Wall Street Doesn't Understand Bitcoin Yet, But It Will

by: Kyle Spencer

They've been laughed to scorn by left and right wing economists, caricatured as the perpetrators (or victims, take your pick) of a global Pyramid scheme, written off, ridiculed, and all-around snobbed to death by Wall Street.

Yet, for all the articles that have appeared in the mainstream media, comparatively few have actually engaged the Bitcoin community itself in the conversation. I believe that's a mistake. What I've discovered over the past 5 days or so I've spent on /r/Bitcoin is not a basket of naive, ideologically fueled freshmen that detractors like Gideon Samid airily dismiss as "The Bitcoin Delusion", but a diffuse, sophisticated and above all ambitious sub-culture that is capable -through raw programming prowess, if nothing else - of changing the way people think about money. This is not some pseudoeconomic post-modern Libertarian cult, it's an un-led, crowd-sourced mega startup organized around mutual self-interest where problems, whether of the theoretical or purely practical variety, are treated as temporary and, ultimately, solvable.

In fact, it is this ability to layer solutions over Bitcoin's existing framework and hack around inconveniences is the reason why Bitcoin won't just crawl up and die, despite five boom/bust cycles, the fall of Silk Road's "Dread Pirate Roberts", the jeers of heavyweight economic influencers like Nobel-prize winning economist Paul Krugman and Euro Pacific Capital's Peter Schiff, and the outright skepticism of Wall Street in general.

Bitcoin started it's pseudoanonymous life as a pet programming project: a protocol designed by the mysterious Satoshi Nakamoto. Though the supporting infrastructure is relatively complex, in practice, Bitcoin operates like cash with a caveat: No one can bring more that 21 million coins into being, while the coins that do exist are near infinitely sub-divisible.

Fig. 1: Total Number of Bitcoins Currently in Circulation

(Click to enlarge)

(Source: ZeroBlock)

The nominal value of Bitcoin tends to increase rapidly vs. the USD with media exposure. At present, that market has a relatively small market cap, between $8-$9 billion USD as of this writing, depending on the BTC Exchange you're using for a reference point.

Fig 2: Bitcoin Market Cap (in $)

(Click to enlarge)

(Source: ZeroBlock)

In other words, the purchase of a single bitcoin or a fraction of a bitcoin is just as much a state in the future profits of the Bitcoin network as a share of stock is a stake in the future profits of a company. The economic rationale underpinning Bitcoin's steady logarithmic increase (once booms and busts are filtered out) in price is in turn based on Irving Fisher's Quantity Theory of Money, which essentially states that the quantity of money determines the value of money.

Liquidity within the Bitcoin community is supplied not by inflation, but rather through the extraordinary divisibility of a single bitcoin into increasingly smaller fractions. In short, the programmers, merchants and developers surrounding the bitcoin protocol/network are effectively stakeholders with the mind-share to keep the Bitcoin system up and running regardless of currency crashes or regulatory interference, something that Beijing appears to realize even if Washington ultimately decides to take a different tack. (The German government recently classified Bitcoin as "private money", taxable as a financial instrument.)

Part of that probably has something to do with QQ, a Chinese virtual currency that became so popular so quickly that it accounted for up to 13% of the Chinese economy before Beijing could rein it in. While QQ had a single point of failure [i.e. Tencent (OTCPK:TCEHY)], Bitcoin highly distributed nature does not. This property makes Bitcoin, like the Internet itself, virtually impossible for a single government or collection of governments to turn off.

Readers should keep in mind that deflationary currencies are not in and of themselves an untenable proposition. Most of the Western world was based on similar standards, and commerce abounded for centuries. And Bitcoin's current volatility cuts both ways: When the Bitcoin price vs. fiat currencies is rising, there are few participants that wish to sell. Nevertheless, as the price of bitcoin is allowed to float vs. a basket of currencies, and because both essential commodities like oil and taxes are denominated in these currencies, the ultimate result is a price collapse to simply shake out the weak hands.

