From mathematical wonder, revolutionizing breakthrough, next-gen money to fraud and one big fat scam – Bitcoin has been awarded a multitude of epithets. While some start their mornings by checking Bitcoin exchange rates, others predict doom and gloom for its adepts. There’s also a third group – those who are just waking up to the new reality of Bitcoin and blockchain looming from everywhere.
“The Internet is among the few things humans have built that they don’t truly understand,” said Eric Schmidt and Jared Cohen in The New Digital Age. Well, I say we can safely add the Bitcoin and blockchain to the list of things humans built that they don’t understand because both are a lot more complicated than the Internet.
If you’re beginning to feel awkward not understanding what the fuss is all about, it’s high time you sorted out the subject.
What Is Bitcoin?
In casual conversations, you can get away with knowing that bitcoin is a digital currency. But in reality, it’s several things:
- Bitcoin is a platform developed by an individual – or a group – that goes by a pseudonym Satoshi Nakamoto.
- Bitcoin (often used with a lower case or abbreviated as BTC) is a virtual currency, and the most valuable cryptocurrency for that matter, at least for now.
- Bitcoin is the first example of a fast-growing type of money known as the cryptocurrency, or crypto.
- Bitcoin is its own payment network devoid of a centralized overseeing authority.
The simplest way to explain a cryptocurrency is it is a digital asset stored on decentralized, peer-to-peer computer database similar to file-sharing networks. Anyone can buy Bitcoin and use it to purchase goods and services online.
How is Bitcoin Different from Normal Currency?
Unlike traditional currencies, Bitcoin and other cryptocurrencies are not issued by any entity. There is no bank, sovereign state or monetary fund that prints, controls and regulates cryptocurrency. It does not exist in physically tangible form.
In theory, conventional currency should be based on gold. But in practice, the U.S. dollar stopped being backed by gold since 1971, and the U.S. government backs the currency ever since.
Bitcoin is not backed by any state, but it is not based on gold, either. It is ruled by computer code and mathematical logic.
Cryptocurrencies are produced by people and businesses running software that solves mathematical problems using the computing power of their computers. The concept of “proof of work” is at the core of Bitcoin generation process. To create – or mine – a new Bitcoin, a computer must complete an extensive mathematical calculation.
In layman terms, you download the software, install it, and let your hardware do the mining. Bitcoins are mined by using the computing power of tens of thousands of computers in a decentralized, P2P network.
The mathematical algorithm used to produce Bitcoins is freely available, anyone can check it. The software is open-source, so anyone can audit it and make sure it works as advertised.
The value of a newly minted currency is whatever the market commands through supply and demand. The more people buy it, the higher its value, just like with your traditional currency exchange rates.
Bitcoin is based on a distributed ledger technology – the blockchain. Blockchain relies on nodes – individual computers in a global P2P network – to run a database that is:
- Always online and up-to-date
- Not tied to a single location
- Not controlled by a single, centralized entity
- Cannot be infiltrated or corrupted because it’s impossible to corrupt tends of thousands of computers across the world at once
The blockchain database verifies itself at certain intervals automatically. This self-auditing feature guarantees the data held by the system is accurate at all times.
Groups of data inside the system are dubbed blocks, which are chained to one another cryptographically. In such chains, individual pieces of information get buried under other blocks and are therefore much harder to corrupt than data in a regular database stored on servers. Changing one part of data within a block requires enormous computing power.
Since the ledger is open and distributed, verification of transactions on the blockchain is ensured through the consensus of every member. The degree of security and trust it provides is unprecedented, especially because it eliminates a third-party overseer from the equation.
This decentralized P2P network also processes transactions made with Bitcoin or any other cryptocurrency, which effectively makes Bitcoin its own payment network.
What’s the Appeal?
Cryptocurrencies possess inherent features that set them apart from state-backed currencies and make them appealing to individuals and businesses alike.
- P2P – The decentralized nature of cryptocurrencies sets them free from one central authority. Every Bitcoin-mining computer is also a part of the payment network. In theory, no centralized overseeing entity can impose a monetary policy on Bitcoin, or pull the plug on the system and bring it down for everyone simultaneously.
- Ease of Use – Even if you don’t understand the technology behind Bitcoin, you can set up a wallet and buy BTC or pay with BTC for online goods and services in a matter of minutes.
- Anyone Can Buy It – No paperwork, mind-numbing red tape, and bureaucratic hoops. Most importantly, no questions asked, no fees to pay. It’s a free software you install and use.
- No Conversion Fees – Bitcoin transactions involve no conversion fee, even if you trade with overseas partners.
- Fast – Transactions come through almost instantly. They only take a few minutes to confirm.
- Global – transactions work anywhere where the global P2P network is available, be it next door or across the ocean.
- Relative Anonymity – Or pseudonymity, since accounts and transactions aren’t tied to real identities. You use the so-called address, a chain of 30-something characters, to receive Bitcoins. That address does not have to be tied to your real identity, and you can change it as often as you wish.
- Transparency – The blockchain holds information about every single transaction that happens on its network. Your public Bitcoin address reveals how many Bitcoins it stores, but not your identity. You can use multiple addresses, and avoid storing all your Bitcoins in a single address as a way of obscuring the publicly available information on your Bitcoin totals.
