Categories
Cryptocurrency Basics

What is Bitcoin? 2.3

Editor’s Note
The following transcript was taken from one of Kelly’s live classes for tax professionals.

SLIDE 42

Here’s the big kahuna. I’m going to tell you what my definition of Bitcoin is and then go into the details. Bitcoin is a cryptocurrency that the government calls virtual currency, but many users call it peer-to-peer digital money. The value of Bitcoin is set by market demands and trading gyrations, similar to the stock market. FinCEN tells us that Bitcoin and other cryptocurrencies are NOT money, and are therefore NOT legal tender. The IRS tells us that it must be treated as property for tax purposes.

SLIDE 43

Bitcoin only exists within the internet because the internet exists, just like email only exists because the internet exists. The internet allows information to be shared across big and small distances via computers running software that use special network protocols. For example, an email program uses an email protocol like IMAP to send messages. Similarly, Bitcoin transactions are sent across the network using the Bitcoin protocol, which is part of the Bitcoin software.

SLIDE 44

ALL bitcoins and ALL their associated transactions are stored on a digital ledger, inside the Bitcoin software. This software runs on a computer connected to the internet. These computers are called “Full Bitcoin Nodes” and they validate bitcoin transactions in a process called “mining”. A miner’s job is to continually validate transactions and manage the digital ledger to ensure no person spends bitcoins that don’t belong to them.

SLIDE 45

Cryptocurrencies like bitcoin can be obtained from a person, an exchange or through the process of mining. They can be used to purchase goods or services. They can be used to pay employees and contractors. They can be traded as property or given as a gift. Individuals keep track of their own bitcoin transactions and balances within a bitcoin wallet. A wallet is an app residing on a computer, a mobile device or a piece of paper. The bitcoin wallet communicates with the Bitcoin software using the Bitcoin protocol. The Bitcoin ledger that tracks all transactions is called the Blockchain.

Transcript of the video shown:
What is bitcoin? Bitcoin is the first decentralized digital currency. Bitcoins are digital coins you can send through the Internet. Compared to other alternatives, bitcoins have a number of advantages. Bitcoins are transferred directly from person to person via the net, without going through a bank or a clearinghouse. This means that the fees are much lower, you can use them in every country, your account cannot be frozen and there are no prerequisites or arbitrary limits.

Let’s look at how it works. Several currency exchanges exist where you can buy and sell bitcoins for dollars, euros and more. Your bitcoins are kept in your digital wallet on your computer or mobile device. Sending bitcoins is a simple as sending an email, and you can purchase anything with bitcoin. The bitcoin network is secured by individuals, called miners. Miners are rewarded newly generated bitcoins for verifying transactions. After transactions are verified, they are recorded in a transparent public ledger. Bitcoin opens up a whole new platform for innovation. The software is completely open source and anyone can review the code. Bitcoin is changing finance the same way the web changed publishing. When everyone has access to a global market, great ideas flourish. Bitcoins are a great way for businesses to minimize transaction fees. It doesn’t cost anything to start accepting them and it’s easy to set up. There are no chargebacks and you’ll get additional business from the bitcoin economy. For more information about bitcoin, visit weusecoins.com.

Audience member question: how do you keep people from hacking or stealing your bitcoins? Answer: We’ll go over the technology that does this in the next part.

Audience member question: what is mining? Debra said “it’s like miners get paid a finder’s fee?” A transaction fee is a more accurate word. Let’s talk briefly about miners.

Without miners, bitcoin wouldn’t exist. A minor is a person who has a computer, that runs a piece of software called Bitcoin with a big “B”. There’s lots of miners all over the world. A miner is sitting there, waiting to do something. He doesn’t get to do anything unless you and I do something with bitcoin. For example you can buy a cup of coffee, send some to your grandkids, give one to your nephew or buy a car with it. You can do all of these things right now. Not necessarily in Portland or Springfield, Oregon, but you can do that in certain places in the world. If you do any of those things, it generates a transaction. What does that mean?

Kelly, please edit the below portion on mining for clarity. I tightened it up a bit, but still feels it’s a bit too colloquial and the sentence structure could be simplified.

