Q. What is Bitcoin and how exactly does it work?

Q. Can you please explain what Bitcoin is and how it works? Is this something that I can invest in or should consider?

A. Bitcoin is a form of digital currency. Created in 2009, it is the first example of a category of money or store of value referred to as Cryptocurrency.

Cryptocurrencies are a US$112 billion market that is currently turning over up to US$5 billion a day.  Allegedly there are more than 900 different ‘Cryptocurrencies’ in existence which is more than physical Sovereign or Fiat (legal tender) Currencies. The two most dominant and commonly traded cryptocurrencies are Bitcoin and Ethereum, On current market valuations, the entire Bitcoin network is valued at approximately US$48 billion and Ethereum’s is around US$35 billion.

Software developer Satoshi Nakamoto devised Bitcoin as an electronic payment system.  The idea was to create a currency independent of any central authority.  Unlike conventional currencies, Bitcoin is unique in that it is decentralised.  No single institution or country controls the Bitcoin network.

There are only 21 million bitcoins in existence.  However, these coins can be divided into smaller units.  The smallest unit is one hundred millionth of a bitcoin and this is referred to as a “Satoshi”.

You buy bitcoins either through Cryptocurrency exchanges or directly from others via Bitcoin marketplaces.  Bitcoins can be traded by exchanging cash or other currencies, services or goods.

The Bitcoin system is peer-to-peer.  Transactions can take place between users directly, without an intermediary. These transactions are verified by computer network nodes and recorded in a public distributed ledger called a ‘Blockchain’.

To buy Bitcoins, you must first establish a Bitcoin “wallet” to store your Bitcoins.  As there is no physical currency, the value is stored electronically. There is a range of “wallet” options available; a software “wallet” stored on your own computer, an online web based “wallet” service or a “vault” based service.  Each option has varied ease of access and varying levels of security.  Trying to keep it simple, the equivalent would be keeping cash at home, having money invested in a bank account or having cash stored in a vault at a bank.

The process of establishing a wallet in Australia is akin to opening a bank account and subject to conventional banking requirements verifying identity and the source of funds.

There is a range of exchanges that you can trade Bitcoins through but be aware they do not offer the same capital protection as banks.

The ATO has stated that income and profits derived from bitcoin transactions are taxable.

The value of Cryptocurrencies changes depending on typical market influences; supply, demand, and sentiment.  Whilst a large market, it is still early days and the market can be volatile and subject to intense speculation.  The value of Bitcoin and Ethereum fell as much as 33% from record highs. Trading around US$3,000 at 12 June, Bitcoin plunged to a low of US$1,938 on 16 July before finishing the week above US$2,300.

The recent volatility in the value of cryptocurrencies is a warning. The primary function of any currency, crypto or otherwise, is to be a reliable store of value. With rampant speculation and competition from alternative cryptocurrencies having a large bearing on the setting of value, ‘Cryptocurrencies’ are far from being a reliable store of value.

Cryptocurrencies should be considered a “frontier” market with the inherent risks and extreme volatility. Over time the market will mature as legitimate uses by mainstream companies increase and are supported by appropriate government regulation. For now, though it is a case of buyer beware.

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