Adam Voorhes Gail Anderson + Joe Newton

Before most people had ever heard of the digital currency bitcoin, Brian Armstrong, a 27-year-old engineer at the home-sharing website Airbnb, thought it could make him a lot of money. At the time—spring 2012—Airbnb was moving a reported $500 million in payments annually in 192 countries through a patchwork of financial networks, and each one claimed a transaction fee. An anonymous, encrypted, government-free online version of money would simplify all that. It would be faster, more secure, and vastly cheaper.

The problem was that the things that made bitcoin attractive also made it bewildering for noncoders. Using it required balky and hard-to-use software called a wallet. Bitcoins were also a challenge to obtain—mostly you had to purchase them from middlemen who operated in the regulatory shadows and who sometimes turned out to be crooks. The money was hard to spend, because few merchants accepted it—the currency was just too new. Armstrong realized that the way to widespread acceptance of bitcoin was a user-friendly wallet.

He wasn't the only one thinking about bitcoin's broader potential. On a discussion forum about the currency, Armstrong met Ben Reeves, a British programmer who ran a bitcoin transaction-tracking website called Blockchain. Reeves understood the technology and was well respected within its tight-knit community of enthusiasts. He had been using bitcoin for a year already and had even built a bitcoin wallet that 10,000 people had tried out. Reeves also wanted to see the currency gain more traction. The two men hit it off and started spitballing ideas for a new kind of company: a PayPal for bitcoin. It would serve as a trusted broker of the cryptocurrency, taking a 0.5 percent charge anytime anyone converted dollars to bitcoins or vice versa. But spending money within the bitcoin network would be essentially free. With a digital wallet and payment-processing services, you could, say, pay that cash-only cab driver with bitcoins via your smartphone. They pitched the concept to the prestigious and highly selective tech-company incubator Y Combinator—and within hours had an invitation to join the class of summer 2012.

But the relationship soon ran into trouble. Armstrong felt that in order for bitcoin to gain mass acceptance, users who lost their wallet passwords would need a way of recovering them. That meant their new company would have to retain access to users' private keys—the 64-character access codes that convey bitcoin ownership. Without that access, users could forever forfeit their entire bitcoin fortune as easily as forgetting their password.

Reeves disagreed completely. The whole point of bitcoin was that it put the person with the bitcoins in control. If you gave some company access to your bitcoins, you were essentially trusting it as you would a bank. It could lose them to hackers or, worse, steal them outright. These rip-offs were already an all-too-common occurrence in the nascent bitcoin world. If Reeves and Armstrong's company maintained a backdoor into all of its customers' wallets, it would be only a matter of time before the government began issuing subpoenas. Yes, the current system meant that users took on more risk, and that would probably turn off some of the more casual ones. But bitcoin wasn't meant for them anyway. Though Reeves planned to build a currency for everyone, he wanted to start with the geeks. "There simply are not that many reasons why the average person would want to use bitcoin," he wrote.

The hammer fell just 48 hours before Reeves was supposed to get on a plane to fly to Silicon Valley. Armstrong's email was diplomatic, even kind. Still, like all breakups, it hurt. "Cofounding is really like a marriage," Armstrong wrote, "and even though I think we have mutual respect for each other, we don't work together extremely well." Armstrong cut Reeves off from their shared online accounts. "I think we have pretty different aesthetics around what sort of product to build," Armstrong wrote. He was going to Y Combinator alone. Reeves was out.

A Flash Guide to BitcoinThe digital currency may have begun as an experiment for techno-libertarians and geeks, but today it’s growing into something much bigger. Still, that doesn’t make it any less complicated than when it was first introduced on a cryptography listserv in 2008. Here’s how bitcoin actually works.

—Cameron Bird

Click to enlarge. Lamosca

1. Puzzle

Each bitcoin is represented by a string of numbers and letters. To verify that every transaction is legit, a worldwide network of computers constantly checks these cryptographic signatures.

2. Solve

Those computers are also locked in a contest to solve cryptographic puzzles. This is called mining. Many partici­pants join mining pools to combine their computational power for faster solving.

3. Mint

The winner gets a block of 25 new bitcoins. Over time, that bounty is set to decrease in size, limiting the total number of bitcoins in circulation. As more computers join the network, the puzzles get more difficult.

4. Verify

Miners serve a vital role: They add bitcoin transactions onto a public ledger called a block­chain. This database allows anyone to follow bitcoins from transaction to transaction.

