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Bitcoin for idiots: An introductory guide

Image Credit: BTCKeychain
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Drama, greed, controversy, conspiracy, crime, risk, theft, speculation, wealth — such was the world of Bitcoin in 2013.

The crypto-currency captivated us with its soaring highs and plunging lows in 2013, rising from $10 to $1,200 in the course of a year. It surpassed the value of gold at its peak before crashing down to $500. Today it flutters between $380 and $682 on different exchanges.

We watched breathlessly as early Bitcoin owners became millionaires and authorities seized millions of dollars worth of Bitcoins from the the Web’s notorious black market, the Silk Road. We witnessed efforts to uncover the identity of Bitcoin creator Satoshi Nakamoto, and we listened to luminaries in finance and economics heatedly debate Bitcoin’s future.

Millions of people followed the saga, but far fewer chose to buy Bitcoin themselves amidst all the uncertainty and volatility.

Now Bitcoin is emerging out of its angsty adolescence into a more mature, adult, stable form. The Bitcoin ecosystem is growing more robust and legitimate, and the movement’s evangelists are pushing hard for mainstream adoption — to turn Bitcoin into a currency rather than an asset or a financial lark and make the most of its unique capabilities.

POLL: Would you buy Bitcoin?

For those of you who spent last year curious but wary about Bitcoin, here is a guide to everything you need to know.

We will take you through what Bitcoins are, how they are created, where to buy and sell them, how to store them safely, and where you can spend them.

What is Bitcoin and how does it work?

To put it very, very simply, Bitcoin is the Internet’s version of money.

Bitcoin is at its core a cryptographic protocol, which is why it is also referred to as a “crypto-currency.” The protocol creates unique pieces of digital property that can be transferred from one person to another. The protocol also makes it impossible to double-spend a Bitcoin, meaning you can’t spend the same Bitcoin twice.

Bitcoins are generated by using an open-source computer program to solve complex math problems in a process known as mining (more on that shortly). Each Bitcoin is defined by a public address and a private key, which are long strings of numbers and letters that give each a specific identity. This means that Bitcoin is not only a token of value but also a method for transferring that value.

In addition to having a unique digital fingerprint, Bitcoins are also characterized by their position in a public ledger of all Bitcoin transactions known as the blockchain. Buying a Bitcoin can be thought of as buying a spot in the blockchain, which then records your purchase publicly and permanently.

The blockchain is maintained by a distributed network of computers around the world. This decentralization means no one entity, such as a government, controls it. Transactions happen digitally from person to person, without middlemen such as banks or clearinghouses. The public Bitcoin network is the official record for all of these transactions. You can also transfer Bitcoin in person (more about this below).

The direct approach significantly reduces the fees involved with transferring traditional money and makes it much easier and faster to send and receive money across the globe. Bitcoin gives an efficiency increase relative to banking transactions comparable to the efficiency of email versus physical email.

People primarily buy and sell Bitcoins through online exchanges. The public address and private keys are both required to trade, sell, and spend Bitcoin.

Since transactions are done using the public keys, the identities of the buyers and sellers are veiled to each other and to the public, even though the transaction is recorded publicly.

People often say Bitcoin is anonymous, but pseudonymous is more accurate. Transactions are currently quite difficult to trace, however, which is why Bitcoin has been associated with illicit activity, such as buying and selling drugs on the now-defunct Silk Road market.

As with paper money, you can save Bitcoins in a wallet, which stores the public and private keys needed to identify the Bitcoins and execute a transation. These can be digital wallets that exist in secure cloud environments or on a computer, or they can take physical form. If a wallet is hacked or you lose your private Bitcoin key, you no longer have access to that Bitcoin. Possession of the public address and private key amounts to possession of the Bitcoin.

Bitcoin can either be used to buy things online from merchants and organizations that accept Bitcoin, or it can be cashed out through an exchange, broker, or direct buyer.

This is a general explainer, but provides a good basis to dive further into the various elements of the ecosystem.

Where do Bitcoins come from?

