With his trim physique, easy smile and ’70s-style, over-the-collar brown hair, L.A.-based Kylae Jordan is a naturally likable kind of guy. He’s soft-spoken, with a pleasant manner, and he’s keenly interested in the conversation around him. With good reason: He’s sitting in a room full of potential multimillionaires, and his chances of hitting it big are about as good as anyone else’s.
That would be a tremendous return to good fortune for the 30-something Jordan, whose current venture, www.garagedooropener.com, is under assault by a slightly more search-savvy entrepreneur who’s undercutting Jordan’s hundreds of hours of search-optimization work.
Realizing that the garage-door game could be up soon, Jordan is looking for something different. That’s why he’s in San Jose in mid-May for Bitcoin 2013, the conference for developers, traders and speculators in the nascent online currency.
“Right now, I’m researching markets for my investors,” Jordan says with a smile. Translation: He’s looking for something his Southern California parents would be willing to invest in, to start him over again.
New Money, Old Rules
What Jordan found at Bitcoin 2013 was probably too complex to explain to his parents, unless they have exceptional math skills and a keen sense of market potential.
In fact, the complexity of the Bitcoin could well be its most damning vulnerability. Four years after its inception, the Bitcoin industry still rests largely in the hands of young, geeky mathematicians and third-rate software developers—marketing novices who could be quickly brushed aside by more ruthless competitors, in the same way Jordan’s clicker business is gasping for a future. Worse, the industry could be torpedoed altogether by the U.S. government. Recent events have made that possibility look frighteningly real.
The same week the conference started, the United States Department of Homeland Security froze the currency trading account of MtGox, the oldest and largest exchange for the virtual currency, and it is likely the federal government regularly searches bitcoin wallets installed on personal computers.
In a published statement, the Department of Homeland Security said it believed that Tokyo-based MtGox lacks a license as a money-transfer company, noting that the owners of the exchange lied on a federal form about their intent to conduct financial transactions across international lines.
The news rolled through the conference like a shock wave, as attendees realized that participants in the Bitcoin economy could no longer pretend to be flying under the radar, too low and too decentralized to be reached by government agencies.
Clearly, the feds were watching, and what they found was so fundamental that everyone in the Bitcoin world would have to adjust their strategies to survive. Bitcoins, said the feds, are transferable and exchangeable, qualities that expose the currency to activities such as money laundering and make it fair game for investigation by the Financial Crimes Enforcement Network (FinCEN).
Several weeks later, the Director of FinCEN reportedly tried to walk back those observations, but only halfheartedly.
Writing in the newsletter Sovereignman, entrepreneur Simon Black said that in a recent speech the director of FinCEN acknowledged that the Bitcoin itself is “nearly impossible to regulate.”
“The government at least seems to understand this point,” said Black. “Which is why the director so emphatically denies attempting to regulate the digital currency. But that doesn’t mean they can’t spread fear, uncertainty, and doubt.
“In this short four-page speech, the director twice made a connection between Bitcoin and (you guessed it) terrorism. Twice more connected Bitcoin to those who would exploit children. And four times linked digital currency to ‘criminals’ in general. It’s certainly enough to scare most people away.”
How did the Bitcoin universe not see this coming? As an outsider, Jordan couldn’t grasp why Bitcoin developers didn’t realize that their digital currency had to stand up to government scrutiny.
The answer, of course, is that there was a whole lot of wishful thinking going on. And that wishful thinking was born out of the Bitcoin mythology itself.
Birth of Bitcoin
To understand how something so fundamental could have been ignored, one need look no further than the basic definition on the virtual money: Bitcoin is a peer-to-peer digital currency with no central authority to issue new money or keep track of transactions.
This definition implies three very powerful concepts: One, the currency can be traded without need of credit cards and their arbitrary rules; two, there are no central banks that can gum up the math by issuing more coins; and three, nobody is watching what you buy with your digital coins.
