Bitcoin's tipping pointNovember 19, 2013: 11:33 AM ET
The four-year-old virtual currency was once dismissed as something of a fad that only gangsters and drug dealers used, but in recent weeks, it has found new sources of credibility.
FORTUNE – Bitcoin has reached a rite of passage. The four-year-old virtual currency was once dismissed as something of a fad that only gangsters and drug dealers used, but in recent weeks, it has found new sources of credibility. Increasingly, investors from the U.S. to China are betting that the alternative currency could some day benefit regular consumers.
On Monday, bitcoin soared to a new high of $700 (it rose to $900 overnight), after senior law enforcement and regulatory officials highlighted the benefits of virtual currencies at the first ever congressional hearing on such monetary instruments. Mythili Raman, acting assistant attorney general, said virtual currencies are legit and "have the potential to promote more efficient global commerce." And even though they aren't backed by a central bank, Federal Reserve Chairman Ben Bernanke echoed similar sentiments, writing in a letter to senators that virtual currencies "may hold long-term promise, particularly if the innovations promote a faster, more secure and more efficient payment system."
The same day, news broke that BTC China, the world's largest bitcoin exchange by trading volume, secured $5 million in investments from institutional investors Lightspeed China Partners and Lightspeed Venture Partners.
The developments signal a shift. Just last month, federal authorities busted an online drug ring called Silk Road, which used bitcoin for all transactions. The bust prompted a major sell off; bitcoin declined by 20% after the website was taken down. It might have been hard to believe then, but the crackdown was probably the best thing that happened for the currency. It helped clean up bitcoin's shady side, bringing it closer to the mainstream financial system.
Since the Silk Road crackdown, bitcoin has made huge gains, and whether it flourishes in the U.S. isn't really the issue. In recent weeks, China has overwhelmingly driven up the price of bitcoin. About a third of the currency's transactions now flow through the BTC China exchange, which is open only to Chinese users, according to Bitcoin Charts, which provides bitcoin data. BTC recently unseated Tokyo-based Mt. Gox as the world's largest exchange by trading volume, and executives say it plans to use its latest round of funding to "aggressively grow and expand the business."
Why the bitcoin love in China? It's surprising Beijing hasn't intervened, as the Chinese government generally keeps a heavy hand over its economy. Bitcoin is volatile, but its price has gone up more than 30-fold this year.
At a bticoin conference in Singapore last Friday, BTC China's vice president Linke Yang told Agence France-Presse that the currency has become big in China because its citizens are big savers and see bitcoin as a vehicle to park and invest their money. His remarks come a few weeks after Baidu (BIDU), often referred to as the Google of China, began accepting bitcoin for some services offered by its subsidiary, Jiasule.
But before anyone gets too excited, it's worth saying that any bet on bitcoin is still more of a wager on its potential and the growing sophistication of its trading technologies than its practical use. Bitcoin will have to overcome big hurdles, experts say, before it goes mainstream with average consumers. Websites like WordPress and Reddit have accepted bitcoin as payment, but it is largely one big monetary experiment being tested across the world, says David Rogers, a Columbia University Business School professor who specializes in digital marketing.
A few risks and logistical challenges to consider: Because the supply of bitcoin is mostly fixed, it has a massive deflationary bias that encourages hoarding. In other words, as the amount of things that bitcoin can buy increases, the value of each coin increases as well. So since each coin should be able to buy more goods in the future than it can today, it's hard to see why consumers would spend bitcoin now when they can use it to buy much more at a later date. That's a kink the bitcoin industry will need to work out.
And for bitcoin to take off, it needs to assure average consumers that their money is safe. Customers' biction wallets are typically stored in their phones or computers, which can be hacked. Proponents often claim that it costs less to process a bitcoin payment than a typical credit card payment, but it remains to be seen if average consumers are willing to give up the security of their money to save on transaction costs.
Federal regulators are developing rules for the virtual currency, however. How bitcoin will exist in the future, if at all, and what it will be used for years from now is unclear. But the currency's fortunes are looking brighter than ever.