With paper money, a government decides when and how much cash to print and distribute. Bitcoin, by contrast, doesn’t depend on a central bank or government — people create Bitcoins through mining.

Mining is the process of solving complex math problems (also called “hashing”) using computers running Bitcoin software. This requires more computing power than regular PCs have, so people buy specialized Bitcoin machines or form groups that chain multiple computers together to mine.

When the program solves one of these problems, it creates “blocks,” or encrypted Bitcoin transactions. When you (or your pool) solve a block, you are rewarded with Bitcoins.

These cryptographic puzzles get increasingly harder as more Bitcoins enter circulation. Also, the rewards are cut in half at regular intervals. In other words, there’s a gradual slow-down in the rate at which new Bitcoins enter circulation. There is a built-in limit of 21 million Bitcoins, meaning when this many have been mined, production will stop completely.

A single Bitcoin can be divided down to 8 decimals, and people can transact with fractions of Bitcoins, known as satoshis, so even if one Bitcoin is worth a lot, the system is still useful for very tiny transactions.

The blocks created by mining make up the transaction record of the Bitcoin system. Every block contains a hash of the previous block, which creates a transaction database — the previously referenced blockchain. The blockchain is a public ledger and records all transactions in chronological order.

A new block is added to the blockchain an average of once every ten minutes. Rather than being maintained by a central body, it is distributed across all the mining computers.

How do you buy or sell Bitcoins?

Now you have a general understanding of what a Bitcoin is. How do you buy one? Fortunately you don’t need to comprehend the nuances of hashes, nodes, and the blockchain to get involved in the ecosystem.

People commonly buy and sell Bitcoins through exchanges, though this isn’t necessary. In order to make transactions on an exchange, you must have a Bitcoin wallet (more about this later) to keep your currency in.

The most well known and one of the largest Bitcoin exchanges is Japan-based Mt. Gox, which is a market exchange — meaning buy orders are matched with sell orders. (Editor’s Note: Mt. Gox filed for bankruptcy and shut down in late February.)

Other exchanges considered reputable are BTC China, Bitcoin.de (Germany), VirtEx (Canada), Bitstamp (Slovenia), BTC-e (Bulgaria), CampBX (U.S.), and Bitcurex (Poland). There are also fixed-rate exchanges and brokers, such as Coinbase, that will trade for you.

Remember, you must be very careful about where you place your trust and your money: Bitcoin exchanges are not highly regulated. While this is part of the appeal for many, it does make it easier to get swindled.

Once you have settled on a broker or exchange, you create an account with a user name and password and link your bank account. Mt. Gox (and others) ask for personal information and photographic scan of a drivers license, passport, or national ID card. Coinbase asks for your phone number, and some exchanges even require a recent utility bill to confirm your identity and location.

Now you can begin buying.

Coinbase and Bitstamp make it pretty easy to buy Bitcoins, exchanging real-world money from your bank for the virtual currency, or vice versa. For first time buyers, there is usually a delay of a couple days to a week for orders to go through.

When you want to sell, you make sure your wallet is loaded with your Bitcoins, and pretty much all you have to do is click “sell.”

Some people prefer to conduct Bitcoin transactions offline. As mentioned above, every Bitcoin has a private, unique, and long numerical ID. If you write this key down or store it on a local drive, you can trade a Bitcoin simply by passing that key off to someone else.

LocalBitcoins.com is a platform that connects people looking to buy and sell locally with trading partners around the world in more than 4,500 locations. This approach can actually be faster than going through a centralized exchange, and it offers more flexible payment options, such as PayPal, cash, and Western Union.

A relatively new method is a Bitcoin ATM made by Robocoin. The first machine opened at a coffee shop in Vancouver, Canada, in October. It lets you buy, sell, and trade Bitcoin in exchange for cash and checks in 60 different currencies.

Next page: How to protect your Bitcoins

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Coinbase makes it easy for the average person and business to use the digital currency Bitcoin. Coinbase lets any consumer to create a Bitcoin wallet and start buying/selling Bitcoin instantly by connecting their bank account. In add... read more »

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