3 reasons Wall Street can't stay away from bitcoin

It's not surprising Apple is rethinking its policy to allow its apps to accept virtual currency payments. Retailers, including Lord & Taylor, Overstock and TigerDirect, are syncing operations to make it easier for consumers with digital wallets to transact business with the cryptocurrency. The trend has venture capitalists bullish on bitcoin. Already, San Francisco Bay-area bitcoin start-ups have received more than $200 million in VC funding, and the number continues to grow.

Why is this happening? There are three aspects to bitcoin that have investors particularly excited today, and it all begins very simply with speculation of the cryptocurrency's value.

Mining pools, such as the heavily funded super-secret 21E6 in San Francisco, are apparently going long on bitcoin by mining as many bitcoins as they can, making the bet that its value will exceed mining costs. 21E6 has raised at least $5 million in venture funding.

Another bitcoin start-up getting big dollars is Palo Alto, California-based Vaurum, which recently announced seed funding of $4 million from Battery Ventures, Tim Draper, RRE Ventures and Steve Case. Vaurum runs an exchange that facilitates over-the-counter bitcoin trading for institutional traders.

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Recently funded LedgerX claims they are building the "the first regulated, compliant derivatives exchange" for cryptocurrencies. Little else is known about this secretive start-up except that it already has more than a dozen investors, according to their AngelList page.

The second aspect of bitcoin that is exciting the venture capital community is the idea of consumers using the currency as a means of payment. Well-funded start-ups, such as BitPay, Coinbase and SnapCard, are trying to make bitcoin payments and purchases easy for the masses—both online and at brick-and-mortars.

Digital currency payment start-ups is where a lot of VC dollars are being funneled. BitPay recently closed a large round of funding led by Index Ventures. Coinbase may very well be the top-funded bitcoin start-up, with more than $30 million in venture funding to date.

SnapCard is a product of Boost, a San Mateo, California-based incubator of start-ups run by Adam Draper, son of well-known VC Tim Draper. The bitcoin payment company made waves earlier this year by announcing that consumers using SnapCard could pay taxes with bitcoin.

BitPay has more than 30,000 enabled merchants in its network, with about 10 percent of those actively executing a bitcoin-based purchase in any given month. According to the start-up's co-founder, Stephen Pair, there is a direct correlation between price rises in bitcoin and the transaction volume among merchants that accept it.

As the digital currency's price remains relatively volatile, that may not bode well for the short-term prospects of their merchants in increasing the volume of consumer bitcoin transactions. BitPay also believes that, ultimately, business-to-business transactions via the currency will be a much larger market for them versus consumer transactions. Given the large cost of international wires and currency exchange, they may be right.

All this speculation in this new form of currency has led to the problem of how consumers manage their bitcoin holdings. I spoke with one investor, who told me he has dozens of bitcoin private keys (secret protective pass codes) and isn't certain where they all are. That's the digital equivalent of saying that you're not sure where your money is kept. Start-ups like Xapo, Armory and, of course, Coinbase are hoping to address this problem by offering digital wallets to help consumers securely store their virtual currency savings.

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Since bitcoin keys are the digital equivalent of cash, the private key cannot be exposed to the public. The masses only see a consumer's public bitcoin "key," the address they use to sell and receive. Some individuals go so far as actually printing their private keys on paper to guarantee privacy. I expect to see a deluge of innovation in private key management in the coming months and years.

The applications of bitcoin go way beyond its use as an alternate currency. This leads to the third, and most complex, area of interest to investors. That said, it may be the area that generates the best return on investment in the long term. I refer to this as investing in the "decentralized trust model" of bitcoin. This new system leverages peer-to-peer computing and cryptographic techniques to create a new model for transactions that is both elegant and extremely useful.

It turns out that the bitcoin block-chain (which is a decentralized general ledger of bitcoin transactions) can be used to represent any type of asset, including traditional currencies, stocks, deeds and titles. It can even be used for alternative investments, like baseball cards, or used to place gambling bets. Companies are now starting to emerge, taking advantage of this new phenomenon. Two of the earliest pioneers: Ethereum and Colored Coins. Both start-ups combine earlier work in "smart contracts" (computer protocol that verifies transactions) with bitcoin's decentralized computing model to create a new platform for decentralized smart contracts.

Colored Coins uses the currency itself to represent other types of assets, such as traditional currencies, stocks or gold, which can be stored inside the bitcoin block-chain. Colored Coins provides extensions to bitcoin for these new asset types to be bought and sold via the standard bitcoin system.

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Ethereum takes a slightly different approach and has developed its own bitcoin–like currency—called Ether—for representing the myriad digital assets that can be created. Ethereum describes itself as "a platform and a programming language that makes it possible for any developer to build and publish next-generation distributed applications."

Ethereum and Colored Coins can, in theory, be used to securitize and trade just about anything, including domain names, financial assets, contracts and even intellectual property. While Ethereum addresses the problem of the limited float of bitcoin in creating any number of assets, Colored Coins may be more attractive, as it uses the existing bitcoin system for executing asset trades. The innovation happening in this area is a boon for e-commerce, no matter who wins favor with clients.

Ripple, another payments protocol, has also been making waves in this area of decentralized financial transactions. The Ripple currency, known as XRP, can be used to represent any form of asset, such as dollars, pesos and even bitcoin itself. It then allows exchanges of these assets to take place and settle directly on the Internet. Recently, Ripple has been gaining some traction with initial bank partners as a means for bypassing traditional correspondent banks to facilitate real-time settlement of cross-border currency wires. While bitcoin purists prefer a world with no central banks, Ripple embraces such institutions, which could mean that it may get short-term traction.