What is Bitcoin and why are people buying it now?

A friend recently asked me how to buy Ethereum. This is a kind of cryptocurrency coming in at silver on the price podium below Bitcoin.

Despite my role as a finance journalist, I had absolutely no clue how to address the question.

Crypto is a financial realm I simply have not ventured into. When it comes to non-tangible hoards of cash without a government guarantee, my blood runs cold and my brain turns off. Like share trading, it seems like something reserved for people on another tier of financial experience. 

To get beyond this insecurity and appear more legitimate at dinner parties – “Ah yes, the economy!” – I decided to venture into the wild world of cryptocurrency.

Dan Petrie is the chief information officer at finance news and data site, Grafa. With his guidance, let’s explore some of the big questions about Bitcoin and cryptocurrency in 2021.

What is Bitcoin?

Bitcoin is a type of digital currency known as cryptocurrency operating outside traditional banking systems. Since its 2009 inception, it’s become the forerunner among thousands of similar digital tokens. 

But how does cryptocurrency work? Petrie explains it is, at its core, an evolution in the process of buying goods and services.

“Like any currency, it’s a medium of exchange. Increasingly people like to talk about stores of value because it’s had this huge run up in its price, but generally speaking it’s a medium of exchange in a digital environment,” he says. 

Rather than passing between banking institutions, crypto relies on blockchain technology. This is essentially a ledger of transactions that’s unerasable, viewable by all users (but not replicable) and not controlled by a single entity. 

The security of this data system is ensured by people known as crypto ‘miners’ who use powerful computers to complete complicated mathematical problems that verify transactions. Purchasing, powering and maintaining the technology necessary to mine crypto makes this a costly endeavour, so they are rewarded by the system with cryptocurrency at the rate they mine it. 

Concerns over the environmental impact of this process have recently prompted an upgrade by Ethereum that aims to reduce the energy consumption of the network

How do I buy and sell Bitcoin?

There are a number of exchanges where you can swap traditional currency – whether it’s the Aussie dollars sitting in your savings account or another international currency – for Bitcoin and other cryptocurrencies. A few popular Australian-based exchanges are CoinSpot, Binance and CoinJar.

You may require different levels of documentation and identification depending on the exchange you sign up for. To start buying and selling, you’ll need to connect the account to a payment option like your bank account or debit card (the exchange platform can charge fees based on this and other factors, so be sure to read the fine print). 

What you’ve bought is then stored in a cryptocurrency wallet. This can be provided through the exchange, but having your own external wallet (which can operate like an app that’s connected to the internet, or be held in a USB offline) is generally more secure. These give you a private key to your funds and help avoid the risk of exchanges being hacked. 

While online purchases are recommended for security reasons, you can also buy crypto in person at participating newsagents and banks. According to research group IBISWorld, there are also currently 46 Bitcoin ATMs around Australia where holders can purchase or cash-out Bitcoins. 

But before you approach the practicalities of purchasing crypto, Petrie says research is paramount.

“With any asset class – be it a stock, FX, crypto, any kind of trading – my very strong view is to do the research first. Because remember, this is an asset class and price is really a function of what people are prepared to pay for it,” he says.

What can I buy with cryptocurrency?

Retailers decide whether or not they accept Bitcoin and other cryptocurrencies. So, what you can buy is in their hands, whether it’s your daily coffee or a new computer. These vendors will have their own digital wallets with a public address you can transfer the currency to from your crypto wallet.

Global online retailers were the first to accept payments in cryptocurrencies, but physical stores are increasingly adopting it closer to home. In 2018, Brisbane airport became the first in the world to allow travellers to make purchases at more than 30 retail and dining outlets in the airport using digital currencies such as Bitcoin, Litecoin and Ethereum.

And with major payment platforms like PayPal, Square and Visa enabling customers in some countries to spend crypto via their services, mainstream use is looking more likely. That being said, many Bitcoin traders don’t use crypto for any day-to-day spending.

Is Bitcoin a risky investment?

When Petrie talks about Bitcoin and other cryptocurrencies being an “asset class”, he is talking about it in terms of buying and trading between currencies to make a profit as values rise and fall. In other words: investing.

While this wasn’t the original purpose of cryptocurrency, the exponential rise in the value of Bitcoin over the last decade means many people and organisations are using it in this way.

To understand the risk related to trading in cryptocurrencies, Petrie says you have to understand the fundamentals of what drives it and other asset classes.

“For example, the Australian dollar [value] is based on Australian exports to the rest of the world, but also that our central bank has a marginally higher interest rate next to the Federal Reserve or the European central banks. Therefore, the yield for the Aussie dollar is a bit higher – so we understand what drives that,” Petrie says.

“In the Bitcoin case, it really is a case of sentiment. The problem with sentiment is that it can change on any given day.”

Petrie urges would-be investors in any asset class to remember forecasts are not future-proof, and to ensure they’re in a financial position to maintain their lifestyle if they do lose money in the process of buying and selling cryptocurrency.

It all comes back to doing the research and abiding by the golden rule: if you don’t understand it, don’t invest in it. 

A lack of internationally accepted regulation is also a major drawback to mainstream adoption of cryptocurrencies. For example, if there’s a fraudulent transaction made through your bank account, the bank may refund the money. 

There’s no similar safety net in place for cryptocurrency transactions. Along with the association of these currencies with illegal trade and money laundering, this makes for a major roadblock.

Who is buying Bitcoin and other cryptocurrencies?

This idea of “sentiment” influencing value operates like a domino effect. As more people buy into a cryptocurrency, others feel more inclined to follow. As confidence in its value or stability grows – based on the growing number of investors or users and media coverage of that growth – so does the price.

Apart from more mainstream adoption of crypto by independent buyers, Petrie says the recent price jumps are closely connected to major institutional investment.

“The likes of the big investment banks in America are now getting involved and it’s part of their portfolios. So there’s a lot more money now going into this space as regulation improves and people use it to structure portfolios,” he says.

There’s also the positioning of Bitcoin as a ‘store of value’. A traditional example of this is gold, which is seen as an asset that will hold its worth if inflation affects an economy. 

While many governments rolled out emergency monetary support in response to COVID-19, a vaccine could enable swift economic recovery which may trigger this kind of inflation. So, some might see Bitcoin and other major cryptocurrencies as a kind of safe haven investment, despite the wild shifts in value crypto experiences.

What happens if Bitcoin’s price drops?

Simply put, you may lose your money. The level of loss is dependent on what price you bought the crypto for and what action you take next. For example, if you bought Bitcoin at its highest price of over $40,000 AUD, and then its value fell to half that and you jumped ship, that’s a loss. 

For anyone who hasn’t traded in stocks or shares, this is a worrying thought. But it is the nature of investment and risk. For instance, you could choose not to sell your crypto stores and the price may recover, so the risk might pay off. 

At the end of the day, Petrie points to history and comprehensive research as essential first steps before making any moves in the cryptocurrency world.

"Knowledge is power, and understanding risk is the key,” he says.

If you feel like you need to go back to money management basics before going any further down the crypto rabbit hole, get stuck into Mozo’s guide to budgeting.