Understanding Bitcoin Part 2: Bitcoin Exchanges

In order to get comfortable with the idea of acquiring and using Bitcoin, you need to get comfortable with Bitcoin exchanges. Bitcoin exchanges are the common marketplace to buy and sell Bitcoin. There are alternatives to exchanges but we’ll cover that later. When approaching Bitcoin as a concept, the first thing you need to do is get comfortable with the basics: how the technology works, where it gets its value, etc. This I covered in another blog post named “Understanding Bitcoin: The Basics.”

There are Bitcoin Exchanges located inside and outside the US and more are on the way. There are two types of business models for these companies, either they are full exchanges or they are a digital ‘wallet’ service to store their customers’ Bitcoins, or both. The combination of exchange/wallet service is getting popular now, with a lot of companies offering a mobile app to easily access your Bitcoins from your smart phone.

Transacting Bitcoin
The important question is, when you execute a transaction on an exchange, what is actually happening? This takes us to one of the most important concepts to understand about Bitcoin: the fact that Bitcoin exist only as evidence of a transaction, rather than a ledger or a cumulative file that equals a certain amount of value.

To explain, if I purchased ten Bitcoin on Monday and twenty Bitcoin on Tuesday, then I would have thirty Bitcoin in my digital wallet. Now what does it mean to have thirty Bitcoin in my wallet? With physical cash (otherwise known as fiat money) the form would be paper notes summing up to thirty and having the appropriate markers and serial numbers to ensure it is not counterfeit. With Bitcoin the form is codes, or private keys, which is the evidence that those two transactions (10 and 20 Bitcoin purchases) took place. The private keys will not be found anywhere else. If the codes were lost, the Bitcoin would be lost. If the private keys were used by anyone else, your Bitcoin would be lost. By executing a transaction on an exchange, you are giving or receiving private keys to order to sell or buy Bitcoin. Depending on the exchange you may only be only able to deal in Bitcoin, while on other exchanges fiat money can be traded for Bitcoin.

Storing Bitcoin
Storage is the other major feature of the Bitcoin experience. There are several ways to handle this, you can

1) Store Bitcoin right on your hard drive (make sure you backup regularly).

2) You can use one of the many online and/or mobile device wallets available, which in some cases means letting the exchange who owns the app keep the private keys; so basically you are using a ‘thin-client’ on your smart phone to transact Bitcoin rather than the full Blockchain program on a desktop computer. The online wallet choice where you don’t have control over the private key has its advantages and disadvantages. One of the advantages being you can access your Bitcoin from any device as long as you can access your account. The disadvantage being that you are putting your faith in the company that runs the exchange. If the company up and vanished (as the Mt. Gox exchange did in early 2014) you could lose your Bitcoin. Remember, Bitcoin wallets are not insured by the FDIC. The good news is as the Bitcoin marketplace grows and more large investors are investing in the technology, Bitcoin exchanges are improving their security measures and are learning from past problems like Mt. Gox. One of the newer Bitcoin exchanges, Coinbase, out of San Francisco is considered to be the first regulated bitcoin exchange in the US; it is also the exchange I use for my own Bitcoin wallet.

3) You can receive paper receipts of transactions with the private key on it and put them in a safe.

Any method works as long as security of the private key is maintained.

Earlier I alluded to alternatives to buying and selling Bitcoin through exchanges. Those alternatives are 1) buying and selling Bitcoin directly from individuals; this usually consists of meeting in a public place to execute a transaction via mobile phones or 2) accepting bitcoin as payment for goods or services as a merchant and 3) Bitcoin mining (mining is how Bitcoin transactions are verified in the Blockchain and the computers or ‘nodes’ that execute these verifications are paid in Bitcoin. This is also the only way new Bitcoin is created and injected into the marketplace.)

There are many choices now as to which Bitcoin exchange you would like to do business with. Refer to the article “A Look At The Most Popular Bitcoin Exchanges” for a run-down of some of the most popular.

I intend to go into greater detail about how it is that the private key can only be used once, however that will be saved for another blog post. Suffice to say, it is at the core of the Bitcoin technology that when you transact Bitcoin the private key being used is verified that it was never been used before. If it is not verifiable, the transaction will be declined.

Have you started using Bitcoin yet? How comfortable would you be with executing transactions on a Bitcoin Exchange? Please leave me your comments.