5. Exchange

Once mined, new bitcoins go into circulation. People can buy them through online services like Coinbase or directly from another user. (In a few North American cities, bitcoin ATMs dispense them.)

6. Hold

Once acquired, btcoins must be stored. Some users keep their cryptocurrency in digital wallets on their computers or smartphones with apps like Bitcoin-Qt and MultiBit. Others store them in the cloud, relying on services like Coinbase.

7. Shop

The number of individuals and businesses accepting bitcoins is exploding. Today they can be spent everywhere from independent restaurants and hotels to major retailers like Overstock.com.

8. Repeat

Once a transaction has occurred, other computers on the network then validate and record it on the official bitcoin ledger—the blockchain. The network groups several transactions together and assebles a new cryptographic puzzle. Miners then begin attacking the new problems, which for now are designed to be solved in about 10 minutes.

Today the conceptual conflict between Armstrong and Reeves is playing out across the volatile and vibrant fledgling bitcoin economy. Once the domain of hackers, libertarian activists, and drug dealers, bitcoin has been adopted by a growing number of mainstream businesses. You can use it to buy a mattress on Overstock.com or a laptop from electronics seller TigerDirect; Zynga will soon begin accepting it for in-game payments. Last year more than $100 million in bitcoin transactions was processed and the value of bitcoins shot up from $13 to $1,200, despite the fact that regulators in China were cracking down. Even when one of the world's best-known bitcoin businesses, a Japanese exchange called Mt. Gox, closed after being hacked—customers lost currency worth hundreds of millions of dollars—new exchanges launched, the value climbed back up, and the mainstreaming of bitcoin rolled on. Regulators are taking a hard look at the bitcoin economy, but investors and entrepreneurs keep coming.

All this activity obscures a fundamental rift over what bitcoin should become. Many of the currency's original proponents—call them crypto-libertarians—see it as a step toward an entirely new economy, one that can't be influenced by an overweening federal government or rapacious financial industry. Bitcoins aren't created or controlled by a central organizing body like the Federal Reserve. They're created—or mined, in bitcoin parlance—by a global network of computers and governed by the cold rationality of mathematics and the laws of supply and demand. Bitcoin's algorithms dictate that no more than 21 million bitcoins will ever be created; the math even determines how quickly new bitcoins get added—25 every 10 minutes. (That number drops by half every four years.) And crucially, from the crypto-libertarians' point of view, the currency straddles the line between transparency and privacy. All transactions happen out in the open, recorded on bitcoin's public ledger. But because bitcoin isn't necessarily tied to any user's identity, it can be spent anonymously like cash, meaning there's a way to keep governments and marketers in the dark about your spending habits.

Meanwhile, some of the new entrants to the bitcoin universe—venture capitalists and entrepreneurs—have a much different vision. They see bitcoin as something more practical: a hyperefficient online transaction system like Visa, but cheaper, faster, and more flexible. It would usher in a world in which we don't have to trust online vendors to safeguard our credit card numbers, in which merchants don't have to pay exorbitant handling fees, and in which payments as small as fractions of a cent could unleash a kind of long tail of commerce, making it just as easy and profitable for an Argentine vintner to accept money from a wine connoisseur in Dubai as it is for Amazon to sell diapers in Dubuque.

This doesn't have to be a zero-sum game, but increasingly it looks as though the two visions of bitcoin are in conflict. With every Mt. Gox–style flameout, consumers and governments press for a more regulated system, even though some regulations threaten to push bitcoin into the deep jungle of international finance. Last year banking regulators shut down a US bitcoin exchange called TradeHill. Today the most popular bitcoin exchanges operate outside the US, in Slovenia, Bulgaria, and Japan. VCs are used to this dynamic—taking a technology nurtured by true believers and massaging it into a broadly acceptable business. But in this instance, they're up against something new. Thanks to bitcoin's skyrocketing value, some of its original proponents find themselves sitting atop massive war chests, and they are willing to spend their newly valuable cryptocurrency to realize their vision of the future.

