And Failure to Understand That Could Cost Investors Billions

It never ceases to amaze me how hard it can be for the media to separate hype from real-world potential in technology.

On one hand, you have amazing breakthrough technologies like the CRISPR immune system, which go virtually unnoticed by the mainstream press, even as they create miracles every day.

On the other, there's the sycophantism of reprinting the hyperbole common among investors with a specific bias to push in their own favor, which goes unchallenged and unchecked. Hedge fund managers, venture capitalists, and other commentators with a monetary interest in their ideas—paid not by readers but by their ability to sell an idea for more than they bought it—speak out with few questions posed as to why they say what they say.

Like with Bitcoin.

Last week famed technology pundit and venture capitalist Marc Andreessen penned an op-ed in the New York Times in which he espoused the world-changing potential of Bitcoin—from freeing us from enslavement by banks to enabling social change globally to saving cute puppies from slaughter (OK, I made that one up). But he tells the story of a technology virtually unbounded in its potential for social and economic change.

That article, while articulate (as Andreessen always is), came just ahead of a meeting held by NY securities regulators to discuss how to deal with Bitcoin. This meeting was scheduled on the heels of news that the FBI had arrested a few noted Bitcoin entrepreneurs in connection with a conspiracy to sell bitcoins to the now-shuttered Silk Road illegal drugs/guns marketplace, thereby enabling that criminal enterprise.

The timing of these items is, of course, not coincidental.

Andreessen painted a very rosy picture for the potential of Bitcoin: one in which transactions on the Internet are not gated by banks and credit card processors—where the customary 2-3% fees these institutions charge disappear—and currencies can be freely exchanged absent from regulations. For him, as an active investor in Bitcoin-related startups (he's ponied up some $50 million), he touts this perceived benefit as the main competitive differentiator. So he's hardly an objective observer; it's in his personal interest to paint exactly such a landscape.

However, the reality is that most of the scenarios he posits in the letter will not work with Bitcoin or with any alternative currency, as they fly in the face of the very political and financial might that make a nation-state possible to begin with. Bitcoin threatens the hegemony of modern power. Its tolerance at any scale, let alone wholesale acceptance, would require the involvement and acquiescence of the very banks and governments most threatened by its existence. What are the chances?

The precedent, in fact, was clearly set when China cracked down on Bitcoin last December. Its central bank didn't outlaw or prohibit individuals from owning bitcoins, but new guidelines specify that it isn't to be considered a currency. The rules prohibit financial institutions in China from trading, underwriting, or offering insurance in bitcoins or any other digital currency. And China's top Internet retailer, Alibaba, prohibited the use of bitcoins on its shopping platforms as of January 19.

Moreover, on a strictly commercial basis, the technology will reintroduce huge problems to the payment infrastructure Andreessen means for it to compete with. These have already been solved. In essence, he advocates moving us back in time to the digital equivalent of the Pinkertons and train robberies.

To be clear, Bitcoin is an excellent technology, with many very good use cases. But for the average end user—be it an individual wanting to pay for goods or a merchant wanting to accept payments—the new reality of those risks will be more than they can swallow.

Breaking Down the Bitcoin Hype

Let me demonstrate with a bit of a point-by-point rebuttal of what Mr. Andreessen proposes is possible in his letter:

"The practical consequence of solving this problem is that Bitcoin gives us, for the first time, a way for one Internet user to transfer a unique piece of digital property to another Internet user, such that the transfer is guaranteed to be safe and secure, everyone knows that the transfer has taken place, and nobody can challenge the legitimacy of the transfer. The consequences of this breakthrough are hard to overstate.

What kinds of digital property might be transferred in this way? Think about digital signatures, digital contracts, digital keys (to physical locks, or to online lockers), digital ownership of physical assets such as cars and houses, digital stocks and bonds … and digital money."

