Bitcoins
have been the talk of the town since the arrest of Silk Road founder Ubricht by
the FBI and the Senate hearings on crypto-currencies. Bitcoin, as this
suggests, is a crypto-currency, which means it is a form of electronic exchange
media that use encryption. Whereas almost all currencies use encryption for
trading, the very existence of Bitcoin is based on complex cryptographic keys
which ensure that there is no fraud. Put simply, Bitcoins are -
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1.
Purely
electronic currency – Bitcoins are created and
traded on the internet. There is no hard currency possible, since, strictly
speaking, the highly fluctuating value of the Bitcoin makes such hard currency
unfeasible.
2.
Lack of
Central control – No central institution controls the Bitcoins. Rather, they are
“controlled” by every user who has a copy of the block chain. (Explained
below).
3.
Partially
anonymous – Trading
is between wallets, which are electronic repositories of Bitcoins. They have
encrypted IDs which do not reveal the personal ID of the user. However, if the
personal ID of one person is known, it is possible to identify the IDs of all
who buy or sell Bitcoins to him/her. This is how the Silk Road was busted.
4.
Limited in
quantity – Perhaps
unique to Bitcoin is the fact that only 21 million Bitcoins can ever be
created. This makes it a limited currency, and hence one whose price will continually
rise.
5. Bitcoins can be destroyed, but it’s difficult – Unlike
normal currency, which can simply be destroyed if the central institution
refuses to support it, or in small quantities, by physical destruction, Bitcoins
cannot be destroyed by either method. They can be destroyed through complex
means, which involve sending, incorrect reference IDs and addresses, but the
complexity makes it a challenging task.
Now that we
know what Bitcoins are, we need to know how they can be obtained. Technically,
anyone can obtain a Bitcoin by mining it. Mining is a process by which special
computers solve millions of algorithms to keep the system running, and are paid
in newly minted Bitcoins. Practically, the price of each Bitcoin mining machinery
is prohibitive, not only in terms of cost, but also electricity consumed.
Further, there are so many miners around and so few Bitcoins produced that the
chance of an individual getting a Bitcoin is extremely low. Miners blend in
“pools” in which each “worker” pools his resources with others and everyone is
given a portion of whatever the pool gets.
While this
may be desirable to those with lots of time and understanding of the complex
protocols and encryption underlying the currency, normal users can simply buy
them. This is done in Bitcoin exchanges (like Mt Gox), which allow people, to
put money into the exchange, buy Bitcoins and use them wherever they want. To trade
Bitcoins -
1.
One first needs to set up a wallet. A wallet, as mentioned above,
is a virtual device which has a unique ID and an encryption key with which it
signs each transaction.
2.
Once the wallet is set up, one needs to go to the required
exchange, and sign up. Most exchanges require ID evidence these days as an
added safety feature, and, therefore, the anonymity Bitcoins originally gave is
no longer valid.
3.
To buy Bitcoins, one first needs to put money
4.
One can place a request for Bitcoins at the existing rate
(measured in terms of dollars, pounds and other leading currencies). If trading
at the existing rate, the trade is carried out within ten minutes due to
the process of verification.
5.
Verification is an automated process by which the transaction is
sought to be entered into a block chain, which is just a huge log book of all Bitcoin
transactions till date. If the transaction is acceptable (based on the wallet
balances of the seller and buyer), then it is accepted as a new block. The
exchange informs the user that the transaction is completed.
6.
If one is not selling at
the current rate, one will have to wait for the price to rise or fall to that
level, or for someone to sell at that rate (not likely).
7.
If one wishes to sell the bitcoins, the process is exactly reversed.
However, removing money from the exchange depends on the means accepted by the exchange
and one needs to be aware of this before putting one's money in exchange.
However, bitcoins,
by their sheer nature, have some inherent risks that other conventional
currencies do not have. These are -
·
Bitcoin
transactions are not quite anonymous – As mentioned above, it is not fully
anonymous, even when you are not using an exchange. As such, it is best not to
carry out transactions that you would prefer not to display in your credit card
or bank records.
·
Transactions
are irreversible – There is no concept of escrow, in which a third party holds the
funds till such time as both parties agree on release. There is no central
institution, so any third party contracted cannot be trusted with the funds.
Though exchanges themselves sometimes perform the task, this is still rare.