Adam Voorhes Gail Anderson + Joe Newton

On March 5 of last year, Wences Casares, CEO of the online-payment company Lemon, was eating lunch at the Dove Mountain Ritz-Carlton, a lavish golf retreat north of Tucson, Arizona. He was hobnobbing with other tech executives, VCs, and entrepreneurs at an invitation-only conference sponsored by boutique investment bank Allen & Company. Casares grew up on a sheep ranch in Patagonia, but he'd made a career building online banks and payment systems in Europe and Latin America. Over the previous year, bitcoin had become something of an obsession for Casares. He thought it would change finance, especially in developing countries, and he wanted to show it to anyone who would pay attention. At Dove Mountain, Casares decided to play a little parlor trick. He'd show the high-powered tech guys at the table how easily bitcoin could move a crapload of money. He had each of his tablemates download a bitcoin wallet to their phone. Then he generated a QR code on his own phone's screen and had the person seated nearest to him take a picture of it. When that person checked their wallet, they had 6,390 bitcoins—worth $250,000.

What followed was perhaps the world's most high-stakes game of hot potato. From seat to seat, the capitalists squirted 250 grand at each other with nothing more than a button push or screen tap. Once the money was safely transmitted back to Casares' wallet, everyone at the table had gotten a taste of how cool and dead-simple bitcoin could be. This wasn't like PayPal, say, which merely lubricates some of the friction between banks and credit card companies. This was money set free.

Bitcoin's JourneyThough it first appeared in 2009, bitcoin didn’t see much action until 2012, when more than 1,000 new merchants began accepting the digital currency. Since then the number of bitcoin transactions has climbed steadily. Its value has risen precipitously too—and fallen in a volatile series of boom-and-bust cycles. —C.B.

Click to enlarge. Lamosca

"It was quite a demo," says Chris Dixon, a serial entrepreneur who is now a partner at Andreessen Horowitz, the venture capital firm best known for its investments in Facebook and Twitter. As a fee-free transaction system, Dixon saw, bitcoin could be an ecommerce alternative for businesses small and large. And because bitcoin was an open platform like the Internet, software developers were free to build things on top of it that they never could with MasterCard or Visa, which carefully control access to their networks. Here was a way to make mobile payments without giving Apple's or Google's app stores a 30 percent cut; here was a way for a college student to write a micropayment app to fund a school newspaper. "The original spec of HTTP was going to have a payment system built into it, but they never got to it," Dixon says. He thought bitcoin might be it. Eight months after the demo in Tucson, Dixon invested $25 million of Andreessen Horowitz's money in Armstrong's startup, Coinbase.

Just as companies like Facebook and Blogger had made it easy for anyone to set up their own online presence, the bitcoin economy needed a middleman to make it easier for everyone to participate.

But writing the Internet's payment protocol was a risky proposition. People had tried to build digital currencies, and the results were always the same: Criminals flocked to them, and the government ended up shutting them down. If bitcoin were to succeed, Dixon reasoned, state and federal governments would have to establish a road map. And bitcoin companies would need to show that they were willing and able to follow the rules by putting the kind of strict controls on their businesses that would keep out criminals and money launderers.

Coinbase hopes to do just that. Today it occupies a 1,800-square-foot apartment in San Francisco's South of Market neighborhood. It's not a particularly impressive setting for a company attempting to build the future of money. A string of white Christmas lights trails up to the apartment's loft, a concession to the holiday season that's just winding down. "For a long time, Coinbase was essentially two desks upstairs," Armstrong says. "Now we're looking at a 25,000-square-foot office space."

Then again, it makes sense that the company might underinvest in real estate. Coinbase is involved in a pricey proposition: obtaining the state licenses and filing the reports necessary to be an official money transmitter. Making bitcoin easy to use, it turns out, isn't so much a technological problem as a regulatory one. When Coinbase started, the most difficult problem for new bitcoin users was buying and selling bitcoins. Coinbase made this easy. You link your bank account to Coinbase and—presto!—you've got bitcoins. But this complicated things for Coinbase. It turned the company into a money-services business, like Western Union. And just like Western Union, if it runs afoul of regulators, they can seize its bank accounts and put it out of business. (As long as the company is in the process of obtaining the proper permits, regulators will not clamp down.)

Adam Voorhes Gail Anderson + Joe Newton

As part of operating an aboveboard money-services firm, Coinbase actively polices its users. It vets customers to make sure they're not criminals or money launderers, has access to their private keys, and helps startups develop apps to run on the Coinbase platform. Oh, and Coinbase takes a 1 percent fee when people use its system to convert bitcoins to cash and vice versa.

