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I was twirling the thought of Chaum's Protocol in my head, its intricacies filling the gaps between my synapses. Impressed by its cryptographic properties, I could not at the same time escape a nagging sensation in another part of my brain: DigiCash.... is ... tooooo..... faaaar... ahead...  of its... tiiiiiiiiiiiiimeeeeeeeeeeee...........

CRASH!! The toppling sound of the once mighty walls of Mt. Gox, the worlds's largest Bitcoin exchange, finally brought me back to my senses. Talk about falling asleep at the wheel! Fast forward a decade or two later from my ruminations on DigiCash, virtual currency (aka "electronic currency", "digital currency", "cryptographic currency", "cryptos") has suddenly made such headway into mainstream thought as to capture the attention of CNN, speculators, The Wall Street Journal, Bloomberg and professional traders alike. Some have described it as the next killer app, akin to email when it first began gaining momentum in the 1980s. What is cryptocurrency and why is it interesting? This post is intended as a primer to answer just that.

What are Cryptocurrencies?

In the simplest sense, cryptocurrency is just electronic money. There is no physical representation of them in the form of paper bills or metallic coins. They exist only in your electronic wallet (software on your computer or in the cloud) and are sent between users by debiting the sender's wallet paired with crediting the recipient's wallet. The "crypto" part is short for "cryptography", a branch of computer science dedicated to securing communications. Cryptography is what keeps military messages secret during war, trade secrets protected as they are passed across the Internet, and your credit card number from being stolen when you register for Amazon. Cryptography is also what drives the cryptocurrencies of today.

This is where things get interesting. Once upon a time, most money came in the form of gold or silver coins. How much a dollar was worth was tied directly to the amount of precious metal it could be exchanged for. Over time, governments have found it more convenient to simply print paper and declare it valuable, without backing their fiat currency with a physical commodity (fiat is Latin for "it shall be"). Every country today uses fiat currency and governments control their worth through laws and regulating supply. Most often this leads to accelerated inflation as governments print more money to get out of the crisis of the day. Remember when a bus ride was only $0.25?

Except cryptos are not fiat. Their value is derived from demand, but supply is not government mandated. Most crypto coins are created by miners setting their computers to work on solving cryptographic problems. A miner can be anyone in the world with a computer and an Internet connection, since generally all crypto technology and protocols are Open Source and free for the Public to download, study and run. If you choose to become a miner, you become part of a peer-to-peer global network of miners and the very infrastructure used to transmit and validate transactions for that particular currency. When a miner finds a solution, they are awarded a few coins through a process known as mining or minting. Most cryptos are designed such that the cryptographic problems in mining become exponentially harder to solve as more coins come into existence, effectively throttling supply growth. Some even have a preset supply so that no more than X coins can ever be created. This leads me to one of my points of why I think cryptos are interesting.

Why are Cryptos Interesting?

To the General Public

  • Deflationary - As long as cryptocurrencies gain in adoption, most of them are, by design, deflationary. We like to complain about inflation as the purchasing power of our hard-earned dollars dwindles with time, but it is actually much worse in other parts of the world. Some cryptos such as Aurora Coin, Spain Coin, and Aphrodite Coin promise to free the citizens of Iceland, Spain, and Greece respectively from their fiat money and current monetary plight (though I'm skeptical). A deflationary currency rewards people for saving, rather than over-spending. It also tends to be advantageous for people with less money.
  • Fast - Sending money on a crypto network is fast, whether it be your neighbor next door or your mom on the other side of the planet. Traditional ACH or wiring is usually measured in "number of business days". Crypto networks run 24/7 with no humans involved. Transmission with validation on a crypto peer-to-peer public network occurs in minutes (sometimes seconds).
  • Cheap - Western Union or traditional banks charge $20 - $50 to send money. Sending cryptos is free (save for a marginal charge usually measured in fractions of a cent to prevent spamming). Short of business or government intervention, sending cryptos will always be free since the infrastructure is Open Source running on machines owned by ordinary people.
  • Anonymous - This can be used for nefarious ends, but if you value privacy, this is a good thing. Electronic wallets have no identifying information about your personal identity. This is arguably safer too, although I'll save that for a later discussion.

To Merchants

If you own a business and accept credit card, you'll know that 2%-4% of your revenue is immediately taken by your payment provider. Wouldn't you like to pocket that yourself or pass it on to customers in the form of lower prices, while still offering the benefits of cash-less transactions? An number of well-known merchants accept Bitcoin (the most popular crypto today) according to this nasdaq.com article. Save for the $103,000 Tesla paid for in bitcoins, most of them are online merchants. Bitcoin transmission and validation is still a bit slow for say, a restaurant, but newer cryptos clear much faster. You also won't need any special hardware with support contracts, just a commodity computer and an Internet connection to accept crypto payments.

