Special Report: Bitcoin: What You Need to Know Before Investing

On November 1, 2008, a man calling himself Satoshi Nakamoto posted a research paper to an obscure online cryptography email list describing his design for a new digital currency.

No one had ever heard of him and it was obvious that it was a pseudonym. After the cryptography experts gave up on trying to find information about the anonymous poster, they realized he or she cracked a problem that stumped cryptographers for decades.

Nearly eight years later, the identity of the creator nay have been revealed as an Australian man facing tax charges, but by then it was just a footnote to the larger story.

The Bitcoin system – convenient, untraceable, open-sourced, and completely independent from government or bank oversight – mattered far more than its provenance.

One of the biggest challenges of designing a digital currency involves the "double-spending" problem, and bitcoin elegantly solves it.

If you are dealing with pure information, free from any physical object, people can simply copy and paste text or code and spend their currency as many times as they want if there are no controls.

The conventional answer used by banks and financial institutions is to use central clearinghouse to keep a real-time ledger of all transactions. The ledger and authorization systems they use prevent fraud, but also require a trusted third party to administer them.

That is something Bitcoin was designed to circumvent through a peer-to-peer system. By publicly distributing the ledger, called the "block chain," ledgers can be compared by everyone using the system to avoid any illicit modifications or entries.

This requires quite a bit of computer power and resources running a special piece of software. To reward the users (called miners), anyone running the software also generates new currency.

Transactions are sent to the whole network, and computers running the software would compete to solve irreversible cryptographic puzzles that contain data from several transactions.

The first miner to solve each puzzle is awarded 12.5 newly minted Bitcoins, and the associated block of transactions would be added to the chain.

Nakamoto himself mined the first 50 Bitcoins on January 3, 2009. Slowly, the idea spread beyond the obscure cryptography circles into the mainstream.

The small band of early bitcoiners all worked to support this open source project. A computer coder bought 10,000 Bitcoins for $50, created a web site called the Bitcoin Faucet and gave them away just to spread them around.

A Florida programmer conducted what bitcoiners think of as the first real-world Bitcoin transaction, paying 10,000 Bitcoins to get two pizzas delivered from Papa John's. He had to transfer the Bitcoins to someone in the UK, who then placed a credit card order over the phone.

At a 2014 exchange rate between Bitcoins and U.S. dollars, $10 million was given away online, and Papa John's sold the most expensive pair of pizzas at $5 million each.

The software has evolved over the years and become more and more robust. The Lead developer for the project is now Gavin Andresen, the same man who gave away 10,000 Bitcoins.

Satoshi Nakamoto has disappeared from the scene entirely. One of his last messages was to Andresen, who said, "Satoshi did suggest this morning that I (we) should try to de-emphasize the whole 'mysterious founder' thing when talking publicly about Bitcoin."

The system he built is, and really has been since its inception, in the hands of the entire Bitcoin community. It is what the people make of it, without any one founder or overly influential person.

At the time of publishing, there are now around 16.4 million Bitcoins in circulation worth over $44.5 billion.

Spending and buying them is still extremely easy. This isn't like Berkshire Hathaway shares, where the value of them creates its own roadblock for investors.

Bitcoin was built with eight decimal points, making the smallest unit of Bitcoin tracked by the system worth a relatively worthless fraction of a cent.

Mining Bitcoins

(Editor's Note: Don't get mired in the details here if you don't want to, I'll give a simple description later.)

At this point, you're probably thinking the best way to get Bitcoins is just to fire up your computer, run the mining program overnight and wait for them to roll in.

Unfortunately, it really isn't that easy. Competition amongst miners is fierce and the cryptographic number problems are amazingly complex.

To control the production and release of new Bitcoins into the system, the difficulty of each puzzle increases as the number of miners increase. By carefully crafting how the evolution of the increasingly complex and massively long cryptographic problems progress, the system limits the creation of blocks of transactions — and thus a new batch of Bitcoins — to one every 10 minutes.

The amount of Bitcoins given to a miner is cut in half every four years. It started at 50 Bitcoins. It was reduced to 12.5 in July 2016. This will continue all the way through 2140, when the system reaches its absolute limit of 21 million Bitcoins.

To create a block and earn a Bitcoin reward for it, your computer will have to generate a 256-bit 16 digit hexadecimal number that is below a set target. Instead of using the standard 0 to 9 numbers, a hexadecimal number uses 0 to 9 along with the letters A through F.