As less-technically-savvy users flood into the bitcoin marketplace, that fee can seem like a bargain. Simplicity, consistency, legality, and reliability are worth money. Just ask the millions of people who prefer to download TV shows from iTunes than to take their chances with BitTorrent. A year ago, when Casares was passing around bitcoins at the Arizona retreat, about 37,000 people had Coinbase wallets. Today that number is more than 1 million. Armstrong sees a future in a whole range of services—integrating the Coinbase wallet with cash registers so you can buy milk with bitcoins at your local grocery store, for example. "It's a new protocol; it's difficult to use, but it has incredible potential," he says. "There's an opportunity to build the first trusted brand on this new protocol and help make it easy for businesses and consumers to use it."

If the anarchic id of bitcoin has an analogue to the straitlaced Chris Dixon, it's Roger Ver. Sometimes called Bitcoin Jesus for the way people mob him after his lectures, Ver is a businessman and onetime Libertarian candidate for the California State Assembly. He left his home state for Japan in 2006 after a 10-month stint in Lompoc federal prison for selling a high-powered firecracker called the Pest Control Report 2000 on eBay.

But Ver is perhaps best known for a billboard. He pays $1,500 a month for it, a giant sign in Silicon Valley that advertises his aftermarket computer parts business. (Its tagline, naturally: "We accept bitcoin.") Ver started buying the currency in 2011, when it traded at $1, and scooped up enough of it to ride its climb in value to a seven-digit bank account. Now he's an early-stage investor in a dozen bitcoin companies. But unlike Dixon, the startups he's funding aren't necessarily trying to make bitcoin a respected and efficient aboveboard transaction system. They're trying to develop the currency's revolutionary potential.

One of these startups is Blockchain, the brainchild of Ben Reeves. After getting Armstrong's breakup email, Reeves resolved to build Blockchain into more than just a data-gathering site. Like Armstrong, he saw the bitcoin wallet as a platform for financial services. But Reeves didn't want Blockchain to have access to its customers' bitcoins. So he hacked an ingenious wallet that can be accessed from a browser or a mobile phone but leaves the critical private key on the user's computer. Blockchain can never lose your bitcoins. However, if you forget your password, it can't find them for you either. None of the Valley's investors wanted anything to do with Reeves.

BITCOIN STRADDLES THE LINE BETWEEN TRANSPARENCY AND PRIVACY. ALL TRANSACTIONS ARE OUT IN THE OPEN BUT ANONYMOUS.

And then he got an email from Ver. Blockchain was a great site, Ver wrote. Did Reeves need any help? The answer, of course, was yes. Ver invested some money—he won't say how much—and with it Blockchain added servers and improved its software. Today it's one of the most reliable sources of information on bitcoin, and Reeves is slowly turning it into a kind of Google for the bitcoin ecosystem—a set of web services that are crucial for bitcoin traders and developers. The success of the company's Blockchain.info website has led people in turn to download Blockchain's wallet software. Today more than 1.3 million customers use it. They can check the latest bitcoin prices, log in to their wallet, and use bitcoins to buy, say, an Amazon gift card. The company's 16 employees are developing a trading platform that will be able to search out the best deals on various bitcoin exchanges, and they're building out a mobile news app called ZeroBlock. The company makes several hundred thousand dollars a month from ads, billed in bitcoin. It has no office and no bank account. "It's a liberating and flexible thing for us," says Nic Cary, Blockchain's CEO. "We don't need a bank."

Reeves was on his way to building a wallet that was controlled 100 percent by the individual user and out of the hands of corporations and governments. You get to do whatever you want with it, and if you lose your private key, that's your problem—rugged individualism, rendered as bits. It was an idea that appealed to libertarians like Ver, who once wrote that "nearly everything the government does makes the world a poorer place."

So what might a government-free bitcoin world look like? It could resemble Acapulco's Playa Condesa. One-horse carriages festooned with blue and white balloons and flashing LEDs promenade up and down the busy street as drunken revelers avail themselves of a 100-foot bungee jump. Jeff Berwick, an anarchist millionaire, is drinking Don Julio at Paradise, an outdoor disco, and living tax-free.