Let me start with a firm agreement with Mr. Andreessen. This is precisely the importance of Bitcoin, its open-source demonstration of an algorithm for establishing trust in an untrusted network—an algorithm which has stood up to extreme scrutiny from mathematicians, computer scientists, and hackers of all stripes over the years since its release.

It's one of the reasons I'm an active proponent of the technology and its further development. However, the fallacy lies in how it's currently applied—as a tool to transfer cash—and its failings in the above.

"That last part is enormously important. Bitcoin is the first Internet-wide payment system where transactions either happen with no fees or very low fees (down to fractions of pennies). Existing payment systems charge fees of about 2 to 3 percent—and that's in the developed world. In lots of other places, there either are no modern payment systems or the rates are significantly higher. We'll come back to that."

It is technically true that there is little to no cost to transfer bitcoins between parties. However, it is not true that it's the first way to do so with no or low fees.

To begin with, there is the Automated Clearing House (ACH) electronic funds transfer system between banks. Any developer can create its own ACH-based payment system—vacation rental startup HomeAway, for instance, made waves in sharing how it did exactly that—and utilize the system for free. A handful of startup platform providers have emerged too, charging only nominal fixed fees (usually between $0.10 and $0.25 per transaction) to make the process very simple for developers.

Then there's the debit card infrastructure in the US, and many similar systems globally. Accepting debit cards requires a payment processor in the middle, but typically fees for accepting debit cards run in the pennies; rarely are they ever based on transaction size.

Nor does it cost anything to authorize a credit card transaction in most cases. The moving of those bits across the Internet is free.

The charges these facilitators provide is ultimately for the transfer of funds between parties. This is a subtle but hugely important difference. Moving money is far more complicated than moving bits. It requires the credit card processor to verify availability, process transfers, and most important provide service when things go wrong.

With Bitcoin, if you send your digital money to a disreputable vendor, there is no recourse to get a refund. There is no "chargeback" system. The funds, once gone, are permanently gone. It requires active participation from the receiver to reverse a transaction—and that's not always an option. This service is in high demand by consumers and is one of the reasons that they push vendors to accept credit cards: that customer-of-my-customer demand is what allows credit card companies to demand fees.

Also, with Bitcoin the sender and receiver each take on exchange-rate risk in the process, in exchange for the ability to effectuate the transaction without a middleman. It's a costly trade-off, though, as the floating exchange rate between Bitcoin and various currencies adds risk for both parties of mispricing goods unless they transfer in and out in real time.

Andreessen subtly admits this fault, referring to scenarios where that real-time exchange happens behind the scenes (emphasis mine):

"You fill your cart and go to the checkout station like you do now. But instead of handing over your credit card to pay, you pull out your smartphone and take a snapshot of a QR code displayed by the cash register. The QR code contains all the information required for you to send Bitcoin to Target, including the amount. You click 'Confirm' on your phone and the transaction is done (including converting dollars from your account into Bitcoin, if you did not own any Bitcoin)."

However, that step almost always requires fees. Mt. Gox, for instance, the largest bitcoin exchange, charges as much as 1.2% to facilitate that transaction on both ends—far more than most ACH or debit vendors. Also, according to many user complaints, it takes Mt. Gox weeks or months to deliver the dollars they take in trade to the final vendor—a stark contrast to the next-day availability most credit card processors offer.

The delay is fixable, of course—but only with cooperation from the government that oversees each currency. That's not cooperation they're likely to provide without imposing serious costs on those vendors to comply with the many laws that govern international transfer of money.

Why do they impose these burdens? Well, for example, with something like Bitcoin in the mix, what's to stop a drug dealer in the US from trading his piles of cash for a USB stick full of bitcoins? He could then walk those bitcoins across the border, carrying anything from $10,000 to $100,000,000 out of the country with zero chance of being caught, and exchange it back for euros, yen, or yuan on the other side of the border. Money successfully laundered. He likely wouldn't even have to leave his home. Those bitcoins could simply be sold on Mt. Gox and the results deposited overseas for a rainy day. Yes, the bitcoins will carry a trace of the transaction, but because bitcoin is peer to peer, the deal doesn't have to pass through any system with a regulatory responsibility to look out for that.

