Quixotic Ventures

I sat down three times to write this post and aborted mission every time. I hoped more research, conversation and consideration would get me off the fence. I just can’t get there.  I’d sure like more dialog though so please read my post and share your insights.

I’m very drawn to the virtual currency space.  I can envision a sprawling, open ecosystem.  The Bitcoin ecosystem is exploding.  VC money is pouring in.  The media is going crazy.  I see sparks of genius (peer-to-peer, distributed, decentralized, open-source, low/no fees) in the design.  Bitcoin has solved some really interesting problems (that distributed general ledger is brilliant).  I can feel it’s potential in my gut.  But I think there are some intrinsic flaws in Bitcoin’s design as a virtual currency and it’s keeping me from jumping into the ecoysystem with both feet.

I spent two wondrous years (2008-2010) as the steward of a significant global “virtual economy” when I was the CEO of Second Life.  At the time, Second Lifers were doing over US $500 million (yes, five hundred million US dollars) in user-to-user transactions via the Linden Dollar (Second Life’s micropayment mechanism).  That’s a big number – especially considering the average transaction is a buck or two.  I can’t claim any credit for creating the staggeringly robust virtual economy called Second Life – that goes to Philip Rosedale and other brilliant Lindens before me.  But I was an eager student and I learned a lot about micropayments and virtual currencies from the creators and participants in the economy.

Despite some key differences, I think the Linden Dollar offers a valid comparison to Bitcoin.  Bitcoin was designed to be a peer-to-peer virtual currency whereas the Linden Dollar was designed by Linden Lab (a central authority) as a micropayment system for transactions *within* Second Life.  Yet because the Linden Dollar is a medium of exchange and because you can trade Linden Dollars on an exchange with a floating rate, I think it offers some important lessons for Bitcoin.

The Linden Dollar works brilliantly because:

• It is ubiquitous:  If you want to buy and sell virtual goods in Second Life you have to use Linden Dollars so everyone transacting does.
• The price is stable: The price rarely fluctuates more than a few percent. People can buy Linden Dollars to use as a medium of exchange without worrying too much about the risk of massive price fluctuations.  Linden Lab operates partly like a central banker and is able introduce liquidity into the system when needed. Diligent Linden Dollar traders can turn a nice profit — which motivates them to participate and smoothes out price fluctuations.
• It is trusted:  Linden Lab employs crack fraud detectors so the community is “protected.”  To transact, you need a Second Life account and there is a money trail.  Bad actors are banned.  I believe this is essential.
• Regulators accept/tolerate it: SL and the Linden Dollar got plenty of scrutiny and are still operating.  Nuff said.
• Friction is low:  To be an effective medium of exchange, a virtual currency must be super easy to trade between partners and transaction fees must be minimal. There were no transaction fees imposed on merchants or customers in Second Life when they use the Linden Dollar for transactions.  The experience must be easy to navigate. Second Life isn’t always easy to navigate.

Let’s look at Bitcoin through the same lens:

• Ubiquity: It’s not possible to know precisely how may bitcoin holders there are but you can look at the currency exchange transaction volume and see that it’s a thin market.  According to bitcoincity.us there are six – yes six – businesses in NYC that accept Bitcoins. Another source says there are 13.  Conveniently, a handful are within a quarter mile of my home in Brooklyn.  Yet, the user base is growing quickly as evidenced by the growth of startups like Coinbase.  Clearly we are incredibly early on the adoption curve.  Can Bitcoin become ubiquitous?  Can it ride the hype cycle up then cross the chasm to wide-spread adoption?  The answer depends on the following…

• Price Stability:  Obviously it’s early, but Bitcoin’s price is highly unstable and varies dramatically across currencies and countries at any given moment.  This attracts traders and speculators but is not good for merchants and customers.  In contrast, the trading range for the Linden Dollar has been very, very narrow.  Stability gives people confidence and is an absolutely fundamental requirement.  I don’t agree with the argument that the hyped price of Bitcoin will drive widespread adoption although the media attention is sure helping.  I think the hyped price is expanding the chasm Bitcoin must cross to get to widespread adoption.  Remember Gartner’s hype cycle and trough of disillusionment?  I’ve walked inside that trough. It’s ugly and the exit wall is steep and slippery.  My libertarian friends will unfriend me for this, but I do believe Bitcoin needs a mechanism for addressing significant price fluctuations…even if it’s done algorithmically.  Supply should be variable and it’s not.  Yes, the bitcoins can be infinitely subdivided but the absolute supply is fixed.  It can’t exceed 21 million bitcoins.  Up to that point, the rate of supply increase is determined by miners’ processing abilities (i.e., computing power).  As a tactic, pegging supply to computing power is sheer genius.  But as a strategy I think it is flawed.  Bitcoin is built like a dam without a floodgate.

• Trust:  Because Bitcoin is decentralized and users are anonymous, fraud is a major concern.  How do you know if your trading partners are reputable?  How are fraudsters caught, punished and deterred?  This could be a major opportunity for third-parties to develop value-added services but it’s a problem today.  And it is a cost that must be added later. Trust is a major factor in adoption.

• Regulator tolerance:  Regulators are looking carefully at Bitcoin, as you’d expect. There are some positive noises from some corners but there is one feature of Bitcoin that will give most regulators heartburn and that’s anonymity.  I understand the desire for anonymity.  But I have to ask myself what kind of person or entity actually needs total anonymity.  I don’t.  Sketchy types (from tax avoiders to drug dealers) do.  Central authorities can make it incredibly hard to move value out of Bitcoin into the “official” monetary system.  That’s a problem.  A big problem.  I’ve heard the argument that Uber is “breaking the rules” and continuing to operate in key markets but that’s a weak argument.  Pissing off local taxi and limo companies (and the politicians that support them) is very different from building a virtual currency that can be used for nefarious purposes.  Regulator tolerance/acceptance/approval likely will require dialog but whom would regulators talk to?  Where’s the Jimmy Wales or Philip Rosedale of Bitcoin?

• Minimal friction: Bitcoin is complicated and feels like an “insiders” game.  In some ways, it reminds me of Second Life.  You need a big brain to enjoy Second Life.  The interface is for creators and power users.  It’s not a casual experience.  As a result, services built on Second Life – like the currency exchanges — tended to be complicated because the underlying platform was and still is complicated.  Compare that to Twitter, Facebook and Apple’s IOS — which are pretty intuitive.  The services/tools/experiences built on those platforms are likewise pretty intuitive.  One could argue that a service/tool/experience that makes Bitcoin easy and intuitive could win the day.  I can’t think of many examples of services/tools/experiences that simplified complex underlying platforms.  Simple begets simple.  Complex does not beget simple.  Can you think of any?

So where does this all get me?  Well, there are plenty of investment opportunities and I see fellow investors jumping in.  I think I’ll stay on the sidelines for now.  When you invest in a startup you don’t assume the founders have it right but you assume they’ll get it right.  My biggest problem with Bitcoin is that it has some systemic flaws and I’m not sure – given the way it’s constructed – that they can be addressed, or who will address them…so I’m reluctant to invest in the ecosytem.