Beyond bitcoin: Inside the cryptocurrency ecosystemDecember 24, 2013: 8:59 AM ET
Bitcoin has spawned numerous spinoffs and imitators. Why the sudden proliferation of "altcoins" – and what are the chances that any of them matter?
By David Z. Morris, contributor
FORTUNE -- Bitcoin's 2013 remains impressive, even after the digital currency has taken a serious tumble since late November – at the December 18th price of $530, a Bitcoin purchased for $13 in January would return over 4,000%. Another explosion has tracked that price's: the emergence this year of 100 or more "altcoins," collections of code and community modeled after bitcoin and with names like Novacoin, Zetacoin, Bitbar, Cryptogenic Bullion, BBQCoin and, yes, Sexcoin. Some offer minor but meaningful variations on bitcoin's technology, while most are outright copies – and a huge proportion are fraud schemes preying on the enthusiasm of cryptocurrency supporters.
Still, these coins are an important part of the story of bitcoin, and some are likely to be part of any future that includes cryptocurrency, a type of digital currency that depends on cryptography. Even after the recent bitcoin decline took many altcoin valuations down with it, there are five altcoins with market capitalizations of over $10 million each, another 20 of over $1 million each, and dozens of others ranging down to the aptly named "junkcoin," with a current market cap of about $75,000. Andreas M. Antonopoulos, a consultant on several bitcoin-related startup projects, author of a forthcoming technical volume on bitcoin, and host of the popular "Let's Talk Bitcoin" podcast, describes this landscape as the "crypto-currency ecosystem."
The ecological metaphor hinges in part on an evolutionary logic. "Altcoins serve two purposes," Antonopoulos says. "First, they test new tech features, showing whether they work and whether the market will accept them." Those new features mostly revolve around variations on bitcoin's mining algorithm – the "proof of work" problem-solving that secures a distributed currency and its transaction records. Variations include those allowing a currency to be processed by different equipment than bitcoin (Litecoin, current market cap $330 million), those purporting to use less energy (Peercoin, $47 million), and those that offer faster transaction confirmation times (many, among them Feathercoin, $5 million). Other cryptocoins claim more idiosyncratic variations, such as the demurrage built into Freicoin ($2 million), which loses value if it is held without being spent. There's even a currency that uses its proof-of-work algorithm to search for new prime numbers (that currency is named, of course, Primecoin, $6 million). Those features that prove attractive and compatible after 'testing' by an altcoin, Antonopoulos says, will likely be incorporated into Bitcoin.
No one seems to foresee any of the altcoins displacing bitcoin as the dominant cryptocurrency. As a recent Bank of America report pointed out, bitcoin's dominance is guaranteed above all by the network effect: the value imparted by the huge size and capital investment of its community of miners, service providers, users, and merchants. Without bitcoin's volume and network strength, many of the altcoins will disappear, as their networks are abandoned or overwhelmed by hackers – Antonopoulos says the second purpose of altcoins is to "demonstrate spectacular failure modes" whose lessons will strengthen the survivors.
But unlike Bank of America, which predicts a future in which Bitcoin stands alone, Antonopoulos sees space for at least a few alternatives after the inevitable shakeout. Those whose features cannot be incorporated into bitcoin, which manage to remain secure, and which build a robust user base will survive, he says. At the end of the process, Antonopoulos foresees Bitcoin holding between 80 and 85% of all cryptocurrency capitalization, with the remaining value divided between as few as five or six altcoins. The surviving altcoins may serve different niches within an evolved cryptocoin ecosystem, and all will offer a 'release valve' for users who feel that Bitcoin is too expensive – a near inevitability, given Bitcoin's strictly controlled growth rate and eventual growth cap.
