In the last few weeks, I have seen a surge in interest in Bitcoin from multiple sources. There were negative reports, such as those describing possible currency manipulation and the possible failure of one Bitcoin exchange. Then a report in the WSJ described that PayPal may be interested in accepting Bitcoin as an official currency. And yesterday, BusinessInsider reported that Chris Dixon, a top Silicon Valley VC and partner at Andreessen Horowitz, the firm founded by Netscape inventor Marc Andreessen and Ben Horowitz, is “really excited” about Bitcoin and has invested significant money into it.
A number of people – especially those outside the tech world – have asked what exactly Bitcoin is and why it is so interesting lately?
For a general introduction to Bitcoin, it is worth reading the Wikipedia entry, or even the official Bitcoin page. At a very high level, Bitcoin is digital currency. Almost all currencies in the world nowadays are managed by a central bank or treasury. The Federal Reserve in the United States determines how many dollars will be in circulation, whether physical or digital. For example, it can purchase bonds from participant banks, removing the bonds from circulation and increasing the cash in circulation. Of course, the Fed doesn’t transfer $20BN in banknotes, which would be a lot of Brinks trucks. Rather, when it purchases $1BN in Treasury notes from JPMChase, it credits JPMChase’s bank account with digital dollars, dollars that JPMChase can lend out to you as a mortgage to buy a home, or invest in securities markets. The Fed has created dollars (or the electronic equivalent) out of thin air. If it creates more dollars than the growth in the economy, then there are more dollars than needed, the value of the dollar goes down, prices go up, and you have inflation. If it creates fewer dollars than the growth, there are not enough dollars, the value of the dollar goes up, prices go down, and you have deflation. The government, via the Treasury and the Fed as well as the Justice Dept, uses its civil and criminal enforcement powers to ensure that (a) that no one creates an alternative currency and (b) no bank credits more in an account than was put in, even digitally, either from someone else or from the Fed (i.e. out of thin air).
Bitcoin is a non-centralized currency. No one body gets to determine how many bitcoins are in existence. Because of this, it isn’t officially a currency per se… except that a currency is not really one determined by a government, but rather one that people agree is a currency. If everyone in the UK suddenly decided that they would no longer accept the Pound for any transactions, and would ignore prices listed in Pounds, but rather would price everything in some other item (e.g. cigarettes are commonly used in prisons and were in WWII POW camps), then that item becomes a currency. In colonial Virginia, tobacco leaves were the currency.
The problem with all alternate currencies is that there is someone who controls the production of the currency item itself, and thus is subject to manipulation. The underlying belief of all modern currency systems – USD, GBP, Euro, NIS, CHF, etc. – is that at least the central authority is responsible to an elected government, and thus is acting in the interest of the nation as a whole, and will be staffed by the best, both morally and technically. In order to continue to maintain that central control, every institution that transfers funds must become, in some manner or another, subject to government regulation. The government has a compelling and legitimate interest in regulating all institutionalize financial transactions, for the integrity of the system (ignoring national security, money laundering, and criminal controls).
Needless to say, this irks startups, who want to change the world via product and market, and do not have the time or funds to deal with complex and slow government bureaucracies. For a great read on this, refer to the PayPal Wars by Eric Jackson.
The creators of Bitcoin recognized that modern technology created an ability to enforce “currency integrity” using purely technological methods via cryptography. They created a currency that is self-integrity-enforcing, and thus not subject to the political whims of central banks and governments, nor does it require heavy regulation. Bitcoin has other behaviours, such as under which terms it issues new Bitcoins, when it will stop issuing them, etc. Most of these terms may actually limit the value of Bitcoin, since the world economy is growing, both on a real and per capita basis.
Entrepreneurs are thus highly interested in a currency that is:
- Global – not subject to foreign exchange vagaries of a particular country
- Unregulated – does not require regulation to maintain its integrity
- Instant – because of its mathematical properties, Bitcoins can be transferred to anyone anywhere instantly at almost no cost
- Technical – the technical geniuses behind most Internet, software and hardware startups can analyze the integrity algorithms themselves, rather than having to rely on vague pronouncements of “trust me” by economists in governmental positions
The interesting questions are:
- Will Bitcoin continue to maintain value?
- Will Bitcoin continue to maintain integrity? While the US Dollar can be and is manipulated for political interests, it does not collapse due to mathematical breakthroughs; Bitcoin is the exact opposite: one breakthrough can destroy the currency.
- Will Bitcoin last or will an alternative?
- Will Bitcoin or other virtual currencies gain widespread adoption? Despite grumbling, most consumers trust their national currency as backed by the “full faith and credit” of the government. Will the mass of individuals and businesses agree to accept it?