(Which also raises the question about seized property, too. If that criminal is caught and, as Andreessen shares, "every transaction in the Bitcoin network is tracked and logged forever in the Bitcoin blockchain, or permanent record, available for all to see," then what's to stop the government from attempting to seize all those ill-gotten coins, even multiple stages down the line? Cash and gold have no ledger, and that provides each holder some assurance that it cannot be appropriated by others. Add a paper trail and that dynamic changes.

It introduces the "nemo dat" rule, a legal precedent that going back thousands of years through multiple legal systems, which holds that someone cannot ever own stolen property, even if he had no idea it was stolen when it was purchased. Through this rule, art, antiques, and much more has been returned to its original owners, sometimes after generations have passed. Imagine the effect of that on your bank account.)

A criminal or a tax dodger could walk gold and paper currency across the border as well, with one difference. The more of these physical things you try to carry across a border, the harder it is to go unnoticed. These things take up space, and that small difference makes the job of criminal investigators worlds easier.

You can be 100% certain that, no matter how persuasive Andreessen is, regulators will eventually put the same requirements on Bitcoin's exchange agents that it does on those who oversee gold purchases and cash deposits—to report large transfers and purchases for scrutiny. Failure to do so would effectively roll out the red carpet to criminal activity.

Even if law enforcement manages to get its hands around the traceability of bitcoins—a feature that Andreessen relies on heavily in his argument but which is trivially defeated using a simple piece of code called a "tumbler"—there's still a much bigger concern to be dealt with:

Every country insists on maintaining control of its money supply and exchange rate, a process that happens through currency controls.

Most Americans know less about this process than the rest of the world, as in our lifetimes the US dollar has been the world's reserve currency and the yardstick against which all others are measured. It has lost value over time through slow, steady, engineered inflation, but never have we experienced quite the shock most other currencies have, with double-digit devaluations virtually overnight—wherein you wake up one morning to find that the last bank crisis didn't just sink the stock market, it made the price of food double overnight.

Never has our country had to impose strict exchange measures, though anyone who's traveled internationally knows you must declare leaving or returning with more than $10,000 so it can be monitored, and that gold purchases above $10,000 must be reported to the government if purchased with cash or cash equivalents. Similar such rules in other countries limit such activity, instead of just monitor it, to prevent massive selling of local currency or moving large amounts of cash out of the country to avoid taxes.

When people lose faith in a currency—as has happened in dozens of countries in the past few decades, including well-known examples like Argentina in 2002—its value on the market can drop dramatically. That inflation or devaluation causes import prices to rise dramatically, and can be devastating to a local populace. The controls on currency movement and exchange is part of how countries encourage a stable economy, but also how they can borrow cheaply, by assuring investors they are taking the steps to maintain a healthy currency.

Bitcoin today circumvents these controls by providing a non-currency intermediary—like a physical good, i.e., a gold coin or barrel of oil—that can be traded electronically and outside any regulated exchange. With an unregulated, mass-market bitcoin, all the world's currencies immediately become truly floating rate, and anyone can easily circumvent currency controls with a few clicks. Some would argue that this is a step forward for global economics—but it would take away many of the very tools central banks use to manage the world's economies during the most extreme circumstances.

Neither currency controls nor financial monitoring for tax and criminal statute compliance are powers any government would readily surrender.

Speaking of criminal activity, the modern-day payment systems Andreessen decries serve a critical role in that detection and prevention as well. He bemoans that role, saying that transaction processors err too far to the side of security.

"In addition, merchants are highly attracted to Bitcoin because it eliminates the risk of credit card fraud. This is the form of fraud that motivates so many criminals to put so much work into stealing personal customer information and credit card numbers.

