Bitcoin is not just digital currency. It's Napster for finance.

January 21, 2014: 5:00 AM ET

In the next year, Bitcoin will start its transformation from a mere currency into an entire open-source, decentralized exchange for everything from futures contracts to car rentals.

By David Z. Morris

140117173247-bitcoin-620xaFORTUNE -- In 2013, bitcoin's valuation didn't just skyrocket, but its infrastructure, services, and adoption exploded as well, culminating in recent announcements that major online retailer Overstock.com and NBA team the Sacramento Kings would accept the digital currency as payment.

Some still doubt bitcoin's usefulness and durability, but 2014 may leave skeptics even further behind -- developers and entrepreneurs are already hard at work building features on top of the Bitcoin protocol that will allow for the decentralized execution of financial services, from currency hedging to loans to stock issuance to rental and purchase contracts. These new services rely on the same innovative proof-of-work model of distributed security and record-keeping that has kept the bitcoin currency secure as its value ballooned well past $10 billion. In the long term, peer-to-peer finance threatens to weaken banks and other financial agents just as peer-to-peer file sharing did the music industry -- and some of the architects of this financial Napster seem gleeful about the possibility.

The Bitcoin protocol (crucially distinct from bitcoin, the currency it underlies) was built from the ground up to support far more complex transactions and relationships than simple value transfers. (Example: "Send five bitcoins to Steve.") Some of the kinds of transactions that Bitcoin can support include so-called M of N transactions, which require agreement between a certain subset of a group, and can be used for escrow, mediation, or shared financial management; time-locked transactions, in which bitcoins are distributed on a strict schedule, useful for trusts or wills; and even data-conditional transactions, in which a script uses a data input such as a regular Google search to monitor real-world events that would automatically trigger disbursements or other actions. More conditional on infrastructure development is the possibility of "smart property," with contracts enforced by digital locks interacting with the Bitcoin blockchain to manage real-world leases, mortgages, and purchase contracts.

All aspects of these transactions would be programmed and automatic, with their transactional integrity guaranteed by the Bitcoin blockchain, constantly vetted by the vast network of "miners" rewarded for their maintenance work with a stream of bitcoin. In fact, the comparison to Napster is somewhat inaccurate, since Napster used centralized servers to track music sharing, while Bitcoin is entirely distributed. That means loans without banks, contracts without lawyers, and stocks without brokers, executed and recorded across hundreds of servers at all corners of the earth.

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Consultant Andreas M. Antonopoulos, echoing a 2012 white paper by software developer J.R. Willett, says that the Bitcoin protocol is to distributed finance what Internet Protocol has been to distributed information. "The blockchain is IP. And through manipulation of that we can build a whole other system." In the same way that IP and the infrastructure of network nodes that make up the Internet now support functions from e-mail to video streaming, the Bitcoin protocol and its miners can support a variety of financial functions. Alternately, Antonopoulos suggests thinking of the "Bitcoin blockchain as having an API" (application programming interface) that makes its data usable by third parties, in the same way that second-layer services like Buffer or Hootsuite use the Twitter API to present and interact with Twitter data in slightly modified or reorganized forms.

Efforts to make complex financial functions a part of Bitcoin have been bubbling through 2013, but 2014 will see them come to fruition. The most prominent active development of these functions is taking place under the auspices of the Mastercoin Foundation, a nonprofit organization of developers along the same loose, collaborative lines that define most "cryptocoin projects." Mastercoin, based on Willett's white paper and programming, is projected to add many functions to the Bitcoin blockchain. These include allowing users to create new asset classes, such as stocks or other ownership certificates, and create a variety of automated "smart contracts."

Independent entrepreneurs are also working to build this infrastructure. One of these is Reggie Middleton, currently building a client called BTC Swap. Middleton, gravelly voiced, dapper, and businesslike, doesn't fit the stereotype of woolly young bitcoin developers. But he slyly describes himself as "not quite an anarchist," and BTC Swap is a shot directly across the bow of the financial industry. Still in early development, BTC Swap is planned to facilitate a variety of what Middleton calls "Zero-Trust Digital Contracts," which recreate financial functions in software code by matching offered and desired transactions between parties without the need for intermediary institutions. Because these contracts are automated, instantaneous, and executed with assets already represented in the Bitcoin blockchain, Middleton says they eliminate counterparty risk while also subtracting conventional banking and brokerage fees.

