- 1 Introduction To Bitcoin
- 1.1 A Complete Guide To Understanding Bitcoin
- 1.2 A Bitcoin Guide
- 1.3 Introduction
- 1.4 Defining Bitcoin
- 1.5 Open Source, Globally Distributed, and Decentralized
- 1.6 Asymmetric Cryptography and Proof-of-Work Consensus
- 1.7 Programmatically Deflationary Financial Energy
- 1.8 Trust/counter-party risk-minimized, censorship and confiscation resistant
- 1.9 Legality and Tax Treatment
- 1.10 Acquiring Bitcoin
- 1.11 Custodying (or “Hodling”) your Bitcoin
- 1.12 Conclusion and Further Reading
Introduction To Bitcoin
A Complete Guide To Understanding Bitcoin
Bitcoin has a steep learning curve, so we wrote this guide to introduce you to a few of the most important Bitcoin concepts. In this guide, we’re going to do the following:
- Define Bitcoin from first principles
- Give an overview of Bitcoin mining and mining pools
- Briefly touch on legality and tax issues
- Talk about methods of acquiring, holding, transacting, and borrowing against your Bitcoin
- Provide links to resources for further reading on these topics
Let’s get started.
Bitcoin refers to both the Bitcoin protocol and network (capitalized) and the digital coins, bitcoins (not capitalized), that are exchanged on this protocol.
Bitcoin is an open source, decentralized, cryptographically secured protocol and network which facilitates trustless, peer-to-peer value transfer. Bitcoin’s “proof-of-work” – the consensus design commonly referred to as mining – organizes transactions into blocks, ensures that these transactions are not censored, and facilitates a fixed and gradually decreasing supply issuance of bitcoins in such a way that only 21 million bitcoins will ever exist. Financial energy is stored on the Bitcoin network in these fungible “bitcoins.” These bitcoins act as digital money, simultaneously serving as a store of value, a medium of exchange, and a unit of account.
In short – Bitcoin is digital money accounted for on a distributed ledger that isn’t controlled by a central authority and therefore cannot be confiscated, debased, censored, or otherwise tampered with by a small group of malicious or incompetent actors. We know this is all a mouthful, but it’s important. We will break it down in more manageable chunks below.
Open Source, Globally Distributed, and Decentralized
Bitcoin was invented by a mysterious person or group of people pseudonymously referred to as Satoshi Nakamoto in the midst of the 2007-2009 Financial Crisis. It was first released to the world in 2008 as the now-famous Bitcoin white paper, but the network didn’t go live until January 9, 2009. On this day, Satoshi mined the first block of the Bitcoin blockchain (called the Genesis Block), and in the coinbase transaction they included the following text:
The Times 03/Jan/2009 Chancellor on brink of second bailout for banks
At its core, Bitcoin was designed to minimize the trust required to conduct financial transactions. Being open-source means that anyone can download the Bitcoin codebase and examine it (or even change it, potentially leading to what’s called a “fork” of the blockchain). Banks and other financial fiduciaries have been required to account for transactions on closed, centralized ledgers to prevent double spending and maintain balances, but Bitcoin’s globally distributed ledger accounts for transactions and balances in a completely open and transparent manner – anyone with a computer can analyze every transaction that has ever occurred on the Bitcoin blockchain using what’s called a block explorer. They can go further by downloading Bitcoin’s source code and self-hosting this transaction history themselves, allowing them to independently and directly verify Bitcoin’s supply on their own computers. This feature – that global consensus is directed by nodes whose software is available to anyone rather than a Central Bank committee – gives Bitcoin its decentralization and means that it cannot be compromised or controlled by a single or small group of actors. These trust minimizing characteristics – open source code, decentralization, and distribution – are nothing short of a financial revolution, and they are all made possible through Bitcoin’s application of public key cryptography and “proof-of-work” consensus algorithms.
Asymmetric Cryptography and Proof-of-Work Consensus
Without getting too deep into the complicated world of cryptography, asymmetric cryptography (also called public cryptography or public-private key cryptography) enables transactions on blockchains to be simultaneously transparent and secure through the use of public and private “keys.” Essentially, public and private keys are generated and function together, with one (the private key) verifying the validity of transactions made to the other (the public key). Public keys are used to create Bitcoin addresses so that users can send and receive funds, and private keys are kept secret and are used by individual users to sign transactions to verify the legitimacy of the origin of the bitcoins associated with an address. Encrypted email uses similar technology. For a rough metaphor, the public key is a safety deposit box, and the private key is the key that opens the safety deposit box. Everyone can see that there’s a safety deposit box there, but only the owner of the private key can open it to deposit or withdraw things from it.
Proof-of-Work (PoW) is Satoshi’s novel consensus algorithm, and coupled with Bitcoin’s public key infrastructure, PoW is another necessary innovation for making Bitcoin’s cryptographic pieces tick. PoW allows Bitcoin to be transacted peer-to-peer without the need for a counterparty (say, a bank) because it enables the entire network (every computer running the bitcoin protocol, but more on that later) to come to a “consensus” on the state of the ledger (the nature of account balances) every 10 minutes, rather than having to trust accountants and auditors to verify account balances.