This trifecta is attractive to libertarians of all stripes, from right-wingers who distrust government because they fear it causes damaging inflation by manipulating the money supply—all the way to civil libertarians who don’t want the government interfering with the free exchange of personal, private pleasures, like purchases of street drugs. The currency is also attractive to anyone in between who dreams of transactions that can’t be taxed, including cyberlibertarians who seek a transnational virtual currency that doesn’t need government oversight. In many ways, the lure of Bitcoin is every bit as elemental and utopian as the age-old lure of gold.
The idea was first described in 2008 by a software developer who made his initial success as a video-game developer in Japan. The developer’s name is a mystery. He or she (or possibly they) published the concept under the pseudonym Satoshi Nakamoto and has not publicly revealed his/her identity. Nakamoto claims to have left the Bitcoin universe entirely to pursue other interests soon after publishing the paper; others say that Nakamoto remains a key player.
If this sounds more like the origin story of a comic-book superhero—wait, there’s more.
Bitcoin operates at two fundamental levels: the Bitcoins themselves, which must be “mined”; and the software system used to exchange them.
Bitcoins are digital expressions of 1s and 0s, just like anything else on the Internet. What differentiates the Bitcoin is the concept of value. Just like gold or platinum, Bitcoins express their value in terms of their rarity, and the effort and energy required to create them.
Bitcoin miners are everyday people who set themselves to the task of mining—that is, finding and calculating special equations that, when solved, become a portion of a block of Bitcoins. Using today’s computational resources, it takes about 10 minutes to mine a single block.
There are a finite number of blocks in the Bitcoin universe, and by extension, there are a finite number of Bitcoins that will ever be mined—roughly 21 million. The “Genesis block” was mined on Jan. 3, 2009. Bitcoin enthusiasts know this date like they know Jesus was born on Dec. 25.
The first 210,000 blocks of Bitcoins—exactly half of all Bitcoins that will ever be released—were extracted by December 2012. Because the complexity of the mining challenge increases as mining continues, it won’t be until around 2040 that 90 percent of all Bitcoin blocks are mined, and it will take about 60 additional years to mine the last 10 percent.
If you’re wondering how a Bitcoin economy can be grown from 21 million coins, consider that the Bitcoin can be digitally fractionalized (0.5 Bitcoin, 0.1 Bitcoin, etc.). The smallest unit of a Bitcoin is called a Satoshi, which is expressed as a one with eight zeroes ahead of it (0.000000001 Bitcoin).
Viewed in this manner, it’s easy to see that although Bitcoins are finite, there is no theoretical limit to the size of the Bitcoin economy. Traded against real dollars, the currency has the potential to represent trillions of dollars as the market expands.
What hooks most people early on is that the Bitcoin is a peer-to-peer currency with no central authority—think of tokens being passed from one video-game player to another.
Transactions are managed by the network, collectively, rather than by an individual or a bank. The software is community-driven, free and open-sourced.
New users don’t need to get into mining or know any of the math behind the Bitcoin to use them. They simply choose a wallet that they install on their computers or smartphones. The wallet generates a Bitcoin address that can be shared with friends or merchants to enable transactions. The Bitcoin itself must be purchased at the prevailing transaction rate of the user’s standard currency.
In fact, Bitcoin transactions are not much different from email exchanges, although with added security features (and the potential for still more security layers, available from various Bitcoin vendors).
From a vendor’s perspective, using Bitcoin is as easy as putting a free Bitcoin logo on its websites. Customers use the Bitcoin transaction system to purchase goods, and the Bitcoin transfers to the merchant’s wallet at no extra cost. This process contrasts sharply with bank-owned payment systems such as Visa and Mastercard, which take a premium from every transaction and still require a lot of additional merchant record keeping.
Indeed, it is so easy to conduct Bitcoin transactions on the Internet that users, merchants and exchanges can be lulled into a false sense of invisibility with respect to regulators.