Since Bitcoin is a digital bearer instrument, the receiver of a payment does not get any information from the sender that can be used to steal money from the sender in the future, either by that merchant or by a criminal who steals that information from the merchant.

Credit card fraud is such a big deal for merchants, credit card processors and banks that online fraud detection systems are hair-trigger wired to stop transactions that look even slightly suspicious, whether or not they are actually fraudulent."

Anyone who's seen a few '70s or '80s action movies should be well aware of the comparison to bearer instruments, or as they are more commonly known, "bearer bonds." For instance, in Die Hard, the criminals break into the building to steal $640 million in these bearer bonds, cash-like securities that are payable to whoever has them at the time they're transferred—which is one of the reasons you rarely see them in use any longer. No record is kept of who owns what, and so when those instruments transfer hands, that's it. Possession is ownership.

The same is true of bitcoins. Anyone who has access to the computer system who stores those coins has access to steal them. For a scenario like Target, whose unfortunate hack resulted in personal information and credit card numbers being released, having used bitcoins would have been far less inconvenient for its customers, yes, but potentially devastating for the company.

With credit card processing, the damage to be done could potentially carry on for years. But, it can also be reversed. Companies can work together to change credit card numbers, alert victims, and mitigate the repercussions. When something does slip through the cracks, the credit providers take on an instrumental role in insuring customers against that fraud.

Had hackers gained access to the stash of bitcoins that Target had amassed in its payment system instead of credit card info, they'd have walked away with an unbelievable sum. And those coins could then be freely spent or transferred globally without recourse. Target's next earnings call would be rough if it had to announce that instead of losing credit card data that can be changed, the company was robbed of the $700 million in cash it had on hand.

The only way to protect against something like this would be for government to gain access to and monitor all Bitcoin block chains, so that authorities would know which transactions passed through Target. Those could then be designated as stolen property, allowing them to be forcibly clawed back and returned to the retailer, or simply seized. But if government inserted itself or the banks as central intermediaries—as would be necessary to carry out such surveillance—much or all of the advantages of Bitcoin would be lost.

Think about the implications for individuals, too. Anyone who's ever had a virus on his or her computer knows just how easily this can happen. Millions more computers around the world have Trojans and other malware, and their owners and/or users have no idea that's the case. Imagine the feeding frenzy if computers like these were used to store bitcoins.

Which is why, of course, most people would choose to store their digital coins with a storage vendor. Already, numerous online wallets for Bitcoin have been hacked, with millions in coins stolen. And that's in a time when bitcoins are hardly used. Do you think that when banks step in we'll be safer? Just pay attention to the headlines and you'll see that the world's largest payment processors, banks, governments, hospitals, retailers, and more have all been hacked.

The current payment system works because once one party discovers a breach, the world can work together to contain the damage. Start relying heavily on bitcoin as a form of cash, and that disappears. The world becomes much more akin to the Wild West, with the digital equivalent of safe crackers and train robbers, secure in the knowledge that once stolen, their spoils can be spent anywhere.

That is, of course, unless the government and banks get involved in order to funnel transactions through trusted intermediaries, who are held to account by the threat of civil and criminal prosecution.

Andreessen then moves on to paint a picture where Bitcoin saves newspapers:

"All of a sudden, with Bitcoin, there is an economically viable way to charge arbitrarily small amounts of money per article, or per section, or per hour, or per video play, or per archive access, or per news alert."

And stops spam:

"Future email systems and social networks could refuse to accept incoming messages unless they were accompanied with tiny amounts of Bitcoin—tiny enough to not matter to the sender, but large enough to deter spammers, who today can send uncounted billions of spam messages for free with impunity."

Who doesn't want those things? Part of the reason that dozens and dozens and dozens of micropayment startups have failed was not for lack of technology, but because neither consumers nor businesses like being literally nickeled and dimed.