Hence, once you set a transaction in motion, and it appears valid, there is no
going back.
·
No central
control – Bitcoins are dependent upon the proper functioning of the block chain
as it exists on a huge number of miner computers across the world. No single
machine, or even 100 machines, can change the nature of the block chain, so
there is no question of any central control. Logically then, the exchanges
where Bitcoin trade takes place are equally, not under any central control. At
most, they are under the control of the country which hosts its servers, but
they can be jurisdictions as different as USA, Japan and China. Hence, if
anything goes wrong and you want to seek remedy, there is technically no one to
turn to.
·
Extreme
fluctuations in rate – Part and parcel of this highly
decentralized control system is the massive fluctuation in rates that occurs.
Whereas forex markets fluctuate due to dips in investor confidence, and decisions
by key governments/economic bodies and international events, one cannot predict
when the cost of bitcoins will rise or fall. Though (as noted above) the rate
of bitcoins usually keeps rising, it is equally true that following the Silk
Road crisis, Bitcoins witnessed their sharpest drop in history, thereby wiping
out the profits of many a Bitcoin trader.
While the
above risks are indeed a serious disincentive to Bitcoin trading, in normal
times the practice isn't as dangerous as it appears. This is because the mere
decentralization that makes Bitcoin trading risky also insures it against
developments in any one part of the world (e.g.| The Iran-US crisis and
subsequent thaw). Still, some precautions are in order to ensure that one does
not suffer from the risks of Bitcoin trading -
◦ Never disclose personal ID – Personal ID has to be revealed to
the exchange if it so demands, but you must not give away your ID to anyone
else. This not only increases your anonymity, but also ensures that fraudulent
entities do not gain access to your wallet or wreck havoc with your exchange
account.
◦ Keep a copy of the block chain – Though this is overkill for the irregular
Bitcoin trader, if you're planning on regular trading, it would be wise to keep
a copy of the block chain (around 6-7GB currently but growing fast) in a
storage media which has a large number of write cycles available since the information
will be deleted and entered hundreds of times every day. This will allow you to
validate transactions locally, and ensure faster processing.
◦
Verify
credentials of the exchange – Each exchange has its own rules
and functions according to the financial rules of the country in which it is
situated. Further, many exchanges have run afoul of the authorities in the past
and are embroiled in litigation. To make matters simpler, below are the top
three most popular exchanges and a brief description of each -
▪
Mt Gox – Mt Gox,
located in Tokyo, is the oldest of the Bitcoin exchanges currently in
operation, and also the most popular. However, it has been criticized for the
difficulty faced by users seeking to withdraw dollars from the exchange. The US
government suspended its operations for a few days but has reallowed it. Though
the best place to find a large number of Bitcoin traders, the risks involved
causing all prices to have a premium attached to them.
▪
BTC – BTC or BT
China is currently the largest exchange by volume but is restricted to China. However,
a number of agents operate from China who accept your money and trade for you.
One has to be careful when relying on these agents, but there are agencies with
solid reputations and low fees. Once you get a reliable agent who offers a
payment method acceptable to you, you can enjoy the relative stability of the exchange
as compared to the rest.
▪
Coinbase- It is
based in the USA, so it requires far greater verification than the above two.
However, you only need a bank account to use it, and the best part is, you can buy
portions of bitcoins as little as 1%.
▪
BitStamp.Net – BitStamp
allows you to login from anywhere in the world and has a simple interface. It
is perhaps one of the fastest exchanges available for Bitcoin trading, though
speeds may vary depending on where you are.
▪
Cryptsy – Cryptsy
is not for those seeking a quick trade, but it is one of the few exchanges
which offers Escrow protection (as mentioned above). Further, it allows you to trade between
dollars, bitcoins and other more obscure currencies if you're planning on
diversifying your portfolio.
Though the
above guide may seem a bit complex, the basics are easy enough to know, and
trading is easy (even addictive) once you get the hang of it. Further, major
online service providers like WordPress, 4Chan, Reddit and others are now
accepting bitcoins just like normal currency, so it makes sense to test one's
hand at Bitcoin trading before prices shoot up further. Keeping the above
points in mind, Bitcoin trading can be not only an fascinating and unique
experience, but it can become a significant source of profit.
Author:
Aritra Mazumdar
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