- Security – The public key/private key cryptographic system works its magic, and as long as only you have access to your private key, your Bitcoins are safe. Each coin movement is recorded and stored in thousands of continuously synchronized blockchain files across the world, which makes it all but impossible for someone to alter the transaction history.
- Limit – there is a cap set on the total number of Bitcoins that can be produced (21 million). Therefore, inflation can’t devalue the cryptocurrency as it can do to state-backed currencies.
- Free from Censorship – cryptocurrencies can be used for transactions that traditional payment processors would censor.
Combined, these features make cryptocurrencies superior to fiat (state-backed currencies) in the way that you don’t need to involve any third parties with your transactions that are cheap, fast, and global. Oh yeah, and your transactions are recorded on a decentralized, incorruptible ledger that anyone can confirm.
A Brief History of Bitcoin
Bitcoin emerged after the financial crisis of 2007-2008 and grew stronger when Occupy Wall Street accused banks of rigging the system and scamming their customers. Bitcoin historians believe that when people realized they put too much faith in the central banking system, they were finally ready to accept a new, revolutionary idea. An idea of a global, transparent currency free from middlemen, centralized authority, interest fees, and corruption.
2008: The Shady Origins
Bitcoin surfaced when Neal King, Vladimir Oksman, and Charles Bry filed a patent for “Updating and Distributing Encryption Keys” in August 2008. A few days later, bitcoin.org was registered. The WhoIs record does not reveal much about the owners, except that they’re registered in Panama, and that the domain expires in 2021.
In October 2008, Satoshi Nakamoto published a whitepaper “Bitcoin: A Peer-to-Peer Electronic Cash System.” Even though the paper mentions the author’s website as bitcoin.org, it remains unclear who Satoshi Nakamoto is, or if it is a single person or a group of people.
Interestingly, “Satoshi” means wisdom and “Nakamoto” means “central source” in Japanese, which leads some inquisitive minds to believe that a group – rather than an individual – is behind the project. One theory suggests Bitcoin is the brainchild of NSA or CIA, claiming that “wisdom” and “central source” allude to “Central Intelligence.”
Proponents of the CIA/NSA theory argue that no one has ever met Satoshi Nakamoto in person, and the group behind the technology most certainly had intelligence training. Other evidence includes the use of PRNG crypto program in Bitcoin, which is believed to have an NSA backdoor. Additionally, the use of the NSA-developed SHA-256 hash function in Bitcoin leads some to assume NSA embedded a backdoor to the hash function to spy on Bitcoin users. There is no conclusive evidence to this theory so far.
Officially, Bitcoin.org states Nakamoto left the project, handing the ownership to a group of individuals so that they could share responsibility and prevent one person from gaining full control of it.
The mystery surrounding the creator – or creators – of Bitcoin keeps the crypto community in suspense. The true origins of the technology could reveal if there is an ulterior motive and hidden backdoors in it, or not.
2009: The Genesis
Bitcoin Version 0.1 was released in January 2009, and the first generated block was dramatically named Genesis. In October 2009, Bitcoin got its first valuation in US dollar at $1 per 1309 BTC, based on the cost of electricity it took for a computer to mine one Bitcoin. And so, the ball – or rather the block – started rolling.
2010: Let It Roll
In May 2010, the Bitcoin community celebrated the Pizza Day, when Bitcoin was first used to buy physical goods – two pizzas worth 10,000 BTC or $25 at the time. That’s $11.47 million today, so let’s hope the pizzas were topped with diamonds (and lots of cheese!).
In August 2010, 184 billion Bitcoins were hacked when someone found an exploit in how the system verified the value of crypto. Notably, that incident didn’t prevent Bitcoin from rising to $0.5/BTC in November 2010 and then to $31 per 1 BTC in February 2011.
Ever since then, Bitcoin grew at an increasing speed, and the fact that a popular exchange service Mt. Gox got hacked didn’t stop crypto adopters from pumping up the mining pace.
2013: The Real Money
2013 was marked by several major events, as Federal Judge Amoz Mazzant declared that Bitcoin was real money, and could be used to buy goods and services. He did admit that it’s limited to the markets that accept it as currency – fair enough.
In November 2013, the first Bitcoin ATM was opened in Vancouver.
In December 2013, China officially declared Bitcoin “not a currency.” The Chinese government feared Bitcoin could threaten China’s financial stability, so it banned the national banks from interacting with the cryptocurrency altogether.
Ironically, a few years later China became the largest Bitcoin trader in the world, only to request Chinese Bitcoin exchanges and traders to halt their services in September 2017. Either they know something others don’t, or it’s a shaped trend of governments tightening the grip on the crypto.
Ups and downs continued in 2013, as Bitcoin became the currency of choice for one of the major dark web marketplaces – the Silk Road – where criminals traded drugs, weapons, and other illegal goods. So Bitcoin got in the spotlight again, but for all the wrong reasons, as it became associated with the criminal underworld. According to Wired, 45% of Bitcoin exchanges shut down in 2013 due to hacks and fraud.
2014-2015: One Milestone After Another
Bad publicity did not rain much on Bitcoin’s parade, however. It certainly did not prevent BTC from reaching parity with USD in early 2014, a major milestone for currency that wasn’t worth a zilch when it first started.
At the same time, the concept of hardware wallets emerged, and users were finally able to save their Bitcoins on external carriers.