Bitcoin Mining as Proof of Work
To understand PoW, a brief word about the structure of the Bitcoin network and a cursory understanding of “mining” is required. The Bitcoin network is simply a network of thousands of internet-connected computers all running the same software, typically Bitcoin Core. These computers support Bitcoin applications like wallets and speak to each other through the Bitcoin protocol to stay on the same page about the state of the ledger. These computers are called nodes. Nodes validate transactions by checking the entire history of transactions in the blockchain to verify that someone who tries to send bitcoins to someone else indeed owns the bitcoins that they want to send. Some nodes, called “mining” nodes ( the specialized, single purpose computers called ASICs, or Application Specific Integrated Circuit) perform the function of organizing transactions and putting them into the “blocks” of data that form the blockchain. The blockchain is simply the globally distributed ledger of all Bitcoin transactions ever conducted.
These mining nodes are the lifeblood of PoW. In order to win a block and broadcast it to the network, these computers have to solve fiendishly difficult cryptographic math problems which essentially amount to a brute-force guess-and-check process. These computers generate trillions of “hashes,” or guesses, every second to find a number that is below a certain threshold (the current network difficulty level), and upon guessing that number, they are then allowed to arrange pending transactions into the next block. Hashrate, the rate at which these computers produce these hashes, is a key metric that roughly measures how much computational power the network produces and thus how much energy it consumes. Hashrate can be viewed like a digital commodity of sorts that requires energy to produce, and which in turn produces the “good” of Bitcoin. Oil is a useful metaphor here: Oil wells produce oil and oil is then used to produce downstream consumer goods (like gasoline, plastic, etc). With Bitcoin, specialized computers produce hashrate and hashrate is then used to produce bitcoins (and other PoW cryptocurrencies).
This is where “proof-of-work” comes in: This guess and check method is incredibly energy intensive, and to do it at scale is enormously expensive in both capital expenditure (CAPEX, like buying mining machines and building data centers) and operational expenditure (OPEX, like buying energy, maintaining machines and facilities, etc.). Miners are willing invest this level of capital into mining because of the reward they receive for doing it – “finding a block,”(i.e., guessing the correct number) means that the miners receive a “block reward” from the fees in the transactions that they order into the block plus the 6.25 bitcoins that are newly-mined in this block (this latter figure, the “block subsidy,” will decrease to 3.125 in May 2024 per the Bitcoin “halving schedule”).
Miners expend an enormous amount of energy in the guessing game that is Bitcoin mining, and more heavily-capitalized players are entering the game every day. At the time of writing, the Bitcoin network’s hashrate was 173.83 Exahash per second, or EH/s. This is 173.83 quintillion, or 173.83 million trillion guesses happening every second. To put this in perspective even further, assuming all mining rigs hashing on the network were hashing at 60 terahash per second, or TH/s (a gross simplification but sufficient for this exercise), there would be approximately 2,883,333 workers (what the mining industry calls individual ASIC computers) attempting to earn the block reward. At this network hashrate, the probability that a single worker guesses the correct number and gets the block reward (called “finding a block”) in one day is 0.01%. The probability that the worker would find a block in 33 days of continuous hashing is 0.3%. At these probability levels, they could find a block in one day, or they could never find a block. This is an example of the concept of “mining luck,” which spurred a critical innovation that changed the mining ecosystem, and thus the most integral part of the Bitcoin network: The mining pool.
What is a Mining Pool?
Bitcoin mining pools, first invented by Slushpool in 2010, essentially serve one purpose: They reduce the luck variance, which translates directly to profitability variance, for miners. This effectively smooths the revenue curve for miners, making it easier for them to cover their operational expenses and plan for future deployment of capital. Pools do this by pooling the hashrate of multiple mining operations, thereby increasing the probability of finding a block. To see how this works, consider: If one miner was contributing hashrate to a network with 99 other miners on it, then that miner would have a 1% chance of finding a block every ten minutes. But if 10 miners pooled their efforts together, those miners together would have a 10% chance of finding a block – a significant increase. This is what pools do for miners, with all participants splitting the reward of blocks found by their pool proportional to the amount of hashrate they contribute to the pool. Mining pools pay their miners in one of a few ways, but by far the most prominent method today is some variation of what’s called “Pay Per Share.” In this method, pools pay their miners for their hashrate based on the expected value of that hashrate, which is calculated through an algorithm that looks at the current block reward, the average value of recent transaction fees, and the average value of recent network hashrate (backward looking between 24 hours and 7 days depending on the pool). This way, miners get paid for their work no matter if it leads to finding a block or not, effectively transferring all luck risk to the mining pool.