Anatomy of a Startup

Perhaps the best analogy for the Bitcoin community is the frenzied start-up activity (and, yes, euphoria and occasional paranoia) that surrounded the emergence of the World Wide Web in the late 90s; a fact that the creator of the Web, Tim Burners-Lee, never hesitates to point out:

In this sense, Bitcoin is more like the PC or the Internet than a Segway. What's important isn't the technology itself, but the ways the technology can enable third parties to build on it. People forget that early PCs seemed as comically pointless as a Segway and Bitcoin do today. In 1979, the PC was about four years old - about the same age as Bitcoin is today...The Internet was even worse. The Internet's predecessor, the ARPANET, was still intimidatingly complex and impractical a full decade after it was first created...Someone with a limited imagination in 1979 could easily have mocked predictions of an Internet-connected PC in every home. Who wants to go through all that hassle just so they can write BASIC computer programs, play primitive computer games, and send e-mails to other nerds? What happened next was not that ordinary users became more tech-savvy or more tolerant of clunky technology. Rather, a growing community of entrepreneurs and hackers used these open technological platforms to build more user-friendly and powerful applications on top of the PC and Internet platforms.

It's an apt comparison when you consider how weak the case for the Internet was prior to 1994:

  1. You had to own a PC (around $3,000 at the time for the floor model.)
  2. You had to spend even more money a modem ($399+ for a 14.4kbps SupraFAXModem 14400), and the software was glitchy and difficult to install.
  3. There were only a handful of immature companies to buy from.
  4. There was no way to trust a seller with your credit card...or, indeed, anything.
  5. It was filled with strangers.
  6. It could be dangerous.
  7. There were no portals - "Jerry's guide to the World Wide Web" (quickly renamed Yahoo!) didn't exist yet - and no search engines, movies, or instant messaging.

None of those significant drawbacks stopped or even slowed the pace of adoption.

Long Ball

What you have to understand about the Bitcoin community is that while riding off into the sunset as indecently rich as possible may be the ultimate goal of Bitcoin enthusiasts, it's not necessarily the immediate goal. In fact, most Bitcoiners don't always cheer sky high prices any more than Warren Buffett does. On the contrary: High prices are something of a calamity for Bitcoin's true believers due to the fact that it makes the currency that much harder to buy.

Yes, some early adopters are hitting the jackpot. But Bitcoiners don't want to just make money. They want to make truly offensive amounts of money and change the world while they're at it.

In the words of one Redditer:

(Click to enlarge)

On balance, the endless "bitcoin millionaires" stories smack more of the kind low-probability/high impact human interest news that always gets airtime and less like a nefarious secret cabal. Yes, there are big fish within the Bitcoin community just like there are in every pond. However, for every miracle, there are at least half a dozen sob stories of early adopters who either gambled their coins away on SatoshiDice, spent them on pizza or left them on a computer that crashed 12 months ago.

An Insider's Perspective

I decided to conduct a virtual interview with Ryan Selkis, a former venture capital associate and current Bitcoin entrepreneur who has filed two patents for technologies that use Bitcoin to disrupt the charitable giving market, in order to get a handle on the some of the current difficulties and opportunities for merchants who might be thinking about taking the plunge into Bitcoin.

K.S. Bitcoin has a number of skeptics, not least in the financial community, many of whom believe that bitcoin is simply another unsecured speculative vehicle. Some analysts argue that the size of the bitcoin-only community doesn't justify the market cap that is being assigned to the technology. Does that change, in your view, if more merchants decide to accept bitcoin?

R.S First of all, let's distinguish between Bitcoin (the protocol) and bitcoin (the currency). You have to keep in mind that bitcoin the currency is both a store of value and a currency. Right now, its utility as a store of value is outpacing its utility as a currency, so you've got what looks like a speculative investment. But I truly believe that it would take a collapse of the underlying Bitcoin protocol (which most computer scientists say is unlikely) to send the currency to zero.

