What concerns does Bitcoin need to address to become a lasting currency?

There’s a new investment theme in the tech startup scene, and it’s called Bitcoin. Basically Bitcoins are a form of currency, like dollars or euros. The key advantage of Bitcoin over traditional currencies is its lower transaction costs. Whereas payments in traditional currencies which need to be processed through institutions like banks and credit card processing companies incur fees ranging from 2% to 5% of the transaction value, payments made in Bitcoin are free. That is until you convert Bitcoins back into a traditional currency. For example, Coinbase, a leading startup in the Bitcoin ecosystem, charges 1% + $0.15 per transaction to convert your Bitcoins into dollars.

As a result of the lower transaction cost of Bitcoins which represent a potentially very large shift in value from financial institutions to consumers, startups attempting to build the ecosystem have attracted significant venture capital interest. Coinbase has raised over $6M from the likes of Union Square Ventures and SV Angel. OpenCoin is backed by Andreessen Horowitz, Lightspeed Ventures, and Google Ventures. And BitPay recently raised $2M led by Founders Fund. But all is not rosy. As is natural for a new ecosystem, volume remains low. Coinbase saw $15M of Bitcoins converted into dollars in April, and BitPay announced that it handles $5M in transactions per month. Although Bitcoin is a very promising currency, it faces three key concerns that it needs to address in order to gain widespread adoption: anonymity, volatility, and deflationary pressure.

Let’s address anonymity first. The first adopters of Bitcoin were groups and individuals who did not want to leave a trail behind as they engaged in illegal activities like online gambling. While the appeal of using Bitcoin to protect your identity in illegal transactions is clear, for Bitcoin to become a universal currency, it needs to be used for legal transactions where the identities of the buyer and seller are known. Fortunately, this is starting to become the case. Gyft, which Romulus partnered with in June 2012, works with BitPay to allow its users to buy mobile gift cards from its retail partners by paying with Bitcoins.

This leads to the second concern surrounding Bitcoin: volatility. The value of one Bitcoin has ranged from $5 in April 2012 to a high of $266 in April 2013. This appreciation in excess of 5000% over the course of one year was followed by a greater than 50% drop over the last month. One Bitcoin currently trades for around $127. Part of the solution to the tremendous volatility in the value of Bitcoin is greater usage. As more and more transactions are conducted in Bitcoin, for example through Gyft, the market will better price the currency. However, there remains a second complicating factor which will be more challenging to solve. While a central bank like the US Federal Reserve is able to moderate the volatility of a currency like dollars through open market operations, the lack of a central bank behind Bitcoin makes volatility a greater concern.

If there is no central issuing authority for Bitcoin, how do Bitcoins come into circulation? The answer is that they are created by a predictable algorithm built by the founder of Bitcoin, Satoshi Nakamoto. There are currently 11 million Bitcoins in circulation, with the production of new Bitcoins taking place at a declining rate. There is a hard limit of 21 million Bitcoins which will be in circulation by 2140. Users capture these new Bitcoins by applying their computing power to solve increasingly complex mathematical problems. The eventual fixed number of Bitcoins, and their declining rate of production, makes deflation a real concern. While a central bank could print money to counteract a deflationary environment in a traditional currency, this is not possible for Bitcoins. If Bitcoins gain widespread adoption, their fixed supply is likely to lead to hoarding. This would create a chasm between the haves and the have nots, which could threaten the very foundation of Bitcoin.

While anonymity, volatility, and deflationary pressure remain important concerns on the road to the widespread adoption of Bitcoin, they need to be seen in the proper context. We are in the early innings of a long ball game. The current structure of the Bitcoin system represents its first iteration. We need to adopt an attitude that is willing to experiment and learn from mistakes to overcome Bitcoin’s rough edges. I am convinced that the tech sector will place its best foot forward. With a little help from regulators, Bitcoin can become a lasting currency that ultimately benefits consumers.