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What is Bitcoin? Cryptocurrencies explained

Find out what Bitcoin is, how blockchain works - and if Bitcoin and other cryptocurrencies are worth investing in.

In this article
What is Bitcoin and cryptocurrency? How does Bitcoin work? Where can I buy Bitcoin? How is Bitcoin stored? Should I invest in Bitcoin?
Beware Bitcoin and cryptocurrency scams What are the alternatives to Bitcoin? Is Bitcoin or other cryptocurrencies liable for tax? Is Bitcoin bad for the environment? 

What is Bitcoin and cryptocurrency?

Bitcoin is one of thousands of cryptocurrencies (also referred to as 'digital' or 'virtual' currency) that aren't controlled by any country, treasury or central bank. 

Bitcoin was created in 2009 by an anonymous developer, who went by the pseudonym Satoshi Nakamoto, and hit the mainstream in 2013 following a rise in its value. 

You can use Bitcoin and cryptocurrency to buy or sell items from people or companies that accept Bitcoin (or other cryptocurrency) payments. 

Bitcoin doesn't exist as a physical currency, which means that there aren't any actual coins or notes. 

 

How does Bitcoin work?

Bitcoin works using a system called 'blockchain', as do many (but not all) other cryptocurrencies.

Blockchain is a network of computers that all have access to every transaction that takes place.

Each time a Bitcoin or other cryptocurrency transaction is completed, the entire network is updated with this information so it can be validated by users on the network. This should prevent counterfeiting or double spending.

The transaction information on the network is encoded using cryptography, which keeps the transaction data secure and prevents anyone from tracking who it belongs to.

Once validated, the transaction information is added to a chain of previously approved transactions.

Where can I buy Bitcoin?

Bitcoin can be bought through online cryptocurrency exchanges.

A cryptocurrency exchange is a service for people to buy or sell their cryptocurrency.

There are a number of exchanges available including Coinbase, Coinfloor and Kraken.

 

How are new Bitcoin created?

 

Every time a person makes a Bitcoin transaction online, the P2P network is updated with new information. 

People called Bitcoin 'miners' use their computers to solve complex mathematical equations to organise this new information into blocks.

The first miner to solve a particular equation is rewarded with newly created Bitcoin. 

This practice has been criticised for its damaging impact on the environment.

 

Are you really buying Bitcoin?

 

Many firms - and many crooks - that advertise Bitcoin are in fact selling investment vehicles that track Bitcoin.

In October 2020 the FCA banned the sale and marketing of financial products that track popular cryptocurrencies such as bitcoin.

The rules affect the sale of derivatives – financial contracts between two or more parties based on the future price of an underlying asset (such as cryptoassets) and exchange-traded notes (ETNs) – debt notes issued by banks that offer returns based on the movements in a specific benchmark such as a crypto index. 

Avoid any such products you see advertised, as they are likely to be scams.

How is Bitcoin stored?

In order to get Bitcoin, you first need to set up a Bitcoin wallet. 

A Bitcoin wallet contains your public and private keys which allow you spend, receive and store your Bitcoin. 

There are several types of Bitcoin wallet, each offering different levels of security, anonymity and control over your cryptocurrency. 

Web wallets

Web wallets allow you to send, receive and store Bitcoin through your web browser. These are usually hosted by a third party provider that manages the security of the private keys associated with your account. 

Desktop wallets

Desktop wallets can be downloaded onto your personal computer. They give you full responsibility over the management and security of your wallet. 

Mobile wallets

Mobile wallets allow you to make Bitcoin transactions through your mobile phone by downloading an app. 

Paper wallets

Paper wallets are an offline way of storing your Bitcoin. They exist in in physical form, usually paper or plastic and include a printed version of your public and private keys. If you lose your paper wallet however, you lose your entire Bitcoin investment. 

Hardware wallets

Hardware wallets are specifically designed to store Bitcoin. They come in the form of digital devices that can be connected to your computer so that you can make transactions. 

Should I invest in Bitcoin?

Bitcoin is an extremely risky investment and you should only consider investing if you can afford to lose any money that you put into it. 

It is true that where there's higher risk, there's more potential for returns. But remember there's also more potential for losses.

If you're thinking about investing in Bitcoin, there are a few risks to consider first. 

Price volatility

The value of cryptocurrencies, such as Bitcoin, can change significantly. It's common to see its price fluctuate by around 10% or more daily. 