What happens when you sit at your computer and create an email? Nothing happens unless you hit the “send” button. Then it goes to a server that reads the protocol and figures out what to do with this message it just received. There’s information in that datastream, those packets of data that just got sent out over the network, that goes to the server that’s reading what’s inside those packets, determining what the protocol is telling it to do, and it sends it off to the right person.

The Bitcoin software does something very similar to that. I create a transaction, think of it as an email. I want to send bitcoin to somebody instead of sending words. Let’s say I want to send it to Bob. I’d generate and send that transaction from my wallet. In order for Bob to receive the bitcoin from me, he has to first have an address for me to send it to. I get his wallet address from him and generate a transaction that says: send it to Bob’s address. That gets sent out over the local network from my computer. Full nodes that are closest to me are going to start gathering that transaction. Protocols notice that there’s some piece of information over the Internet that they can deal with, that speaks their language. So a transaction went out per Bitcoin protocol. Multiple nodes start grabbing that transaction. Not every node grabs every transaction. I don’t quite understand that part, but that’s all right.

We’ll say all the local nodes grab the transaction and put it into what’s called a memory pool. It’s sitting there waiting to go into a block. Lots of notes are doing that. Everybody starts gathering up transactions and putting them into blocks. Two blocks may look the same. They’re similar, but they’re not the same. Every 10 minutes a new block gets added to the Blockchain, like clockwork. So those transactions got put into a memory pool and then the miner gets to decide which one they want to take out of the memory pool and put into a temporary block. They generally pick the ones that are paying the highest transaction fees, because miners are in business.

All the nodes are doing the same thing, so nine minutes and 50 seconds later they all start to solve a puzzle. This is not rocket science, but it’s interesting how it’s put together. They all try to solve a computer puzzle, a math puzzle, that only a computer can solve. The first one of those nodes that gets the right answer to that puzzle, gets to add it to the Blockchain. Once they solve the puzzle first, all the other computer notes have to validate that they agree with that answer. If they say we agree with you, that person who got there first, gets to have their block added to the Blockchain. What do they get in return for all that computer work? It’s not a fee. They actually get rewarded in bitcoin. That’s how bitcoins get created. It’s the only way that bitcoins get created.

Starting in 2009 when it was birthed, a block was added to the Blockchain every 10 minutes and 50 bitcoins got awarded to the miner with a full node. The miner who solved the puzzle got their block added to the chain. Every 10 minutes 50 bitcoins went into somebody’s bitcoin wallet. The wallet is built into the software.

Audience member asked a question. Answer: Miners get paid a fee. Whoever sends the transaction, pays the transaction fee. Most of the time that transaction fee is pennies and there’s the difference. When the network is overloaded with transactions, it does create a bit of a bottleneck and that’s when the fee can go up a little bit. It depends on how much we are sending, could be a couple of dollars.

Audience member asked a question. Answer: what she’s bringing up is that a miner is rewarded in bitcoins when their block gets added to the Blockchain. That happens every 10 minutes. When Satoshi Nakamoto designed this system, he said that every four years we’re going to half that reward. So 50 bitcoins went down to 25 bitcoins. Bitcoin started in 2009, add four years, so the reward got cut in half in 2013. Every four years that reward is going to continue to get cut in half, until the last bitcoin is mined. I have some statistics that I will bring up in a little bit that will go over these numbers. I believe there’s 21 million bitcoins that will ever be mined. It’s anticipated that the last one will be mined in 2140. It’ll be a very small amount in reward by then. The question that she has is this, once that happens, what’s going to keep the bitcoin network going? It will be the transaction fees that we pay. Will those fees go up? I don’t know. By that time there will be so many Blockchains out there, so much new technology. By that time quantum computing might exist. There’s a big fear that quantum computing will cause Blockchains to not be very viable, because a quantum computer can work so fast that it can break the cryptography. I’m not worried about that because I know that the Blockchain people are in the process of working on a solution to that. By then there may be some variation on the Blockchain in the quantum computing world. Technology is going so fast right now, it’d make your head spin.