To Speculators and Traders

In 2009, a bitcoin (BTC) sold for... well, nothing. At its peak earlier this year, it traded for $1,000 USD. Talk about ROI! There are about a couple of hundred different cryptocurrencies last I checked with new ones being announced everyday. I would not be surprised if we have already surpassed the number of types of fiat currency. Many are pump-and-dump schemes admittedly, but some have real innovation that can be valuable to the world. As a trader, none of this matters though. There is tremendous opportunity for quick profits (and loss) due to high volatility and arbitrage gaps on cryptomarkets, even more so than traditional forex. Retail investors and Wall Street professionals alike have been trading for some time, and recently CNBC reported a Wall Street-backed Bitcoin fund.

To Researchers, Scientists and Mathematicians

Remember when I said mining is computers working on cryptographic problems? In the case of Bitcoin, the work done is to help validate transmissions on the public ledger. But what if a crypto was designed to take all that computing power and work on something useful to other people? Primecoin awards miners for finding Cunningham chains and bi-twin chains, reaaaaallly large special prime numbers useful in mathematics and cryptographic research. Gridcoin takes miner's CPU power to work on BOINC projects, projects that involve finding a cure for cancer or compute-heavy problems in clean energy. Sometimes the altruistic machinery is simply associative. For example, Ripple, a startup with investment from Google Ventures, gives away their currency for compute time donated to BOINC.

To Software Developers and Entrepreneurs

Inventing your own crypto aside, there's a world of software and sites to build if cryptos continue to gain traction. Wallet aggregators, improved merchant and payment tools, wallet backup and recovery solutions, wallet address contact list management, price movement and news alerts, social media integration, weapons-grade trading tools found today only for equities, cheap micro-transactions for tipping your favorite blogger (hint hint :D).... it's a whole new frontier. Nuff said.

To Other Trades

As if that wasn't enough, since cryptos introduce a cryptographically secure infrastructure independently validated by multiple nodes on a public network, there is even talk of using them as a vehicle for legal documents such as deeds and titles, replacing an entire layer of lawyers, brokers and middlemen. Just as exotic is a vision to create companies that exist entirely on the Internet with its own crypto representing shares of said companies, which can then be traded against other "traditional" cryptocurrencies.

Challenges Ahead

Some may point to the Mt. Gox debacle and other lesser known exchanges being hacked as a reason cryptos will fail. To me these are just indicators of current industry immaturity. The Bitcoin protocol had a weakness which was fixed by designers, but not applied by Mt. Gox to its operations. As the technology hardens and "real" professionals build real businesses with common best practices around the technology, these problems will become fewer and farther in between (shoot - for all I know Mt. Gox could have stolen their own customer's bitcoins). 

Some may point to Warren Buffet's comments as reason to stay away from cryptos. I respect his investing philosophies a lot and undoubtedly his track record, but for all things Internet, I would look elsewhere for advice in a heartbeat. By his own admission, he doesn't understand technology companies and stays away from them. If anything, the fact that Warren Buffet has heard of bitcoin makes it that much more interesting to me.

What I see as a major hurdle for cryptocurrencies is the cryptocurrency community itself. The fast, anonymous, unregulated nature of cryptos draws a lot of organized crime, scammers, hackers, money launderers and noobies. Businesses running exchanges, gateways, web applications or multi-pools need to be that much more vigilant and responsible for ensuring their users' safety and understand they are pioneers of something much greater than making quick buck. Joe Public needs to be that much more careful when traversing crypto sites which could be laced with malware, be leery of providing any kind of personal information and do enough due diligence before selecting an exchange or gateway. Crypto inventors should focus less on pump-and-dump schemes, and focus on innovations with real value and real problem-solving. The same is true for traders, speculators and investors. Only by building a more secure, faster, reliable, value-creation-focused platform will cryptos realize its full potential.

The next challenge is that incumbent industries threatened by cryptos will surely not simply roll over and die. Goldman Sachs's "All About Bitcoin" report estimates a $200 billion industry involved in payments and the movement of money, an amount that can be theoretically saved by consumers and merchants if they switched to cryptos. You can be sure companies like Visa, Mastercard and Paypal are keeping a close eye on things, if they haven't already mobilized aggressively to quell the threat politically, technologically or business-wise.