For businesses, the subscription model works much better because they can borrow against predictable revenues. As for spam, if the amount required to send a legitimate email is inconsequential, then so is the cost to send spam. These companies continue to email—in spite of having to pay designers, developers, electricity, hosting, bandwidth, and many other not-so-nominal charges—because spam works. We continue to buy the products they hawk, and so they can't afford not to email. It's not free… not even close. But if the amount is nominal enough to not affect a legitimate mailer, it's nominal enough not to matter to a spammer.

In fact, that already exists with companies like ReturnPath, which offer advertisers guaranteed trips to the inbox for a fee and follow a few simple rules—a cost no spammer can pay, but thousands of big companies are happy to bear.

The non-solutions jump into high gear when Andreessen moves from social commerce to social revolution, painting a happy picture of societal change fomented by mass media. Not only will Bitcoins help reduce transaction fees, it will stoke social development around the world by supporting cultural movements:

"Today protesters want to get on TV so people learn about their cause. Tomorrow they'll want to get on TV because that's how they'll raise money, by literally holding up signs that let people anywhere in the world who sympathize with them send them money on the spot."

Andreessen holds that this is a real revolution waiting to happen, and uses as an example someone who held up a sign at a football game asking people to send bitcoins and made $25,000 on the novelty. This same parlor trick has been in use for years. The back pages of Popular Science have carried little "mail me a dollar" ads for decades. Someone once sold every pixel on a web page for $1 each and made much more than the football guy. But just because it's possible when it's novel and silly doesn't mean it will take off as a new form of commerce.

Plus, the protestor example is completely possible today. Has been for many years. As it is, protestors could easily hold up a sign with their PayPal email address (much easier than a QR code to deal with) and accept donations from around the world, transferred fee-free from bank accounts globally.

The problem is that no matter how much money a protestor in Jordan or Egypt gets, that money is only as good as the ability to withdraw or spend it.

A bucket full of bitcoins is as worthless to a group of protestors as a PayPal account is. Sure, for the WWF or PETA, it works fine. But when it comes to real social change—those without the infrastructure to solicit and collect—then banks will be used in that conflict… without the ability to turn those bits into shipments of posters or guns. If your local government has labeled you a terrorist, good luck getting that money out of the bank in local currency—unless you want to turn to the black market. That's the one area where Bitcoin is better than PayPal for this purpose, when you want to fund someone that a government would prefer you didn't.

What happens when that group of protestors ends up being branded a terrorist organization by the government of your home country? Many of the groups leading the riots in Egypt have since been revealed as linked to prominent terror groups. In the US at least, funding such an organization is a crime, like it or not.

For this scenario, Bitcoin does little but create a dark-alley alternative to many other options that already exist.

That's OK though, because in addition to its support of social upheaval, Bitcoin will bring untold millions into a banking system currently out of their reach:

"Every day, hundreds of millions of low-income people go to work in hard jobs in foreign countries to make money to send back to their families in their home countries—over $400 billion in total annually, according to the World Bank. Every day, banks and payment companies extract mind-boggling fees, up to 10 percent and sometimes even higher, to send this money.

Switching to Bitcoin, which charges no or very low fees, for these remittance payments will therefore raise the quality of life of migrant workers and their families significantly."

And, of course, lest a few of the more domestically focused politicians want in on the fuzzy love, he points out that Americans can join in the fun:

"And even here in the United States, a long-recognized problem is the extremely high fees that the 'unbanked'—people without conventional bank accounts—pay for even basic financial services. Bitcoin can be used to go straight at that problem, by making it easy to offer extremely low-fee services to people outside of the traditional financial system."

For the "unbanked" globally, the reason their services cost so much has nothing to do with lack of sufficient technology. It's about the cost of customer service. These folks would require computers, smartphones, or other complicated devices to store their bitcoins, or still be reliant on the same intermediaries that charge these hefty fees today. Maybe cellphone companies or app providers would step in to offer competition, but they'd still be in a messy and expensive business.

