After a disastrous few days in early April, bitcoin is back over $100 and up on the month, the year and its short lifetime. ConvergEx's Nick Colas is intrigued and continues to believe that this phenomenon is the most provocative economic experiment since the invention of the euro and well worth watching. The next chapter of the story, he believes, will be the entry of a host of "Smart money" venture capitalists looking to build the currency's infrastructure. Money and currency are exactly the kind of large, scalable and complex opportunity that gets VCs very, very excited. Yes, it could all still end in tears, either by regulation or mismanagement. But bitcoin isn’t dead just yet, and it remains one of the most potentially disruptive forces in modern finance.

Via ConvergEx's Nick Colas:

What Doesn;t Kill You Makes You Stronger

Of all the quotes about money in screen and song, I think the best one comes from film legend Lauren Bacall: “Money doesn’t make me happy, but it doesn’t make me unhappy either.” She probably felt that way about gold, diamonds, furs, and trips to the Riviera as well. Wise woman, that… A lot of economists and market watchers would do well to follow her example.

The nature of money and currency is, in fact, one of the most hotly contested questions of the last five years. OK, the debate goes back much further, truth be told, but the Financial Crisis really brought the question to a head. “Only gold is money!” some will say. “Who cares about money? What we need is a currency system which maximizes total output while minimizing recessions” others will retort. “Bah! It’s credit growth you need to focus on, not money” chimes in a third. Here’s a modest proposal: if you think anyone besides about 1,337 people on the planet care about the difference between money, currency and credit, you need to get out more. A lot more.

Happily for this assemblage of quarreling economic eggheads, there’s a new kid on the block: bitcoin. If you haven’t heard of it before, here’s a quick summary:

It is essentially an online currency invented by an anonymous programmer about five years ago.

The system that supports the infrastructure of tracking transfers of wealth and new issuance of bitcoins is a piece of open source software, available to anyone.

It runs on thousands of computers around the world and the owners of these systems race to solve a complex puzzle every 10 minutes. If they come up with the answer first, they currently get 25 bitcoins. Along with that ongoing effort, they also keep an ongoing list of user transactions.

If they come up with the answer first, they currently get 25 bitcoins. Along with that ongoing effort, they also keep an ongoing list of user transactions. There is currently $1.1 billion worth of bitcoin outstanding. It is the world’s best performing currency year to date, up from $13.48 on January 1 to about $115 as I write this note. It is also the most volatile, peaking above $260 a few weeks ago.

It is the world’s best performing currency year to date, up from $13.48 on January 1 to about $115 as I write this note. It is also the most volatile, peaking above $260 a few weeks ago. No, none of this is made up. I am not that clever.

Bitcoin is without any serious competition for most provocative development in global currency markets since a bunch of previously warring European countries decided it would be a good idea to form the euro. And in its short life it has garnered almost as much praise and scorn as that “real” currency. Bitcoin’s story is still evolving, but the preliminary lessons are profound:

Trust in technology can trump belief in government institutions, even in notionally free societies. The greatest demand for bitcoin is dollar denominated. And for all the negative chatter about the dollar and the parlous state of U.S. sovereign finances, the greenback is still the world’s reserve currency. Want gold, oil, guns or a large shipment of illegal drugs? Better bring the Benjamins...

The greatest demand for bitcoin is dollar denominated. And for all the negative chatter about the dollar and the parlous state of U.S. sovereign finances, the greenback is still the world’s reserve currency. Want gold, oil, guns or a large shipment of illegal drugs? Better bring the Benjamins... Interest in bitcoin, measured in the number of Google searches for the term, comes from Russia, the US, Finland, Estonia and Sweden. This isn’t just a bunch of Tea Party folks, or nerdy techheads, or spooked Russian billionaires. Bitcoin is essentially the Esperanto of money, but without the need to learn a new language.

This isn’t just a bunch of Tea Party folks, or nerdy techheads, or spooked Russian billionaires. Bitcoin is essentially the Esperanto of money, but without the need to learn a new language. The policy responses to the ongoing global financial crisis seem to have eroded public confidence in the concept of money/currency as a store of value, at least at the margin. New ideas for currency, even as nerdy as bitcoin, resonate enough to generate $1 billion of value in fairly short order. Now, most economists will tell you that money shouldn’t be a store of value, for that leads to hoarding and slower economic growth. They would prefer its users invest it or spend it, adding to the capital society has to deploy or increasing GDP. But people – as opposed to economists, I suppose – have an inherent selfish streak almost as immutable as any law of physics. And some of them want a currency that will hold value, or even increase in worth over time.

