What to watch as the bitcoin drama develops

By Sarah Lacy , written on May 14, 2013

From The News Desk

We all knew this was coming.

Bitcoin is disruptive in the most raw sense of the word. Not the "hey, it's another photo sharing app!" form of disruptive, or even the libertarians wanting new ways to get from point a to point b without saying the word "taxi" kind of disruptive. The biggest bitcoin bulls say it has the potential to be the third major way to buy and sell goods that the world has ever known, after bartered goods and government-backed money.

If the promises of bitcoin could ever be unlocked – perhaps one of the biggest ifs in the tech world today – it's about as big of a venture-style opportunity as you could imagine. Right now the value of the system is a headline-grabbing $1 billion. But if its potential to be a global, borderless way of buying and selling goods via the Internet were ever achieved, it's value would one day be in the trillions. It's a massive potential for value creation that suddenly has people in a lather. Investors like Fred Wilson's Union Square Ventures have already placed some significant bets – with many more investors quietly mining for opportunities. But despite the massive potential upside, bitcoin is fraught with so much complexity and risk that the potential seems almost impossible to unlock.

Enough of the waiting game. The first big risk to bitcoin's future is now upon us: a government smack down on the largest exchange, Mt. Gox. This will not be resolved quickly – if ever. By its sheer rate of adoption bitcoin is unlike any other online currency that's come before. It's murky whether bitcoin is a currency (taking the place of money), a security (it's an agreement between two people that something is worth a set amount) or a commodity (metaphorically it's based on a limited amount of "digital gold.") So the government is likely arguing within itself about what branches should even be trying to regulate this thing. There may never be clarity on whether the US will allow bitcoin to thrive.

In the past the government has gone after those who have tried to create alternative currencies. When the government prosecuted Bernard von NotHaus for issuing notes based on precious metals – he called it the Liberty Dollar – it charged him with "conspiracy against the United States." It almost sounds like treason, doesn't it? After he was found guilty the FBI said, "It is a violation of federal law for individuals . . . to create private coin or currency systems to compete with the official coinage and currency of the United States."

Online currency plays have not been exempt from government heavy-handedness. In 2007, prosecutors went after e-Gold, which had created a currency that could be redeemed for gold. This time it took a different legal tack. Because users didn't have to show identification – transactions were anonymous like bitcoins are – e-Gold, the government argued, was enabling money laundering and child pornography. The site's owners were convicted of operating an unlicensed money-transmitting business, the business shut down, and the CEO sentenced to house arrest.

While legal authorities may hold sway on businesses on American soil, they don't rule the online world, and that's more the case now than ever. Like BitTorrent and KaZaa, bitcoin is a global peer-to-peer, decentralized phenomenon and those are hard to enforce. A hard stand against bitcoin – if the government is making one, which no one really knows yet – could only cause other countries to become hot beds of the bitcoin economy, just as happened with hacking, gambling and other underbellies of the Web that the US forced offshore.

And that may not be a bad thing for those countries. It's a good way to start a local software industry and not compete with the US, for one. And from a moral point of view, even if bitcoin is a haven for money laundering and seedy dealings, for countries with unreliable currencies it could prove the more stable option. Don't forget the libertarian factor: The more governments try to crack down on bitcoin, the more attractive it could become to people who like it because they feel currencies are already too regulated.

So if the US isn't going to resolve its stance on bitcoin anytime soon, what happens to this budding economy and the investor frenzy around it? (Won't someone think of the Winkelvii?) The key thing several of them we reached out to said they will be watching is the price. It'll clearly crash. But what happens next? Does it recover? How resilient is the market? Do quality entrepreneurs continue to flock to the space? And do quality investors continue to place bets in the bitcoin economy? Or is everyone scared off? Does the government give any guidance on what is trying to do – squash illegal activity or kill off an area of technology no one quite understands? The answers to these questions in the immediate aftermath of the Department of Homeland Security's move is arguably more important than what the government does in the long run.

There's an argument to be made that if the value of bitcoin can hold up and quality entrepreneurs and investors still believe in the promise, the government can't crush it. At some point it if works and is successful, the government has to deal with it. Or as one person we spoke to said, "It needs to keep gaining traction over time and force the world to react to it, not the other way around."

While the promise of bitcoin may yet take decades to come to fruition the coming weeks will be a crucial make or break period – likely one of many even if the wildest hopes and dreams of the currency are going to come true.