Bitcoin: VC firms eye Asia opportunities

South Korea's bitcoin economy is a fraction of China's, but the country's largest exchange dedicated to the digital currency turned profitable in under a year of operation. Korbit was founded last July and counts over 20,000 registered users of its platform. Its success attracted the interest of Silicon Valley investors such as Tim Draper, founder of Draper Fisher Jurvetson, who led an angel round of $400,000, alongside Naval Ravikant of AngelList, SV Angel's David Lee and SecondMarket founder Barry Silbert.

Korbit's growth reflects the phenomenal rise in the digital currency's value over the course of 2013, from niche interest to moneymaker. Bitcoin prices rose from $13.60 in January to $146,000 in December. A long-only bitcoin hedge fund riding the wave returned 4,847% over 12 months.

The number of bitcoin start-ups has also risen in step with its popularity as businesses spring up to target pools of emerging digital currency users. "While many of the start-ups are currently US- based, we are seeing more and more Asia-based start-ups as well," says Jeremy Liew, partner at Lightspeed Venture Partners.

One of these is the BTC China exchange which raised $5 million from Liew's firm and Lightspeed China Partners (LCP) in September. It had spent almost two years running as a part-time operation with modest revenue before the investment, but in November BTC became the world's most active exchange, driven by Chinese demand. Bitcoins in China were selling at a premium of 20% compared to foreign exchanges trading other currencies against bitcoin.

The People's Bank of China (PBoC) responded by banning financial and payment institutions from dealing with bitcoin and stressing that it cannot be used as currency in the market.

However, the global, decentralized nature of bitcoin means it can exist beyond the reach of national regulators, with users able to move their holdings to any platform in any country. Venture capital investors therefore see the digital currency as a sustainable payment channel that offers a lower cost solution than its competitors or reaches places they cannot.

Strength in numbers

Bitcoin emerged around 2009 from a software system built by an anonymous computer programmer or group of programmers using the pseudonym Satoshi Nakamoto. The decentralized digital currency relies on peer-to-peer technology - transactions are managed and money is issued collectively by the network instead of a central bank or authority.

Bitcoins are held by the owner at an address on the internet, with a transaction transferring ownership from one address to another. About every 10 minutes, a block of transactions is confirmed to a public online ledger called the block chain, which maintains a record of all transactions ever processed and ownership balances. Multiple addresses can be managed with a type of program called wallets, which are installed on a computer, mobile device or used off a website.

The technology allows direct transfers across the internet without use of a third party. However, the transactions are irreversible by design. Each bitcoin can be divided into one hundred million units, which makes it is possible to transact a fraction of a bitcoin instead of the whole.

To help it grow, the software was released open-source on the internet and runs across a network of machines called bitcoin miners. A miner is rewarded with new bitcoins for successfully confirming a transaction block.

In addition to wallets, programs being built for the bitcoin ecosystem are exchanges, which allow trading and conversion from fiat currency to bitcoins and back, and payment processors to help merchants accept bitcoins.

As such, bitcoin is not only a currency, but also a commodity and security to hold money and move it around the world. This potential to disrupt the traditional payments business has VCs excited. "The key value proposition of bitcoin is the potential for dramatically lower transaction costs using btc as a payment mechanism," says Liew.

In developing countries where the payment infrastructure is not as well built out, it presents an opportunity to leapfrog to the bitcoin alternative. As e-commerce takes off in Asia, the mechanism allows remote transactions in place of credit cards.

Another benefit could be to cross-border trade, where normal banking channels can take two days to get the money to suppliers and there might be currency movements over that time period. Bitcoin is quicker and costs less than Visa or PayPal.

Niki Scevak, managing director at Blackbird Ventures and investor in Melbourne-based bitcoin wallet CoinJar, sees another potential use on freelance job marketplaces. "All these people working on global marketplaces like oDesk get paid in a very high fee payment way - Western Union or PayPal and that's not even available in countries like Russia or Serbia," he says.

The technology also enables micro-payments, offering an edge over credit cards that require a $0.20-30 flat fee plus a 3% commission. App stores currently account for the majority of micro-transactions of $0.99 or less.
Rules of engagement

The decentralized nature of bitcoin is a concern for government regulators. For countries with capital controls, such as China, the digital currency is potentially a means of circumventing limits the inbound and outbound movement of money. Others might be worried from a tax, money-laundering, and funding terrorism perspective.

The risk varies according to the nature of the bitcoin platform - those dealing with fiat currency, or not. "In terms of the complexity of regulatory challenges, it ranges from virtually none in the case of a software service provider all the way to high when it comes to exchanging fiat for digital currency," explains Eddy Travia, co-founder of bitcoin start-up incubator Seedcoin.

Exchanges may need money operating or transmitter licenses depending on the country in which they are operating. Banking partners are necessary to get funds in and out of the exchange and this can become an issue in the event banks decide or are forced to break their relationships with exchanges.

Payment processing is under a much simpler regulatory environment than a bitcoin exchange. "In the US, for example, it is much easier to establish a payment processor than an exchange, which will need one money transmitter license per state," Travia adds.

A bitcoin wallet provider will not deal with any fiat currency and may not need a bank account to operate as long as its business partners pay in bitcoin or it can pay its expenses in bitcoin. The challenge is technical, mainly ensuring the wallet is secure enough to repel hackers.

In the US, where bitcoin start-ups have attracted the largest sums of venture capital investment, the Treasury has decreed that businesses must register as money services businesses and impose anti-money laundering checks on customers, just like traditional banks. Most of the 50 US states also impose their own regulations on money services businesses, so the legal process can be expensive and cumbersome.