Audience member asked a question on whether there will be less bitcoins. (please rephrase her question for clarity) Answer: there is a set limit of bitcoins that will ever be generated. There is supply and demand so the value should go up with time. She said, let’s say when this all started there was only 50 bitcoins from the first transaction, 10 minutes after it was born. Let’s say they were worth a penny a piece.

That’s $50. (wouldn’t that be 50 cents?)

Four years later there’s no more than 50 bitcoins. (I am so confused, there are lots of bitcoins cause they get born every ten minutes for 4 years). We now cut the award in half. Now there’s 25 bitcoins that are born. There’s more bitcoins, there are 75 bitcoins. Well, if there’s more bitcoins and the price doesn’t go up, technically they would be each worth less. Does everybody agree? But supply and demand is what determines the value of bitcoin, and since 2011 roughly, the price has not been down to a penny. It just keeps going up, and it’s the supply and demand that’s giving bitcoin its value. Mining creates the bitcoin.

Who creates the money for US dollars? Federal Reserve creates the money. Call it mining. It creates money out of thin air. It puts the money into the system, and we now have it to spend. Bitcoin mimics the Federal Reserve system by using mathematics, computer code and cryptography. A miner won’t generate a cryptocurrency like bitcoin unless there are people that have transactions that need to get processed. We have these wonderful people who are validating transactions, making sure there’s no double spends, making sure they’re valid transactions. Miners had to buy computer equipment and pay electrical bills and what they get in return for their service is bitcoins and a small transaction fee. They do not get rich on the transaction fees. The only reason that they became millionaires is because the whole world decided that those bitcoins that they’re generating are worth something. You and I decided we like this stuff. It acts like money and looks like money, it quacks like money… we’re calling it money! We’re spending it because we know there’s somebody in Nigeria that we can have a transaction with. I’ve done that. Some of the best members that I have at Life with Crypto are in Nigeria. It is hard for people in the United States to wrap their heads around as to why it matters and why it’s important. That’s because we have such a sophisticated financial system here. We have debit cards, credit cards and we don’t even notice how much we’re paying fees in order to use a debit card. But these folks in Nigeria are so excited.

ADD A PHOTO OF VICTOR HERE

I have a young man who is in his 20s and we met each other accidentally through another network. He’s just all over this. He is now my one and only ambassador in Nigeria and I pay him just a tiny bit. A bit of US dollars goes a long ways in Nigeria. I paid him 80 bucks in order to start a MeetUp in their local area and to contribute articles to my space. He’s a newbie and he is so excited so I want him to write for me.

I wanted to pay him 80 bucks. Now I’m like, HOW am I gonna pay you? Nigerian exchanges are not as sophisticated as they are here. At first I paid him in what’s called a stable coin. This one is called DAI. A stable coin matches the value of the US dollar. A dollar and DAI is roughly a dollar in US dollars. I wanted to send him DAI instead of bitcoin. Anyone want to guess why? Part of our problem was that he couldn’t turn his DAI into cash, because DAI is a convertible virtual currency at Coinbase where I have most of my stuff, but not at the exchange that he has available to him in Nigeria. He could not convert the DAI to his local fiat currency. NGN or Naira is his local currency.

A member comments that bitcoin has a different value from DAI. You’re getting close. What if I send him $80 worth of bitcoin today, and tomorrow the price of bitcoin could easily fluctuate 30 or 40% in a day, and tomorrow it may only be worth $75. Volatility is a good thing and is a bad thing. I sent him 80 bucks for a specific reason. What he really wanted and needed was a new cell phone. 80 bucks would buy him his first choice in a cell phone. I thought holy moly, I can make this guy’s world by paying him enough to buy an Android cell phone. I had him tell me what the model was because at first I was going to try to buy him a cell phone and mail it to him. But there’s a learning opportunity here. Why don’t I pay him in some crypto currency and let’s see how this works.