In exchange for assuming this risk, the mining pool will charge a fee to the miner. In this way, mining pools effectively serve as hashrate liquidation platforms for miners, buying at a slight discount (around 98% of the hashrate’s expected market value) and then earning a profit by using that hashrate to mine on a blockchain or selling that hashrate to a third party like a hashrate market or even another pool. In return, miners’ luck risk is minimized, they earn a stable revenue stream, and with some of the better pools, they even earn more profits through profit switching or “best price execution” algorithms that generate “uplift” over normal mining profits. Mining pools are engaged in a highly competitive free market for hashrate where miners are always looking for the best-in-class services and rates. When considering a mining pool, miners look at fee rate (which is getting pushed closer and closer to 0%, especially for larger mining operations), pool uptime, efficiency rate (how much of a miner’s hashrate is actually being applied to the Bitcoin network), and any other products provided by the pool (e.g. data analytics like Luxor Mining Pool’s HashrateIndex.com, hashrate derivative products, profit switching algorithms, etc.).
Together, miners and pools make-up the beautiful game theory that enables the entire bitcoin network to function securely: Bitcoin miners deploy significant capital into equipment and energy that gives them the privilege to arrange validated transactions into blocks on the blockchain to update the ledger. Pools buy their hashrate in bulk to smooth their returns and make their business model more sustainable. In return for this enormous expenditure of capital and energy, the mining industry is rewarded with bitcoins from both the block reward and transaction fees. If miners or pools wanted to, they could try to erroneously arrange these transactions (for example, executing double spends for profit), but these erroneously compiled transactions would immediately be detected by the validating full nodes on the network, and all the energy used to find that block would have gone to waste because the network’s nodes would reject the block as invalid. For miners then – the nodes on the network most responsible for keeping the blockchain ticking – self-interest, the profit motive, and asymmetric cryptography orient them towards the behavior most beneficial to the entire network itself. In this way, many conceptualize the bitcoin mining industry as the “security spend” of the bitcoin network – akin to America’s Department of Defense for today’s current fiat petro-dollar financial system.
Programmatically Deflationary Financial Energy
Unless you’ve been living under a rock for the past year, you have likely heard rumblings of inflation resulting from government fiscal and monetary policy responses to COVID around the world.
What is Inflation?
Merriam-Webster defines inflation as “a continuing rise in the general price level usually attributed to an increase in the volume of money and credit relative to available goods and services.” Thought of another way, it’s the debasement or devaluation of a currency through the creation and circulation of new units of that currency. It doesn’t matter what the currency is; it’s simple supply and demand. Say I have 10 widgets and 100 dollars circulating within a simple economic system. Initially, those 100 dollars are competing to purchase those 10 widgets. The bid-ask process will clear the market at some equilibrium that depends on consumer demand, which for argument’s sake is a nice round $10 per widget. Now, for whatever reason, the central bank of this very simple economy decides to print 100 more dollars and put them into circulation. Now you have 200 dollars competing for the same 10 widgets. With more liquidity in the market, the bid-ask process will bid the price of those same 10 widgets higher as people with more money compete for the same amount of scarce resources. Widget prices rise to $20, and since in this economy the value of our currency is measured only against those widgets, the real purchasing power of our dollars falls.
This is inflation, and it is a feature of fiat currency regimes (government-issued currency not backed by a commodity). Keynesian economists contend that low levels of inflation are good because this incentivizes consumption, which drives growth, which is the measuring stick that modern economists use to measure the health of an economic system. Without wading into the underlying problematic elements of this argument, even modern Keynesians agree that high levels of inflation are damaging because it erodes the purchasing power of currencies and makes holders of those currencies worse off. Central banks typically have target inflation rates and certain metrics to determine if they are meeting that target. For example, the US Federal Reserve officially sets a target inflation rate of 2% per year, and they measure this through the use of the CPI, or consumer price index. Now to go back to our example above, in the wake of the 2008 financial crisis the Federal Reserve enacted a policy of “quantitative easing” (sometimes critically referred to as money printing) to provide liquidity to the market, suppress interest rates, and spur economic growth. They accelerated this policy in the spring of 2020 in response to the COVID lockdowns, and in 2020 alone the Federal Reserve increased the US broad money supply by 26%, the greatest expansion since 1943. In other words, there is now over 26% more US dollar denominated money in circulation than there was a year ago. And this is happening in central bank economies all across the globe.
CPI continues to register at or around the 2% target rate, and people are increasingly skeptical of CPI as an accurate metric for inflation. Searching for a way to assess true inflation, some skeptics are now using the annual growth in the broad money supply as a proxy for inflation, and by this metric in the US alone we have experienced over 20% inflation in the last year. If this is accurate (and it should be noted that some claim it’s indeed overstated) for those holding cash, they are 20% poorer in real terms even if they saved every cent of their financial energy. A look at commodity and asset prices over the last year suggests at least the partial validity of this analysis. And this is happening to a greater or lesser extent in many economies around the world today.