It’s this quality of the Bitcoin environment—combined with the fact that some 90 percent of all Bitcoin exchanges are transmitted through Tokyo-based MtGox—that allowed many Bitcoin fans to discount the potential for government scrutiny.
In their estimation, Bitcoins are a digital currency, not a commodity, so they don’t require government regulation. Regulators disagree, however, saying that online transactions—especially those that leave a digital footprint into and out of the United States—deserve scrutiny because Bitcoins can be exchanged for items of real-world value, including established currencies.
If you bring up the subject of taxation of Bitcoin transactions, you’re likely to think you just walked into a Libertarian Party conference. There’s a clear sense of immunity from taxation in the Bitcoin universe. But there are also warning signs that the immunity isn’t very broad.
Black Hat Bitcoins
It’s long been suspected, for example, that the low visibility of Bitcoin transactions made them popular with drug dealers and money launderers. If a hundred dollars could be exchanged for a Bitcoin, and a Bitcoin could be used to purchase commodities or traded out for a different currency, that made it an ideal environment for money laundering.
The concern is not without precedent. For example, the virtual currency exchange Liberty Reserve, which in 2010 became one of the first exchanges to convert U.S. dollars to Bitcoins and vice-versa, was just targeted by the feds for money laundering.
Liberty Reserve was reportedly shut down after U.S. and Costa Rican authorities arrested founder Arthur Budovsky Belanchuk in Spain. Investigators said that Budovsky’s businesses in Costa Rica, including Liberty Reserve, were used to launder money for child-pornography websites and drug trafficking.
Budovsky had been previously indicted, along with partner Vladimir Kats, for illegally transmitting at least $30 million into digital currency through another business venture called GoldAge. The two were sentenced to five years in prison in 2007 but only ended up serving probation, after which Budovsky started Liberty Reserve.
In addition, hackers have tried numerous times to break into Bitcoin exchanges and wallets. MtGox itself has been hacked several times, and various attempts have been made to create malware and other programs that turn unsuspecting computers into Bitcoin mine bots. Recently, a developer at a game company was fired for manipulating customers’ computers to mine Bitcoins for him.
Gary Kremen, founder of Match.com and Sociogramics, says that amateurs in the Bitcoin economy are naïve about the government perception of virtual currencies: “There are a lot of amateurs in the market. I call them cyberpunks. They don’t understand currency or finance or even how governments look at currency.”
Kremen continues, “I just had a government guy in my office telling me that they have forensic software looking for Bitcoin wallets on your machines. And if they find one, they lock onto you, because statistically, if you were in Liberty Reserve or using a lot of anonymous money, you were probably doing something wrong.”
Kremen adds that government analysts “are confident that cyberpunks are using anonymous money for criminal purposes or tax evasion unless they are on the fringe, believing virtual currencies to be the next Gold 3.0.”
Insiders have long anticipated that a larger federal investigation of Bitcoin would begin at one of these points of attack, but if Kremen and others are right, the government reaction has already gone way beyond that.
Curiously, despite this vulnerability, one of the most popular businesses in the Bitcoin universe remains the money exchange, where dollars are turned into digital counterparts, largely because the exchange takes a cut of every transaction (usually between 2.5 and 3.5 percent of the transaction value).
This situation is likely to change rapidly, though, as the Department of Homeland Security investigation sends a strong message to the Bitcoin universe that financial transactions must comply with federal and state regulations.
At its simplest level, this means Bitcoin exchanges and vendors must know who their customers are. Operationally, it means companies will need processes and procedures that prove compliance.
One lawyer on a Bitcoin 2013 panel discussion estimated that it would take 18 months and $1 million for an average Bitcoin exchange to achieve regulatory compliance—if done correctly. Another speaker noted that 45 percent of Bitcoin exchanges fail—and take their Bitcoins with them, ostensibly removing them from circulation forever.