Another challenge for cryptos of course is government regulation and intervention. Some of their intent I'm sure will be honorable, such as regulation to protect legitimate users of cryptos and to persecute criminal uses of cryptos. Other intent will be more debatable depending if you believe in big government or not. After all, cryptos can debase a fundamental pillar of a government's strength, their ability to create and control money. The whole point of today's peer-to-peer cryptos is that there is no central bank or authority. Then of course there is the question of taxes. How will fast, anonymous movement of money be taxed as it circulates across all sorts of jurisdictional boundaries? My hope is government will be relatively laissez faire to cryptos, at least in its infancy.

The Next Killer App?

So are cryptos the next killer app? My guess is about as good as yours. What I do know is that despite challenges ahead, the technology involved and their applications hold tremendous, disruptive, earth-shattering potential. If you take the top 100 cryptocurrencies of the world today, their total market capitalization is only approximately $10 billion USD, a tiny fraction of the estimated $40 trillion (with a "t") worth of fiat currency circulating the world today, and an even smaller drop in the $225 trillion of estimated global wealth. If you believe in cryptos, it seems like we have only begun to scratch the surface of how this technology can transform our world.

* Photo credit: bitcoinmagazine.com

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Tags: bitcoin, cryptocurrency, cryptos, digital currency, virtual currency

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Comment by Joseph Lui on March 25, 2014 at 10:17am

Interesting, Dan! I've always assumed it was a taxable asset with gains realized in a year or less taxed at your income tax bracket, and gains realized after a year treated as capital gains. Didn't realize the $600 limit. The real pain is doing your own accounting since I don't think you get tax forms from any of the exchanges. And since a lot of exchanges are abroad, I wonder if you have to file FBARs. Lesson here: don't play with more than $600 worth of cryptos. lol

Comment by Mike King on March 25, 2014 at 10:11am

@Nishi: I just read about that this morning on Bloomberg. The Bloomberg article went in to a bit more detail on how the capital gains would actually be applied:

http://bloomberg.com/news/2014-03-25/bitcoin-is-property-not-curren...

It's interesting, because on a technical level, I'm not sure how the IRS can enforce this on the individual, due to the anonymous nature of the currency.

@Joseph: Even if regulations stifle growth, I don't think its a showstopper IMO. Others probably feel differently, but I personally don't want to be buying Starbucks with Bitcoin, or any other crypto. I believe the protocol holds many more possibilities than just as a digital currency, some of which you mentioned above. In the near term, I think it will be interesting to see businesses "going public" on the blockchain, and/or using cryptos as crowd-funding/kickstarters. That in itself can change the way we think about startups and public companies.

Comment by Daniel Nishimura on March 25, 2014 at 9:42am

Looks like the IRS is going to treat BTC as taxable property:

http://money.cnn.com/2014/03/25/technology/innovation/irs-bitcoin/i...

Comment by Joseph Lui on March 24, 2014 at 4:23pm

Yeah, Mike, decentralization is inherent to most crypto architecture. Simply preventing merchants from accepting it though can be a real drag or even showstopper on adoption. 

Fascinating article you posted... Windows XP will be end-of-life-d in less than a month, meaning any system running that will become non-PCI-compliant with the next reported vulnerability. This theoretically compels merchants to accept cryptos as payment. A bit of a stretch here maybe, but I can see it being more relevant in other countries in Europe and S. America where BTC is more widely accepted by brick-and-mortars.

Comment by Mike King on March 24, 2014 at 3:21pm

Authorities will only be able to regulate legal businesses in my opinion. I don't think any government has the means to regulate individual usage of BTC anymore than they have the ability to regulate usage of Bittorrent and all of the copyright infringements that come along with it.

On a side note, Microsoft may be inadvertently ushering in the era of Bitcoin and digital currencies after April 8th:

http://bitcoinmagazine.com/11337/hold-bitcoins-april-8-2014-might-d...

Comment by Joseph Lui on March 23, 2014 at 5:09pm

Thanks Dan! 

Regarding regulation, the stereotypically authoritarian Russian government has banned BTC outright. The less authoritarian Chinese government has effectively strangled conversion between BTC and yuan, but still allows for its existence online (in alt coin exchanges for example). The United States seems to be giving it a cautious head nod. Hopefully, governments in general will treat cryptos as freely as they did with the Internet as a whole... if for no other incentive than to make it easier to spy on everyone. hahahaha

Comment by Daniel Leuck on March 23, 2014 at 1:32pm

Great writeup! I agree that the single largest challenge is the seemingly inevitable association with criminality, and the likelihood that shortsighted politicians will react with stifling regulation.

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