Bitcoin’s Deflationary Nature
Enter Bitcoin. Bitcoin is programmatically deflationary, meaning that instead of a central authority imprecisely targeting a single digit-inflation rate, Bitcoin’s inflation rate is built into the protocol, unalterable, and declining to 0% over time. The supply of bitcoins on the network grows at a fixed and declining rate: That rate is cut in half every four years in an event we refer to as the “Halvening.” In the first four years, 50 bitcoins were created every 10 minutes through the mining process; in the second four years, 25 bitcoins; in the third four years, 12.5 bitcoins. We are currently in the fourth mining epoch in which 6.25 bitcoins are created every 10 minutes. This halving process will continue, programmatically, every four years until circa 2140 when there will be no more bitcoins to mine, leaving miners reliant on transaction fees for revenue. At this time, there will be 21,000,000 bitcoins in circulation, and there will never be any more created. This is what a perfectly deflationary currency regime looks like.
This protocol is immutable, meaning that the issuance rate and the total number of bitcoins in circulation cannot be arbitrarily changed, unless through total network consensus. The “blocksize wars” of 2015-2017 battle tested this idea, whereby a small group of bitcoin elites wanted to change some fundamental aspects of the Bitcoin protocol. These elites were met with overwhelming resistance, and the Bitcoin protocol carried on as is, with a few new “fork” currencies being created and ultimately failing to gain any material market share. This was an incredible test for Bitcoin – it cannot be a reliable long-term store of value if it can be debased. It passed this test, and by May 2021 the Bitcoin network was worth over $1 Trillion.
Bitcoin as Monetary Technology
Its deflationary nature is perhaps what has allowed it to gain so much popularity and by extension, so much of the crypto market cap. Money, classically defined, performs three basic functions: It stores value, it acts as a medium of exchange, and it acts as a unit of account. There are arguments over the efficacy of Bitcoin as a medium of exchange that hinge on transaction capacity and speed which are beyond the scope of this article. It is sufficient here to say that billions of dollars are transacted on the network every day – the day this sentence was written Bitcoin daily transaction volume came in at approximately $9.7 billion. In the future, technologies like the Lightning Network which enable smart-contract enabled off-chain transactions will likely allow transaction volume to scale up dramatically, as it already is. Today, Bitcoin is already functioning as a unit of account in the cryptocurrency space, with most other cryptocurrencies pegged against BTC (e.g. ETH/BTC) as a measure of their value. Many talk about denominating their lives in bitcoins now (or satoshi’s, the smallest unit of denomination in Bitcoin that represents 1/100,000,000th of a bitcoin), signaling that we could be in the early stages of a transition to a standard of accounting where Bitcoin becomes the primary unit of account. Thousands of stores (particularly online) and payment processing companies are starting to accept it as payment (including PayPal), professional athletes are being paid in it and you can now purchase or sell a home denominated in bitcoins if you so choose. And while these two aspects of monetary technology – unit of account and medium of exchange – are important, the fundamental use case and most valuable aspect of Bitcoin is arguably in its utility as a store of value.
Bitcoin as a Store of Value
Bitcoin’s deflationary, perfectly scarce nature gives it the potential to be one of the best store-of-value assets ever invented. Gold, the traditional store-of-value asset long thought of as the best hedge against inflation, has a consistent inflation rate of about 2% per year achieved through mining. No one knows how much gold is left in the earth’s crust to mine, which means its supply is not fixed, and emerging technologies could someday make it possible to extract gold particles from ocean water or mine it from asteroids, which would drastically increase the supply of gold in the market. Additionally, many gold transactions are not physically settled, meaning that “paper gold” is transacted, which effectively serves as promissory notes on future delivery of gold. It is a widely held belief that there is enormous fraud in the gold markets and that the same type of fractional reserve practices which inflate the fiat money supply are carried out in the gold market, meaning that more promissory notes are in circulation than there is physical gold to back them. There is no easy way to audit gold holdings short of physically inspecting vault reserves, and to catalogue those holdings across the globe is an endeavor fraught with difficulty and inaccuracies.
Bitcoin does not suffer from any of these issues. It has a transparent and predictable issuance schedule. It has a perfectly transparent global supply – there will never be any more than 21 million bitcoins in circulation. It is infinitely auditable – anyone with a full-node can audit the bitcoin blockchain personally. Anyone with access to an internet connection can access a third party block explorer and audit the blockchain data aggregated by someone else. There are at least 9,000 copies of this distributed ledger spread around the globe and synced to consensus every ten minutes. Because it takes practically no money or energy expenditure to “physically” settle Bitcoin transactions (it requires the payment of a small transaction fee and 10-60 minutes to achieve minimum confirmation threshold), there is no fraudulent creation of promissory notes against it, and hence no synthetic inflation. In short, it is the hardest money human-kind has ever seen – a vessel in which to store your financial energy that is not subject to the inflationary whims of central bankers and politicians. This is an essential value proposition of Bitcoin, and what many believe is going to propel it into primacy as a world reserve currency of the near future.
Trust/counter-party risk-minimized, censorship and confiscation resistant
These final fundamental aspects of Bitcoin are really just fancy ways to say that Bitcoin is money that is actually yours and only yours (provided you know how to handle it correctly, which we’ll cover below).
