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.

There are also some bright disinfecting patches of sunlight appearing amidst the shadows. Professional Wall Street traders have started to show meaningful interest in Bitcoin, citing attraction to the volatility and the "by design" deflationary nature of the currency. Citizens of countries with unstable currencies or banking systems or currency controls, such as Argentina, Spain, Iran and Cyprus are starting or trying to adopt Bitcoin. Cross-border payments and trade are an increasingly identified core use case.

Consumer usage is still largely confined to hobbyists, but some large Internet companies have started accepting donations and payments in Bitcoin, including Expensify, Wordpress and Reddit. Although the number of merchants who take Bitcoin can still be listed on a single page, you can buy everything from a home to pizza to baklava to alpaca socks with Bitcoin today.

Bitcoin has a long way to go before it threatens Western Union, Visa or First Data, but the draw of zero (or close to zero) transaction costs is very appealing. The Innovator's Dilemma may keep the big players in payments out of the Bitcoin market for a long time as they may fear cannibalizing their currently very attractive margins. It is likely that startups with nothing to lose will drive the most innovation for the next few years, in areas including exchanges, Bitcoin storage in the cloud and merchant services. Disruptions like Bitcoin can cause massive value destruction and massive value creation – and this is incredibly interesting to me as a venture capitalist.

If Bitcoin continues to live up to its potential, it could be a massively disruptive force in financial services, dramatically cutting the costs of doing business for millions of Americans, and billions of people worldwide.  But to get to that scale, the Bitcoin ecosystem will need to grow a hundredfold to a thousandfold from current levels. This is conceivable, as it has already grown by 30 times in the last year alone. Three things need to happen before Bitcoin can get that big:

  1. Bitcoin volatility needs to be dampened due to the need for a deep and liquid exchange market between Bitcoin and government fiat currency.
  2. The regulatory framework needs to become clearer
  3. Most importantly, reputable merchants need to start accepting Bitcoin

All these things are starting to happen. More exchanges are springing up to handle Bitcoin volume and more traders are jumping in as Bitcoin prices continue to rise. With the European Central Bank writing white papers on Bitcoin and the U.S. Treasury providing guidance on virtual currencies, the regulatory environment is becoming clearer. The sheriff is coming to town. And as noted above, legitimate use of Bitcoin is increasing.

It's these changes that could propel Bitcoin to become a real and credible payments alternative. With the sheriff in town and more homesteaders turning up, we will start to see the basis for Bitcoin growing from $1 billion to tens or even hundreds of billions in value.

Jeremy Liew is a managing director at Lightspeed Venture Partners in Menlo Park, Calif.