Disaster struck when Mt. Gox got hacked again in March 2014. Millions of Bitcoins were stolen, leaving customers high and dry.
A few months later, in mid-2014, the Silk Road was shut down. After the government auctioned confiscated Bitcoins, the cryptocurrency got rid of the dark web associations (at least partially) and continued on its course to global success.
In late 2014, Microsoft started accepting Bitcoin payments for games and videos on the XBox platform and apps in the Windows phone store. More and more merchants began accepting Bitcoins.
The next thing you know, the New York Stock Exchange “taps into a new asset class” making a minority investment in one of the leading platforms Coinbase in early 2015.
By the end of 2015, approximately 160,000 companies accepted BTC payments.
2016: ICOs – It’s Raining Money
The same year saw a rise of ICOs, the initial coin offerings, as Golem raised $8.6 million in BTC in 20 minutes.
That same year, the CEO of a US-based exchanger Cryptsy was charged with $3.3 million worth of BTC theft, while $72 million worth of BTC were stolen from a Hong Kong-based exchange Bitfinex and $2 million from GateCoin.
2017: All-Time High
In March 2017, BTC price surpassed that of an ounce of gold. In June, the crypto hit an all-time high as it reached $2967.48 mark. The number of Bitcoin-related projects on GitHub exceeded 14,000. At the same time, the blockchain technology is actively adopted in other fields such as healthcare, banking, cybersecurity, and many others.
Bitcoin not only grew strong, but helped grow smaller cryptocurrencies such as Ethereum, LiteCoin, or DogeCoin. The industry of cryptocurrencies is gaining traction, securing millions in funding from tech and financial sectors.
ICOs have revolutionized the financing landscape for start-ups and surpassed the early-stage venture capital funding. By now, ICOs have funded companies for over $1.2 billion.
However, some experts claim it is the blockchain that holds the keys to the future, not Bitcoin. Some analysts and Bitcoin early adopters fear that Bitcoin is a bubble “that’s going to blow up in many people’s faces,” and that ICOs are a scam.
Despite the pessimistic voices, the crypto community is ecstatic, forecasting that Bitcoin will change the banking industry forever.
As you can see, Bitcoin’s is a history of bold ups and downs, astounding success, and abhorrent fraud – all wrapped in one. Considering its humble beginnings, it grew to be a global cryptocurrency in less than a decade. Now it has its own application programming interface, exchange rate, and price index.
All over the world, merchants accept BTC payments – from Microsoft to PayPal, Dell and Expedia to REEDS Jewelers, private hospitals, and a multitude of online services, VPNs included. A substantial number of online magazines, forums, and websites promote it, discuss it, and trade it.
The sheer volume of analytics on Bitcoin’s future is overwhelming. While some publications are all-hyper about crypto, others anticipate the bubble is about to explode. This is how Jordan Belfort, the banker portrayed by Di Caprio in The Wolf of Wall Street, describes Bitcoin and ICOs:
"Probably 85% of people out there don’t have bad intentions, but the problem is, if 5 or 10% are trying to scam you, it’s a ***king disaster."
So, how can you tell promotional fanfic from analytics based on facts, and legitimate concerns from fear mongering? In the next chapters of this guide, I am going to try and take a critical look at Bitcoin and cryptocurrencies.
Recent News and Case Studies
In case you haven’t been following the Bitcoin news, its price went up 600% over the last year, and 1600% over the previous 24 months. Priced at over $4,200, BTC is now three times more expensive than an ounce of gold while Bitcoin evangelists predict the growth will only intensify in the next few years.
Financial analysts are not so optimistic because the price of cryptocurrencies depends on many circumstances. How governments around the world react to crypto is one of the critical factors defining the present and future of Bitcoin.
Is Bitcoin Legal and Regulated?
There is no simple answer. It depends on where you are and what you do with your coins.
The extent of semi-anonymity BTC allows, and its decentralized nature do facilitate illegal transactions. Bitcoin was the only currency accepted by the notorious Silk Road, shut down in 2013. It was the currency favored by two of the dark web’s largest marketplaces Alphabay and Hansa, which were recently seized by joined forces of the European police, the FBI, the DEA and the Interpol.
Not helping Bitcoin’s reputation is the fact that it was the primary payment method used by criminals in the recent WannaCry ransomware attack that sent shock waves across the world.
Because some Bitcoin owners use it to buy illicit drugs and chemicals, there is a flair of illegality to the cryptocurrencies. But can you think of any currency, precious metal or commodity that does not have a history of facilitating money laundering, tax evasion, extortion, or bribery? Many believe it’s not Bitcoin that the regulators should go after, but the illegal activities.
Regardless, the question of Bitcoin’s legality is complicated. Some jurisdictions already have regulations and laws in place that deal with Bitcoin, while others are still hesitant.
In the United States
In the US, the legal landscape for Bitcoin is a patchwork of varying approaches because each state can do as it pleases. For instance, a U.S. Magistrate of New York ruled that BTC is not money. In the meantime, a judge in Manhattan ruled that it was an acceptable means of payment.
What this means for you:
- Users - If you buy Bitcoins and use them to purchase legal virtual goods and services, you are doing it legally, according to the U.S. Financial Crimes Enforcement Network, FinCEN. BTC received from another person as a result of exchange counts as gross income subject to income tax.
