The basics of Bitcoin

E*TRADE Securities

12/01/21

Summary: Bitcoin is a digital currency that commands the majority of the crypto market. We explore the history and evolution of Bitcoin, along with investing considerations for this volatile asset.

Bitcoin is considered the first type of cryptocurrency, launched in 2009 by an anonymous person or group named Satoshi Nakamoto. It allows users to make peer-to-peer transactions with digital money without a third-party intermediary, such as a bank or credit card company. Instead, Bitcoin uses algorithms to verify transactions, which are recorded in the Bitcoin blockchain. There is a limited number of bitcoins that can be created, and of the 21 million total, close to 18.7 million have been mined already.

By design, Bitcoin is public. So, theoretically, anyone with a computer and internet can become a miner—no one person or group owns or controls it. It’s also decentralized, meaning it doesn’t have a single server, organization, or computer “running Bitcoin.” Instead, different stakeholders control different aspects.

The Bitcoin network includes two main components: the actual currency, Bitcoin; and the blockchain, a decentralized ledger system that logs the funds in and out.

A bit on mining

Miners are the people that use their computing power to make the Bitcoin network run. Miners are continuously competing to verify Bitcoin transactions by solving highly complicated math problems. The first miner to confirm the pending transactions and create a new block on the blockchain is awarded a newly minted Bitcoin.

While technically anyone can mine Bitcoin, the amount of processing power and electricity needed to mine competitively is huge. This means the majority of mining is done by specialized companies or groups who pool their resources together to maximize their chances of successfully solving the complex math problems required to unlock new Bitcoin.

Adoption and growth

Claiming roughly two-thirds of the cryptocurrency market, Bitcoin is the largest digital currency by market capitalization. Its rapid and significant price appreciation has generated enthusiasm for its potential, as investors look for new “stores of value.”

A few key factors have contributed to broader interest in Bitcoin, including:

  • Availability of products. The adoption of digital wallets/payment systems may have been accelerated in part by a need for contactless options amid the COVID pandemic.
  • Institutional acceptance. Several mainstream companies have expressed interest in using Bitcoin, seemingly legitimizing the crypto.
  • Demand for portfolio diversifiers. Investors, particularly long-term investors, face a dwindling list of uncorrelated assets, prompting them to seek out new investment alternatives. Cryptocurrency has emerged as a way to diversify a traditional equity/bond portfolio with an asset that does not move in lockstep with the broader economy.

Risks

While enthusiasts may be looking to Bitcoin as a new frontier in financial markets, the risks of investing in Bitcoin abound. Bitcoin is considered one of the most volatile assets—significantly more volatile than the S&P 500® or Nasdaq 100. As quickly as its price can rise—it can fall equally as fast or faster. Additionally:

  • Laws regarding Bitcoin can change. If a change in the law restricts or impairs holding cryptocurrency, its price may decline.
  • Since Bitcoin is not issued or controlled by a particular person or group, there may not be any recourse if it’s lost or stolen.
  • The value of Bitcoin may be based solely on supply and demand, meaning investors may face the total loss of their investment if the market for a cryptocurrency disappears.
  • New technologies like cryptocurrency are often used to perpetrate fraudulent investment schemes.
  • Cryptocurrency exchanges or wallet services may stop operating or permanently shut down due to fraud, hackers, or malware.

Investing considerations

Bottom line when considering Bitcoin: Proceed with caution. Like other emerging technology, the fate of Bitcoin is unpredictable, and some challenges are likely still unknown.

Investors who are looking to gain exposure to this burgeoning asset class should do their homework. Get familiar with the unique crypto terminology, use cases, investment product alternatives, and risks.

Ultimately, all investing decisions should align with financial goals and individual risk tolerance.

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