(Bloomberg) -- The initial price of Bitcoin, set in 2010, was less than 1 cent. It recently crossed $23,000. Once seen as the province of nerds, libertarians and drug dealers, Bitcoin these days draws millions of dollars from hedge funds and companies like MicroStrategy and Square, while PayPal lets consumers use Bitcoin to pay for goods and services. The recent price surge could reflect recognition by the financial community that so-called cryptocurrencies -- digital forms of money -- can be useful, and that Bitcoin in particular can fill the role of gold as a hedge against inflation better than gold can. Or it could just be a repeat of wild Bitcoin bubbles of the past.
1. What exactly is Bitcoin?
It’s a form of money that’s remarkable for what it’s not: It’s not a currency you can hold in your hand. It’s not issued or backed by a national government. At their core, Bitcoin and its imitators are sets of software protocols for generating digital tokens and for tracking transactions in a way that makes it hard to counterfeit or re-use tokens. A Bitcoin has value only to the extent that its users agree that it does.
2. Where did the Bitcoin system come from?
The original software was laid out in a white paper in 2008 by a person or group of people using the pseudonym Satoshi Nakamoto, whose identity remains unknown, despite several efforts to assign or claim credit. Online fantasy games had long used virtual currencies. The key idea behind Bitcoin was the blockchain -- a publicly visible, largely anonymous online ledger that records Bitcoin transactions.
3. How does that work?
Think about what happens if you make an online transfer using a bank. It verifies that you have the funds, subtracts that amount from one spot in a giant database it maintains of accounts and balances, and credits it in another. You can see the result if you log on to your account but the transaction is under the bank’s control. You’re trusting the bank to remove the right amount of money, and the bank is also making sure you can’t spend that money again. The blockchain is a database that performs those tracking functions -- but without the bank or any other central authority.
4. Who performs the bank function for Bitcoin?
It’s done by consensus on a decentralized network. Bitcoin transactions can be made through sites offering electronic “wallets” that upload the data to the network. New transactions are bundled together into a batch and broadcast to the network for verification by so-called Bitcoin miners.
5. Who gets to be a miner?
Anybody, so long as you have really fast computers, a lot of electricity and a desire to solve puzzles. The transaction data in each batch is encrypted by a formula that can be unlocked only through trial-and-error guessing on a massive scale. The miners put large-scale computing power to work as they compete to be the first to solve it. If a miner’s answer is verified by others, the data is added to a linked chain of blocks of data and the miner is rewarded with newly issued Bitcoin.
6. How does the system prevent cheating?
Because every block contains data linking to earlier blocks, an attempt to spend the same Bitcoin twice would mean revising many links in the chain. Plus, as miners compete, they verify each other’s work each step of the way.
7. Who buys and uses Bitcoin?
Bitcoin used to be the domain of Libertarians and drug dealers. Not any more. By now prominent money managers like Mike Novogratz and Alan Howard have invested hundreds of millions of dollars in Bitcoin and other cryptocurrencies. A survey Fidelity Investments conducted earlier this year found that 36% of institutional respondents held crypto in their portfolios. More than six out of 10 expressed interest in Bitcoin and other cryptocurrencies, up from fewer than half in 2019. Amid recent meteoric price appreciation -- Bitcoin has almost tripled in 2020 -- retail investors are getting in on the game, too, with many new users jumping into crypto this year.
8. Why is Bitcoin’s price rallying like crazy this year?
Long-time Bitcoin fans point to the so-called halvening that happened earlier this year, and cut in half the amount of new Bitcoins issued to miners for verifying transactions. Halvenings happen every three to four years. Because they limit the growth of Bitcoin, they are typically followed by rallies (often followed by deep crashes). At the same time, the entry of institutional investors, buying up hundreds of millions of the currency, has also pushed the price up.
9. What’s the appeal for investors?
Zero and negative yields on traditional assets are driving hedge funds and even companies like MicroStrategy to pour cash into Bitcoin, which while being highly volatile has appreciated substantially over the long term. While nay-sayers have long said that Bitcoin’s value will go down to zero, many have recently had to revise their thinking -- simply because enough people seem to believe in Bitcoin.
10. Why is Bitcoin compared to gold?
As a scarce resource, gold has traditionally been a hedge against inflation. Governments can speed up their treasuries’ printing presses and thereby debase their currencies, but miners can’t flood markets with gold, goes the thinking. Part of Bitcoin’s appeal lies in the fact that it isn’t controlled by governments or their monetary policies, and that its supply is limited even more strictly than gold’s: halvenings help slow down the mining of new coins and production will cease entirely at 21 million coins. With the vast spending by governments and central banks in response to the pandemic raising fears of inflation after economies recover, more attention than ever is being paid to Bitcoin as “digital gold,” even as inflation remains muted.
11. What’s happening with institutional investors?
They seem to be feeling more comfortable wading into Bitcoin in part because of better safeguards. The U.S. Treasury Department, for instance, has proposed requiring banks and other intermediaries to maintain records and submit reports to verify customer identities for certain cryptocurrency transactions. Over the past few years, Bitcoin has also developed a more substantial financial infrastructure. There are custody and trading services -- with proper licenses and credentials -- that cater specifically to the large regulated investors.
12. So is this another bubble, or is Bitcoin really digital gold?
That’s still unclear. As quickly as institutional investors got into it, they could get out of Bitcoin, pushing down prices dramatically: Bitcoin is still a thinly traded market, where so-called whales, controlling large quantities of coin, hold huge sway. In fact, ownership concentration in Bitcoin has increased during the latest rally, since July, with about 2% of anonymous accounts that can be tracked on the coin’s digital ledger called blockchain controlling 95% of the available supply, according to researcher Flipside Crypto. A whale’s exit -- a more likely event now that Bitcoin is the domain of not just believers but also pragmatic financiers -- can send ripples throughout the ecosystem, and pop the bubble.
13. Could another cryptocurrency supplant it?
As the number of cryptocurrencies and tokens continues to multiply -- they now reach into the thousands -- Bitcoin remains the best-known, time-tested and valuable. It’s also the one coin that’s considered to be a potential store of value. Others, such as Ethereum, are used for other things, such as issuing tokens for use in decentralized finance applications. While a digital-gold alternative could yet emerge, it’s increasingly looking unlikely.
14. How can I buy Bitcoin or invest in it?
There are a bunch of ways, all with different risks. People can buy the coins directly from exchanges like Coinbase. Accredited investors can also invest in vehicles like the Bitcoin Investment Trust, which tracks Bitcoin’s price. Now investors can buy or sell Bitcoin futures, and soon may be able to buy Bitcoin exchange-traded funds, once regulators feel comfortable with the idea. But be warned: Even plenty of people who believe in Bitcoin’s future think some wild rides lie ahead. The big runup in Bitcoin’s price back in 2017 was followed by an 83% rout that lasted a year.
©2020 Bloomberg L.P.