- Miners – If you mine Bitcoins and exchange them for fiat currency, FinCEN views you as a money transmitter, which could make you liable for money transmitting business (MTB) classification. There is little clarity on that matter for now, though. BTC earned by mining is viewed as income by IRS and is taxable with the expenses accrued being deductible (i.e., computing power). When miners sell their coins, they are taxed on the increase in the BTC value between the time the coins were mined and when they were sold.
- Exchanges – These are definitely viewed as MTBs by FinCen. In tax terms, BTC earned through trade or running an exchange falls under capital gains and are taxed.
- The IRS issued a draft guidance on virtual currency on how it views BTC as a taxable asset.
- You also need to account for how much your coins are worth in relation to USD, keep a detailed BTC expense report, and record the BTC value when you spend it.
Around the World
Internationally, Bitcoin’s legality, as well as corresponding regulations, are complicated, too. Some countries view it as a commodity, others as a currency. Some countries like Estonia are encouraging the use of crypto while Bolivia, Ecuador, Bangladesh, and Kyrgyzstan have banned it. Most countries are in the gray zone with little clarity on crypto’s legality and regulations.
- EU - In the European Union, BTC is viewed as a currency not subject to VAT/GST and income tax when you convert it from crypto to fiat. At the same time, if you buy goods online and pay in BTC, the transaction is taxable. The European Central Bank declared that the current regulations made for fiat and traditional financial sector do not apply to cryptocurrencies. Mario Draghi, the president of the ECB, said crypto was too immature to be considered a viable payment method.
- UK - The United Kingdom has not implemented much of regulations on Bitcoin, treating it as private money. This means profits/losses during BTC trading are subject to capital gains tax. VAT applies to any transactions when goods or services are bought for the digital currency. The British approach is applauded by the start-ups, which can experiment with the ICO funding without red tape.
- China - China’s attitude to crypto took a sharp turn in 2017, as it first banned the ICOs and then the crypto exchanges altogether. Some believe the ban is temporary until the authorities decide on how to tighten the grip on record-keeping, licensing, and anti-money laundering (AML) laws for exchanges. The rumor also has it China might be building its own cryptocurrency.
- Japan - Japan’s regulations aim to normalize Bitcoin payments, protect its users and facilitate BTC transactions’ compliance with AML laws. Japan’s regulations create a favorable climate for start-ups so that they could act in a stable business environment. Japan also gained from China’s exchange ban, authorizing a dozen crypto exchanges and welcoming Chinese traders to an efficient and well-regulated ecosystem.
Obviously, there is no global agreement on how crypto should be defined, taxed and regulated. There might never be. Nonetheless, how regulators view cryptocurrencies is important because it affects the exchanges, the value of crypto and how – or where – the tech industry develops.
Initial Coin Offerings
ICO, or initial coin offering, is a big deal, and major publications have been allocating hefty real estate to it for a good reason: in Q2 of 2017 alone, ICOs have made $800 million. But what are ICOs and why is the sudden hype around them? Most importantly, how can anyone wrap their head around why startups are jumping on the ICO bandwagon en masse while the majority of experts warn they are extremely risky?
What is an ICO?
Start-ups often struggle to get the traditional angel or venture investments, which typically secure them for up to $3 million. An ICO secures up to $10-12 million! With ICOs, companies are crowdfunding their projects by offering crypto when their project will have launched.
In a traditional IPO, participants buy shares. In an ICO, participants use Bitcoin to buy tokens. Now, tokens are very particular – they can either be used in a specific environment or grant the holder rights or discounts within that environment.
For example, if you buy tokens from a cloud storage provider, you can then exchange your tokens for extra storage space as was the case with Storjcoin. The tokens can be used for voting powers – the more tokens, the more voting power. But in many cases, you can just exchange tokens for other currencies.
Unlike stocks, however, the token does not give you any ownership rights in the tech company, nor entitles you to any dividends.
How ICOs Work
ICO is currently one of the easiest methods for companies to fund their projects. It’s also one of the easiest ways for regular users to become investors. ICOs are also very easy to structure and set up. Thanks to technologies like ER20 Token Standard, companies skip a lot of development hassle when creating a new crypto asset.
A typical ICO event usually lasts from a week to a month, and everyone is allowed to buy newly issued tokens for Bitcoin or Ether.
An ICO usually has a specific goal or limit, and tokens have a pre-defined price that does not change during the ICO period. It is also possible to have a limited amount of tokens but a dynamic funding goal. In the latter case, token distribution depends on the funds collected, i.e., the more funds a project receives, the higher the token price will be.
Token supply can also be dynamic and depend on the funds received – the price of each token is static, but every time one coin is sent a new token is generated. In this case, the token limit is set based on the project goals or time.
If an ICO campaign fails, your funds will be returned. But even if an ICO campaign is successful, there is no guarantee the developers will deliver the product, and the token price will go up.
By now, ICOs have become a proven way of crowdfunding crypto projects, provided the product is in demand. For example, during Ethereum ICO in 2014, investors could buy a token for $0.3-$0.4. When the project’s platform launched in mid-2015, the price of tokens reached $19.42 per unit, which is over 6000% ROI.
In 2017, the crypto community saw about 140 ICOs so far, with over $2 billion in token sales. Experts predict $4 billion will be raised by the end of the year. Several ICOs launch every day while Silicon Valley is literally obsessed with them.
