Friday, June 5, 2015

Why bitcoin has failed to achieve liftoff as a medium of exchange


It's pretty simple, really. For any medium of exchange to displace another as a means for buying stuff, users need come out ahead. And this isn't happening with bitcoin.

We can break any exchange medium's user base into consumers and sellers. Now we know that sellers love bitcoin—they've been adopting it at a blistering pace, from Amazon to Microsoft to CVS. No wonder when we consider the cost savings they enjoy. A merchant is required to pay around 1.5-2.0% for each credit card transaction. Bitcoin payment processors like Coinbase, Bitnet, and Bitpay charge just 0.5% while simultaneously absorbing all of merchant's forex risk. A retailer with $1 million in sales that converts all of its shoppers from Visa/Mastercard payments to bitcoin has just earned themselves $10,000. It's a no-brainer.

While sellers are jubilant, consumers aren't. Tim Swanson shows that bitcoin payments haven't budged in over a year with bitcoin processor Bitpay's transactions volume amounting to a piddling $57.5 million or so in 2014 (not including precious metals and mining). Bitpay controls at least a third of the payments market. That's what failure looks like, folks.

I think that this aborted takeoff can be blamed on the fact that the dominant consumer payments medium, the credit card, leaves the consumer with significantly more resources after each payment than bitcoin does. Consider the fact that consumers are always paid in U.S. dollars (or whatever their respective national currency happens to be). At the same time, sellers price their wares in dollars and accept payment in that unit, the dollar being both the dominant unit of account and medium of exchange. This is highly convenient to consumers. If someone wants to buy an annotated hard cover edition of War & Peace for $100, they never have to leave the dollar ecosystem.

Paying in bitcoin, however, means that the consumer must endure the cost of exiting the dollar ecosystem and entering the bitcoin ecosystem. One portion of this cost is comprised of the fixed non-recurring expense of learning how to set up the dollar-to-bitcoin portal. The next portion has to do with the commission that a bitcoin exchange will extract from the consumer for buying bitcoin, around 0.5%. At the same time, a consumer will have to pay an additional cost as they reach across the spread between the bid and ask price in order to amass the requisite bitcoin. Finally, consumers must bear the cost of coping with the incredible volatility of the stuff. In order to preserve the U.S. dollar purchasing power of the bitcoin up to the point of purchasing the $100 edition of War & Peace, the consumer needs to buy insurance. Either that or bear ghastly bitcoin exchange rate risk.

You can see why credit cards come out ahead. They are easy for the consumer to setup, they do not extract a foreign exchange commission, nor do they force users to bear any exchange rate risk. Let's work out the numbers. If a consumer earns $100 in salary and want to buy War & Peace for $100, a credit card provides them with enough purchasing power to consummate the deal. However, if they try to buy that same item with bitcoin, they won't be able to afford it. Assuming it costs 50 cents to buy bitcoin and 50 cents to hedge the price risk until the point of consummation, they need to earn at least $101 to afford War & Peace. It's out of reach.

There are ways to modify this setup so that War & Peace is brought back into the reach of the bitcoin paying consumer. Let's assume that bitcoin advocates are right and that the total resource cost of maintaining a bitcoin-based payments network is cheaper than running the credit card network by a significant wedge. The above calculations show us that, at the moment, consumers don't enjoy any of this wedge. In order to induce consumers to make the leap from credit cards, bitcoin sellers and payments processors have to share the savings with them.

Sellers can provide part of this inducement by introducing a lower U.S. dollar sticker price for bitcoin payments. Here's how it works. Our seller maintains their offer to sell War & Peace at $100 for credit card users but drops the price by seventy-five cents to $99.25 for bitcoin users. Let's further assume that the seller pays $2.00 in fees to the credit card network but only 50 cents to its bitcoin payments provider. Despite having discounted War & Peace's bitcoin price, the seller still comes out ahead for each switch from from credit card to bitcoin payments. Each bitcoin sales nets them $98.75 ($99.25 minus 50 cents), but each credit card payment only nets them $98.00 ($100 minus $2). Since they earn an extra 75 cents if they use the bitcoin payments ecosystem, sellers still have an incentive to adopt bitcoin payment.

The subsidy provided by the retailer reduces the consumer's overall cost of using the bitcoin ecosystem. As before, our consumer earns $100. Given the reduced $99.25 sticker price, a 50 cent fee to buy bitcoin, and a 50 cent fee to buy insurance, their net cost has fallen to $100.25 from $101. Its still out of their reach, but not by as much.

