Why VCs Love The Bitcoin Market

JEREMY LIEW

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Editor’s note: Jeremy Liew is a managing director at Lightspeed Venture Partners. Follow him on Twitter @jeremysliew.

As a VC, my interest in the Bitcoin ecosystem is not ideological but mercenary. I see the opportunity for Bitcoin to disrupt multi-billion-dollar markets, but in doing so also create new big markets. There are three key markets in Bitcoin:

Wallet. Holding your Bitcoins for you, serving some of the checking account functions of a bank.

Exchange. Converting from USD to Bitcoins and back.

Payments. Helping merchants accept Bitcoins for their transactions.

As a rule of thumb, VCs like to see billion-dollar markets to get excited. How can each of these markets get to be a billion dollars in size?

WALLET

It is free to get your own Bitcoin wallet, a piece of software on your computer that you can use to send or receive Bitcoins. However, this entails storing your Bitcoin private key on your computer, which risks loss or theft. Increasingly many Bitcoin users are turning to hosted wallets, which hold the money for you, and are accessed over the web. But you have to trust that your hosted wallet will not run off with your money (which has happened before). Because client wallets are free, hosted wallets have typically been free, as well.

Let’s assume that one day in the future, hosted wallets will be able to charge 0.5 percent of funds in the account as an annual fee. This is likely a high estimate, but not impossible if the wallet offers enhanced security, insurance against loss, and perhaps some kind of escrow or other fraud purchase protection. For the wallet market to be worth $1 billion, this would imply that $1 billion/0.5% = $200 billion in Bitcoins would need to be held in hosted wallets. This means that the market cap of Bitcoin would need to be at least $200 billion, relative to $1.5 billion today. Bitcoin would need to appreciate by almost 150x to reach this level. Bitcoin has gone up by 30x in the last year, so that isn’t impossible to believe. Two more years like that would get you there.

EXCHANGE

It will be a long time, and probably never, that Bitcoin becomes the default world currency. As a result, there will be demand for exchanging between Bitcoin and fiat currency for a very long time.

Consumer level exchanges charge between 50 to 100 basis points on each trade. Bigger trades currently pay closer to 10 basis points. Let’s assume that in the future trading commissions run around 25 basis points. To get to $1 billion in market size we would need to see $1 billion/0.25% = $400 billion in annual trading volume. Last month, exchange volume was around $60 million, this month it looks like it may get to $200 million. Annualizing this gets you to between $720 million – $2.4 billion in annual trading volume. Assuming the top end of the estimates, trading volume would need to go up by 200x current levels to hit this market size.

Transaction volume, i.e. transfers of Bitcoin within the real economy, has historically floated within a constant multiple of trading volume of between 2 and 20. If the relationship between transaction volume and trading volume remains roughly linear, transaction volume would need to rise by 200x current levels to hit our target $1 billion market size. This is believable given that transaction volume has gone up 30x in the last year.

PAYMENTS

Ultimately, the key driver of both Bitcoin price appreciation and exchange volume has to be payments volume. If people aren’t using Bitcoin to pay merchants for transactions, then there is no real economic driver for either price or exchange volume to rise. It would be driven purely by speculation.

One of the key advantages of Bitcoin is that it nominally has zero transaction costs. That being said, there are a number of additional merchant services that could be added on top of transaction processing that could justify 25 basis points or more in merchant fees. Bitpay today charges 1% or more. To get to $1 billion in market size, we would need to see $1 billion/0.25% = $400 billion in annual transaction volume.

Last month, transaction volume was around $250 million, and this month it looks like it is on track for $750 million. Annualizing this gets you to between $3 billion and $9 billion in annual transaction volume. Again, taking the top end of estimates, this would require an increase in transaction volume of around 50x current levels. In the last year, transaction volumes have gone up by 30x. As a comparison point, world GDP is around $82 trillion, so this would represent about 0.5 percent of all world transactions using Bitcoin. As a comparison point, $2.5 trillion is spent on credit cards per year in the U.S. alone out of $15 trillion in GDP, so about 16 percent.

HOW DO WE GET THERE?

All of these market-sizing analyses require a 2 to 2.5 order of magnitude increase over current levels. Those same metrics have shown a 1 to 1.5x order of magnitude increase in the last year, so it doesn’t stretch the imagination to think that it might be possible. But the question is how? It would be impossible to get to those sizes on illicit usage only and you can’t get there just on speculation. Bitcoin usage would have to become mainstream. The only way to get there is through merchant preference because of the lower transaction costs. This could be appealing to industries with low net margins (e.g. grocery, Amazon.com), or with high transaction costs (e.g. cross border trade, micro transactions), and these may be the industries that pioneer Bitcoin acceptance.