ICO experts warn, however, that for an ICO to be successful, a company must have blockchain at its heart. A multitude of ICOs fail when that’s missing.
Any investment is a gamble, but ICOs are beyond the extreme points of gambling. The reason - most of them raise funds pre-product, i.e., they are selling an idea, not a product.
Most companies have a white paper, but many things can happen between conception and product delivery, especially now that many companies simply want to pick up on the market hype.
Vetting an investment or the technology behind it is difficult, which makes ICO investments extremely risky, and facilitates downright fraud. Experts warn - only invest funds you are fine with losing.
Unfortunately, too many ICOs are opportunistic and fraudulent while hackers target ICOs and steal the collected Bitcoins. Recently, scammers stole $7 million in under 3 minutes by hacking a CoinDash ICO.
The ICO craze has also given rise to some indirect scams. The SEC recently issued a warning that some companies tout an upcoming ICO only to inflate their shares price, and cash out when investors buy in. The CIAO Group announced a $530 billion (!) Blockchain and Cryptocurrency Target Market collaboration in mid-2017, which was supposed to lure a multitude of investors into buying their stock. The SEC suspended shares trading of four companies that were pumping up their shares value by talking up ICO.
Another risk is ICOs will slow down at some point. According to CryptoHustle, “ICO mania is likely due to early Ethereum adopters making serious returns after the last bull run.” However, that doesn’t mean Ethereum’s run will keep fueling ICOs forever. How long the good times will last for ICOs is yet to be seen, but predictions are already there.
Are ICOs Regulated?
The risk also comes from the regulatory side. Despite the craze, ICOs are new and reside in the gray zone of law. For example, if the token buys you access to a network, the unregulated asset is most likely safe. But if you can exchange it and gain value, it most likely is a security regulated by securities law. The IRS said that crypto is taxable as long as it can be converted to USD.
Recently, the Securities and Exchange Commission (SEC) established a task force to target cybercrime, with the primary focus on ICOs (mainly thanks to the notorious investigation into the Decentralized Autonomous Organization’s ICO). The main takeaway from the investigation is that tokens are securities under US law.
Some companies are already launching platforms regulated by SEC. For example, tØ is launching an alternative trading system for tokens categorized as securities, which will be regulated by the Financial Regulatory Authority and SEC.
Some observers believe SEC will soon begin to clamp down on ICOs before they raise cash:
"If the SEC doesn't crack down, this party will be amazing, the biggest party in town for a long time. If they do crack down, a lot of people are going to feel a lot of pain," said investor Naval Ravikant.
The bottom line is ICOs are sort of regulated, depending on location, but globally, regulation is out of the mix. At least, for now.
Some argue that the absence of regulation is good because it allows the market to evolve and innovate quickly. For legitimate start-ups with great ideas that couldn’t get funding otherwise, that is true. But that doesn’t mean regulators shouldn’t act to protect investors and industry as a whole from the plague of fraudsters.
The Dangers of Bitcoin
One of the critical downsides of Bitcoin, cryptocurrencies, and blockchain in general, is it is still new, despite being around for nine years. The technology is not yet completely secure while BTC itself is extremely volatile. The industry is advancing through trial and error, and when an error happens, many people are left empty-handed.
BTC is vulnerable to public perception, Twitter trends, and events in the global or regional politics. What causes a minor fluctuation for fiat, can push BTC into freefall.
No central authority regulates the crypto’s supply and demand, and the BTC prices are highly susceptible to speculation and manipulation. Since the project is open-source, news of newly discovered security flaws often cause a price drop. A series of DDoS attacks on Mt. Gox sent crypto value into a dramatic decline.
Whenever coin exchanges are under attack, the resulting down times affect traders badly. In early-2017, a US-based exchange Kraken was robbed of more than $5 million in a hacker heist. During the attack, the price of Ether fell more than 70%, and many traders’ positions were liquidated with no further compensation.
Because crypto exchanges aren’t regulated like stock exchanges, there is no circuit breaker to stop trading during wild price swings. BTC prices have fluctuated violently, rising to $1,100 and falling to $76 in short lapses. Traders who lose money during such swings have no way of recovering them, and no one to blame.
Not helping Bitcoin is the fact that hackers are stealing a significant chunk of the total Bitcoin pie, according to Chainalysis. The total market value of cryptocurrency is about $135 billion. If hackers stole 1% ($225 million) of Ethereum’s total market value last year alone, the toll on Bitcoin is estimated to be even larger. That, too, affects crypto’s volatility.
The 51% Attack
51% is a notable security flaw in Bitcoin. If more than 51% of nodes – computers in the P2P network – tell a lie, the whole network treats it as the truth.
Satoshi Nakamoto warned about it, so the crypto community monitors BTC mining pools to ensure no one gains such influence. If one entity takes over enough nodes, it could then dictate its own version of the blockchain, or spend the same coins multiple times.
As of now, the largest BTC owner holds 15% of the total hashing power.
Some argue the very structure of Bitcoin and lack of regulation make fraud prevention hard. One of the biggest strengths and its weakest spot is Bitcoin’s irreversibility – when the transaction is through, there is no way to retrieve your coins.
If you buy something from fraudsters and pay with your credit card, you can cancel the transaction, and banks will often insure you. With BTC, you can’t cancel your payment or receive a refund.