In fact, there very well could be a natural floor to the price because so many big investors are piling in (SecondMarket, Winklevoss twins, China) and buying on the dips. That's because they believe in the long-term applications possible with the Bitcoin protocol. And since there are a finite number of bitcoins that will ever make it into circulation, these speculators are treating their bitcoin much like they would stock options: you can only lose 1x your money in the event of a collapse, but with many thinking the value of bitcoin could be $10k per coin in the not too distant future (that would put its market cap at about 1% of the global USD reserves), that's might be a decent bet.

The expected value is so sky-high for many investors (rationally or not), that merchant adoption probably doesn't need to ramp up immediately for their underlying assumptions to change. However, it would certainly help, not to mention fuel even more speculative investment. As long as there is some incremental progress, and the U.S. government doesn't over-regulate the industry (which looks less likely after this week's Senate hearings), bitcoin's value could keep going up.

Near-term merchant adoption isn't everything, though, because at the end of the day, investors are looking at bitcoin as if they have the opportunity to retroactively buy a portion of the total value of the early internet. I'd argue the "internet of money" comparison is appropriate--with the caveat that the units of ownership might not necessarily be bitcoin in the long-term, but quite possibly some other alt-currency like litecoin.

Fig. 3: # of Retailers that Currently Accept Bitcoin (U.S.)

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(Source: Coinmap)

K.S. Still, one of the biggest objections you hear about Bitcoin is that there are only so many things you can buy with it directly -

R.S. I actually think the bigger issue is getting consumers to spend their bitcoins, which I'll address in a second.

But for merchants, this really is a no-brainer. Companies like BitPay and Coinbase (and likely Circle, soon) are providing tools that help them accept bitcoin in a matter of hours or even minutes. The merchants pay virtually nothing for the services, unless they convert the bitcoin to U.S. dollars, which they can do instantaneously if they don't want to take the currency risk. (i.e. The merchant lists a good's price in USD, a bitcoin consumer pays in bitcoin, and then BitPay instantly charge the appropriate bitcoin based on the current USD exchange rate and converts it for the merchant.) On top of adding 2-3% of pure profit to the merchant vs. credit cards, they don't have to worry about chargebacks and enjoy near-instant settlements, depending on the transaction size.

In fact, some merchants love bitcoin so much, they're taking the 2-3% savings they earn relative to credit cards and keeping it in bitcoin, with the belief that they are playing with house money and that those reserves could appreciate significantly. So far, those merchants have been right.

The biggest hurdle for most merchants might simply be education. For a select few, another hurdle might be the market's illiquidity. For instance, online jewelers will have a tough time instantly converting large bitcoin sales to USD, and you won't see Amazon accepting it anytime soon with its $60 billion in revenue. They would break the market.

Like I said, the real issue is getting consumers to part with their bitcoins. Merchants have downside protection with some of the tools that are out there, but consumers don't have the same "upside" protection. After all, why pay for something with a currency that might appreciate 50% the very next day? This is really anyone's guess.

Here's how I would approach it: Most of the people buying with bitcoin today will be consumers who have hit the jackpot as early adopters. Rather than diversifying by cashing out through an exchange, why not just buy things from merchants, save the extra 1%, and in the process, help demonstrate the utility of the currency to the broader market, so that more speculators get excited and pile in? Some people buying secret (not illicit) gifts will transact in bitcoin. Over 95% of bitcoin users are males, some of them are married or in serious relationships. If you want to buy something discretely, it would be better to do it with bitcoin when your significant other can't check your checking or credit card statements.

How about getting hedge funds (and I am honestly baffled as to why this hasn't happened already) to reduce volatility for more conservative bitcoin users by guaranteeing the value of those users' underlying bitcoin -- almost like a mini-FDIC. Even if one of the big funds threw $25mm to test this out with a subset of users, it could send enormous positive signals to the rest of the community. In the event bitcoin appreciated, maybe the user would reap 80% of gains, and the fund 20%. With a fund backstopping 100% of losses, it seems like there would still be amazing option value for the funds and good peace of mind for the consumers.

