Why I Take Bitcoin Seriously as a Venture Capitalist

Today, Bitcoin is the wild, wild West. But the sheriff is coming to town, and just like in the Old West, we'll see even more value creation once the law, the railroad and the homesteaders get here.

For those who are not familiar with Bitcoin, it is a cryptography-based, decentralized, open source virtual currency and payment system started in 2009. The core attractions to Bitcoin are:

• Its value cannot be changed by the fiat of any single government or entity (unlike "fiat" currencies like the U.S. dollar controlled by the Federal Reserve Board)
• It is nominally anonymous (or more accurately, pseudonymous) in that transactions are tied to wallets (essentially numbered accounts with passwords), not to people
• It should be a "deflationary currency," meaning that its buying power should theoretically always go up over time
• Its transaction costs are zero (or close to zero)
• Its transactions are irreversible (which is attractive to merchants)

In many respects, it is useful to think of Bitcoin in the same way as we think of gold, although in practice the transaction and storage costs of gold are substantial.

There are currently around 11 million bitcoins in existence, but there will never be more than 21 million, a cap built into the Bitcoin protocol. As of this writing, Bitcoin is at around $1 billion in market capitalization, with monthly exchange volume of $50 million to 150 million (coins bought or sold), and daily transaction volume of $5 million to $35 million (coins transferred). All this is up from zero since the first coin was created on Jan. 3, 2009. But the volatility goes both ways – there have been three major crashes since then as well.

Even beyond exchange rate risk, Bitcoin is a risky currency to hold. As with cash, if you lose your wallet, you lose your coins. The biggest six hacking, theft and fraud incidents involving Bitcoin exchanges, wallets, or investment vehicles have resulted in a total 1.2 million coins being stolen. This means that more than 10% of all Bitcoin in circulation has been stolen, and this does not include many smaller thefts and losses from individual wallets. There has been a great deal of malware in the wild, targeting individual wallets held on computers, and even hijacking computers into botnets to "mine" Bitcoin on the behalf of hackers.

Early Bitcoin proponents fall into three categories: "crypto-punks" who are fascinated by the math, radical libertarians who dislike the idea of central control of any currency, and some shady elements who prefer that their transactions be "anonymous." 

The shady elements are currently the largest component of the Bitcoin economy. Some estimate that 50% of daily Bitcoin volume is through Satoshi Dice, an online gambling site. Silk Road, an online illegal drug market, has received a lot of attention but accounts for less than 1% of Bitcoin use. Pornography has been alleged to be a major use case, but this appears to have become less true over time. But the "anonymity" of Bitcoin appears to be phantom as more research is done to tie Bitcoin wallets to individuals. This is anticipated to reduce the overall level of shady Bitcoin activity.