Bitcoin and Counterparty Risk
When you hold your private keys, meaning you self-custody your Bitcoin, you can send that Bitcoin to anyone in the world with a Bitcoin wallet and receive Bitcoin from anyone in the world without having to trust a third party to execute that transaction for you. When you send fiat currency to someone using today’s payment rails, you are implicitly trusting someone – a counterparty – to execute that transaction for you. This could be your bank, someone else’s bank, Zelle, Venmo, CashApp, Western Union, or any other number of counterparties that are charged with transferring your financial energy to someone else. When you pay for something or get paid for something using anything other than cash, you are relying on a counterparty to execute that transaction – Visa, Mastercard etc. When you store your money in a bank or other financial institution, you trust a counterparty with custody of your financial energy. If any of these counterparties are negligent, corrupted, hacked or seized by some authority, the integrity and finality of your transaction or financial reserves could be compromised. Your transfer could be rejected, or it could be intercepted by a third party, or it could be duplicated. A payment to you could be reversed before final settlement, so someone who paid you for a good or service could have that payment reversed long after taking delivery of your labor or goods. A bank that you hold your money in could be robbed, hacked, or fail to maintain enough liquidity to pay out account holders in the event of a run. In some countries there is insurance for bank account losses that covers up to a certain threshold, but even then for large amounts you are trusting the security of your financial energy entirely to the custodian counterparty.
If the idea of trust minimization seems strange to you, I suggest you read or watch this interview with Nick Szabo on the topic. The Bitcoin protocol minimizes the trust required in your financial life (and will in the future potentially minimize the trust required in our lives more broadly, as Szabo touches on). When you send money to someone, you do it on a peer-to-peer decentralized network, broadcasting your transaction for all nodes to see with no counterparty to rely on for proper execution or accounting. When you pay someone, this is just another type of transaction with the same peer-to-peer decentralized assurances. And perhaps most important of all, when you store your financial energy in cold storage on a hardware wallet or in a multi-sig vault (or simply in a memorized seed-phrase), you hold your private keys, meaning that you rely on yourself and only yourself for the security of your financial energy.
Bitcoin and Censorship Resistance
In today’s largely cashless system, it is easy for an authority to censor the ability of people to transact in the system. In some cases, this is a fine aspect of the system in which pre-established rules are enforced. Provide material support to known terror groups, get sanctioned. Attempt to purchase child pornography, get arrested. All good so far. But in other cases, a cashless and censorship vulnerable system has material effects on individual financial freedom when it allows elites to change the rules of the game in the middle of a play. The recent Gamestop/Robinhood episode is a good example of this. Retail traders banding together to pump a stock up in a “short squeeze” succeeded in causing its price to rise dramatically, with daily trading volumes threatening market and exchange liquidity. In order to mitigate this liquidity crisis, Robinhood and other brokerages drastically curtailed or in some cases halted altogether trading of Gamestop shares, causing thousands of people to lose material amounts of money in an enormously volatile couple of trading sessions. This rightfully enraged many retail traders, who for the first time felt on a visceral level what censorship of their financial liberty feels like. Capital controls are a much more pernicious and common method of financial censorship, in which citizens of a jurisdiction are not allowed to leave that jurisdiction with their money. In the GameStop instance, people were interacting in a system that they thought was bound by a certain set of rules, and when that system was stressed, these rules were seemingly changed to benefit the largest actors and to “protect” against systemic failure. With some of the more extreme forms of capital control, citizens of a country exchange their labor or goods for money, but are only allowed to transact with that money within the sovereign borders of their country of residence, effectively tethering them to their state. Bitcoin mitigates both forms of censorship.
With Bitcoin, provided you understand the technology and necessity of self-custody, you do not face this type of censorship risk. If you hold your own private keys, no government, bank, brokerage, regulatory agency, or any other counterparty or authority can prevent you from transacting with your bitcoins on the Bitcoin network. No one can freeze your funds. No one can confiscate your bitcoins. Memorize the seed phrase that represents your private keys, and you need nothing more than your “brain wallet” to store and transfer your financial energy wherever you please (this is not a recommended primary or sole method for normal self-custody of your bitcoin, it should be noted). You hold your keys, you are your own bank, and you have complete financial liberty.
To sum this long primer up pithily, Bitcoin is a way of storing and transacting with your financial energy that minimizes risk and maximizes freedom through the use of novel technology and well-aligned incentives. This financial freedom, however, comes with its own set of responsibilities, including taxes! In the rest of the guide, we will cover some common topics around bitcoin, including taxes, acquisition, and custody.