Those are just a few simple ideas. The Bitcoin community is going to come up with many, many more.

So, what does the development time-line look like, here? Is bitcoin something that both investors and companies should be paying attention to now, or is it still too early?

I think that investors and companies alike should have been looking seriously at Bitcoin (the protocol and the ecosystem) yesterday. Seriously, if you are a VC and you don't at least pick up the phone and call every CTO in your portfolio to evaluate what they think of the potential here, I've got to question why limited partners would trust you with their money. I'm also very long the bitcoin currency, but that is high-risk / high-reward, and not indicative of the real opportunity. I could lose all of my bitcoin and still be bullish on Bitcoin.

I already outlined most of the clear-cut benefits to companies in the last question. One additional benefit is the marketing value many companies are getting out of it, especially companies with young, male, educated, tech savvy (and libertarian) customer bases. Uber just integrated with Paypal, but why not Coinbase while they're at it? Why aren't digital publishers all over this? For the first time ever, it's realistic to effectively collect micro-payments from readers (e.g. $0.25 per article). There's even a company called Bitwall, which won the Bitcoin 2013 hackathon, actually working on exactly that.

(Click to enlarge)

(source: Coinbase)

The most mind-boggling thing is that computer scientists are calling this "the internet of money," the value of the currency is up 50x year over year, and yet some VC firms seem to have written this off as too good to be true or a bubble/mania without any further research. All because of a couple of dips in what is otherwise a logarithmic growth curve. I've talked to friends at two separate brand-name venture capital firms who told me that the firms weren't even aware of Coinbase, much less the other start-ups in the industry. And this after an industry blogger just posted a compelling case for how Coinbase was on track for a billion dollar valuation after just 18 months!

Companies and investors have immense opportunities right now. They should at least be paying attention, if not diving in with both feet.

There are signs that some big very players - individuals, as well as businesses - are beginning to stand up and take notice. The recent U.S. Senate hearings on Bitcoin were described by The Washington Post as "a Bitcoin love-fest." There's the Winklevoss twins and Second Market, of course. As I write this, billionaire Richard Branson is announcing that his space-tour company Virgin Galactic is now accepting bitcoins for a ticket to the stars. And in a recent interview with the Financial Times, eBay (NASDAQ:EBAY) president and CEO John Donahoe said that the company was keeping its eye on Bitcoin and that in the months and years to come, digital currency is going to be "a very powerful thing".

The key to that power is what's known as the blockchain. Like the relatively assuming TCP/IP protocol that underpins the Internet, the Bitcoin blockchain is a cornerstone that future layers can be stacked onto. One such innovation involves the use of so-called "colored coins" that effectively transforms Bitcoins into tokens that can theoretically be used to transfer the ownership of any asset class - real estate, stock, automobiles - all for a cost of about $0.05 USD.


Perhaps the real problem lies not in economic theory, but in institutional memory. The consensus view within the financial community at present is that the "Wild West" aspect of Bitcoin commerce will inhibit consumer spending and dissuade merchants from accepting it at all. Bitcoin transactions are non-reversible and have little to no built-in consumer protections. The same was more or less true of eBay fifteen years ago, and yet millions still shopped there anyway for the novelty of the experience. The strong rate of 1998-2005 growth is reflected on the company's balance sheet.

Table 1: eBay's Early Growth (Revenue + Net Income, 1998-2005)

(Click to enlarge)

If Bitcoin can be near-instantaneously converted to dollars right at the register via an exchange plug-in like the one offered by Coinbase (along with all applicable sales taxes, of course), then why should retailers care if it's a bubble or whether or not a deflationary currency is economically tenable? After all, the euro could disappear next year.

What the expansion of Bitcoin's user base offers is sales opportunities that are ultimately measurable in dollars today. Those dollars can, in turn, translate to any number of wonderful things, from quarterly earnings beats to higher transaction volumes. One thing is for certain: If digital currency is even remotely successful, the rewards will go to the investors of the companies that were crazy enough to slap a "We Accept Bitcoin!" sticker over the door.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.