Bitcoinsa continue to attract attention but remain somewhat difficult to understand (see the May 2014 Communications Economic and Business Dimensions column by Marshall Van Alstyne, "Why Bitcoin Has Value"). They are by far the most used of several hundred "crypto-currencies." Theoretically, they are free and available to anyone with a computer and an Internet connection. They could replace cash, credit and debit cards, money transfers, and currency conversions through banks and other financial intermediaries. They represent another potentially disruptive Internet technology. But are they truly free and easily available? Not really. For most of us, bitcoins are a complex platform technology that requires the help of intermediaries—an ecosystem of "complementary" product and service providers that charge fees.
The software solves the dilemma of how two or more people who do not know each other can establish trust and mutually agree upon a transaction: the so-called "Byzantine Generals Problem." The technology first appeared in 2008 after its creator (or creators) known as Satoshi Nakamoto made the software freely available.2 Bitcoin generates a public ledger (a "block chain") when anyone creates, buys, or transfers a bitcoin. No one can change this ledger, and anyone can see it by downloading the open source peer-to-peer software. This scheme offers significant protection against theft or counterfeiting. However, because the ledger does not contain names or physical addresses, some criminal use of bitcoins to transfer and store money has occurred.5 (Anonymous overseas bank accounts might be worse in this regard.)
Bitcoins are currently less like a currency and more like a computer-generated commodity.
Bitcoins are currently less like a currency and more like a computer-generated commodity. Those who solve calculations receive blocks of bitcoins in decreasing size as more are produced. The value of a single bitcoin, which has ranged from fractions of a penny to over a thousand dollars, comes primarily from speculators. There were about 12.5 million bitcoins in mid-2014, valued at approximately $7 billion (just under $600 each).b Unlike currencies that governments create, Bitcoin software limits the supply to 21 million units, a number that might be reached around the year 2140. Yet bitcoins can be divided into fractions and more fractions, which are especially useful to conduct micropayments over the Internet, such as for music or newspaper articles. In principle, the supply of bitcoins could be large enough to function as a currency substitute. Moreover, bitcoin users can avoid high transaction fees. Goldman Sachs estimates intermediaries siphon off as much as 10% of value for money transfers.4 Credit cards include 2% or 3% as charges to vendors ultimately paid by consumers, or about $500 billion a year, excluding other card charges or currency conversion costs.7
Yet bitcoins are not yet ready for prime time. The technology is more like Windows, iOS, or Android in their early stages. Yes, Bitcoin brings multiple parties together for a common purpose—to make financial transactions over the Internet. But, like other new platforms, we need an ecosystem of complementary products and services to make the technology truly easy to use (see my January 2010 Communications column, "The Evolution of Platform Thinking").
The Bitcoin ecosystem must solve several common platform-market problems. One is the "chicken-and-egg" dilemma: If more vendors accept bitcoins, more people will use them; and if there are more bitcoin users, vendors are more likely to accept them. Conversely, vendors will not accept bitcoins unless more people have them, and people will not use bitcoins unless vendors accept them. New operating systems and credit cards all faced this dilemma. In addition, the supply of bitcoins is limited by a numerical ceiling and algorithms that increase in complexity each time someone generates another bitcoin. Creating bitcoins today therefore requires big investments in computers and electric power. Limited supply causes prices to rise and fluctuate due to speculation. Buying bitcoins from people who already own them requires transferring money, but many banks that would provide such services refuse to handle bitcoins.14 If more governments join China to outlaw bitcoin payments or impose capital gains reporting on sales of bitcoins, as the Internal Revenue Service does in the U.S., then bitcoin use could be severely compromised.1,12
Bitcoin entrepreneurs follow the value chain. The first step is mining, creating more BTC units from scratch, and then we have storing bitcoins in virtual "wallets." The wallets resemble smartphone apps with the equivalent of digital bar codes to hold keys and transaction information. To buy or convert bitcoins to traditional currencies, a wallet company needs information from a user’s bank account or credit card, and then must interact with another step in the chain—payment processors or exchanges that convert bitcoins into other currencies or send bitcoins to vendors as payments. These companies generally charge between 0.5% and 1%. Finally, we need other companies to guarantee against losses from fraud, theft, or huge swings in value.
Mining companies have received mixed reviews when the costs are not always transparent. Cloud Hashing, founded by Emmanual Abiodun in London in 2013, started by mining bitcoins on a PC, later moved to commercial-scale machines, and now rents out computing power and "mining contracts" as a service.c,10 It can cost more to generate bitcoins than they are worth on the market but, if value goes up, customers eventually win. Bitfury, founded in 2011 and now located in San Francisco, received $20 million in venture funding to design application-specific integrated circuits (ASICs) for Bitcoin mining.d,15
Payments processors and wallet firms are critical intermediaries and have also raised a lot of venture capital. Bitpay, founded by Tony Gallippi and others in 2011 in Atlanta, GA, has relationships with more than 30,000 vendors and has received some $35 million in funding, led by Richard Branson (Virgin Atlantic), Jerry Yang (Yahoo), and Li Ka-Shing (Horizon Ventures).e San Francisco wallet company Coinbase, founded in 2012 by Brian Armstrong and Fred Ersham, received $25 million in venture capital from Andreessen-Horowitz and others. It holds about 20% of all bitcoin customer wallets (1.3 million, growing about 30% a month), charges 1% to convert into or out of bitcoins, and has relationships with more than 30,000 merchants.f,4,11 New entrant Circle Financial, founded in 2013 in Boston by Jeremy Allaire, formerly of Macromedia and Brightcove, has received $26 million in venture capital. Circle Financial provides payment acceptance tools for merchants who must pay, as well as easy and free ways for consumers to buy, sell, store, or receive bitcoins.g,16 Bitstamp, the most prominent current exchange, was co-founded in 2011 by Nejc Kodrič, originally based in Slovenia and now operating out of the U.K.h
Despite such successes, the largest exchange and wallet service, Mt. Gox of Tokyo, went bankrupt in 2014. Hackers exploiting poor accounting practices or a loophole in the block chain caused the company to lose somewhere between $350 and $500 million in bitcoins from customer accounts. There is a paradox here: The Bitcoin community has tried to get around traditional banks and government regulation but now they probably need banks and regulators if bitcoins are to become more secure and widely accepted.3,9
Theft or loss from computer hardware failures or other risks has also created demand for insurance. U.K.- based Elliptic will store bitcoins and cover holdings against loss for a fee of 2%, similar to a private Federal Deposit Insurance Corporation.i Inscrypto is designing a hedge fund to protect against large swings in the value of bitcoins.j,8
Finally, it remains unclear if the average consumer will treat bitcoins as a currency replacement or as a commodity for speculation. Users might pay less than credit card fees, but not much less, and the chicken-and-egg problem will be difficult to solve. To build some momentum, Circle Financial and Coinbase are giving away $10 bitcoin accounts.k,6 The Massachusetts Institute of Technology (MIT) Bitcoin Club also raised $500,000 to give each MIT undergraduate (there are 4,500) $100 in Bitcoins in September 2014.13 What these new users do with their free accounts should provide some insight into Bitcoin’s future.
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