Nakamoto, originally described the need for “an electronic payment system based on cryptographic proof rather than trust.”

Every Bitcoin transaction ever made is contained in a public ledger that is accessible to everyone, making transactions difficult to reverse and difficult to counterfeit. It’s by design: At the core of their decentralized nature, Bitcoins aren’t backed by the government or any issuing institution, and there’s nothing to guarantee their value except the proof baked into the heart of the system.

“The reason it’s worth money is simply because we, as humans, decided it has value – the same as gold,” says Anton Mozgovoy, co-founder and CEO of digital finance company Holyheld.

Since its public launch in 2009, Bitcoin has risen dramatically in value. Although it once sold for less than $150 USD per coin, as of October 26, 2021, one Bitcoin is now selling for nearly $38,000 CAD in May 2022. Because the supply is limited to 21 million coins, many expect the price to only continue to rise after as time goes on, especially as more large institutional investors begin to treat it as a kind of digital gold to hedge against market volatility and inflation.

How does Bitcoin work?

Bitcoin is built on a distributed digital record called a blockchain. As the name suggests, blockchain is a linked set of data, consisting of units called blocks that contain information about each and every transaction, including date and time, total value, buyer and seller, and a unique identification code for each exchange. Entries are compiled in chronological order, creating a digital chain of blocks.

“Once a block is added to the blockchain, it becomes available to anyone who wants to see it, acting as a public ledger of cryptocurrency transactions,” says Stacey Harris, consultant for Pelicoin, a network of cryptocurrency ATMs.

Blockchain is decentralized, meaning it is not controlled by any organization. “It’s like a Google Doc that anyone can work on,” says Buchi Okoro, CEO and co-founder of African cryptocurrency exchange Quidax. “No one owns it, but anyone who has a link can contribute to it. And as different people update it, your copy gets updated too.”

While the idea that anyone can edit the blockchain may sound risky, it is actually what makes Bitcoin reliable and secure. For a transaction block to be added to the Bitcoin blockchain, it must be verified by the majority of all Bitcoin holders, and the unique codes used to recognize users’ wallets and transactions must match the correct encryption pattern.

These codes are long, random numbers, which makes them incredibly difficult to produce. In fact, a scammer who guesses your Bitcoin wallet key code has about the same odds as someone who wins a Powerball lottery nine times in a row, according to Bryan Lotti of Crypto Aquarium. This level of statistical randomness blockchain verification codes, which is required for every transaction, reduces the risk of someone making fraudulent Bitcoin transactions.

How does Bitcoin Mining work?

Bitcoin mining is the process of adding new transactions to the Bitcoin blockchain. It’s a tough job. People who choose to mine Bitcoin use a process called proof of work, deploying computers in a race to solve mathematical puzzles that confirm transactions.

To entice miners to keep racing to solve the puzzles and support the overall system, the Bitcoin code rewards miners with new Bitcoins. “This is how new coins are created” and new transactions are added to the blockchain, Okoro says.

In the early days it was possible for the average person to mine Bitcoin, but that is no longer the case. The Bitcoin code is written to make it more and more challenging to solve the puzzles over time, and requires more and more computing resources. Today, Bitcoin mining requires powerful computers and access to vast amounts of cheap electricity to succeed.

Bitcoin mining also pays less than before, making it even harder to recoup the rising computational and electrical costs. “In 2009, when this technology first came out, every time you got a stamp, you got a much larger amount of Bitcoin than you do today,” says Flori Marquez, co-founder of BlockFi, a crypto asset management company. “There are more and more transactions [now, so] the amount you get paid for each stamp gets smaller and smaller.” By 2140, it is estimated that all Bitcoins will have entered circulation, meaning that mining will not release new coins, and miners may instead have to rely on transaction fees.

How to use Bitcoin

In Canada, people commonly use Bitcoin as an alternative investment, helping to diversify a portfolio apart from stocks and bonds. You can also use Bitcoin to make purchases, but the number of providers that accept the cryptocurrency is still limited.

Major companies that accept Bitcoin include Microsoft, Newegg, and Overstock, which is US-based but ships to Canada. You may also find that some small local retailers or certain websites take Bitcoin, but you have to do some digging.

