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What is Bitcoin? Cryptocurrencies explained

Find out what Bitcoin is, how this cryptocurrency and the blockchain works - and if Bitcoin is really worth investing in.

In this article
What is Bitcoin and cryptocurrency? How does Bitcoin work? What is blockchain? How are new Bitcoin created? Where can I buy Bitcoin? How is Bitcoin stored?
Should I invest in Bitcoin? Bitcoin: the risks of investing Bitcoin scams: how to avoid them Alternatives to Bitcoin Can Bitcoin be hacked? Is Bitcoin liable for tax?

What is Bitcoin and cryptocurrency?

Bitcoin is a digital currency (also referred to as 'cryptocurrency') that isn't controlled by any country, treasury or central bank. 

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

You can use Bitcoin to buy or sell items from people or companies that accept Bitcoin 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'.

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

Each time a Bitcoin transaction is completed, the entire network is updated with this information so it can be validated by users on the network.

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.

What is blockchain?

Blockchain aims to cut out middlemen, such as banks and online market places like eBay and Amazon, when it comes to trading with one another.

The technology isn't exclusive to Bitcoin or even the financial services industries.

Its use is becoming more widespread and has been adopted by sectors such as pharmaceuticals, fashion, and even humanitarian agencies like the UN.

How are new Bitcoin created?

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

People called Bitcoin 'miners' 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. 

A maximum of 21m Bitcoins can be created, and as of June 2017 there were 16,366,275 in circulation. 

It's estimated that, at the current rate of creation, it will be 2140 until the 21 millionth bitcoin is made.

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, Kraken and Bittylicious.

How is Bitcoin stored?

In order to get Bitcoin, you first need to set up a special 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're financially equipped and willing to lose any money that you put into it. 

The value of Bitcoin is volatile, and it's common to see its price fluctuate by around 10% or more daily. 

On top of that, Bitcoin and other cryptocurrencies, are not protected by the Financial Services Compensation Scheme (FSCS). 

Ordinarily the FSCS will compensate you up to £50,000 worth of investments (£85,000 in April 2019) if you have received bad investment advice, or if a regulated investment firm goes out of business and cannot return your money. 

If something goes wrong with your Bitcoin investment, you stand to lose everything. 

Bitcoin: the risks of investing

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

Losing everything

Bitcoin and other cryptocurrencies aren't currently regulated by the Financial Conduct Authority (FCA). There also isn't any compensation available from the FSCS so if things go wrong, you stand to lose your entire investment. This also means that if you lose your wallet or it gets stolen, there is no way of getting your money back. 

Price volatility

The value of cryptocurrencies, such as Bitcoin, can change significantly. Towards the end of 2017 for example, Bitcoin lost a third of its value and dropped by $2,000 in one day. 

Cyber attacks

Bitcoin exchanges are vulnerable to attacks, which could lead to an irreparable loss of your investment. 

Companies stop accepting it

If companies stop accepting Bitcoin, it will inevitably lose value and become worthless. 

It loses its appeal

Similarly, if consumers lose favour with Bitcoin and move to a new cryptocurrency - or just leave digital currencies alone - Bitcoin will also lose value. 

Bitcoin scams: how to avoid them

A number of cryptocurrency scams have emerged recently. 

Criminals have started using celebrity images to trick people into investing in cyrptocurrencies such as Bitcoin. 

In March alone there were 21 reports of victims targeted by celebrity Bitcoin scams, losing over £34,000.

The fake cryptocurrency investments have been advertised through social media and other websites. 

People who click on the adverts find a full page article showing the images of well-known financial experts - such ad Deborah Meaden and Martin Lewis, recommending that they invest. 

Scammers often use platforms like Facebook, Instagram and Twitter to trick people into these investments. 

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. 

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

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

Can Bitcoin be hacked?

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

Cryptocurrency exchanges, however, have fallen victim to cyber attacks which has lead to Bitcoin being stolen on a large scale. 

For example, in 2013, a major Bitcoin exchange called Mt. Gox was hacked and over 850,000 Bitcoin (worth around $473m) was stolen. 

Mt. Gox, which was responsible for around 80% of all Bitcoin transactions at the time of the hack, later filed for bankruptcy. 

Recently another major cryptocurrency exchange, Coincheck, was hacked and over $500m in various cryptocurrencies was stolen. 

Is Bitcoin liable for tax?

Income from Bitcoin 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 tax-free allowance and any allowable expenses (e.g. dealing costs, stamp duty, advertising.)

Currently, basic-rate taxpayers are charged 10% and higher-rate taxpayers are charged 20%.

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