Nevertheless, the essential value of the Bitcoin today lies not in Bitcoin exchanges or even merchandising, much to the dismay of the Bitcoin Foundation. Rather, it derives from speculation on the real-money valuation of the Bitcoin itself.
Earlier this year, for example, the value of the Bitcoin launched from $16 to $266 amid growing interest from mainstream news organizations, and then just as quickly plummeted to $105 when insiders began worrying that the inflated price would damage the currency.
“People who say the only reason to buy Bitcoin is to watch it appreciate are idiots,” says Kremen. “They’re assuming that demand is always going to go up. And sure, you can divide a Bitcoin by a thousand or more, but demand is not always going to go up. It could go down. Is the yen going up or down?”
That kind of growth does not go unnoticed, and today most of the interest in Bitcoin comes from speculators, like Jordan, although some have far more real cash in their pockets.
The prime example is the Winklevoss brothers—the twin Harvard grads who famously sued Mark Zuckerberg for allegedly stealing their ConnectU idea and turning it into Facebook.
After settling for an undisclosed amount, the twins now operate as venture capitalists. One of their more recent projects involves mining for Bitcoins. Earlier this year, the Winklevoss twins claimed to have mined more than $11 million worth of Bitcoins—a significant enough stake to prompt the Bitcoin Foundation to invite the twins to keynote Bitcoin 2013.
Sporting the standard attire of the Silicon Valley entrepreneur—black jeans and untucked cotton shirts—the brothers arrive with a small entourage, stride awkwardly onto the low-key stage and take turns walking through a slideless presentation, taking cues from monitors at their feet.
The keynote is intended as a rallying cry to the audience, an appeal to raise the game of Bitcoin merchandising and embrace the new reality as defined by FinCEN. This is necessary, the Winklevii say, to convince big brands to begin accepting Bitcoin as a legitimate currency.
If the speech had been given to a roomful of Facebook haters or even Amway reps, it might have gotten a great reception. But the nerd factor of the Bitcoin audience is deep—so deep that almost nobody even bothers to approach the brothers after their speech.
The lack of awareness of obvious opportunities goes a long way toward explaining why only geeky brands such as Reddit, WordPress and a few others currently offer Bitcoin payments. More prosaically, Bitcoins can be used at consumer businesses like Ocean Blue Sushi in Sunnyvale. On the other hand, there’s a certain rationale at work, too. Today, many of the earliest Bitcoin owners are speculators, and few seem willing to shake the tree for the benefit of others.
Jon Holmquist, the twentysomething owner of Bitcoinstore.com, is a rare exception. Holmquist buys geek products—computers, game players, etc.—in bulk and sells them online and at cost for Bitcoins.
“Our strategy is to showcase how Bitcoin works and force Amazon.com to begin using Bitcoins,” says Holmquist, noting that Amazon currently offers its own digital currency—Amazon Coin. The drawback to Amazon Coin is that it is not transferable outside of the Amazon site.
Others, like Gli.ph, are taking more innovative approaches. Gli.ph, which began as a secure texting start-up, has created iOS and Android apps that allow Bitcoin users to convert their Bitcoins to gift cards.
“So far, we are the only Bitcoin application that has been approved by the Apple store,” says Gli.ph co-founder Rob Banagale.
Still, the naivete of most Bitcoin innovators is stunning. One young man who discloses while questioning a panelist that he is interested in investing in Bitcoin ATMs is knocked back to his seat when a lawyer tells him he should first look into the federal and state regulations regarding ATM transactions.
“Federal laws have penalties,” adds another lawyer, Dax Hansen of Perkins Coie. “If you get it wrong, the stakes are very high.”
The seriousness of Hansen’s tone is deliberate. The Bitcoin universe will only survive if it recognizes that it exists in reality, not in some fantasy digital universe. As such, participants need to start playing by real rules.
One major proponent of this strategy is Peter Vessenes, founder of CoinLab, one of the largest Bitcoin exchanges and a bitter rival of MtGox. Many see Vessenes, with his loud, energetic and decisive presence, as the new sheriff, doing his best to make an impact early and loud.