You can also use a service that allows you to link a debit card to your crypto account, such as the Shakepay Visa card, which works like a Visa card wherever Visa is accepted, but converts cryptocurrency held in your account on the Shakepay cryptocurrency exchange to Canadian dollars at the merchant side. There are other prepaid credit and debit cards available in Canada that also do the same.

In other countries – especially those with less stable currencies – people sometimes use cryptocurrency instead of their own currency.

“Bitcoin provides an opportunity for people to store value without relying on a currency that is backed by a government,” says Montgomery. “It gives people an opportunity to hedge against a worst-case scenario. You’re already seeing people in countries like Venezuela, Argentina, Zimbabwe — in countries that are heavily leveraged, Bitcoin is gaining tremendous traction.”

That said, when using Bitcoin as a currency, not an investment, in Canada, you need to be aware of certain tax implications.

How to buy Bitcoin

Most people buy Bitcoin via cryptocurrency exchanges. Exchanges allow you to buy, sell and hold cryptocurrency, and setting up an account is similar to opening a brokerage account – you need to verify your identity and provide some form of funding source, such as a bank account or debit card.

Major Canadian exchanges include Netcoins, Coinberry, Coinsmart, Bitbuy, Shakepay and Newton. You can also buy Bitcoin from an online broker like Wealthsimple.

Regardless of where you buy Bitcoin, you need a Bitcoin wallet to store it in. This can be what is called a hot wallet or a cold wallet. A hot wallet (also called an online wallet) is stored by an exchange or a provider in the cloud. Online wallet providers include Exodus, Electrum and Mycelium. A cold wallet (or mobile wallet) is an offline device used to store Bitcoin and is not connected to the Internet. Some mobile wallet options include Trezor and Ledger.

Some important notes about buying Bitcoin: Although Bitcoin is expensive, you can buy parts of Bitcoin from some suppliers. You also need to watch for fees, which are usually small percentages of your crypto transaction amount, but can really add up for small dollar purchases. Finally, be aware that Bitcoin purchases are not instant like many other stock purchases seem to be. Because Bitcoin transactions must be verified by miners, it may take you at least 10-20 minutes to see your Bitcoin purchase in your account.

How to invest in Bitcoin

Like a stock, you can buy and hold Bitcoin as an investment. If you don’t want to invest in Bitcoin directly, but profit from its volatility, you can invest in a Bitcoin ETF. There are several Bitcoin ETFs you can invest in right now on the Toronto Stock Exchange (TSX), including Purpose Bitcoin ETF (BTCC), 3iQ CoinShares Bitcoin ETF (BTCQ), Ninepoint Bitcoin ETF (BITC), and Evolve Bitcoin ETF (BITC).

Regardless of where you choose to hold your Bitcoin, people’s philosophies on how to invest it vary: some buy and hold for the long term, some buy and aim to sell after a price rise, and others bet on the price going down. Bitcoin’s price over time has experienced wide price swings, going as low as $5,165 USD and as high as $28,990 USD in 2020 alone.

“I think in some places people can use Bitcoin to pay for things, but the truth is that it’s an asset that seems to increase in value relatively quickly for some time,” Marquez says. “So why would you sell something that’s going to be worth so much more next year than it is today? The majority of people who hold it are long-term investors.”

One important note, though: While crypto-based funds can add diversification to crypto holdings and reduce risk a bit, they still have significantly more risk and charge much higher fees than broad-based index funds with a history of consistent returns. Investors who want to increase their wealth steadily can choose index-based mutual funds and exchange-traded funds (ETFs).

Should You Buy Bitcoin?

In general, many financial experts support customers’ desire to buy cryptocurrency, but they do not recommend it unless customers express interest. “The biggest concern for us is if someone wants to invest in crypto and the investment they choose doesn’t do well, and then suddenly they can’t send their kids to college,” says Ian Harvey, a certified financial planner (CFP) in New York City. “Then it wasn’t worth the risk.”

The speculative nature of cryptocurrency leads some planners to recommend it for clients’ “side investments.” “Some call it a Vegas account,” says Scott Hammel, a CFP in Dallas. “Let’s keep this out of our real long-term perspective, make sure it doesn’t become too big a part of your portfolio.”

In a very real sense, Bitcoin is like a single stock, and advisors would not recommend putting a significant portion of your portfolio into one company. At most, planners suggest putting no more than 1% to 10% into Bitcoin if you’re passionate about it. “If it was one stock, you would never allocate a significant portion of your portfolio to it,” says Hammel.