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Bitcoin for idiots: An introductory guide

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Image Credit: BTCKeychain

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

How do you keep your Bitcoins safe?

Once you have bought Bitcoins, the next step is to keep them safe.

As mentioned above, Bitcoins are represented by long strings of numbers that make up the public and private keys. If someone gets hold of those digits, they can steal the Bitcoins they represent. If you lose the keys, that Bitcoin is lost to you forever. It’s not like credit cards, where you can report a theft and have a transaction voided or get a replacement in the mail if you lose the card.

As a result, safe storage is extremely important.

A common way to store Bitcoins is in digital wallets like Coinbase. This is the easiest solution if you are actively transacting with Bitcoin.

However there have been dozens of stories of wallets getting hacked. In a recent theft, hackers made off with 4,100 Bitcoins totaling $1.18 million from Bitcoin wallet Inputs.io.

Inputs.io shut down, and its founder, using the alias TradeFortress, later said, “I don’t recommend storing any Bitcoins accessible on computers connected to the Internet.”

What’s the alternative? Keeping Bitcoins offline, or in “cold storage.” There are a couple of ways to do this.

You can save the Bitcoins on a USB or external hard drive.

You can even save them in a paper wallet by printing out a public address and the private key. Bitaddress.org is a popular service for doing this, but remember to generate the paper wallet offline so you don’t expose the private key to hackers and so you can keep the physical copy safe.

When you want to spend Bitcoins that you have printed out, you have to load the private key back into a digital wallet.

What can you buy with Bitcoin?

Now that you have a Bitcoin stash, where can you spend them? The list of merchants accepting Bitcoin is growing every day.

An Orange County, Calif., Lamborghini dealership recently sold a Lamborghini Gallardo in exchange for Bitcoin, and we’ve heard various tales of mansions being sold for Bitcoin. Making large purchases like these in Bitcoin means quicker approval time (as long as you have the correct amount on your wallet, you are good to go), and significantly lower transaction fees than going through a bank or credit card company.

You can now use Bitcoin to make in-app purchases in Zynga games. You can use Bitcoin to pay for gift cards, airline tickets, an account on OKCupid, plastic surgery, food and drink at bars and restaurants, and wares from independent merchants on Etsy and Shopify. You can even buy the news: The Chicago Sun Times partnered with Bitwall to experiment with a Bitcoin paywall for its content.

Overstock.com recently became the largest retailer to accept Bitcoin to date, and the company made $124,000 through 780 Bitcoin orders within less than 24 hours of accepting it as a form of payment.

Want to use Bitcoin in the real world? Coinmap is a useful tool for finding physical establishments that accept Bitcoin.

Should you prefer to redeem your Bitcoin for cash, there’s always the aforementioned Robocoin ATMs. More units are shipping around the world this year.

Bitcoin enthusiasts such as Adam Draper, who runs a Bitcoin startup accelerator called Boost.vc, say merchant adoption is critical to creating a vibrant ecosystem around the Bitcoin. Right now, it is treated more as an asset than a currency — something you hold on to rather than spending on a piece of pizza or new bed sheets. Given the recent volatility of Bitcoin’s price, it doesn’t make sense to use it as a daily currency. But more opportunities to spend Bitcoin will create more liquidity in the market, which in turn will encourage more growth.

There are benefits to merchants as well: The transaction fees are significantly lower than credit cards or PayPal, and you can cash out the value of the Bitcoin right away so as not to lose money if the price drops.

Bitcoin: Good or evil?

Understanding Bitcoin is very different from believing in its viability or future. Despite how far the ecosystem has come, a flourishing crypto-currency is still uncharted territory.

New York Times columnist Paul Krugman, who won the Nobel Prize in Economics, wrote that “Bitcoin is evil” and he remains “deeply unconvinced” that Bitcoin can ever be a stable store of value.

Reuters’ economics editor Edward Hadas called Bitcoin a “fool’s gold standard.” He said it is not backed by anything substantive enough to make it viable, and that it is particularly susceptible to crashing — its popularity represents “widespread economic amnesia.”

These are voices worth paying attention to. Bitcoin raises security concerns and has few protections in place for its investors. If hackers get into your wallet or your hard drive crashes, that’s it — your money’s gone. And Bitcoin hacking is not merely a theoretical worry; many incidents of hacking and theft directed at exchanges have already happened.

However, there are other experts who see tremendous promise in Bitcoin.

Marc Andreessen is a well-known venture capitalist who helped create the SSL cryptographic protocol for Web browsers. He has helped invest $50 million into Bitcoin startups and recently wrote that Bitcoin matters because it transforms one of the most fundamental things people do — make payments.

Andreessen said one of the most exciting applications is in international remittances. Immigrants send $400 billion a year back to their families in their home countries. Banks and payments companies extract up to 10 percent or more of these transactions, whereas Bitcoin fees would represent a tiny fraction of that amount.

Lower fees also have broad implications for merchants, particularly those with a narrow profit margin or those that sell inexpensive items. If you sell coffee for $3 per cup and payment fees gobble up $0.25 of each transactions, the cumulative loss is significant.

In both of these examples, by cutting out the large financial institutions, people get to keep more of their money.

Bitcoin also creates new opportunities for micropayments, meaning payments below $1. Right now, those are too expensive to process efficiently through the existing credit card and banking systems. With Bitcoin, it is possible to send pennies at a reasonably low cost. This means it is possible to charge someone a tiny amount for a small act, like reading one newspaper article.

Bitcoin makes it easier to send cash to a complete stranger as well. In December, a college student held up a sign with the QR code to send money to his Bitcoin wallet. His sign made it into ESPN’s game footage and the story took off on Reddit. As a result, he received $23,000 worth of Bitcoin, sent by total strangers who had nothing more than his QR code for an address. This could have huge implications for disaster relief, fundraisers, or protests.

It is these kinds of possibilities that have Bitcoin evangelists so excited.

However, possibility and excitement do not translate into economic reality — not necessarily.

Ultimately, only time will tell whether Bitcoin is a viable long-term currency.

In the mean time, you can still buy a cup of coffee — in the right cafes — with a fistful of satoshis.

More information:

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 addit... read more »

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