But merchants won’t switch to Bitcoin for lower transaction costs if the tradeoff is volatility of exchange rates. As long as their costs are in fiat currency, they will want to switch out of Bitcoin and into fiat immediately when they take payment since they won’t want to bear currency risk. That requires deep liquidity in the exchanges, and this is where the professional traders come in. They have already started to enter the market.

If the current volatility in the Bitcoin exchange rate is reduced in the future, merchants may be willing to hold Bitcoins for longer periods of time, and even make payments in Bitcoins.

The other way that Bitcoin may become mainstream is in countries where the currency or financial system is already more volatile than Bitcoin.

Mainstream adoption will require bright line regulatory compliance by all elements of the Bitcoin ecosystem. That is why last month’s guidance on virtual currencies from FinCEN (part of the U.S. Treasury) caused Bitcoin prices to go up. As Bitcoin gets closer to the U.S. regulatory umbrella, it moves closer to legitimacy. These rules and the ones that will follow will increase the overhead costs of all players in the space, but that is a small price to pay for legitimacy.

WHAT DOES IT MEAN FOR STARTUPS?

Not all big markets are opportunities for startups. Bitcoin has some attractive characteristics because it is so disruptive to the current system. The innovator’s dilemma may keep the big players in payments out of the market for a long time, as they may fear cannibalizing their current very attractive margins. But one day that competition will come.

The key questions for any startup are: What is your competitive advantage and how do you defend against a large late entrant? For exchanges, liquidity is the barrier to entry. Although there have been examples where new entrants have cracked open marketplace businesses, it is hard. For wallet and merchant services, it is less clear what the barriers to entry will be.

The risks associated with Bitcoin are worth mentioning as well. The six biggest hacking, theft andfraud incidents involving Bitcoin exchanges, wallets, or investment vehicles have resulted in a total 1.2 million Bitcoins being stolen, out of a total of 11 million Bitcoins in existence. This means that more than 10 percent of all Bitcoin has been stolen, and this does not include many smaller thefts and losses from individual wallets. Just this week, another wallet service was shut down after suffering an attack. Given this environment, Bitcoin startups cannot remain bootstrapped for long and will need to raise more substantial capital from VCs to mitigate these risks with better security and proactive regulatory functions.

In all the scenarios that I’ve painted above, Bitcoin prices need to go up by 100x or more. If that were the case, then maybe just buying Bitcoin is a better investment than putting money into a Bitcoin startup. You get plenty of upside and no execution risk, but it won’t be anywhere near as much fun.

Tags: Bitcoin, Column

Bitcoin: more than just the currency of digital vice

Bitcoin, the digital coin with a questionable past, is gaining ground as a legitimate currency, trading at $32 a share last week

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• • Arwa Mahdawi
  • guardian.co.uk, Monday 4 March 2013 11.54 EST
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Bitcoin has become the world's best performing currency, with its value spiking at 130%. Photograph: Zach Copley/Flickr/CC.

Dale doesn't exactly look like an international crypto-criminal. He's soft-spoken, baby-faced, and a senior at an Ivy League college. But every couple of weeks the political science major logs onto the Silk Road, an online black market that has been described as an "amazon.com of drugs" to buy wholesale quantities of "molly" (also known as MDMA, a particularly "pure" form of ecstasy), LSD and magic mushrooms. Some of these will be for his personal use, and the rest he'll flog to less tech-savvy classmates at a mark-up of up to 300%. On a good weekend, he can net a profit of around $2,500. It's a more lucrative sideline than waiting tables.
 
While Dale prices his party favours in dollars, he pays for them the only way you can pay for anything on the Silk Road: by using Bitcoins, an untraceable digital currency founded in 2008 by the pseudonymous "Satoshi Nakomoto". Despite persistent efforts to uncover his identity, little is known about Nakamoto: he's the Banksy of the internet. Or, rather, he was. Nakomoto disappeared without a trace in 2011, after telling a developer "he'd moved on to other things". Bitcoin itself, however, shows no signs of vanishing: in the past two months it more than doubled its value against the dollar and after reaching an all-time high last Wednesday, it has been trading at above $32 a share.

Unless you're a major tech geek or a regular patron of the shadowy computer underworld known as the dark web, you've probably never heard of – let alone used – Bitcoins. But below the "real" economy of legal tender and federal reserves, Bitcoins fuel a shadow economy that connects students, drug dealers, gamblers, dictators and anyone else who wants to pay for something without being traced. It has found a niche as the currency of internet vice, digital "pieces of eight" for modern-day pirates.

Despite these unsavoury associations, Bitcoin is increasingly winning a place on the internet as a legitimate currency, albeit one that will probably never quite shake off its dodgy past. Bitcoin is part of a gradual, technological shift in the way we think about money. It poses a tangible threat to centralised banking and the guardians of fiat money. Bitcoin won't knock off the dollar any time soon; the euro can sleep easy. But it is clearly a force to be reckoned with. Bitcoin has become the world's best performing currency, with its value spiking 130% just this year.

