Why do VCs favor the soaring Bitcoin market? What entrepreneurial opportunities are there?

Note: The price of virtual currency Bitcoin has been fluctuating violently recently. On the evening of April 3, CNN reported that Bitcoin rose to $147 on Mt.Gox, one of the major Bitcoin exchanges, but then quickly fell back to $125, and then rebounded to $141. Two weeks ago, Bitcoin was only $47.
Bitcoin (English: Bitcoin, abbreviated: BTC, currency symbol: ?) is an electronic currency generated by software using open source P2P technology. Bitcoin is currently the most widely used alternative currency. As of March 30, 2013, the total value of all issued Bitcoins converted into US dollars at market prices exceeded US$1 billion.
The following article is from the American technology blog TechCrunch, written by Jeremy Liew, managing director of venture capital firm Lightspeed Venture Partners. He believes that virtual wallets, foreign exchange and payment are the three major areas where startups can get involved in the Bitcoin market. Translated by Sina Technology:
As a venture investor, my interest in the Bitcoin ecosystem is not in the idea, but in the business opportunity. Bitcoin has the opportunity to disrupt a multi-billion dollar market and create massive new markets at the same time. There will be 3 key markets for Bitcoin:
1. Virtual wallet. Virtual wallet services help users hold Bitcoin and provide some of the functions of bank current deposit accounts.
2. Exchange. The exchange service converts USD into Bitcoin, or converts Bitcoin into USD.
3. Payment. Payment services help merchants accept Bitcoin payments in transactions.
Generally speaking, venture capitalists are interested in markets that are worth billions of dollars. So how will these markets grow to billions of dollars?
Virtual Wallet
It will be free to have a Bitcoin wallet, which is a piece of software installed on your computer that helps you send or receive Bitcoins. However, this also means that private information related to your Bitcoin account needs to be stored on your computer, so there is a risk of loss or theft. More and more Bitcoin users are turning to wallet custodian services, which are digital wallets that store your Bitcoins and can be accessed via the Internet. However, wallet custodian services must be trustworthy and will not cause the loss of user funds. Such services should also be free.
We can assume that someday, custodial wallets will be able to charge an annual fee of 0.5% of account funds. This is a high estimate, but it is not impossible if custodial wallets provide security, insurance against losses, and protection against fraudulent transactions. If the virtual wallet market is worth $1 billion, it means that the amount of Bitcoin managed in custodial wallets will need to reach $200 billion. The total value of Bitcoin is only $1.5 billion at present. Bitcoin will only appreciate by about 150 times to reach this level. In the past year, Bitcoin has appreciated by 30 times, so a 150-fold appreciation is not impossible. In two years, Bitcoin may be worth this much.
Exchange
It may take a long time for Bitcoin to become a world currency, and such a goal may never be achieved. Therefore, for a long time, the exchange of Bitcoin and real currency will be a market with great demand.
The transaction fee for exchanging Bitcoins for ordinary consumers can be 50 to 100 basis points, while the transaction fee for large transactions can drop to 10 basis points. We can assume that in future transactions, the transaction fee will average about 25 basis points. In order to achieve a market size of $1 billion, the annual transaction amount needs to reach $400 billion. Last month, the exchange volume of Bitcoin was $60 million, and this month it may be close to $200 million. This means that the annual exchange volume is $720 million to $2.4 billion. At the maximum, the exchange volume must increase by 200 times to achieve the desired market size.
Trading volume, or the transfer of Bitcoin within the real economy, has traditionally been 2-20 times the volume of exchanges. If the relationship between trading volume and exchange volume remains stable, then trading volume would need to grow 200 times to achieve a $1 billion market size. In the past year, Bitcoin-based trading volume has grown 30 times, so this scale is achievable.
Payment
Ultimately, the appreciation and exchange volume of Bitcoin will depend on the number of payments based on Bitcoin. If people do not use Bitcoin to pay, there will be no motivation from the real economy to drive the appreciation and exchange volume of Bitcoin. Such a development will be completely speculative.
