Investing in Bitcoin or other crypto-currencies can be a profitable business strategy, but it can also be confusing. It’s difficult to understand where and how to start. This should serve as a helpful primer explaining Bitcoin and its risks – as well as how to make money from it.
What is Bitcoin?
Bitcoin is treading new ground in the cryptocurrency arena, both on a technological level and a theoretical one. By taking control of payment systems out of the hands of Central Banks to a large extent, it is shifting the locus of power, along with our entire understanding of payment systems and currency.
But things are rarely as simple as that. Bitcoin is, fundamentally, a way of reaching crowd-sourced consensus in widely dispersed systems – an achievement previously though either impracticable or just impossible. Dispersed systems, you say? Crowd-sourced consensus? What has that got to do with money? Quite a lot, as it turns out. Bitcoin is much more than simply an electronic currency. In fact, despite seeming like a simple, elegant way of peer-to-peer payments, Bitcoin remains enveloped in controversy. Let’s take a look at some of the major pros and cons.
Bitcoin as a Payment System
Bitcoin is based on the idea that a payment system does not actually need a central authority to sustain itself. It set out to resolve the infamous Byzantine Generals’ Problem seen in game theory. Essentially, the generals must work out a way of coordinating an attack on a city by sending messages to one another. The attack will only be strong enough if more than half attack simultaneously. If they don’t, they will all perish in the attempt. They suspect each other of being disloyal and sending fake messages, but cannot know which messages are fake and which are real. Without a central coordinator and a means of distinguishing real from fake, how can they possibly coordinate an attack?
Bitcoin might have the answer. All the generals begin working on a mathematical problem which should take ten minutes on average to solve, assuming each general has the same computational resources. Once one of the generals finds the solution, they tell all the others. They then all begin working on extending the solution, which should also take ten minutes, and so on. Each general works on extending the longest solution they have seen so far. After this happens 12 times, it is statistically almost certain that no group controlling less than half of the generals could have created a solution of similar length. So the existence of the chain proves that a majority have been working on it.
It sounds confusing, and that’s because it is. The basic idea is that a consensus can be reached, because computational resources are limited. To stop one “general” (a Bitcoin user) trying to control the computational power of another, Bitcoin rewards those who contribute computational power (known as “mining”) to the overall system. If Bitcoins become more valuable, it is logical for a user to mine as much as is profitable. This is what makes Bitcoin an efficient currency: it needs consumer confidence (the reward system), but users only mine it to the extent that it is profitable to do so – and therefore never uses more computational resources than necessary to uphold its value at any one time. So as long as the computation problems remain constant, confidence is self-reinforcing.
What makes Bitcoins valuable?
Bitcoin is not worth anything in itself, but it represents a way of generating consensus in complex systems, bypassing the need for a central authority. Just think about how important that is. The way in which Bitcoin uses encryption keys ensures that users can verify each other’s identity without resorting to a centralised authentication system. So it can be used to fight censorship, web traffic monitoring and centralised imposition. It can get around the fact that ‘secure’ https:// connections require hundreds of security certificates (and if any are compromised, someone could access your private data).
What are the problems with Bitcoin?
Illegal trading and Bitcoin are made for each other. All the above means Bitcoin is most useful for goods and services that are difficult to buy using cash issued by a Central Bank. This is great if you live somewhere with little or no hard currency. But now the alarm bells start to ring, and quite rightly: Bitcoin and its sister Dogecoin have long been used by illegal narcotics networks across the dark recesses of the Web (just Google “Silk Road”). Bitcoin can also make financing of terrorist activities virtually untraceable: clearly a serious problem for the NSAs and CIAs of this world.
Bitcoin is volatile. Many people immediately associate Bitcoin with volatility – and for good reason. Though the supply is fixed, there is no clear mechanism to deal with fluctuations in demand. We try to convince ourselves that because Bitcoin’s price rose yesterday, it will keep rising tomorrow. A great strategy, until it’s not any more (see US sub-prime mortgage crisis) and triggers a large fall in price as demand disappears.
Deflation is unavoidable. In this context, deflation (the opposite of inflation) essentially means the value need less of a currency to buy the same amount of goods. Bitcoin’s properties mean demand for it will keep rising over time (disrupted by volatile demand spikes as described above). So it’s great for a digital wallet – but not so good for accounting, foreign exchange or international pricing as it is much more volatile than other currencies. As a measure of intrinsic value, it has its drawbacks – but as a means of exchange, arguably it does not.
Don’t Panic, or else. Bitcoin is more susceptible than most currencies to ‘bank runs’ – a situation where everyone tries to sell it at once due to a crisis in confidence in either Bitcoin’s value or the system that upholds it. One solution is only to hold enough Bitcoin for everyday transactions – meaning that if it collapses, it’s ‘only’ like having your wallet stolen.
Is Bitcoin a good idea?
There is no doubt that the concept of decentralizing money is an exciting one. But all the unknowns mean you should be very careful. If you’re looking to become a Bitcoin user, here are some tips to bear in mind:
- Don’t hold more Bitcoin than you need in the short term – like cash in your wallet. This way, volatility and deflation won’t be a serious problem;
- Be aware of the risks of investing in Bitcoin: it’s got nothing to back it (like a commodity or a Central Bank);
- Don’t do your accounts in Bitcoin – its value is too unstable (at least for now);
- Bitcoin’s value will not reach zero as long as there are situations where it is a good substitute for paper money.
What’s next? Well, the jury’s still out on this one. It seems increasingly apparent that people want a decentralised monetary system able to function without kowtowing to authority. That’s what really makes Bitcoin valuable. Since the demise of the Gold Standard, most currencies (like Bitcoin) have not been backed by anything and rely on a) trust and b) ease of use to hold their value. Perhaps this is the biggest hurdle to overcome.
How do I make money investing in Bitcoin?
Note: before doing any investing in Bitcoin, it’s important to remember that you should never invest more than you are willing to lose. Please be cautious, always do your research and take care to make informed decisions.
First of all, in order to make money with Bitcoin, you’ll need to understand why Bitcoin offers a large speculative upside. In the past decade, it’s gradually become more difficult to decentralize your assets (and this trend will likely continue). However, more people are becoming aware of the strict capital controls and difficulties involved with international transactions and, fortunately, cryptocurrencies like Bitcoin offer a secure, decentralized alternative to traditional banking and investments.
The transaction volume of Bitcoin is also huge. It will very likely surpass PayPal soon. Naturally, a lot of these transactions are through dark markets, but as Bitcoin rises in popularity and gains more mainstream appeal / acceptance, it will become a standard payment method. This means that the currency will very likely appreciate in value in the coming years, offering a clear opportunity for arbitrage.
Investment in Bitcoin follows the same basic principles as investing in any other security: buy low and sell high. First, you’ll need to watch the price of Bitcoin. You can do so at Coindesk and Winkdex.
After monitoring the price, you’ll need to actually purchase Bitcoins. Some high-quality exchanges can be found at Bitstamp, Kraken and Bitfinex.
Just like any other security, there are numerous strategies for making money from Bitcoin. You’ll probably want to have access to good statistics, so we’d recommend watching the charts over at Bitcoin wisdom.