Why Bitcoin Goes Down as Well as Up (Plus What It Is): QuickTake

(Bloomberg) -- The initial price of Bitcoin, set in 2010, was less than 1 cent. It crossed $19,000 late last year. But its wild ride involves downs as well as ups: It recently fell below $9,000. The ups were been driven by investors anxious to get in on the best-established cryptocurrency as new trading opportunities nudged it toward the mainstream. Escalating regulatory threats from India, China, South Korea and elsewhere contributed to the slump, along with a $500 million heist of a different digital currency called NEM.

1. What exactly is Bitcoin?

It’s a form of money that’s remarkable for what it’s not: It’s not currency you can hold in your hand. It’s not recognized by most Main Street stores. It’s not issued or backed by a national government. At their core, Bitcoin and its imitators are sets of software protocols for generating digital tokens and for tracking transactions in a way that makes it hard to counterfeit or re-use tokens. A Bitcoin has value only to the extent that its users agree that it does.

2. Where did the Bitcoin system come from?

The original software was laid out in a white paper in 2008 by a person or group of people using the pseudonym Satoshi Nakamoto, whose identity remains unknown, despite several efforts to assign or claim credit. Online fantasy games had long used virtual currencies. The key idea behind Bitcoin was the blockchain -- a publicly visible, largely anonymous online ledger that records Bitcoin transactions.

3. How does that work?

Think about what happens if you make an online transfer using a bank. It verifies that you have the funds, subtracts that amount from one spot in a giant database it maintains of accounts and balances, and credits it in another. You can see the result if you log on to your account but the transaction is under the bank’s control. You’re trusting the bank to remove the right amount of money, and the bank is also making sure you can’t spend that money again. The blockchain is a database that performs those tracking functions -- but without the bank or any other central authority.

4. Who performs the bank function for Bitcoin?

It’s done by consensus on a decentralized network. Bitcoin transactions can be made through sites offering electronic "wallets” that upload the data to the network. New transactions are bundled together into a batch and broadcast to the network for verification by so-called Bitcoin miners.

5. Who gets to be a miner?

Anybody, so long as you have really fast computers, a lot of electricity and a desire to solve puzzles. The transaction data in each batch is encrypted by a formula that can be unlocked only through trial-and-error guessing on a massive scale. The miners put large-scale computing power to work as they compete to be the first to solve it. If a miner’s answer is verified by others, the data is added to a linked chain of blocks of data and the miner is rewarded with newly issued Bitcoin.

6. How does the system prevent cheating?

Because every block contains data linking to earlier blocks, an attempt to spend the same Bitcoin twice would mean revising many links in the chain. Plus, as miners compete, they verify each other’s work each step of the way.

7. Wasn’t Bitcoin used by drug dealers?

Yes, back when its primary appeal was its relative anonymity. It was, and still is, used by websites peddling everything from arms to drugs to paid hits. One such $1.2 billion marketplace, Silk Road, was shut down by federal agents in 2013. But others soon took its place. Joseph Stiglitz, a Nobel laureate in economics, said recently that Bitcoin "ought to be outlawed” because it’s designed to evade regulation and "doesn’t serve any socially useful function."

8. What changed?

Bitcoin’s reputation was improving after an incident in 2014 in which Bitcoins were stolen from a Bitcoin exchange called Mt. Gox. Security has improved, but the NEM theft in Japan shows it’s still an issue for digital cash. Now, regulators may make it harder for people to buy and sell cryptocurrencies.

9. What is blockchain’s appeal?

Enthusiasts see it as a new way of doing all sorts of business. Costs could be lower without a central middleman doing the work of keeping track of transactions, and charging for it. Banks and stock exchanges have invested heavily in developing blockchain technology, while retailers like Wal-Mart Stores Inc. are experimenting with using blockchain for ensuring food safety. Central banks are even speculating about issuing blockchain-based official currencies. And other forms of blockchain emerged, often using their own cryptocurrencies to facilitate transactions. The most prominent is the ethereum blockchain, sometimes described as a platform for so-called smart contracts.

10. Why hasn’t the competition hurt Bitcoin?

As the number of cryptocurrencies and tokens multiply -- they now reach into the thousands -- Bitcoin remains the best-known, time-tested and valuable. That’s led to it being viewed by some as the most predictable venue for people wanting to bet on blockchain’s exponential growth.

11. What explains the surge in Bitcoin’s price?

The spurt last year was mostly fueled by the news that futures trading was in the offing. Cboe Global Markets Inc. began trading futures contracts tied to Bitcoin on Dec. 10, and CME Group Inc. followed suit on the 17th, while Nasdaq plans to start this year. The ability to trade on bitcoin’s price without owning it -- and to bet that its price will fall -- is seen as expanding Bitcoin’s appeal to investors. The fact that Bitcoin’s software guarantees that there will be a finite supply has added to the fear of missing out for some investors. Coinbase, a Bitcoin exchange, was overwhelmed by two to three times its normal traffic on Nov. 29, when Bitcoin’s price soared past $11,000, making its service temporarily unavailable to some users. New crypto-focused hedge funds are opening up weekly, and already surpass 100. Most of them invest at least part of their funds in Bitcoin.

12. What explains its fall?

Some people, most notably JPMorgan Chase & Co. Jamie Dimon, have called Bitcoin a “fraud,” even though his own bank is considering offering Bitcoin futures to clients. Fund manager Mike Novogratz called cryptocurrencies “the biggest bubble of our lifetimes,” and yet he is starting a $500 million fund to invest in them. The regulatory crackdown along with fears of price manipulation and Facebook’s ban on cryptocurrency ads all contributed to a loss of confidence.

13. How can I buy Bitcoin or invest in it?

There are a bunch of ways, all with different risks. People can buy the coins directly from exchanges like Coinbase. Accredited investors can also invest in vehicles like the Bitcoin Investment Trust, which tracks Bitcoin’s price. Now investors can buy or sell Bitcoin futures, and soon may be able to buy Bitcoin exchange-traded funds, once regulators feel comfortable with the idea. But be warned: Even plenty of people who believe in Bitcoin’s future think some wild rides lie ahead. And yes, you can bet on a crash.

The Reference Shelf

• A QuickTake explainer on Bitcoin and blockchain.
• When might Bitcoins be an accepted way to buy Big Macs?
• Bitcoin might be a bubble, but blockchain is a real breakthrough, says a Bloomberg View editorial.
• A QuickTake Q&A on potential splits in the Bitcoin software community.
• A QuickTake Q&A on initial coin offerings and cryptocurrencies.
• CoinDesk has a Bitcoin price index; Bitcoincharts.com has a range of data.
• Two explainers, one aimed at kindergartners and the other a you-too-can-mine-Bitcoin project, plus an exploration of the double-spending problem.

To contact the reporter on this story: Olga Kharif in Portland at okharif@bloomberg.net.

To contact the editors responsible for this story: Dave Liedtka at dliedtka@bloomberg.net, Reed Stevenson, John O'Neil

©2018 Bloomberg L.P.