Bitcoins, unlike the cash you have in your pocket, are finite. There are currently 10.8m Bitcoins in the system, and this will cap out at 21m coins by the year 2140, according to market research firm ConvergEx. Limiting supply has been a major plus for Bitcoins, and a major reason why prices have gone up.

If you want to buy Bitcoins you simply go to an online exchange service such as Bitinstant and convert your local currency into the virtual money. These are then stored in a "wallet", which functions as a sort of online bank account. You can then go and spend these anywhere that takes Bitcoins to buy anything from socks to drugs.

The Bitcoin network is structured like a guerilla movement: it is decentralised, controlled by its users rather than governments. This means it is (theoretically, at least) anonymous, and that, unlike credit cards and PayPal, which block payments from a number of countries, it enables instant payments to anyone, from anywhere in the world. That's why criminals love it and why some online retailers do, too. It's money without any kind of safety net below it. There's no legislation to protect your investment and you can't protest fraud.

It's worth bearing in mind that while Bitcoin operates outside the parameters of governmental control and is often used to dubious ends, so too is a lot of the money we see around us. The US Treasury printed 3bn $100 bills in the 2012 fiscal year and, 80% of them go overseas, according to Federal Reserve estimates. As Nicholas Colas, ConvergEx Group chief market strategist, notes, "many of them simply facilitate the global drug and arms trade, not to mention tax evasion and human trafficking".  Bitcoins fit into the world of real currency more than anyone would like to think.

While governments and legislators have long been waging wars on traditional funny money, they are only just starting to wake up to the effects alternative currencies may have on the financial landscape. In 2011, two Democratic senators, alerted to the thrills of the Silk Road by a Gawker article, wrote to the US attorney general demanding that something be done about Bitcoin. And in October last year, the European Central Bank published a paper that recommended that developments in virtual currencies be regularly examined to reassess the risks.

The association between Bitcoins and drugs is clearest on Silk Road, where the currency is the only method of payment that is accepted. But Dale, the Ivy League student, uses the currency with care – not least because of its volatility. "I try to purchase only as many as I will need for a specific transaction, because they have historically had pretty wild inflation and deflation."

Dale sees Bitcoins as the glue that binds a certain type of digital trade: "It seems to me like Bitcoins are essential for the currently thriving digital underground economy, but they also represent the beginning of an extra-governmenta, international digital economy."

Bitcoin isn't just for petty criminals, however: it has also made its debut in geopolitics. Last year, Iran was cut off from the European and US currency systems. High inflation caused the native currency, the rial, to plummet in value. With no dollars or euros available, Iranians used Bitcoin as a way to gain access to the international currency markets: they bought Bitcoins and later swapped them for dollars through an exchange site like Mt.Gox.

While Bitcoin has so far operated at the margins of the economy, there is some evidence that it is slowly entering the mainstream. Wordpress,Reddit, and Megaupload have just started to accept Bitcoins and you can now even buy pizza with them. In December, the currency took its biggest step towards legitimacy yet, after partnering with a payments service provider in France. They also had a booth at this year's Consumer Electronics Show (CES), which featured a picture of a wholesome looking woman holding an iPhone running a Bitcoin app.

Edward Castronova, a professor of telecommunications at Indiana University Bloomington, who has who pioneered the economic study of virtual worlds, doubts that Bitcoins will ever become a mainstream currency, however. Castronova's scepticism stems from the way that Bitcoin is structured as a currency with a fixed size. "It just isn't very fun. We've learned from game currencies that people like a little inflation in their economies. But Bitcoin is built to deflate. And we've just seen, culturally, people don't like deflation."

While it seems unlikely that Bitcoins will ever represent a full-scale challenge to regular money, they point to the rise of virtual currencies and changing definition of currency. Alternative currencies continue to slowly creep in around the edges of the economy: in February, Amazon announced that it is introducing its own custom currency called, rather imaginatively, Coins.

Starting in May, US customers will be able to use Coins to buy apps, games and in-app items on the Kindle Fire, with Amazon giving out "tens of millions of dollars worth of Coins" as a preliminary stimulus package. 

And calculations by the Economist in January 2005 suggested that the total stock of unredeemed frequent flyer miles was worth more than all the dollar bills in circulation.

Castronova notes that among young people, the mental accounting on different sorts of "money" is already very fuzzy. "Twenty-year-olds don't see any difference at all between dollars, gold coins, GPAs," said Castronova. "They're all just digital score sheets".

The future of money may or may not include a Federal Reserve Bank of Amazon, but it probably does involve the gradual decentralisation and democratisation of currency. Virtual currencies aren't just a new-fangled sort of Monopoly money. Rather, they may just be the thing that ends the monopoly on money.