So far, one feature has been more important than any other in helping any altcoin build user buy-in: honest, transparent, and relatively selfless behavior by its developers. Litecoin lead developer Charlie Lee made great efforts to ensure cryptocurrency supporters' awareness and access at Litecoin's launch, when any cryptocurrency is easiest to mine. "I released the source code a week before the launch [in October of 2011], so people could prepare [to mine]." In part thanks to this push for fairness and openness, litecoin is now the second-biggest cryptocurrency after bitcoin. Creator Sunny King similarly released the sourcecode for his peercoin nine days before mining opened in August of 2012. Peercoin is currently the third-ranked cryptocurrency.
In the 2013 altcoin explosion, though, Lee says "I haven't seen any other coin roll out with the same level of transparency." It certainly hasn't been the M.O. of the flood of bad actors looking to make a quick buck by starting bogus cryptocurrencies. This is usually accomplished through what's known as a "premine," in which the founders of a currency generate a large chunk of currency for themselves before releasing the mining code to the public. Those founders will then undertake a big marketing push, including, it is rumored, the occasional payoff to a prominent spokesman and bribes in exchange for listing on cryptocoin trading exchanges, which can confer a sheen of legitimacy. Then, when the hyped, bogus coin is released, adoption by cryptocoin enthusiasts can give its value a brief bump, and unscrupulous founders can unload their premined loot. "In excess of 80% of altcoins are pump-and-dump schemes in the most traditional sense of the term," says Antonopoulos.
By contrast, Charlie Lee claims he hasn't disproportionately benefitted from the creation of litecoin. "I have some, I wish I had more, like everyone else." Lee has benefitted, though, in terms of community stature and influence, as he and litecoin have come to exemplify the role of altcoins in strengthening the overall cryptocoin ecosystem. "The litecoin development team works pretty closely with the bitcoin dev team. The latest bitcoin release contained a lot of code that had been tested out in litecoin for a while, because we're a slightly smaller market and we're more nimble to make changes."
Lee credits several factors besides his own honesty with the success of litecoin. First, because litecoin uses a different base code from bitcoin to secure its transaction records, it has not been mined on the same processors as bitcoin. This separation keeps miners from switching back and forth between bitcoin and litecoin during periods of low competition for coins, reducing volatility and vulnerability. Litecoin's adoption has also been helped because it represents a small improvement over bitcoin – litecoin's transaction confirmation is 12 times faster than bitcoin's. Hence the name.
In addition to useful innovations and honest developers, Andreas M. Antonopoulos says that the most important way to evaluate the long-term viability of a cryptocurrency is its acceptance by merchants as payment for real goods. That remains a high bar – litecoin is the only altcoin with so much as a handful of merchant adopters, and even bitcoin advocates still trumpet every new merchant acceptance as a watershed. But developers and communities are beginning to make adoption a priority alongside technology: the fledgling feathercoin, according to spokesman Chris Ellis, has an entire team devoted to merchant relations.
Community acceptance is, logically, the fundamental driver of cryptocurrency utility and value, since all currency ultimately operates on a basis of collective trust. It remains challenging to persuade most people that cryptocurrency can be as trustworthy as a printed government guarantee, but Ellis gave me perhaps the most concise and convincing version of that pitch I've heard. "It turns out, money is just a ledger. It's a way of recording all the economic activity in a society."
Above and beyond all the hacker experimentation and raw avarice, the altcoin explosion is driven by a belief that the cryptocurrency model represents a radically new, cheaper, and better way to keep that ledger. Cryptocoin advocates, including altcoin founders, believe that cryptocurrency will trigger an epochal power shift away from the controllers of today's financial system. "Banks are operating a tollbooth economy," said Ellis. "Banks want 10% of revenue for credit cards," a cost that cryptocurrency's distributed efficiency slashes to nearly nothing. Altcoins, Ellis said, demonstrate that "anyone with sufficient will and devotion and time to nurture the community" can now build their own money.
That remains to be seen, and in the meantime, altcoins are in for a very bumpy ride. "99% of them will expire in the process of creative destruction," says Antonopoulos. "And that's fine, because every once in a while, something unique and amazing will pop out."
Follow David Z. Morris on Twitter: @davidzmorris