Bitcoin’s bumpy ride in the virtual currency race

Feb 13, 2014

FORTUNE -- In recent weeks, the arrest of Bitcoin Foundation’s Charlie Shrem and the near collapse of Mt. Gox, the world’s largest Bitcoin exchange, have added plenty more debate over the virtual currency’s survival and future. Of all the talk, however, what’s often overlooked is that the payment and verification technologies that bitcoin has spawned can be separated from the crypto-currency itself.

Investing in startups developing products and services that support bitcoin is different (and potentially less risky) than actually buying the digital currency. Why? Because these startup firms are preparing for a revolution in transfer technology, which may be through bitcoin, but may also be through a competing virtual currency or, potentially, through no currency at all.

When you buy bitcoins, the value of your investment is tied to the bitcoin currency. If a competing virtual currency -- say, a “superbitcoin” -- wins the virtual currency race and becomes dominant, the bitcoin currency loses its value. However, companies building technologies that support and complement virtual currencies can still be valuable in a “superbitcoin” world, since they are often impartial to any one virtual currency.

The obvious question is then will bitcoin -- the first iteration in virtual currencies -- become the dominant one?

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One of its perks is that it enjoys widespread use and significant traction. In other words, a network of users supports bitcoin. That’s significant, but if we look back at some of the biggest networks today -- social networks being the most obvious comparison -- the current winners are not the first iteration. Think of the evolution from Friendster to Myspace to Facebook.

Bitcoin is an important leap in the development of a harmonious cryptography-based technology, but it is by no means the final one. Dozens of virtual currencies exist today: Ripple, litecoin, peercoin, etc. How they may or may not overcome serious issues surrounding their usage will say a lot about who will dominate the market for digital currencies.

A host of issues face today’s technology and exchanges; they require more development, security, and stability. More efficient tracking is needed to combat illegal money laundering, tax evasion, or other criminalities, and security is needed against hacking or simple accidental loss of bitcoins.

Another obstacle: governments. Imagine bitcoins appreciating significantly and becoming a stable, regulation-free store of value. Governments stand to lose some of their monetary policy power, and many traditional currencies stand to become inferior (in stability and reliability) to bitcoin. Governments will not easily part with such powers or easily allow their local currencies to depreciate. They also will not like the limited ability to track the spending and monetary transfer behavior of their constituents. All of these are power, and power is not easily surrendered.

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In a similar vein, financial institutions stand to lose some very profitable intermediation business, including for example, fees for money-transfer services, and some credit card transaction fees, potentially worth orders of magnitude more than the current total of the bitcoin float. Giving up profitable businesses is not something financial institutions like to do.

All of these large institutions can play a role in the success of bitcoin by intervening in law or in the markets. While there are merits to the open, free (and perhaps anarchic) development of the currency, there are strong forces to oppose this. The successful virtual currency will have to make some peace (or win a very difficult war) with such institutions.

Big investors also pose a threat to bitcoin. They may decide today to buy bitcoins in mass, at its current (significant) value of $645, or to rally around a competitor (at an earlier stage) that stands to appreciate more. (There is more to gain from a currency starting at zero than from bitcoin at its current value.) Coordination and collective action, especially by big players, are a potential major threat to the existing network advantage bitcoin has.

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Also, bitcoin is perceived to be a complex technological and financial mechanism; there is widespread ignorance about the virtual currency; its merits and the participation base are small. There is also limited downward pressure on the bitcoin currency as bets on the downside (for example by “shorting”) are not fully available.

Many have recently been lured more by the windfall gains that bitcoin has provided its early adopters than by intelligent speculation about its future. This leads to much uncertainty about the wisdom in bitcoin prices and much volatility in the adoption and value creation.

The bottom line is that any successful technological revolution will experience glitches early on, and uninformed investors will inevitably overreact to them. The ultimate value of bitcoin will depend on the resolution of the fundamental issues in the virtual currency and payment technology race. The winner of this race may be a tweaked version of this first fantastically interesting iteration, but the prize is still very much up for grabs.

Moshe Cohen is an assistant professor of finance and economics at Columbia Business School.

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