One of the key advantages of Bitcoin is the almost zero transaction cost. However, there are currently multiple merchant services that charge 25 basis points or more for Bitcoin transactions. For example, Bitpay currently charges 1% or more. Therefore, if you want to achieve a market size of $1 billion, the annual transaction volume based on Bitcoin needs to reach $40 billion.
Last month, about $250 million was traded on Bitcoin, and this month it will probably be $750 million. So the annualized volume would be $3 billion to $9 billion. At the maximum, a $1 billion market would mean that volume would need to grow 50 times from current levels. Over the past year, Bitcoin-based volume has grown 30 times. Global GDP is currently about $82 trillion, so $40 billion in volume would account for about 0.5% of global GDP. For comparison, the United States alone currently processes $2.5 trillion in credit card transactions per year, which is 16% of the country's $15 trillion annual GDP.
How to achieve these goals
Analysis of the market size shows that Bitcoin's various indicators need to grow by 2 to 2.5 orders of magnitude from the current level. However, these indicators have grown by 1 to 1.5 orders of magnitude in the past year alone, so future goals are still achievable. The question now is how to achieve such development? The market cannot achieve such scale through illegal means or speculation. Bitcoin's use needs to become mainstream, and the only way to achieve this goal is to make Bitcoin accepted by merchants, which relies on Bitcoin's extremely low transaction fees. This advantage can attract industries with low net profit margins, such as food and e-commerce companies, or businesses with high transaction costs, such as cross-border payments and small payments. These industries may become pioneers in the use of Bitcoin.
However, if the exchange rate of Bitcoin remains unstable, merchants will be unlikely to switch to Bitcoin simply because of the lower handling fee. Since merchants' costs are settled in real currency and they are unwilling to bear the exchange rate risk of Bitcoin, merchants will immediately exchange Bitcoin for real currency after accepting Bitcoin payments. This requires Bitcoin exchange services to have high liquidity, so professional companies can intervene in this field. At present, some companies have entered this market.
If the exchange rate fluctuations of Bitcoin tend to stabilize in the future, merchants will be willing to hold Bitcoin for a longer period of time, and even use Bitcoin for payment. In addition, if the currency and financial system of some countries is not as stable as Bitcoin, then Bitcoin will be more easily accepted in such countries.
If Bitcoin wants to be accepted by mainstream users, all elements of the Bitcoin ecosystem need to comply with regulations. This is why the price of Bitcoin soared last month after the US Treasury Department's Financial Crimes Enforcement Agency issued virtual currency regulations. As Bitcoin moves closer to the US regulatory system, the virtual currency will be further legalized. These regulations, and subsequent regulations that may be issued in the future, will increase the cost of using Bitcoin, but this is not a high price to pay for legalization.
What it means to startups
Not all markets that are big are opportunities for startups. Bitcoin is attractive because it disrupts the current system. The innovator’s dilemma may keep big companies away from the payment market for a long time because they worry that it will destroy the current extremely high profit margins. But competition will come one day.
The key question for startups is: what is your competitive advantage, and how do you deal with market followers? In the bitcoin exchange business, liquidity will be an extremely high barrier to entry. Although there are some examples that show that new entrants can adopt an open market model, it is still difficult to do so. In businesses such as bitcoin wallets and merchant services, it is not clear what the market barriers are.
The risks of Bitcoin are also worth mentioning. Hacking, theft, and fraud related to Bitcoin exchanges, wallets, and investment vehicles have resulted in the theft of $1.2 million worth of Bitcoin, while there are only $11 million in Bitcoin in stock. This means that more than 10% of Bitcoin has been stolen, and this does not take into account small thefts and personal wallet thefts. Just this week, a Bitcoin wallet service was forced to shut down after being hacked. Given the current environment, Bitcoin startups need to obtain more financing from venture capital to resist risks and provide security measures and proactive monitoring measures.
In any of these scenarios, Bitcoin would need to appreciate 100x or more. If that were to happen, buying Bitcoin would be a much better investment than building a Bitcoin startup. You’d get a high return without facing execution risk, but it wouldn’t be much fun either.