As cryptocurrencies grow in adoption—and perhaps more enticing, price—all types of investors are exploring them as a potential alternative to traditional stocks and bonds. While bitcoin (the first and largest type of cryptocurrency) has technically been around since 2009, it’s recently become a tantalizing option for investors looking to jump on a growing trend. But what is it, exactly? How does it work, and is it really a viable investment option?
What Is Bitcoin?
To put it plainly and simply, bitcoin (and cryptocurrency as a whole) is a unique digital asset that exists exclusively online. While traditional electronic money transfers rely on centralized and permissioned bank networks and services, bitcoin works within decentralized and permissionless networks that rely on “confirmations” rather than “approvals.”
In the traditional world, banks essentially act as the middleman: Money transfers must be completed through the bank and only with the bank’s permission. But in the decentralized and permissionless world or cryptocurrency, every party has direct access to every other party, as shown in Figure 1 below.
Figure 1: Value Transfer in the Traditional World vs. the Crypto World
Source: CFA Institute
In addition, bitcoin transactions are available for all to see on a public ledger. Contrast that with flat currency, where there are no shortages of ways that financial institutions can hide what is happening with its creation or movement. Many see this transparency as a potential valuable alternative against money printing and central bank manipulation.
How Is Bitcoin Created?
Bitcoin exists on a blockchain network. Blockchain is essentially an online database that stores information in a specific way, and for our purposes, it is the ledger that keeps track of all bitcoin transactions.
It works like this: Newly proposed bitcoin transactions are bunched together and stored in what’s called a “block.” Each block created is linked together in a “chain” (hence the name blockchain). Each time a bitcoin transaction is proposed, a block is added to the chain. And each time a block is added to the chain, the blockchain becomes harder to replicate and manipulate, because all the data within the network is linked together in a single chain, and it’s all visible to every computer in the network.
Additionally, bitcoin works on what’s called a “proof of work” mechanism. Blocks are created by miners, which are powerful computers that compete with one another for the right to settle an open block and complete proposed bitcoin transactions. There are incentives for settling blocks, and settlement requires the computer to solve a challenging mathematical puzzle. Within bitcoin’s specific network, miners create “hashes,” essentially guesses at what the answer is to a cryptographically secured algorithm. This complex formula, called SHA-256, requires a tremendous amount of computing and electrical power to solve. Once the puzzle is solved and verified by the other computers in the database, the block is settled, the transaction is completed, and the miners are rewarded for doing their part in securing the network.
Is Bitcoin Secure?
It might come as a surprise, but bitcoin is actually considered very secure, and it’s the blockchain network that makes bitcoin so safe. All the data within the network is linked together in a single chain, and it’s all visible to every computer in the network. So, as mentioned before, for our purposes, the blockchain database is the ledger that keeps track of all the bitcoin transactions in the network. Since all the transactions (the data) on the chain are visible to everyone in the network, everyone plays a part in ensuring the ledger is up to date and accurate.
Transparency and competition keep the data in the blockchain safe. Because everyone can see the data stored in the blockchain, and because new blocks are added to the chain every 10 or so minutes, it’s difficult to copy or falsify that data.
Think of it this way: Let’s say you buried some treasure in your yard, and every 10 minutes, you pour more dirt on it. Anyone trying to dig up your treasure has to start over every 10 minutes, and every time they start over, they have further to dig to reach the treasure. By keeping all the data stored on a single blockchain, the data becomes harder to tamper with every time a new block is added, because it’s protected by the constantly compounding blocks within the chain.
Is Bitcoin Worth Investing In?
While the blockchain network helps ensure your bitcoin and data are safe, that doesn’t mean investing in bitcoin is a sure thing. Investors need to be aware of the risks involved in pursuing digital assets like bitcoin. Financial goals can still be met by investing in more traditional asset classes, and the risks of substantial downturns exist across the crypto ecosystem.
This content is for general information only and is not intended to provide specific investment advice or recommendations. All information is believed to be from reliable sources, but accuracy is not guaranteed. Both traditional and cryptocurrency investing involve risk, including the possible loss of principal.