The bitcoin payments processor can join the merchant in providing consumers with an inducement. Say that for each transaction the processor pays the consumer a cash reward of 25 cents out of the 50 cents they earn from the retailer in fees. Let's rework the numbers. Given the $99.25 sticker price, a 50 cent fee to buy bitcoin, a 50 cent fee to buy insurance, and a 25 cent rebate, the consumer's net cost has fallen to $100. Paying for War & Peace with bitcoin is now competitive with a credit card. Only now does it makes sense for a consumer to make a leap from the credit card rails onto the bitcoin rail. If merchant and processor can afford to add even more inducements, consumers will switch to bitcoin all the faster.

As an aside, some readers may have noticed I haven't included credit card rewards (i.e. points, air miles, and cash back) into my calculation. I'm making what I think is a pretty fair assumption that no one gets something for nothing. Those running the credit card system fund the rewards they pay to consumers by charging merchants a higher fee. To preserver margins, merchants will build this fee into the U.S. dollar price of the products they sell. This means that the value of rewards that the average card payer earns is entirely canceled by the higher price premium, effectively driving their benefit to zero.

Back to bitcoin. Inducing participation from the consumer isn't a technical problem, it's coordination problem, one that bitcoin entrepreneurs haven't seemed to figure out yet. As far as I can tell, retailers are not providing visible bitcoin price discounts in U.S. dollar terms, nor are payments processors like Bitpay and Coinbase providing consumer's with rewards. By focusing on offering merchants a superior product and omitting the consumer side of the equation, bitcoin entrepreneurs are trying to lure the cat into the door whereas a true tipping point requires going after the tiger.

Alternatively, they may not be going after the tiger because they can't. The ability of bitcoin payments processors and retailers to induce participation from consumers depends on the size of the wedge. If a bitcoin payment system does not provide any resource cost savings, then there is no kitty from which to buy consumer participation. In which case, long live Visa and Mastercard.

There is a misguided view out there that the problem of coaxing consumers into the bitcoin loop will solve itself as bitcoin's volatility disappears and trading costs fall, thus reducing the average consumers' costs of engaging with the cryptocurrency. See the founders of Coinbase here, for instance. This view is wrong. Take trading costs. Even if bitcoin trading commissions fall to zero, there will always be a bid ask spread that consumers will have to endure in order to get bitcoin, and therefore some disincentive to switch away from cards.

As for volatility, the only way bitcoin will ever shake it's toing and froeing is if it is pegged to the dollar by some powerful organization. Not likely. Nor will increased participation flatten out bitcoin's screaming ups and downs. Unlike stocks, gold, or U.S. dollars, bitcoin lacks a non-monetary stabilizer (see here and here). Put differently, its price is indeterminate. More buyers and sellers participating in bitcoin markets will not change this fundamental fact. So contrary to hopes that Bitcoin will become more cuddly, its future is destined to be a frenzied one. Unless consumers are compensated for bearing this volatility, or shielded from it, they'll keep using cards. If they can, retailers and payments processors should be trying their best to subsidize these costs. Without such subsidies, bitcoin is unlikely to ever achieve liftoff.



I started to write this post a few days ago. This is a snippet of the original: "Bitcoin's inability to achieve mass consumer adoption is a good indicator that it will never take off." So you can see that I've changed my mind in writing this post.

30 comments:

  1. actually the biggest plus for using visa is the charge back, while merchants don't like this, the people with money to spend like the protection, with no reversible option on bitcoin the consumer will never feel in the driver seat making the purchase, and therefore will never use it..

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    1. This was my first thought of a missing benefit when reading also.

      Why would a net cost of the same figure encourage me to use Bitcoin with all the hassle it comes with?

      Bitcoin needs to be able to buy goods at a discount OR have advantages that fiat currency via credit card does not... otherwise what is the point? Even at a discount... if it was a $100 book and I could get it for $99 using Bitcoin then maybe I'd switch for smaller value goods, but for big ticket items like airfares, electronic goods and similar I would stick with a credit card and the protection it offers.

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    2. Yes, I forgot to mention charge backs. They fall in the same category as card rewards. Buyers insurance has a maintenance cost which the card network probably extracts from merchants. As they do with the cost of rewards, merchants will build this cost into their sticker prices, so that consumers are paying for insurance via the back door.

      If the bitcoin rails are truly cheaper than the card rails, then payments processors should be be able to fashion some sort of equivalent to credit card buyers insurance, all the while continuing to charge merchants a low enough fee that they can pass off to consumers via a lower bitcoin sticker price.

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  2. my two cents ... i had, and have, no understanding of bitcoin .. love the idea in principle, but what the heck is "mining"

    so i will say apparent complexity is one big reason btc hasn't taken off

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    1. In order to effect a bitcoin exchange someone outside the transaction must confirm that it happened by checking the encryption verifications from both parties. Only then will the transaction appear in the block chain. In order to motivate third parties to provide the service, new bitcoins are created and given to the third party who adds the transaction to the ledger. The third party is called a miner and the act of adding transactions to the block chain is called mining.