New ideas for currency, even as nerdy as bitcoin, resonate enough to generate $1 billion of value in fairly short order. Now, most economists will tell you that money shouldn’t be a store of value, for that leads to hoarding and slower economic growth. They would prefer its users invest it or spend it, adding to the capital society has to deploy or increasing GDP. But people – as opposed to economists, I suppose – have an inherent selfish streak almost as immutable as any law of physics. And some of them want a currency that will hold value, or even increase in worth over time. Public interest in new currencies is deep enough to forgive some pretty serious teething pains. Bitcoin has a tough month of April, the result of everything from aggressive hacking of “Wallets” (online accounts where individuals can swap “Real” currencies for bitcoins and hold balances) to multi-hour outages at popular exchanges. The price of a bitcoin went from +$260 to $60 in six days. And yet from those lows on April 17 it is has doubled back to $110 or so on April 21.

The most provocative feature of this dramatic rags-to-riches-to-rags-to-riches yoyo is that it is actually a diversion from the upcoming main event. Venture capitalists see a much larger narrative surrounding bitcoin, and the capital they can put to work shaping the future of this novel currency far exceeds the $1.4 billion of bitcoin value currently in the system. Here’s what they see:

VCs look for three things when making an investment: a huge (usually +$1 billion) market size, a disruptive technology, and lots of ways to play those two features. Those thousands of tech-savvy folks who run the bitcoin system have created a new and very low cost method for transferring money around the world. For the potential 25 bitcoin reward of solving one of those 10 minute puzzles, they keep track of all the transactions created by users around the world. The current system for money transfers – banks, brokers and other financial institutions – want a lot more for their efforts than a few thousand dollars six times an hour. Bitcoin is to money what Amazon is to retail or Netflix is to video content – a much more efficient way to meet the needs of millions of people around the world.

Those thousands of tech-savvy folks who run the bitcoin system have created a new and very low cost method for transferring money around the world. For the potential 25 bitcoin reward of solving one of those 10 minute puzzles, they keep track of all the transactions created by users around the world. The current system for money transfers – banks, brokers and other financial institutions – want a lot more for their efforts than a few thousand dollars six times an hour. Bitcoin is to money what Amazon is to retail or Netflix is to video content – a much more efficient way to meet the needs of millions of people around the world. There are three major vectors for investment: exchanges, service offerings for individuals, and service offerings for businesses. The first is the gateway for the bitcoin system, allowing users to swap bitcoins for dollars/euros/whatever. The other two make it convenient and safe for people and institutions to use the system.

exchanges, service offerings for individuals, and service offerings for businesses. The first is the gateway for the bitcoin system, allowing users to swap bitcoins for dollars/euros/whatever. The other two make it convenient and safe for people and institutions to use the system. There are serious challenges to making bitcoin viable over the long term, so scarce intellectual capital in areas such as online security will carry a large premium. Take, for example, the well-publicized problems at Mt. Gox, the largest exchange for bitcoins or Instawallet, previously a large wallet operator. The former had to go down for 12 hours to upgrade its systems, putting the bitcoin world in temporary disarray. Hackers attacked the latter and put it out of business.

Take, for example, the well-publicized problems at Mt. Gox, the largest exchange for bitcoins or Instawallet, previously a large wallet operator. The former had to go down for 12 hours to upgrade its systems, putting the bitcoin world in temporary disarray. Hackers attacked the latter and put it out of business. Venture capital faces a huge challenge in making bitcoin user-friendly and secure enough to be ready for prime time. Hackers in bitcoin land are ferocious competition, attacking the weakest link in the system to drive prices down. They then scoop up the currency during the confusion and wait for it to rebound. The fact that shorting bitcoins is difficult at best is one of the currency’s saving graces at the moment. As a hacker you can most easily profit by eventually betting its price will rise again. That limits the damage hackers wish to incur to temporary drops in price; no one benefits from bitcoin going to zero at the moment.

Hackers in bitcoin land are ferocious competition, attacking the weakest link in the system to drive prices down. They then scoop up the currency during the confusion and wait for it to rebound. The fact that shorting bitcoins is difficult at best is one of the currency’s saving graces at the moment. As a hacker you can most easily profit by eventually betting its price will rise again. That limits the damage hackers wish to incur to temporary drops in price; no one benefits from bitcoin going to zero at the moment. In the end, VCs must address the security issues of the system first, and then work on making bitcoin a relevant currency for global financial transactions. Progress on both would remove much of the volatility in the price, since “real” transactions would have a more even weighting of buy and sell side orders. Right now, the bitcoin market is thin and limited on the supply side unless there is a panic underway. That’s not to say that the currency upward bias of bitcoin prices is irrelevant to this effort, for it does validate the sustainability of the currency while VCs get their ducks in a row and make their initial investments.