There is no regulatory framework for bitcoin in most countries, but financial hubs such as Hong Kong and Singapore have so far shown a laissez faire attitude towards the digital currency. Asia's first bitcoin ATM is expected to start operating in Hong Kong by the end of January, making the currency more easily accessible to users.

While this has attracted start-ups, entrepreneurs are asking regulators for guidelines. Hong Kong-based exchange ANX is a case in point. It went live in July last year and has 7,000 registered users - 40% from China, 30% in Hong Kong and the rest from other parts of the globe.

"We reached out to Hong Kong Monetary Authority (HKMA) and the Customs & Excise Department (CED) on whether or not we really needed a license," says Ken Lo, CEO of ANX.

The HKMA said it is not regulating the bitcoin industry for now so the ANX team got a money services operator license from the CED for remittance. In Singapore, meanwhile, itBit, an institutional-grade trading platform backed by Canaan Partners, is the process of applying for licenses locally as well as for those required in the US.

Big in China

While use of bitcoin is growing in the economy, few merchants accept it yet and the majority of transactions are speculative. That's certainly the case in China, according to Zennon Kapron, founder of research firm Kapronasia. "Buying bitcoin on BTC China was amazingly easy - you could fund and withdraw from your bank account directly or by using Tenpay, the online payment platform from Tencent, which is one of the biggest in terms of market penetration," he says. "Purchasing a bitcoin was no different than buying stock."

One factor in bitcoin's popularity in China is that a lot of the manufacturing of the bitcoin mining machines is located there and so much of the mining happens locally. Holders of these new bitcoins stand to gain from the ever-rising prices and the arbitrage occurring across various exchanges.
But the real interest started in May 2013 when CCTV, the government controlled national broadcaster, carried a documentary on bitcoin. There were about 40,000 wallet downloads in the country that month, more than in the US, Kapron explains.

Although some Chinese traders could have moved to exchanges abroad since the ban, others have found a way to work under the current set of rules. The PBoC's current position is that bitcoin can be used as an online tool for processing trade transactions, with users having to bear the risks personally.

"They have essentially legitimized it and the government has narrowed it to the field of internet and technology," says Ron Cao, founder and managing director at LCP. "The company is properly located in China and legally operating as an internet business, but a lot of other factors are unknown because it relates to payments and storing value and all that touches various government bodies."

Local exchanges must find alternative methods of moving money on and off the platforms now they are prohibited from working with financial institutions. A voucher system is currently the preferred option, whereby users buy a voucher for a certain sum in bitcoin from a platform like Paipai, go on to the exchange, type in the code and have their account credited with that amount.

It seems to be working, given trading volumes have picked up since the ban and the bitcoin price has reached mean parity with some of the foreign exchanges.

Prospects for the digital currency in China remain uncertain, but entrepreneurs are pushing forward, confident in it not going the same way as Q coins - a virtual currency for users of Tencent's QQ to make in-game purchases for their avatar and blog. The authorities responded by banning its use in the real world.

"They were centrally controlled by Tencent, so there was one entity to regulate that controlled the supply and flow of the Q coins," says Kapron. "Regardless of the Chinese regulations in place, as long as the rest of the world grows to accept bitcoin there will always be, at a minimum, a niche opportunity for bitcoin in China."

SIDEBAR: Digital assets, the regulatory approach

CHINA

In December, the People's Bank of China issued a notice declaring bitcoin a kind of a virtual product. It does not have the legal status of a currency, and it cannot not be allowed to circulate in the market as a currency. However, bitcoin could be used online as a tool to process trading transactions, although individuals use it at their own risk.

Financial institutions and payment companies can't give pricing in bitcoin, buy and sell the virtual currency or insure bitcoin-linked products. Neither can they directly or indirectly provide any bitcoin-linked services, including helping clients register to trade bitcoin and providing clearance and settlement services.

They are also prohibited from accepting bitcoin as a payment currency, providing exchange services between it and other currencies, engaging in bitcoin deposit and mortgage services, issuing any bitcoin-related financial products, and treating it as trusts and investment funds.

HONG KONG
The Hong Kong Monetary Authority has decided that it will not regulate bitcoin because it is "a virtual commodity" not a currency. However, the Secretary for Financial Services and the Treasury, Caejer Chan Ka-keung, issued a statement, warning the public of the risks of the highly speculative commodity.

INDIA

The Reserve Bank of India has made it clear that Indian bitcoin exchanges lack the regulatory approval needed to exchange digital currencies for rupees and other national currencies. It issued a public notice warning users to stay away from digital currencies.

SINGAPORE

The Monetary Authority of Singapore has decided not to intervene in the use of bitcoin by individuals or businesses. Singapore has given guidance on how it intends to tax bitcoin transactions for businesses and merchants, covering capital gains, earnings, and sales tax on bitcoin exchanges and bitcoin-related sales.

US

Money transmission registration and licensing: The US Treasury Department's Financial Crimes Enforcement Network (FinCEN) released official guidance on the use of bitcoin in March 2013. It stated that any administrator or exchanger of bitcoins must be a registered money services business (MSB) under FinCEN's money transmitter regulations. They also need to comply with applicable state law and register with certain state regulatory agencies.

Various state regulators have followed FinCEN's example in requiring that bitcoin exchanges and service providers register and/or seek licenses on a state level as money transmitters or MSBs.

Anti-money laundering and other requirements: Digital asset service providers that qualify as MSBs are also required to implement anti-money laundering, know-your-customer and financial information reporting policies and procedures. They may also be subject to analogous requirements under similar state laws.

 

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• Topics
• Venture
• Technology
• Blackbird Ventures
• Lightspeed Venture Partners
• China