The most immediate function Middleton envisions for his system is for hedging bitcoin against existing national currencies. With bitcoin's valuation still showing huge volatility, Middleton claims the availability of distributed hedging will both ensure the value of bitcoin for individuals holding the asset and provide systemic stability. (Given persistent skepticism, there should be plenty of takers to short bitcoin against the dollar.) And the entire system relies on decentralization for its security and integrity: "My contracts are peer-to-peer," says Middleton. "If you hack my servers, there's nothing to get." Somebody call Target (TGT).

Such hedging functions have particularly unique promise because of the extremely low transaction costs of peer-to-peer currency. Bitcoin makes microtransactions ranging down to fractions of a cent viable, but Middleton says that "right now, if you do micropayments, the volatility of bitcoin can really take you out." Because of the low cost of Middleton's swaps, "I can let [payees] manage risk and decrease volatility at the micro-level."

The most speculative and long-range potential functions of peer-to-peer finance and smart contracts are forms of what's known as "Smart Property." This idea was explored in a 1997 paper by computer scientist and former George Washington University law professor Nick Szabo (who has come under occasional suspicion of being pseudonymous bitcoin creator Satoshi Nakamoto). In the paper, Szabo defines smart contracts as agreements enforced not by law, but by hardware or software that would "fully embed in property the contractual terms which deal with it." Szabo offers the humble vending machine as an existing case. But combining telecommunications with the Bitcoin blockchain presents more intriguing possibilities -- for example, cars able to read the blockchain could disable themselves if a loan payment wasn't made on time. Mike Hearn, one of the main developers of the Bitcoin architecture alongside the mysterious Nakamoto, has said that any implementation of the concept is at least a decade away because of the need for hardware upgrades on physical goods.

The functions that advocates say could be automated through the Bitcoin network seem nearly endless, including peer-to-peer investment funds, Kickstarter-like crowdfunding, binding arbitrations, and even non-financial transactions such as naming rights management and encrypted communication. And all could be executed without a cut for intermediaries. Bitcoin partisans, from developers down to rank-and-file users, often seem to revel in the idea that they are threatening the control and profits of Wall Street institutions, who they see as rent-seeking fat cats. If it were limited to the loss of fees on payments and transfers, bitcoin's threat to existing financial institutions would still be substantial. But with a full array of commission-free financial services on the horizon, there is even more reason to take heed.

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Middleton sounds a bit like an 18th-century pirate striking back against the Empire when he declares that "what I'm doing right now is a direct threat to fiat merchant banking." For him, excitement over value fluctuations in the bitcoin currency is missing the point: "It's not a threat as people sit there and ponder whether bitcoin is a bubble or not. But if people go through the protocol and use their imagination, the existing system is threatened."

However, there is a substantial obstacle to this coming revolution. Despite the emergence in 2013 of entities like Coinbase that have drastically streamlined the process, it is still difficult to exchange bitcoin for national currencies in a quick, reliable manner. It's unclear how Middleton's automated dollar-bitcoin hedging will work without a lightning-quick and reliable dollar-bitcoin exchange platform. So, the true "automation" of bitcoin functions that integrate with the economy as a whole may require a reconciliation with existing trading platforms.

Dominik Zynis, the Mastercoin spokesperson, sees a gentler, more granular transition. Citing studies on disruptive innovation by the likes of 20th-century economist Joseph Shumpeter, he makes an analogy with the energy industry. "We're still [burning] wood. There's coal-fired power plants. Those didn't go away, [new technology] just got added on top." Usually, of course, that new technology has ultimately proven more powerful, and often enough more profitable. Some financial institutions, Zynis predicts, will be nimble enough to adapt. "If I'm an investment firm, do I see [peer-to-peer finance] as an opportunity, and adopt it, because it's ... more efficient? Or do I not make the investment, and in 10 or 20 years I become irrelevant?"

So, all bankers and stockbrokers might not go the way of the coal miner, telephone operator, or record store clerk. But the hard lessons of other upturned industries may now be relevant to the financial sector in ways they never were before.

Follow David Z. Morris on Twitter: @davidzmorris.

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