The chances of having a standard computer guess a number like this is so small that scientific notation is normally used for anything similar. The last time I looked, your odds are 0.000000000000000000329.

To put this into perspective, your odds of winning a Powerball lottery jackpot are 0.00000000571, or over 1.7 billion times better than the odds of you getting the right answer for a block of Bitcoins, if you took one wild guess.

Keep in mind that Bitcoin rewards go out every ten minutes while there are only two Powerball drawings per week and many times no one wins. That means someone out there 'wins the Bitcoin lottery' — so to speak — 100,798 more times week at a minimum, not that it helps your odds much at all.

The reason for such a massive disparity is the sheer number of miners, and the vast differences between the computers being used by high tech miners and the lowly desktop in your office.

Competition to build high-end, parallel computing "mining rigs" is extremely intense. There are now entire buildings filled with systems dedicated to mining Bitcoins. The capital required to build, power, and maintain these systems is astronomical.

These private Bitcoin miners are notoriously secretive about their systems and finances. The Bitcoin ledger is public information though, and most estimates put the profit margin for these operations around 10%.

Smaller miners have resorted to pooling resources together online and sharing any Bitcoins they earn as a result. It takes thousands to compete with the big players though, and the payoff is heavily diluted if your pool gets a block. Most estimates suggest you'll lose money just from the electricity your home computer uses, and rapidly burning out your hardware, to participate.

It is possible to hit the jackpot and get all 12.5 Bitcoins on your own, but in reality, the odds are overwhelming that this will never happen in an entire lifetime.

Making Sense of It All

Now for the simple explanation: Bitcoin is a lot like gold.

Of course, there are a whole lot of differences, but on some key points they are very similar.

First, there is a finite amount we can bring into the market. For gold, there is a set amount in the ground. For Bitcoin, the absolute limit is 21 million.

No one can create anything identical to them, although with gold you might be able to fool someone with a fake coin.

Second, as more of them go into circulation, it becomes harder and harder to bring more into the market.

Gold mines are always being depleted. The easiest and purest deposits are stripped bare first and the work is quick. The next mine will have to go deeper in the ground or the ore will be harder to refine.

A price floor forms that constantly increases, where prices can't support the cost of extraction of more.

For Bitcoin, over three-quarters of the absolute cap of 21 million that will exist are already in circulation. The equations that need to be solved by your computer are far more complex than they have been, and are only getting worse.

Third, fighting over dwindling resources has made competition fierce enough to price potential miners out of the market.

For gold, the days of heading to California to pan in a stream are long since gone. Your average person has zero chance of finding gold out in the wild, and even companies with tens or hundreds of millions of dollars struggle to get the first ounce out of a gold mine.

The same goes for Bitcoin mining. The days when you could mine them on your home computer are long since gone. Building a specialized supercomputer is far beyond the average person.

Yet people will continue to mine gold and Bitcoins when it is economically viable. If they drop too far in value, miners will stop. This makes it more probably that those who keep mining bitcoins will get the next batch.

Evolution of Value

Through 2009 and early 2010, Bitcoins had no actual value. The project was still in its infancy and there were no transactions taking place.

  • In the first six months after Bitcoin trading commenced in April 2010, the value stayed below $0.14.
  • In summer 2010, Bitcoins started gaining traction. With a limited supply and new-found demand, value started moving up...
  • By early November, it hit $0.36 before settling down to around $0.29.
  • In February 2011, it rose again and hit "dollar parity;" it hit $1.06 before settling in at roughly $0.87.
  • In April through May of 2012, exposure through a Forbes story on the new currency pushed prices up from $0.86 to $8.89.
  • In June 2012, it tripled to about $27.

As exposure and popularity amongst Bitcoin buyers and merchants ramped up, production remained limited to the preset algorithm. The growing number of people buying Bitcoins to hold and not spend created some sharp spikes in the going rate in the market.

Here is a chart of the exchange rate between Bitcoins and the U.S. dollar from the beginning of 2013 through early 2015. Demand soared, but no one was selling and supply was inelastic, so a dramatic spike formed.

bitcoin spike and fall

There is now a good reason for Bitcoin to maintain – and gradually increase – in value from here on out.

They are being adopted as a form of payment worldwide, creating a real value to customers and merchants alike.