Vessenes disagrees. “There are a lot of voices working for a good situation for Bitcoin,” Vessenes says. “The foundation exists to let us pool our efforts. There are other important voices too, like ones who want Bitcoin to stay decentralized, so we all have different roles to play.”
Still, it is Vessenes, not the Winklevoss twins or the lawyers, who puts the fear into the audience at Bitcoin 2013. “There have been 18 million transactions since Bitcoin began,” Vessenes says in his opening address at the Bitcoin conference. “There are expected to be 20 million transactions in June alone, or 27,000 a day. Many large banks have researched this phenomenon, and they are going to be in our space.”
Banks, of course, aren’t his only concern. If Bitcoin is to really grow its market, it has to earn partnerships with major online sites, and many of them are still reluctant to play.
Earlier in May, for example, The Wall Street Journal reported that PayPal’s parent company eBay was considering adding Bitcoin to Paypal’s payment options, but quickly added that it was likely too soon to make a decision.
“It’s a new disruptive technology, so, yeah, we’re looking at Bitcoin closely,” said CEO John Donahoe. “There may be ways to enable it inside PayPal.”
But, he said, new concepts like virtual currencies and free music sites often fail the first time around, to be followed by similar “more legitimate” ideas.
Shortly after that, an investment group called Liberty Ventures announced that it was starting a $15 million fund to invest in Bitcoins and other digital currency startups. And although Liberty Ventures is a relative newcomer to the investing industry, having been founded less than a year ago as the early-stage venture arm of investment management firm Cedar Hill Capital Partners, it’s exactly the kind of interest Vessenes is hoping to attract.
To get there, Bitcoin really has to look the part, and today, it does not. So the sheriff is cleaning up.
In part because of his growing frustration with the performance of MtGox, which suffers from an aging infrastructure that is hard-pressed to handle the growing volume of Bitcoin transactions, Vessenes forced a partnership agreement with MtGox earlier this year whereby CoinLab would become the primary Bitcoin exchange for customers in the United States. A stipulation of that agreement called for MtGox to transition all North American customers to CoinLabs’ systems by March 22, which Vessenes claims did not happen. As a result, earlier this month CoinLab sued MtGox for $75 million over the breached partnership agreement.
Whether the suit is won by one party or the other, that and the DHS investigation will both force the Bitcoin universe to reassess itself and enter, in a meaningful way, the world of legitimate commerce.
When it does, the real race begins.
“We need technologists, we need international chapters willing to work with regulators in other countries. We need board members,” Vessenes says. “Somebody is out there, somebody is going to get to the kids and take your candy from you. Hungry innovators. Bankers will be there. Everybody is going to have to up their game.”
Kremen agrees, noting that it’s possible that the Bitcoin economy could be swept aside by a different currency that has “government protection or big insurance policies. I see a lot of vulnerability other than that. I think the phenomenon of anonymous cash is very interesting, but we already have something like that in the United States. It’s called cash.”
What the Bitcoin economy needs, Kremen explains, is the legitimacy of a larger market: “The market is very thin. What I mean by that is, to have a really good market you need buyers and sellers, people to go long and short, liquidity … they’re just not there. Bitcoins are not like a true currency market yet. You can’t make big trades, you can’t buy a million dollars worth of coins at any time.”
After the conference, Kylae Jordan emailed me with his perception of Bitcoin. It was a long and detailed missive, but I couldn’t help noting that at the end of it, there was still a significant spark of excitement.
“There are many Bitcoin millionaires currently, but the potential has only been scratched,” wrote Jordan. “It’s more than simply a penny stock that rose out of the darkness and into fruition. This is the next generation of how money is transacted. That is what the valuation of Bitcoin really is.”
Still, Jordan has moved on. He has decided that his next venture will be in the entertainment industry.