Legality and Tax Treatment
Bitcoin is legal in most jurisdictions around the world. There are exceptions to this, of course, and as the world continues to grapple with mass adoption of Bitcoin, the regulatory environment shifts quite often. It is common to see headlines of some country (typically a country suffering from inflation or some other monetary crisis) “banning” bitcoin, only to see adoption in that country increase significantly shortly thereafter (as happened recently in Nigeria and Turkey). As of this writing, the following countries have “banned” Bitcoin:
The Republic of Macedonia
And the following countries place significant restrictions on Bitcoin and its use, in some cases banning cryptocurrency exchanges and in most cases prohibiting financial institutions and firms from holding or exchanging Bitcoin:
There is nothing close to a uniform method of treating Bitcoin from a tax perspective across jurisdictions. Some countries have taken an extremely liberal approach, not taxing it at all or creating significant exemptions for cryptocurrency holders and investors. Some countries, on the other hand, tax it heavily. It is best to understand the laws in your jurisdiction before deciding to take a position in Bitcoin or any other cryptocurrency. There are numerous tax software platforms available to help simplify the process of figuring out what you owe at the end of each fiscal year, and with these programs often come tax education content to help you make sense of things. It’s important to understand which types of transactions trigger “taxable events” in your jurisdiction. For example, some day-trading strategies look profitable on the surface, but in the wrong tax jurisdiction the short term capital gains tax could wipe out any profits you think you may have been making. As always, do your research before you start taking positions or trading.
There are numerous ways you can acquire Bitcoin. Below, we cover centralized exchanges, ATMs, decentralized exchanges, Bitcoin mining derivatives, and Bitcoin mining.
It is widely recommended for most people new to Bitcoin to simply sign up for a retail account at one of the major cryptocurrency exchanges like Coinbase, Kraken, Gemini, or Binance (a list of exchanges ranked by market cap can be found here). Once you’ve chosen an exchange, you can create an account, go through any KYC (Know Your Customer)/AML (Anti-Money Laundering) identity verification processes they may require, link your bank account, and start purchasing Bitcoin with your fiat currency. Certain exchanges are prohibited in certain jurisdictions, so make sure you sign up with an exchange that is authorized to do business within your jurisdiction. There are guides aplenty on YouTube and elsewhere that can help you choose the best exchange for your specific circumstances (Coin Bureau has a good one here and typically puts out good content on a variety of crypto related topics). Most reputable exchanges have easy sign-up processes and have robust education content on their platform, providing primers for Bitcoin and other popular cryptocurrencies as well as well-written FAQ pages. Be aware that some places that allow you to “buy” Bitcoin on their platforms (like Robinhood) do not allow you to withdraw it from their platform, and hence, to hold your own keys in self custody (a topic we’ll get into more below). We recommend staying away from these types of dead-end funnels. Ensure that wherever you buy your Bitcoin, you can withdraw it from the platform by sending it to another Bitcoin address.
There are also Bitcoin ATMs in many countries around the world, which allow you to buy, and in some cases sell, Bitcoin right from the kiosk. This is a popular method of acquiring Bitcoin in a non-KYC method (meaning there is no link between your identity and the bitcoins you purchased as there is when transacting on a KYC-regulated exchange such as Coinbase or Kraken). The downside, however, is that transaction fees are typically very high, in some cases as high as 25%, making this a fairly cost inefficient method of buying and selling Bitcoin.
Decentralized exchanges (full list by market cap here) such as Bisq have gained popularity with the explosion of the DeFi scene, and are now seeing fairly large daily trading volumes. On decentralized exchanges, or dex’s, users download software that allows them to connect through Torrent to a network of users wishing to buy and sell Bitcoin in an anonymous, peer-to-peer fashion. Utilizing multisig escrow accounts, dex’s like Bisq allow users to transact with one another without having to go through a centralized exchange that requires KYC compliance and trust in a counterparty to execute the trade. This is a popular (if somewhat technically demanding) method of acquiring bitcoin for people who want to avoid the “privacy fiasco” of having to provide your personal information to an exchange and forever having your identity tied to any bitcoins you obtain from said exchange.
Finally, you can invest in bitcoin mining products or bitcoin mining hardware itself to obtain Bitcoin. On the easier and and more liquid end of this spectrum, you could purchase what are called hashrate tokens such as Binance’s BTCST or Poolin’s pBTC35, which are ERC20 tokens that represent a claim on a certain amount of mining hashrate and the output of that hashrate paid in BTC. Stepping up from there, you could purchase a cloud mining contract, which is similar to purchasing hashrate tokens in that you are purchasing the right to obtain the bitcoins produced through block rewards and fees from a certain amount of hashrate, but different from hashrate tokens in that these contracts are fairly illiquid and require the buyer to either wait until the contract reaches full maturity or sell point to point with another purchaser when wishing to exit the position. Buyer beware, however, as both of these methods of obtaining bitcoin through investments in bitcoin mining products carry with them significant risks. Many cloud mining companies have been revealed to be scams, and hashrate tokens are still in their infancy, with some likely being significantly overpriced even after accounting for the liquidity premium one might reasonably be willing to pay.