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  3. Why do you think that "buying stuff" is a relevant variable for measuring the moneyness of a good? As far as I know, that contradicts the definition of monetary demand of every school that I'm familiar with. You could use the same argument to analyse the monetary demand for gold or for US treasury bonds and conclude that they are a failure.

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    1. Also, credit cards are not a medium of exchange, which makes the whole article even more puzzling.

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    2. Peter, cards are not the medium of exchange. But cards do allow for the creation of a form of short term revolving credit that is a medium of exchange.

      I am not saying that bitcoin isn't liquid or that it doesn't have moneyness. I'm saying that in retail transactions, it makes very little sense for consumers to exercise the liquidity of bitcoin over the incumbent (unless changes are made to the way merchants set bitcoin prices).

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    3. "Peter, cards are not the medium of exchange. But cards do allow for the creation of a form of short term revolving credit that is a medium of exchange."

      If by "a form of short term revolving credit", you mean a demand deposit then yes. If you mean the loan created from using the credit card, then no.

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    4. If I buy a $100 book with a card, the network has allowed me to create a short term $100 IOU and use it as a medium of exchange.

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    5. Credit card debt is not a medium of exchange. It is illiquid and it is not held for liquidity purposes. It's a revenue stream for the lender, not a medium of exchange.

      I can only repeat that measuring medium-of-exchange-ness by retail payment is an idea which has no reflection in any economic theory that I am familiar with. There are situations where these two variables correlate positively, when they correlate negatively, and when they are uncorrelated.

      I don't know why people like Swanson invented the idea, nor do I know why you repeat it. During a hyperinflationary collapse of fiat, Swanson will be jubilating that bitcoin is dying because everyone is hoarding it and prefers to pay in fiat instead.

      Similarly, the idea that people choose a medium of exchange based on the stability of its price is not supported by any economic theory I know of either. Again, this appears to be invented by Swansonites. But you have read more papers than me, so maybe you know of some. Since Swanson ignores my requests to provide support for his claims, maybe you can.

      Also, you focus on the fees involved in the transaction, and ignore other forms of transaction cost, but that's en empirical question, I'm not hung on that too much.

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    6. Would you take less offence to this post if I had called it "Why bitcoin has failed to achieve mainstream success as a retail medium of exchange?"

      Apart from that, I think my logic is pretty sound.

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    7. Yes I would have much less problem with that. And I would have take no offence at all if you labeled it "Why bitcoin has failed to achieve acceptance as a retail payment platform" and omitted the "medium of exchange" term altogether.

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    8. Perhaps since we're already talking about, are you aware of any academic paper or even a school which analyse and lead to the conclusion that:

      - retail transaction volume is positively correlated with moneyness
      - people choose medium of exchange based on price stability

      ?

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  4. You never gonna undestand bitcoin because US citizens are living in the new Soviet Union and don´t realize of it. #1 rule for freedom is privacy advocate, and it´s lost in the USSA.

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  5. Bitcoins could have a more stable and predictable price if they were not deflationary, but then they wouldn't generate the excitement of a casino reward to holders which seems like a key factor to their popularity.

    If the Bitcoin community was serious about crypto currencies as a medium of exchange, instead of as a lottery ticket, they would switch to a version that predictably loses value over time forever like all other stable currencies.

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    1. There are a number of plans to develop stable cryptocoins, in which case consumers wouldn't have to be compensated for the costs of insuring against volatility. This would make crypto more competitive with cards.

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  6. Any predictably priced intrinsically valueless currency has to lose value over time or at least always have a risk adjusted return bellow intrinsic stores of value. By intrinsic, I mean stores of value of which an accumulation is tied to and increase in future availability of things people want or tied to an increase in production capacity of such things. Such store of value would look like stockpiles of stuff, investment in businesses, in infrastructure etc.

    Intrinsically valueless currencies that are designed to be used as stores of values having above private market returns get hoarded and when time preference changes and people want to spend their savings, the money is there but the stuff you are supposed to be able to buy with the money isn't and boom price volatility.

    Will anybody care about cryptocurrencies once it is designed to weed out the cheerleading early speculators looking to make a quick cryptobuck?

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  7. The level of payment card fraud is relatively low as a percent of transaction volume however if half the transaction volume were to drop by half (due to Bitcoin or other alternatives) the payment card fraud would remain at the same level (thus the rate would be twice its current rate). So instead of merchant rates being in the 3% range, the rates would need to rise to 4% or higher to compensate for the higher rate of fraud.