- Ponzi schemes hook you by offering an abnormally high interest rate (1-2% per day) and redirect your money to the thief’s wallet. One of the red flags is the fraudsters operate using their Bitcoin address rather than a payment processor.
- Mining scams offer to mine astronomical amounts of BTC for you. Naturally, you need to transfer your crypto to them first.
- Exchange scams offer services that typical exchanges can’t offer, such as credit card and PayPal processing, or overly lucrative exchange rates.
- Online wallet scams appear as regular Bitcoin online wallets, but when you transfer your coins to your new address, it turns out the address is not yours but the scammers’.
- Then, there’s a multitude of stories like this Maryland retiree, when scammers put up a false car ad online and instructed the buyer to send them money using a Bitcoin ATM.
Security and Bitcoin
There is this nagging controversy that should bother you about cryptocurrencies unless you get brainwashed with crypto hype and success stories of average people getting rich. The controversy is if Bitcoin and blockchain are so secure and incorruptible, why investors and exchanges get hacked all the time?
Bitcoin fans seem to be hypnotized by some powerful NLP and deny the inherent security vulnerability and fatal flaw in BTC irreversible transactions. Meant to make cryptocurrency censorship-free, in a way that no one can stop a BTC transaction from happening, this irreversibility increasingly attracts thieves to crypto rather than fiat.
Is Bitcoin Secure?
Bitcoin fans say that because everything in blockchain is traceable, the system is secure. But cases, when hackers ransack individual electronic wallets and hack major exchanges, are frequent. So, is Bitcoin not as secure as they say, or are hackers extremely smart?
It’s both, plus the fact that securing Bitcoin wallets and exchange accounts requires the level of technical savvy most users might not have. At the end of the day, your digital wallet is as secure as the endpoint device you are using to access it.
If you use your smartphone to manage your Bitcoin wallet or trade, your coins are not secure. If you do it from your computer connected to a home network with a dozen devices like computers, printers, smart gadgets and routers, your coins are not secure.
John McAfee says any mobile device that’s ever accessed a porn website is infected with a keylogger or spyware. Thousands of mobile devices are currently infected, and somebody out there is watching your activity. It doesn’t matter who or where they are. What matters is when you install a Bitcoin wallet and set up your two-factor authentication, they know you’re up to something they can monetize.
Here is how a typical Bitcoin hack happens for an exchange customer:
- The attackers have a wide range of methods to pinpoint their targets, be it via spyware or by scouting social networks for people who are into Bitcoin trading. What they need is your email, phone number, and name.
- The attackers then contact your mobile service provider and port your number to a device under their control. Now, your two-factor authentication SMS will be redirected to their device, not yours.
- Since people often use their phone numbers as a way to backup their Gmail accounts, the attackers now gain access to your Gmail account. They reset your Gmail password and do the same for your exchange account. Voila!
- The scammers then transfer your coins to their wallets. The stolen coins are easy to track since everything in blockchain is visible, but the culprits are anonymous.
- Once the transaction is complete, it’s irreversible, remember?
- The scammers then either transfer the stolen coins to a foreign exchange, convert it to other cryptocurrencies that are harder to track or convert it to cash. Mission completed!
The Crypto Market is the New Wild West
In 2016 alone, $28 million losses from crimes involving BTC were reported to the FBI, three times more than in 2015. The FBI numbers are based on voluntary reports from individual victims and don’t account for large-scale crypto heists of exchanges. So the magnitude of the total theft of Bitcoin is seriously underestimated.
At least three dozen crypto heists occurred since 2011. Many of the exchanges had to shut down as a result, and more than 980,000 of Bitcoins worth $4 billion were stolen. Very few have been recovered while scammed investors have been left empty-handed.
Three years after the hack, 25,000 users of Mt.Gox are still waiting for their compensation. Since Mt. Gox collapsed into bankruptcy after losing 650,000 Bitcoins (around $500 million), investors’ odds of getting their compensation are dim.
Last summer, thieves pillaged some $72 million in BTC form a Hong Kong-based Bitfinex. Users of US-based exchange Coinbase lose up to $5 million a year to hacks. Coinbase representatives say the hacks “help them learn,” which sounds like a weak consolation for the victims.
In mid-2017, a federal judge in Florida ruled that the owner of Cryptsy, a collapsed US exchange, must pay $8.2 million to its customers. Some 11,325 BTC had been stolen, but Cryptsy doesn’t seem inclined to pay, which caused one of the plaintiffs’ attorneys to say cryptocurrencies heists are “no different that the Wild West.”
Making matters worse, Bitcoin exchanges aren’t covered by the FDIC, or bound by any consumer protection laws. Moreover, when hackers breach investors’ accounts exploiting weaknesses in user endpoint devices and porting phone numbers, it is not exchange’s fault.
How Can You Protect Your Coins Then?
John McAfee recommends using nothing but hardware wallets, and always using a standalone, clean device for your Bitcoin operations. It won’t help if you keep your hardware wallet offline only to connect it to an infected computer or a keylogger-infected smartphone to access your keys. Also:
- Contact your mobile provider and order a “do not port” service for your number
- Use apps like Google Authenticator for two-factor authentication – do not rely on SMS
- Maintain healthy password hygiene
Some users resort to medieval methods to protect their coins. They print out their private key on paper, cut it into pieces, and hide them in various places. They store it on encrypted USB sticks hidden in cookie jars, and whatnot. These “security” methods are rigged with self-inflicted losses. Isn’t it ironic for a revolutionary technology of the future to require such archaic security measures?