Moving up from cloud mining contracts, you could purchase an ASIC mining computer (such as an Antminer S19) and either run it in your home or host it with a mining colocation or hosting service such as Frontier Mining. Both come with costs and benefits. Mining in your home is very likely not profitable due to high residential electricity costs, whereas hosting your miner comes with its own costs and prevents you from having custody of your miner. But both are options to explore should you decide you want to start mining to obtain your bitcoins. Profitability is less of a black box than it used to be, with several popular mining profitability calculators available now like this one from Luxor Mining Pool’s Hashrate Index. With the growth of the Bitcoin network has come commensurate growth in the mining space, and it is quite difficult for retail miners to profitably enter the space now (unlike the early years, when a GPU in your basement could net you handy profits as an individual miner). That said, this is still within reach of retail miners if they are smart and know who to talk to, how to time the market to buy their equipment, and have access to extremely cheap power. It’s another good way to both dollar-cost-average into your bitcoin position, and perhaps do it in a non-KYC manner, so it’s worth checking out if you are ready to commit some time to research.
Custodying (or “Hodling”) your Bitcoin
As with acquiring Bitcoin, there are numerous ways of holding (or, in common Bitcoin parlance, “hodling”) your Bitcoin. Below are some of the most common methods.
Once you have started building your Bitcoin position through whichever method you prefer, you now have to decide how to store it. It’s pretty much universally frowned upon to keep any material amount of Bitcoin on exchange “hot wallets” (Bitcoin wallets connected to the internet) – thousands of bitcoins have been lost to exchange hacks (Mt. Gox being the most notorious), and newer users with bitcoins stored on exchange wallets are more susceptible to social engineering attacks.
There are numerous ways outside of exchange hot wallets to store your Bitcoin, each with its own pros and cons. Three of the most common options are: Yield-bearing accounts with a cryptobank or crypto financial services provider, self-custody on a hardware wallet, or custodian enabled self-custody in a multi-sig vault. We will go through each one briefly with links to where you can learn more.
Bitcoin Interest Accounts
Yield-bearing accounts, (known variably as Bitcoin interest accounts, crypto interest accounts, or crypto savings accounts), are a relatively new phenomenon that are gaining in popularity as the players in the space grow larger and more legitimate and yields stay relatively high. A review of these products and list of service providers can be found here. Essentially, you keep your Bitcoin in an account with a company like BlockFi, Gemini, or Celcius, and they pay you a yield on that Bitcoin that ranges between 2% and 6.2% APY. If you store some of your wealth in stablecoins on these platforms, you can earn truly ridiculous yields of up to 17%. But buyer beware: You earn this yield because these companies use your Bitcoin in their other business verticals, meaning they lend it out to (mostly institutional) investors looking to borrow funds for investing purposes, or they post it as collateral for their own borrowing purposes. The big names in the space all have robust and seemingly secure custody solutions that they either outsource (in the case of BlockFi with BitGo and Gemini) or hold in house (in the case of Gemini, who recently completed both their SOC 1 and SOC 2 examinations, which are the industry standard for security). For those Bitcoiners who love Bitcoin for reasons of self-sovereignty, however, no amount of security certifications or virtue signaling will overcome the “not your keys, not your coins” philosophy. For them, no amount of yield – and the associated risk therein, no matter how small – is worth giving up their private keys.
If you’re in this boat, or find yourself in this boat in the future as you continue to dive down the rabbit hole, then self-custody of your Bitcoin in a hardware wallet is the next step up the custodial ladder. With this option, you purchase a hardware wallet (e.g. Trezor, Ledger, or Coldcard), set it up (don’t forget to write your seed phrase down and store it somewhere safe!), send your bitcoins to it, and sleep well at night knowing that you and only you have control over your private keys and therefore the wealth you have stored in Bitcoin. Here is a review of the best hardware wallets of 2021. This is a good option for those Bitcoiners who live in countries that are unfriendly to Bitcoin, or where political or economic instability leads them to fear that at some point, someone may try to prevent people from owning Bitcoin. In this instance, some of the first places to be attacked would likely be exchanges, with funds frozen in accounts and withdrawals made illegal, effectively preventing anyone with bitcoins stored on exchange hot wallets from ever withdrawing them. These types of capital controls are not without precedent (the “6102 attack” is an interesting topic to research for anyone curious about what governments can do in the midst of a currency crisis, for example).
With self-custody in a hardware wallet, no one controls your bitcoins but you. You can store it and transfer it without anyone else’s permission, effectively mitigating all counterparty risk. This is also the downside of this method: To do this safely you have to up your own personal responsibility game. If you store all your Bitcoin on a hardware wallet, and then lose the actual hardware piece and also lose your back-up seed phrase, you just lost all your Bitcoin and there is nothing anyone can do about it. No FDIC, no customer service, just you with all of your Bitcoin gone forever. Further, if you self-custody and aren’t smart about it, it can really hurt your family if and when you die. Unless you have a deliberate estate plan in place, it is possible that something could happen to you, and your family and loved ones would have no way of retrieving your Bitcoin. Scroll Reddit for a little while and you’ll likely be able to find horror stories just like this. The cost of self-sovereignty is responsibility.