There are over 100,000 businesses accepting them. Many major online and retail businesses do, such as Amazon, CVS, Overstock.com, Subway, Tesla, Expedia.com, Whole Foods, Home Depot, the Apple App store, Macy's, Sears, JCPenney, Gap, Microsoft, Dell, Square etc.

A man in Canada recently listed his home on the market in dollars and Bitcoins.

There are even ATM's that will exchange Bitcoins for your cash on the spot. On October 30, 2013, the first machine went live. On its 29th day, it had already logged over 1 million Canadian dollars worth of transactions.

Bitcoin is even starting to see serious consideration by widely respected figures in the financial world. David Woo, FX and Rates Strategist at Bank of America/Merill Lynch had this to say when Bitcoin was at $1,300: "We believe Bitcoin can become a major means of payment for e-commerce and may emerge as a serious competitor to traditional money transfer providers. As a medium of exchange, Bitcoin has clear potential for growth, in our view."

Even Ben Bernanke weighed in through a letter to a Senate committee, stating that Bitcoin "may hold long-term promise" and is keeping a very open mind towards digital currencies.

Since Bitcoins started to gain widespread usage in the real world, the currency has really taken off..

The increase in buying and selling driven by this, along with the large increase in total Bitcoins in circulation since the early days, also smoothed out the large percentage spikes and drops between 2015 and 2017.

Here is what a full chart of Bitcoin prices looks like today. You can see how the tumultuous early days gave way to steady increases in value over several years.

bitcoin all time june17

2017 has seen a massive spike so far, and time will tell if prices fall back in line with the longer trend line.

If and when they do, a significant buying opportunity will be on hand.

What You Need To Get Started

Capitalizing on the advantages of a government-proof and bank-proof currency also means you need to take full responsibility for some of the work and security governments and banks provide for traditional currencies.

Bitcoin is easy to use once you get the hang of it, but it does require some work, knowledge and new habits.

First, you will have to decide how you want to purchase Bitcoins. Some people prefer to buy them in person by meeting a seller and handing over cash. By doing this, you assume some risks, just as you would by meeting up with someone to buy something off of Craigslist or from an ad in the back of a newspaper.

Before you meet in person, you will also have to set up a digital wallet. This wallet is a collection password-protected data that includes a public and a private key.

The public key is used as an address to which others can send bitcoins. Anyone wishing to use Bitcoin can create one or more Bitcoin addresses.

The private key is used to decrypt and access the public key. Securing and protecting your private key is absolutely essential. If the private key for an address is not kept secret, the Bitcoins may be stolen.

Another option is a "paper wallet." This is a method of generating a very similar wallet that does not store the encrypted private key online or on your computer. You print out the information and store it somewhere secure.

This allows you to avoid any issues with a compromised or hacked account, but if you lose the paper record, your bitcoins are irretrievable.

If you choose to purchase Bitcoins through one of the many online exchanges, you will have to set up an account with them. This will often create a digital wallet for you.

If you want to use a different digital wallet or paper wallet after you get your Bitcoins, you can easily transfer once the transaction is complete. In fact, this is often a good idea considering this information is going to be stored by the online exchange.

Going through a web site exchange will require entering your bank account information, or your credit or debit card details.

Most web sites will require bank account information at first. Bitcoin transfers are irreversible, but credit and debit transactions can be reversed. You will have to make several purchases before online exchanges will start to trust you with a potential way to buy bitcoins while reversing your payment.

Linking bank account information can be risky, so you may want to check with your bank to see if you can create a second checking account just for your Bitcoin funds. If you do this and the account information is compromised, there will be no way to tap the funds in your primary account.

Some Bitcoin exchanges will accept money orders or cashier checks through the mail as well. There aren't many and once you mail it the money is gone, but it speeds up the Bitcoin transaction and doesn't require any of your sensitive account details.

Once you have made your Bitcoin purchase, you may want to set up multiple wallets to spread out your Bitcoins and minimize the risk of a catastrophic loss.

Whatever you do, keep an exhaustive list of your wallet information and Bitcoin balances, either printed out with no saved copies on your computer, or handwritten. The best place to store this is in a fire-proof safe.

Continuing Coverage

With the unprecedented and disruptive nature of Bitcoin for the entrenched status quo of fiat national currencies, the Outsider Club will continue to watch the evolution and development of the world's first major digital currency. Stay tuned for more research and analysis.


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