If you can spare 25 minutes to watch John McAfee’s explainer of Bitcoin security issues, you’ll have enough reasons to think twice before jumping on the crypto bandwagon.
The Future of Cryptocurrencies
Bitcoin emerged to bypass banks, not governments. The cryptocurrency allows people to transfer funds in a peer-to-peer fashion without ever having to trust and depend on the banks because it is the banking system that has earned itself a reputation of the world’s biggest villain.
Do Banks Fear Bitcoin?
According to a recent CNBC report, banks are most likely to be very afraid of Bitcoin. Financial advisers believe the harsh criticism coming from the likes of Jamie Dimon, JPMorgan’s CEO, is no more than a knee-jerk reaction of the banking system to a disturbing growth of crypto value.
Rising from zero in 2009 to $5,600 in 2017, BTC finally got the attention of Wall Street. Despite its inherent volatility and hacking issues, Bitcoin is gaining traction now that the general public is looking to invest in crypto instead of traditional assets controlled by banks.
Fear of Losing Control and Power
Banks enjoy a unique position of a trusted intermediary with zero accountability or transparency. For example, the Federal Reserve can just refuse to allow an independent audit of its $4.5 billion balance sheet.
The 2008 financial crisis saw stock markets collapse and some countries go bankrupt as banks robbed nations with an unprecedented immunity from prosecution. Every time banks victimize their customers, governments aren’t willing to seek jail time against financial institutions’ owners. It’s the taxpayers that get to bear the burden through inflation, government bailouts, lost homes and jobs, and higher fees.
“[Banks], frankly, own this place,” said Sen. Dick Durbin about financial lobby in the US Congress, basically confirming that banks and governments around the world are in bed.
No wonder millions of people are looking to eliminate the greedy intermediary. By contrast, blockchain logs every transaction enabling a complete transparency of its digital ledger, forcing no fees on its users.
Potential of Losing Money
Bitcoin lets people do what banks never allowed – invest and trade without any red tape because anyone can buy Bitcoin, and no paperwork is required for a crypto transaction to take place. Moreover, you don’t have to pay astronomical fees.
“People who could not access trade and finance ten years ago can do so today. This will lift many out of poverty,” said Chris Skinner, author of Digital Bank.
To get a better idea of how Bitcoin can leave banks without a significant piece of the pie, consider how banks use your money. When you make a bank deposit, your money is no longer yours – it’s your bank’s. While your money is with your bank, it doesn’t stand still – the bank is using it for various transactions to earn more for itself. And then, the bank charges you fees for storing your money. There are multiple layers of transactions, in which the bank is using your money - hence the 3-5 working days delay with most transactions. You never know the details of these transactions thanks to the legalized zero transparency.
Yes, banks have an infrastructure to manage, and employees to pay, but the odds never seem in your favor when you keep your money in a bank, especially if the 2008 scenario strikes again.
Now that blockchain solves the issue of double-spending, and increasingly more vendors accept Bitcoin, people choose to make their payments and investments in crypto. Bitcoin “disrupts the need for a bank to intermediate transactions,” says Vanity Fair. A report by BNP Paribas echoes by confirming blockchain “has the potential to transform the world of finance and beyond,” making traditional banks redundant.
According to a UK Banking Report, crypto is definitely a threat to banks because thanks to Bitcoin consumers choose to ignore the banks and transfer their money elsewhere:
“Bitcoin users can handle many of their daily payments needs themselves, without the need for interaction with banks, and avoiding the need to incur bank fees. In the same way, value stored in PayPal accounts moves outside of the bank’s payment systems, depriving banks of valuable payments revenue.”
Potential of Becoming Less Secure Than Cryptocurrencies
Crypto has quite a few security issues, as exchanges and wallets get hacked, and investors are left with no means of recovering the stolen funds or seeking justice. But let’s be honest – banks get hacked, too. Because banks are centralized, they are more vulnerable to hacking attacks.
The JPMorgan, Citigroup, TD Bank and Equifax hacks made the headlines because the information became public, but the true scale of data leaks in the financial sector is a well-guarded secret. Today, banks aren’t more liable for hacks than largely unregulated crypto exchanges.
As the security advantages of blockchain transactions are slowly dawning on banks, they don’t want to cede any ground to crypto, seeking to implement blockchain technology or participate in the crypto trade to secure their relevance in the new market.
Banks Want to Enter Crypto Market to Control It
Some say banks need to leverage blockchain and embrace Bitcoin to remain relevant. Instead, banks actively lobby for government regulation of crypto. These efforts aren’t always successful. For example, Hawaii requires for the exchanges to hold the cash amounts equal to the value of the crypto transactions, which urged Coinbase to pull out of Hawaii altogether. On the bright side, the US Commodity Futures Trading Commission granted LedgerX exchange approval, and now it is the first federally regulated exchange in the US, giving investors an opportunity to hedge against price swings. The move is set to attract users to federally regulated exchanges.