Take Western Union, for instance, one of the major providers of transfer services for these migrant workers. Western Union has no problem at all dealing with security between various Western Union franchises. They accept cash on one end, transmit bits to another, and that end dispenses cash. They charge 10% to do so, because that's necessary to cover the risks they take and still profit—risks like running storefronts with rent, workers, and drawers full of cash to be potentially stolen. The high cost of their services is not changed in any way by putting Bitcoin between their branches.

Andreessen of course means to remove those intermediaries. That's fine for those who already have such devices on both ends—like the many Indian and Chinese colleagues I had at Microsoft who sent their money home via electronic funds transfer for free with ease. But doing so would be immensely complex for most of the unbanked—those without the means for basic security and privacy.

If you store your life savings on a cellphone, for instance, how do you divide it and keep portions safe from thieves? Or do you need to carry it with you all the time, risking your savings every time you leave the house? The argument is not to break it up and store it like cash, but to use a cloud provider. However, that cloud provider will inevitably charge fees. And so will the provider who allows that cash to be turned into bits to begin with… and the vendor who allows it to come back out the other side. That a few companies provide all of these services end to end and charge commensurately for the convenience seems to me a triumph, not a failure, of capitalism.

The rosy picture that Andreessen paints is one where the entire world has a means to store and transmit these digital coins. But if all these migrant workers had an online wallet, are they really all that better off than if they simply had a bank account? Those customers will still be expensive to provide service to, with telephone operators, brick-and-mortar locations, and other infrastructure required to collect, store, and transmit their coins. In other words, bitcoins work fine when they're exchanged between the technologically savvy, wealthy folks who trade them today. Put in the infrastructure to support the mass population, however, and the costs of that support will rise dramatically. And companies who rise to serve those populations will demand, as they should, to be compensated for the risk to their invested capital in the form of profits.

Which is where we get fees for all the services card providers charge.

Add in the cost of compliance to criminal investigation and currency controls and you can begin to understand why those fees sometimes seem much higher than they should be for shuffling bits around the Web. It's the fraud analytics software, telephone operators, compliance attorneys, and all the rest—plus the critical role in insuring customers from fraud and mistakes—that make for the universe of fees we currently occupy. Some competition from Bitcoin could do a great deal to challenge the current Visa-centric hegemony in the payments world and lower fees for all, but only if it does so on a level playing field.

The world Andreessen would like to see is apparently one where his payment system is held to a lower standard of consumer protection, combating of criminal activity, and support of monetary policy—providing an unfair cost advantage over the status quo. I'd happily lobby for the same edge if I thought I could find it for my business. But realistically, if Bitcoin is to survive, let alone thrive, it must not just please consumers and businesses: it must appease the government—and that will cost a lot of coins.

Even if given that cost advantage, most of the warm and fuzzy scenarios Andreessen paints as a result will fail to materialize. The current banking system has every incentive in the world to bring the billions of people still outside the system into it finally, and has been trying hard to do so given the tight regulatory bounds it must work within. Should those handcuffs be loosened a bit, let it be done across the board, not just in the name of one technology. That would truly move the world's digital and offline economies forward, even if it would make it harder for Andreessen to make a profit from all his bitcoin investments.

Bitcoin is a monumental technical achievement in its simplicity and effectiveness. But just as the dot-com era overestimated the impact of the Web in the short term by several orders of magnitude (a hype-filled time during which Mr. Andreessen made his initial fortune selling a piece of free software to AOL, only to see it fall from grace and never monetize) so too do investors risk once again pouring billions into the currency equivalents of Web Van and Pets.com, failing to analyze all the dynamics of the market in which it competes. Pet food is heavy and expensive to ship, and most stores sell it at break-even to get you in the door for more expensive items. And dealing in currency requires protection of government and consumer interests—neither of which Bitcoin is well suited to.

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