Berwick made his first fortune as the founder of the finance news site Stockhouse. His second fortune came from bitcoin. Right now he's trying to persuade me to go out for one more drink. "I know a place where they have midgets on roller skates," he says. When Berwick isn't partying, he and a group of like-minded people are trying to set up a free-trade zone in Honduras; they believe that president Juan Orlando Hernández will approve the deal any day. "There's already a bunch of bitcoin guys getting ready to move down there as soon as the free zone is set up. They want to do a lot of bitcoin-related businesses, partly because there is not going to be any real regulatory thing," Berwick says.

BLOCKCHAIN CAN NEVER LOSE YOUR BITCOINS. BUT THE WALLET-BUILDER CAN'T FIND THEM FOR YOU, EITHER, IF YOU FORGET YOUR PASSWORD.

For about 45 bitcoins, Berwick will sell you a Paraguayan passport so you can live tax-free as a bitcoin anarchist in Acapulco. He will broker real estate deals for you there too. In fact, he is just about to close a sale on a 30th-floor penthouse with a killer view of the city. A month earlier, a German businessman living in China snatched it up for a 17-bitcoin down payment—he won't let me use his name, but via email he tells me that with China's strict monetary controls, it was the easiest way for him to get money out of the country.

American tourists largely avoid Acapulco, in part because of its reputation for drug-cartel violence. But Berwick says he feels safer here than in the US (possibly because he has a bodyguard). "I've fallen off my scooter drunk here. The cops just picked me up and helped me on my way," he says. He can also sell real estate without a license.

That's not to say that crypto-libertarian purists are above engaging with officialdom when necessary. In 2012, Ver and Mark Karpeles, then CEO of Mt. Gox, ponied up 5,000 bitcoins each to kick-start the Bitcoin Foundation. It was a decent endowment at the time, worth maybe $55,000. But as bitcoin's value has mushroomed, the Bitcoin Foundation has become a well-funded lobbying organization worth millions. In August 2013, as federal investigators probed bitcoin's connections to the Silk Road—a free-for-all drug bazaar fueled by anonymous bitcoin transactions—the foundation held a series of meetings with staffers at the US Justice and Treasury departments and the FBI. The months-long lobbying effort culminated in a pair of bitcoin-friendly congressional hearings that The Washington Post described as "lovefests." The Bitcoin Foundation called it a win—and so did venture capitalists.

The new bitcoin millionaires are a weird breed: government-hating libertarians rich enough to hack the systems that make Washington, DC, function. In that town they even began to sound a little like VCs themselves. "Setting regulatory certainty is very important for bitcoin," Ver says. "I'm opposed to the regulations, but the bitcoin businesses need to know the rules of the game in order to move ahead."

Neither venture capitalists nor crypto-libertarians will win the fight for bitcoin's soul if the currency's fledgling system implodes. And it could. Companies in the emerging legitimate bitcoin industry—wallet builders, exchanges, payment-processing services—can't get banking services because bankers still have no clear idea how regulations apply to these companies. On top of that, the bitcoin network itself is struggling to deal with its own rapid growth. It can process only seven transactions per second (Visa can handle 10,000).

But some clarity may be coming. This year the superintendent of the New York State Department of Financial Services, Benjamin Lawsky, expects to spell out a set of guidelines for plugging bitcoin companies into the financial system. These rules are likely to influence states across the US. If they're too stringent, bitcoin companies will probably close their doors or set up business offshore. This is the risk that playing nice with regulators presents: They might regulate you out of existence. Meanwhile, Mt. Gox represents the risk of the Wild West approach: Without safeguards, a centralized authority, or some way to protect people's digital holdings, the whole thing may be seen as fundamentally unstable and collapse on itself.

Coinbase, meanwhile, is forging ahead like it's building the next billion-dollar Silicon Valley company. It has tripled its staff in the past six months, hiring a star compliance officer, Martine Niejadlik. Her job is to sort through all the rules an official financial-transactions business has to follow—and whatever new ones Lawsky comes up with. Its VCs, Andreessen Horowitz, have extended their commitment, investing $50 million in bitcoin businesses.

Other than Christmas lights, Armstrong's team hasn't had time to install much in the way of office decorations. But on one wall hangs an 8- by 10-inch picture frame filled with Zimbabwean dollar bills—a currency that went through a period of hyperinflation in the late 2000s. Today most transactions in Zimbabwe are conducted in US dollars or South African rands. Nailed to an office wall, it looks like a shrine to failed currency. I ask Armstrong if I can take a picture of it, and he tells me no. Nobody wants bitcoin linked with funny money.