This is where multi-sig vault enabled self-custody comes into play. Multi-sig cold storage vaults combine the sovereignty benefits of self-custody with the assurance that comes from knowing that if you lose your wallet and your seed phrase, you will still be able to recover your Bitcoin. Most commonly, this method involves setting up what’s called a “2 of 3” multisig vault, in which you hold two sets of private keys (a hardware wallet is in actuality just a “key”, so in this case you hold 2 hardware wallets) and the vault custodian (like Unchained Capital), holds the third set of private keys. It’s called “2 of 3” because to access the Bitcoin and transact with it, two of the three keys are required in quorum. This is a popular option for businesses that hold bitcoin on their balance sheet or use it operationally but don’t want to give up physical custody, for high-net-worth individuals who want to add an extra layer of security to their holdings while mitigating the various single-point-of-failure risks associated with simple self-custody, and for individuals who do deliberate estate planning with their Bitcoin holdings and want to ensure their heirs have access to their Bitcoin when they are gone. It is complicated, yes, and it does slow down your ability to transact with your Bitcoin, but it is by far the most secure way to store your Bitcoin and therefore something to consider as your stack grows.
Borrowing With Bitcoin Collateralized Loans
Speaking of growing your stack, as the old adage goes, “friends don’t let friends sell their Bitcoin.” As you dive further and further down the rabbit hole, the conviction may strike you one day that you need to start denominating your life in Bitcoin because of how valuable your bitcoins are likely going to be in the near future. This is the transition you make when you stop caring about how much your bitcoins are worth when denominated in fiat currency pairings, and simply start worrying about how much Bitcoin you are accumulating.
If and when you make this transition, two things will likely happen at the same time: You will become increasingly hesitant to ever sell any of your Bitcoin, and a larger and larger percentage of your net worth will start to be denominated in Bitcoin. This can make you pretty cash poor pretty quickly, and there may come a time when you need to fund an unexpected expense. With Bitcoin collateralized loans (offered by companies like Celcius, BlockFi, Gemini, Unchained Capital, etc.), you simply post your Bitcoin as collateral and receive a loan in stablecoins or fiat currency. You can typically borrow up to 50% of your collateral value denominated in fiat (called your “Loan-To-Value” ratio or LTV), so if you post $20,000 in Bitcoin, you can borrow $10,000 against it. Be careful though – if the price of Bitcoin all of a sudden drops and your LTV goes too high, you will get margin-called (they will ask you to post more collateral) and if you can’t, they may liquidate your Bitcoin to pay the loan back (at BlockFi, for example, this happens automatically when your LTV reaches 80%). For the everyday Bitcoiner, these types of loans should be used conservatively and sparingly, but they are a good way of covering short term expenses without having to liquidate some of your Bitcoin stack.
Bitcoin Debit and Credit Cards
With the Bitcoin financial services industry maturing, new products are being released all the time that make it easier to transact with your Bitcoin and even earn Bitcoin rewards for spending your fiat. Bitcoin debit cards are becoming ubiquitous, and generally come in two types. Some, like Coinbase’s debit card, allow you to spend your Bitcoin (or other cryptocurrencies if you have them) anywhere that accepts Visa. It basically does an automatic currency conversion at whatever the spot rate is when you swipe it at a vendor and debits your Coinbase account appropriately. Other cards, like Fold’s debit card, allow you to load the card with your fiat currency, spend, and then earn Bitcoin rewards back. Finally, Bitcoin rewards credit cards are poised to hit the market soon, with both BlockFi and Gemini releasing offerings that boast some pretty healthy Bitcoin reward rates (between 1.5% and 3.5%). These are normal credit cards in almost every way, except that your rewards are credited to you directly in Bitcoin. Though they haven’t been released yet and the specific terms are still in flux, there are hundreds of thousands of eager customers already signed up to apply for one.
With all of these cards, you should keep a few things in mind when comparing and contrasting. First of all, many of them have pretty high fees that are piled on piecemeal (for instance, Coinbase charges 2.49% cryptocurrency liquidation fee, 1% for withdrawing over the daily limit, and 2% for using the card abroad). Next, you want to do some research on the card company’s security model, especially if you are holding your bitcoin in a hot wallet to enable you to transact with it through your debit card. Large reputable companies like Coinbase are likely pretty secure, but it is a tradeoff that you need to consider especially in light of the above conversation on the risks of storing your Bitcoin on exchange hot wallets. Finally, user experience varies with all these companies (customer service, app functionality, etc.), so be sure to dig into each one before signing up.
Conclusion and Further Reading
By way of conclusion, I will just say that this guide doesn’t even scratch the surface of the Bitcoin ecosystem and all there is to learn about it. I don’t think you’ll meet a true Bitcoiner that will claim to know all or even most of what there is to know about Bitcoin. So to wrap up, here is a repository of just some of the most important works in the Bitcoin oeuvre, written by some of the smartest people in the space. Have fun diving down the rabbit hole!