But overall, the evasive nature of the decentralized peer-to-peer network makes it impossible just to pull the plug on the entire market until it’s regulated. China and South Korea are trying to pull off the trick by banning crypto and exchanges. But they also risk stalling innovation and driving it someplace else with a better legal climate, like Japan.
Banks are notorious for unfair account manipulations, such as applying debits before credits and then charging customers for insufficient funds. With the nearly immediate availability of Bitcoin free from intermediaries, banks won’t be able to get away with such poor attitude to their customers for much longer. Chris Skinner says banks need to become more customer-friendly to compete with cryptocurrency in the long run.
American Banker, too, acknowledges crypto presents opportunities banks should seize:
“The roles banks could play include processing payments, providing escrow services, facilitating international cash transactions, helping customers exchange their money for Bitcoins, and even making loans in the currency.”
The financial system and governments are already entering the crypto market in an attempt to gain control over it. Japanese banks trade Bitcoin, while JPMorgan (the irony!) and Morgan Stanley are looking to create a blockchain-based Enterprise Ethereum Alliance. Russia created CryptoRuble, Citibank launched CitiCoin while the International Monetary Fund is looking to create its own version of crypto, too.
Christine Lagarde, IMF Managing Director, pictures IMF as a global regulator of crypto, noting that an IMF-created currency Special Drawing Right, or SDR, designed to be an international reserve, could incorporate crypto.
According to Lagarde, global financial organizations are taking risks by not understanding emerging fintech products with the potential to change the system. "I think that we are about to see massive disruptions," she said.
Is Bitcoin a Bubble?
Bitcoin adopters argue that, despite fear mongering and extreme volatility, Bitcoin has come to stay. John McAfee says crypto is not going anywhere anytime soon. At the same time, financial analysts and some early Bitcoin adopters cautiously warn - “Very bubble. Much scam. So avoid.” Somewhere in between is a group of Bitcoin investors who say “nobody knows if it’s a bubble at this point.”
- Sharp increases in price
- Public excitement
- Media hype, with stories of people turning rich with minimum effort
- Increasing interest in the asset of general public (the not-so-investment-savvy)
- Unprecedented price surges are justified by “new era” (technology of the future?) theories
- A decline in lending standards
There is no denying Bitcoin scores 6/6 here.
Some financial analysts argue Bitcoin, as money, fails on three critical fronts, based on the main characteristics of money:
- A storehouse of value – with Bitcoin’s daily volatility being 5-10% and a history of major price swings, can BTC meet the criterion?
- A unit of account – if it is a unit of account, analysts have yet to define for whom.
- A medium of exchange – despite the hype, Bitcoin is not as widespread, adopted and accepted as to meet this criterion, either.
In most cases, analysts agree on two points:
- The blockchain technology is disruptive and will lead to groundbreaking transformations, even if Bitcoin fails to survive.
- BTC, most likely, is a bubble. Some early adopters will reap the rewards if they get out before the burst while the majority – especially those late to the party – will end badly.
As you can see, the two points are not mutually exclusive. Many believe even if Bitcoin dies, another crypto may take the lead. Or banks and governments will unleash a state-controlled cryptocurrency and marginalize unregulated crypto into the confines of the dark web, again.
Should You Invest?
You should be asking yourself some serious questions before you venture out into the crypto market. First of all, are you familiar with risks associated with investments in cryptocurrencies? How much do you know about blockchain and are you making your decisions based on facts, not media hype or wishful thinking?
As Ben Doernberg, a former Dogecoin Foundation board member, put it:
“When you have a situation where people stand to put in a dollar and take out a thousand dollars, people lose their minds.”
If you intend to invest your next paycheck into your first Bitcoin, stop and think:
- Assess your finances – income, debts and associated interest rates, unforeseen expenses and total net worth. Account for things like having a compulsive spender in the household and having an emergency fund for three to six months to cover things like unplanned travel, illness, or, god forbid, unemployment.
- Can you afford to lose the invested money? With Bitcoin’s high volatility and lack of anything to back it but public demand, you should be prepared to lose your investment and take it easy.
- Think twice before investing if you have pending debts you’re better off paying, especially the high-interest ones.
- Assess your goals – why are you investing and how much risk can you tolerate? If you are after short-term investments, you are better off with lower-risk options.
If you can afford to risk:
- Do your homework and research the topic. Are you looking to invest in Bitcoin now that it hit an all-time high?
- If you want to invest in an ICO, look for markers of scam, research the product and development team, and their track record of actually delivering a product rather than selling an idea.
- According to financial advisers helping start-ups set up ICOs, a product should have blockchain at the core of its technology to be successful. So, look into tech start-ups that build their products on blockchain and offer tangible value in today’s market. Cybersecurity, cloud storage, secure inbox and things along the line are trending.
- While you’re doing an ICO background check, research the development team’s business viability, transparency of their ICO process, and controls that govern funds release, as well as the availability of scam protection, and defined legal framework. Can the team manage collected funds efficiently?
Ironically, some crypto adopters say Bitcoin almost seems like a conservative investment when compared to the chaos ruling over the unregulated, euphoric ICOs.
Finally, consider that many analysts warn it might be too late to hop on the crypto/ICO bandwagon because we might soon see the bubble explode. Investing in an immature, unregulated, unbacked asset can turn out to be a dream come true if you outrun a possible storm. It could also be a nightmare if you don’t know what you’re doing.