At first I paid him and DAI because I was not wanting him to lose any value. Of course, had the value gone up, he would have gained. I sent him DAI and he tried to figure out how to convert it into Naira through the exchange available to him, and they wouldn’t let them do it. It wouldn’t convert it back into his fiat. So he sent the DAI back to me. I bet that was hard for him. We decided I would pay him in bitcoin and take our chances with the fluctuation. I sent him bitcoin and he was able to convert it at his local exchange. Remember, bitcoin is a convertible virtual currency there too. He converted it from bitcoin by selling it, and he sold it back into his local fiat currency. Then he was able to withdraw that money from that exchange into his regular bank account and go buy his phone. He sent me a picture of it. He is going to write an article about that experience and that will be coming up on the Life with Crypto website. Article posts are free to everybody who joins.

Audience member wanted clarification on not being able to convert DAI to his local currency. Answer: yes, he could not convert the stable coin. That exchange didn’t allow people to convert DAI to a stable coin as sometimes some exchanges will have limits. For example, you may need to have a certain amount in there before you can convert. I haven’t studied his local exchange thoroughly so I don’t know what all the limits are, but he said it wasn’t possible. So I said no problem. I sent him bitcoin, he sold it. What happened when he sold his bitcoin back into cash? Tax liability, at least in the US. I don’t know if he had a tax liability in Nigeria. I’d have to look into their tax law. I don’t think he’s too worried about it.

Audience member wanted clarification that the miners are validating the transactions and they get paid. Answer: yes, and they get paid in bitcoin. Audience memer said: so the bitcoin is a new bitcoin, and not pieces from other transactions. Answer: very good question. Bitcoin is generated by the software. It does not exist before it comes into creation, just like quantitative easing. Don’t they just make up numbers out of thin air?

An audience member is trying to understand how a transaction works with $100 of bitcoin. Answer: if you buy a hundred dollars in bitcoin, that would be a fraction of a bitcoin. Let’s go with the approximate $8,000 valuation, which is where it’s at today. So if a bitcoin is worth $8,000, can I send a hundred dollars worth of bitcoin? Absolutely. Bitcoin is divisible by eight digits. Why do you suppose bitcoin is divisible by eight digits and not just two? It’s simple. How many bits are in a byte, if anybody’s ever written any computer code? There’s eight bits in a bite. Because it’s a computer code, they wrote it because they can take advantage of how a computer works, at least the way they currently work. There’s eight bits in a byte so they decided that a bitcoin could be divisible down to eight bits.

Back to the hundred dollar question. Let’s say I’m going to send one bitcoin that’s worth $8,000. He’s going to send you $8,000 of something and you’re going to send him one bitcoin. That transaction could be pennies. Those fees are built into that transaction. There’s no creating of new bitcoin for fees. When you went to send him $8,000 for a bitcoin, which is worth 8 grand, you to sold it. If you send it to him, that’s a gift. If he’s giving you money back, you sold it to him. Let’s say you sold it to him, and you’ll notice they do this at Coinbase, you’ll see what the fee might be. There’s a potential fee from Coinbase and a fee from the miner. Let’s assume the fee is just from the miner. Let’s say it’s a dollar. Your bitcoin that you sent him, that’s gonna come out of your wallet, will be $8,001. He’s going to get $8,000, and $1 is going to go to the miner. You pay that fee out of your bitcoin. (my recent purchase of $340 worth ended up giving me $337 worth of XRP, and the $ went to Coinbase fees, they didn’t ADD the fees, just gave me less XRP.)

New bitcoins are not created when fees get paid. It’s similar to using a debit card. Somebody wants to pay my $500 tax return with their credit card. How much do I actually get in my bank account? $485 for $500 tax return, which is why I don’t like getting paid with a card. it’s no different than in bitcoin. Somebody’s having to pay that fee, and in this case the person receiving the money is paying the fee. In bitcoin, the person selling the crypto currency I believe is the one who pays the fees. Why would this matter in a tax training like this? Because you have to keep track of basis. We’ll talk more about that later.

An audience member asks if miners essentially receive “free” bitcoins for their work, since they didn’t exist before. Answer: I wouldn’t call it free, and neither would they. Miners can receive both fees and they are the ones that are creating new bitcoins through the process of mining, if they are rewarded for the work that they performed. I wouldn’t call it free because a lot of electricity goes into generating that bitcoin and there’s a lot of equipment. These mining farms can be the size of this whole building in some places.

Last audience question: do all cryptocurrencies have a finite limit as to how many will be created? No, they’re all different.