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Bitcoin 101: Why It's Attracting Wall Street Investment

Despite its infancy, Bitcoins are being called one of the greatest developments of the new financial services landscape. Here's why.

Ten months ago, I set up my digital wallet and bought my first bitcoin. Weeks later, after five years on Wall Street, I decided to leave behind the bulge-bracket banks and their endless rows of gray and navy suits and join the ranks of forward-thinking disruptors who just might transform the financial services industry forever.

Considering my conservative finance background, you’re probably wondering why I made the jump. More importantly, you would be smart to ask whether the esteemed institutions I left behind would even consider looking at something as nascent as Bitcoin. It’s true that Bitcoin and digital currencies are still in their infancy, but what they lack in age, they more than make up for in potential. Bitcoin might radically alter our concepts of money, store of value, and the means by which assets are exchanged the world over, and therein lies the opportunity -- and the risks.

Today I spearhead investor outreach for the broker-dealer providing sales and marketing for the Bitcoin Investment Trust (BIT), a private, open-ended trust that is invested exclusively in Bitcoin and derives its value solely from the price of Bitcoin. I spend my time educating hedge funds, asset managers, family offices, and other investors about the digital currency space. As such, I thought that it would be helpful to provide this audience with a “Bitcoin 101.” Upon learning about Bitcoin, I think you’ll come to understand why it has attracted so much attention and investment from the venture capital community and, increasingly, from Wall Street.

So, what is Bitcoin?

First, you need to understand that “Bitcoin” actually refers to two different things. There is Bitcoin, big “B,” which refers to the underlying technology and global payment system, and bitcoin, little “b,” which refers to the digital currency that makes the network and technology work. I’d argue that the two cannot be separated.

Bitcoin, the open-source protocol, was released in 2009 by an anonymous programmer who called himself Satoshi Nakamoto. At its core, Bitcoin centers on the concept of “the blockchain,” a public ledger, which records every transaction on the Bitcoin network. The blockchain employs innovations from cryptography, peer-to-peer technology, and economics to allow two parties who don’t know each other to instantly and securely transfer assets -- without a trusted third-party intermediary.

Payments are a good early use case. Jill can send Jack money without a bank clearing the transaction and without Jack ever worrying that Jill has duped him and “double spent” the same funds with another party. Jill sends funds to Jack by broadcasting a transaction to the Bitcoin network that she wants to transfer funds from her public key (a randomized alpha-numeric address stored on the blockchain) to Jack’s public key, and she proves that she is entitled to transfer those funds by providing her corresponding private key. Don’t get hung up on the terminology: The public and private keys are just the Bitcoin equivalent of your bank account number and password. The key difference between Bitcoin and banking is that while transactions are public and pseudonymous, the addresses and numbers of bitcoins involved in a given transaction are known to everyone and are recorded on the blockchain.

Bitcoins come into existence through a process called “mining,” where individuals/institutions who have invested in powerful computers to run the Bitcoin software compete to correctly process transactions on the network. This involves confirming the ownership and movement of Bitcoin between owners. The reward for spending time, energy, and computing processing power? Freshly minted or “mined” bitcoins.

Mining solves two problems: first, how to fairly distribute the new currency; second, how to incentivize early pioneers to process transactions. The Bitcoin protocol awards miners with new bitcoins according to an algorithm that adjusts predictively over time. There are approximately 13.4 million bitcoins in circulation, which at today’s price of US$350 per bitcoin, carries a market capitalization around 4.5 billion dollars. The Bitcoin protocol stipulates that there will only ever be 21 million created, and we can estimate that the 21 millionth bitcoin won’t be mined until the year 2140.

In contrast to fiat currencies, Bitcoin has no central authority, such as a government or central bank, nor do tangible bitcoins exist. Some of you may grapple with the concept of a currency that you can’t physically touch or smell, but in an increasingly digital world, efficiency and cost reduction quickly outweigh the antiquated benefits of cash. And its predictable scarcity and finite supply attract many investors who liken it to digital gold.

(If you’re still not sure you understand Bitcoin, I’d suggest you pause here and visit our friends at the Digital Currency Council, who have put together additional explanatory materials to educate financial professionals, attorneys, accountants, and other professionals on digital currencies.)

This might sound great in theory, but why should you care? I’d argue that financial services are ripe for disruption and that Bitcoin is well-positioned for disruptor status. It is only natural for businesses to embrace solutions that reduce costs, cut out middle men, and increase efficiency. Bitcoin has the power to do just that across many industries. Atop Bitcoin’s disruption list are remittances, estimated to be a $500 billion market annually. Why, with the technologies available to us today, do foreign currency wires take multiple days to complete, not to mention involve intermediaries and fees? Bitcoin allows the movement of any amount of value anywhere in the world instantly and virtually free.

Let’s be clear, I’m not saying that Bitcoin will be adopted as the global currency tomorrow or that any of these disruptions will occur overnight. In fact, it will likely take many years. Fortunately, it is still early days and opportunities still abound. Again, investing in Bitcoin or digital currency doesn’t come without its risks, so buyer beware. Investing in bitcoin/Bitcoin securities lends itself to storage/security issues and price volatility, not to mention regulatory and tax treatment uncertainty.

If that doesn’t deter you and you’re interested in purchasing a small amount of Bitcoin, I invite you to visit our friends at Coinbase or Circle. There you’ll link up a credit card or bank account and purchase some bitcoin. For those of you that qualify as an accredited investor, you have the option of investing through the Bitcoin Investment Trust; here you’ll be purchasing a titled security whose value is derived from the bitcoin’s price. Unfortunately, for those of you looking to invest in the Bitcoin ecosystem, you’re going to have a hard time deploying capital into Bitcoin companies. At present, the companies building Bitcoin infrastructure, wallets, exchanges, etc., aren’t publicly traded, and the capital they’ve raised and will continue to raise will likely be reserved for the venture capitalist set.

If it isn’t already clear to you, I’m passionate about Bitcoin and am making a personal, professional, and financial bet on my jump from Wall Street to Silicon Alley. Hopefully, you realize that a financial renaissance is already well underway; programmers, engineers, mathematicians, and entrepreneurs are employing digital currency to fundamentally shift how we think about and use money. I don’t know about the rest of you, but I’m glad I’ve secured a front-row seat to watch and partake in the development of the new financial services landscape.

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