    If that were to push even more transaction volume over to alternatives, the fraud rate on cards would increase such that the merchant rate might need to rise even higher to compensate, e.g., to 5%. Eventually, credit cards just couldn't compete due to the fraud.

    In reality, chip&pin plus bank mobile apps (which collect and report location) causes the rate of payment card fraud to drop to minimal levels. Some businesses (e.g., travel industry) will continue to have higher fraud levels than others but they already get charged a higher merchant rate.

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  8. Two false statements that you base your whole conclusion on:
    "Consider the fact that consumers are always paid in U.S. dollars"
    Nope, I am paid in bitcoins via bitwage which allows me to get my paycheck converted to bitcoins for free.
    "retailers are not providing visible bitcoin price discounts in U.S. dollar terms"
    gyft.com and egifter.com which allow you to purchase merchandise with bitcoins at eBay, Home Depot, Applebees, Burger King, Target, Chili's and about 100 more retailers gives you 3% off of your purchase.
    Purse.io allows you to purchase items with bitcoins on Amazon.com for up to 50% discount with the average discount being 21% while you can do an immediate purchase for 5% off. I have personally received 35% off of my Amazon purchase through them by paying with bitcoins.
    The only reason that Bitcoin has not taken off is that people who make their purchases from these sites with their credit card do not understand Bitcoin enough to know that they could be getting a discount on their purchase fairly easily.

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    1. Thanks for engaging.

      1. Do you really think you represent the average US wage earner?

      2. Gyft.com appears to give 3% in Gyft points to people who buy a gift card using bitcoin, and 2% if they use a credit card to by a gift card. This shouldn't be construed as a situation in which the actual retailers provide the discount. We want to see Walmart directly offering a discount on its website before we can say that retailers are trying to share bitcoin's purported network cost savings with consumers. The Amazon discount you mention only appears to work because bitcoin is so difficult to get into that people will pay a large premium via an Amazon "back door". In other words, its not the kind of discount that I'm talking about. We want to see Amazon offering a direct discount to bitcoin payers before we can say that it is trying to share cost savings with consumers.

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    2. Purse works not because bitcoin is difficult to buy, but because fiat is difficult to sell.

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    3. I think I agree. Although it seem to me that it's not fiat that is difficult to sell, it is Amazon credit (which is indexed in fiat units) that is difficult to sell. The illiquidity of Amazon currency is what Purse is capitalizing on.

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  9. Why would anyone want to things to subsidise Bitcoin? It's future won't be frenzied. It will just slowly drift down to zero.

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  10. I don't think Bitcoin was meant to help American consumers... we have it pretty damn good. But what about the other half of the world? There are over 3 billion people (estimate) that do not have access to banking or credit cards. Bitcoin doesn't need a bank or credit card, all it needs is an internet connection or a phone. Unfortunately this article doesn't address these benefits and misses this entire point completely. I've never visioned Bitcoin changing the way Americans consume but I do see how it could change the lives of the billions who aren't as fortunate as us to have banking and monetary safety abroad.

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  11. A common misunderstanding. Bitcoin does not fight against the credit card system. First of all it provides a money system to the unbanked. Yes, a lot of people don't have credit cards and live in crappy countries where the volatility of the currency is much higher then the one of the bitcoin system.
    US Dollar falls the last, not the first, but in the end, all paper money will be worth only the papier it's printed on.

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  12. Joel Aaron FreemanJune 11, 2015 at 4:21 PM

    Good post, JP. In order for bitcoin to become a medium of exchange, it must differentiate itself and be the most convenient tool for one particular purpose. There's plenty of room for new mediums of exchange, at least in theory. People choose to hold $1 bills, $5 bills, $10 bills, and checking accounts -- so we already have a multiplicity of mediums of exchange.

    The best answer I've come up with is tourism. A bitcoin entrepreneur could open a bank account in 10 neighboring countries with 10 different currencies, and then create a smartphone app(?) that allows a tourist to make retail payments in each country. The tourist is able to hold some amount of bitcoins while country-hopping, and doesn't have to micro-manage 10 different currencies.

    Unfortunately, I can't think of a region where this makes sense. Central America? The creation of the Eurozone was, I think, very unlucky for bitcoin.

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  13. Good post. One comment on volatility: a lot of the volatility so far has been due to uncertainty about Bitcoin's future. The price went up to $1000 because people were thinking "maybe Bitcoin will be widely adopted as a currency", and it went back down to $225 when people started to have doubts about this. In time our uncertainty about Bitcoin's role in the economy will decrease, which should reduce the volatility to some degree. The underlying value of a bitcoin is roughly determined by the equation of exchange, so it should fluctuate with expectations about the value of total Bitcoin transactions increasing (either because Bitcoin usage as a percentage of other payment methods changes, or because the economy as a whole grows/shrinks).

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