If you're investing with a specific goal in mind - buying a property, for instance - price swings could put your plans in jeopardy. 

Lack of regulation

Bitcoin and other cryptocurrencies aren't regulated by the Financial Conduct Authority (FCA) in the same way as investment platforms or banks.

This means you may not get access to the Financial Ombudsman Service if you have a dispute with a provider. 

Cryptocurrency firms are however required to register with the FCA, to comply with anti-money laundering and terrorist financing regulations. They may also carry out regulated activities.

You can check firms on the FCA Register.

Provider failure

Because Bitcoin and cryptocurrencies aren't protected by the Financial Services Compensation Scheme (FSCS). 

If the provider of your cryptocurrency wallet went out of business and shut down, you wouldn't be eligible for compensation from the FSCS.

Ordinarily the FSCS will compensate you up to £85,000 worth of investments if you have received bad investment advice, or if a regulated investment firm goes out of business and cannot return your money. 

Cyber attacks

The blockchain system is very secure, making it difficult to break into people's Bitcoin wallets. 

However, there are still security risks. You should have the security of a transaction linked to an email address or mobile number. If a hacker can determine some of your non-Bitcoin personal information like this, they may be able to gain access to your digital wallets. 

It loses its appeal

If consumers lose interest in Bitcoin and move to a new cryptocurrency (or vice versa) - or just leave digital currencies alone - Bitcoin will also lose value. The same goes for other cryptocurrencies.

Governments could also crack down on firms involved in cryptocurrencies, or make them impossible for businesses to accept as payment.

Beware Bitcoin and cryptocurrency scams

Scammers usually advertise on social media or search engines - often using celebrity images and slick websites to promote these types of investments.

The firms operating the scams are usually based outside the UK but will claim to have a UK presence, often a prestigious City of London address, according to the Financial Conduct Authority (FCA). 

The regulator says scam firms can:

  • manipulate software to distort prices and investment returns
  • scam people into buying non-existent cryptoassets
  • suddenly close consumers’ online accounts and refuse to transfer the funds to them or ask for more money before the funds can be transferred.

You should also watch out for initial coin offerings (ICOs), a digital way of raising funds from the public using a virtual currency like Bitcoin. Some issuers might not have the intention to use the funds raised in the way set out when the project was marketed.

You can find a list of unregistered cryptoasset businesses on the Financial Services Register. It shows UK businesses that appear to be carrying on cryptoasset activity without being registered with the FCA, and should hence be avoided. 

If you suspect you've clicked on a fraudulent link or have been targeted by scammers it's important to contact Action Fraud as soon as possible. 

Which? has launched a free email service revealing the latest scams.

What are the alternatives to Bitcoin?

While Bitcoin is the most recognised cryptocurrency, there are a number of other digital currencies available. 

These include:

  • Ethereum
  • Litecoin
  • Zcash
  • Dash
  • Ripple
  • Dogecoin 
  • Cardano

All cryptocurrencies carry similar risks and should only be invested in if you have the financial capacity to lose whatever you decide to buy. 

Investors willing to take on risk in exchange for reward should consider investing in equities - i.e. individual company shares and investment funds and trusts.

While you could still lose money, you'll benefit from more regulatory protections.

Is Bitcoin or other cryptocurrencies liable for tax?

Income from Bitcoin or other cryptocurrencies will usually be subject to capital gains tax or corporation tax. 

Capital gains tax is paid on the profit you make from selling an asset that's increased in value. 

This means that if you sell your Bitcoin for more than bought it for, you could be liable to pay tax on the profit made, minus your annual tax-free allowance (£12,300, as of the 2020-21 financial year) and any allowable expenses (e.g. dealing costs, stamp duty, advertising).

You'll only need to pay capital gains tax when you sell - an asset simply increasing in value doesn't trigger tax.

Is Bitcoin bad for the environment? 

Cryptocurrencies require large amounts of energy. This is because mining for crypto involves heavy computer calculations to verify transactions. 

Using large amounts of energy is a major contributor to air pollution and climate change.

According to a study by Cambridge University, Bitcoin alone uses more electricity than the whole of Argentina. 

In addition, 65% of Bitcoin miners are located in China, a country that generates most of its energy from burning coal, a significant contributor to climate change due to the carbon dioxide it produces. 

However, not all cryptocurrencies have significant environmental impacts. For example, some may use an alternative to blockchain which removes the need for miners. 

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