When I speak to clients or the media about bitcoin the most frequently asked question relates to regulation. Here are the issues:

One of the essential points of the system’s core architecture is anonymity. Once you have a bitcoin identifier – a long series of numbers and letters – associated with a balance you are essentially “Off the grid.” Yes, all those nerdy folks out there managing the system will track that number, but not your name or social security number or other state-approved identifier.

Once you have a bitcoin identifier – a long series of numbers and letters – associated with a balance you are essentially “Off the grid.” Yes, all those nerdy folks out there managing the system will track that number, but not your name or social security number or other state-approved identifier. In the world of technology, that’s a feature, not a bug; but, in the world of anti money laundering, the reverse is true. And that’s potentially a problem for the growth of bitcoin, given the global focus on funding sources for terrorism and the illegal drug trade.

And that’s potentially a problem for the growth of bitcoin, given the global focus on funding sources for terrorism and the illegal drug trade. At the moment there simply isn’t the liquidity in bitcoin for large-scale money transfers, which means drug lords will be relying on stacks of $100 bills for a while longer. And global terrorism still has the informal but highly effective Hawala system to move money around the world.

If the venture capital community wants to make bitcoin the “Next big thing”, staving off regulation by bringing the currency into the light is just as important as their other goals. Yes, the U.S. Treasury recently issued some guidance, essentially bringing bitcoin into the regulatory fold. At the same time, regulators do have the facility to make life difficult for bitcoin if they so choose. Recall that they were able to essentially shut down online gambling in the U.S. a few years back by forbidding U.S. banks to fund overseas accounts for the purpose of playing cards or games of chance.

In the end, however, it would be very hard to shut down bitcoin on a global basis. Recall that the system runs on thousands of servers around the world and once money enters the system, the only trace of its existence is a letter-and-number key. Anyone who has that identifier can exchange it for sovereign currency in any country that allows its banking system to plug into a bitcoin exchange.

My humble recommendation to venture capitalists to avoid further regulation or an outright ban is to quickly convince global charities to use the bitcoin system for both donations and money transfers. It is, after all, ideally suited to the purpose of taking in money in rich countries and efficiently moving it abroad to places with limited financial infrastructure. According the National Philanthropic Trust, individual Americans gave $218 billion in 2011, the most recent information available, and there are over one million charitable groups operating in the U.S. Presumably they all have bank accounts to process payments and would like a more efficient way to distribute funds.

That move alone would begin to remove the “Cokehead currency” imprimatur which bitcoin still struggles to overcome due to some early press about its use on illegal drug distribution websites. If shutting down bitcoin would hurt worthwhile charities by pushing them back into a higher-cost banking system, regulators might think twice about excessive regulation or an outright ban. This would give the bitcoin ecosystem time to resolve the security and compliance issues we’ve described previously.

In summary, bitcoin is what I would call a “Beta currency.” To the tech world, that means something that is still in development. It’s eventual success or failure is a technological challenge, mixed with business development issues. And in the milieu of high finance, the “Beta” moniker means risk. Investing in bitcoin has been a white-knuckle ride so far, and nothing in its near future points to a different trajectory. How it all shakes out, however, will be both instructive to watch and potentially profitable for those on the right side of this very novel trade.

Addendum: A few worthwhile reads, in case you want more information:

Bitcoin as a bubble: http://techcrunch.com/2013/04/20/what-can-behavioral-finance-can-teach-us-about-bubbles/?utm_source=feedburner&utm_medium=feed&utm_campaign=Feed%3A+Techcrunch+%28TechCrunch%29

What economists say: http://techcrunch.com/2013/04/14/iterations-how-five-real-economists-think-about-bitcoins-future/

Places to spend bitcoin: https://www.spendbitcoins.com/places/

VCs who are getting involved: http://mashable.com/2013/04/12/bitcoin-startups/ And http://www.wired.com/business/2013/04/whats-riskier-than-bitcoins-bitcoin-companies/

From one VC about how he sees the opportunity: http://techcrunch.com/2013/04/05/why-do-vcs-care-about-bitcoin/

And one very clear short piece on the ins and outs of bitcoin: http://www.newyorker.com/online/blogs/elements/2013/04/the-future-of-bitcoin.html