Starbucks, monetary superpower

I recently spent some time on Twitter discussing the monetary wonders of Starbucks. In this post I'll bring a bunch of tweets together into a single blog post.

I don't go to Starbucks very often, so I only recently learnt that the company has succeeded in getting many of its customers to stop using cash and debit/credit cards to buy coffee. Instead, they are using  Starbucks's own payments option:

Wow Starbucks, what a great gig.

Starbucks has ~$1.6 billion in 'stored value card liabilities' i.e. the Starbucks Card. So ~6% of the firm's liabilities are comprised of coffee addicts paying 0% for the privilege of lending to their supplier.
Source: https://t.co/nGH2arujYz pic.twitter.com/cGcSW3L4MM

— JP Koning (@jp_koning) August 11, 2019

Starbucks has around $1.6 billion in stored value card liabilities outstanding. This represents the sum of all physical gift cards held in customer's wallets as well as the digital value of electronic balances held in the Starbucks Mobile App.* It amounts to ~6% of all of the company's liabilities.

This is a pretty incredible number. Stored value card liabilities are the money that you, oh loyal Starbucks customer, use to buy coffee. What you might not realize is that these balances  simultaneously function as a loan to Starbucks. Starbucks doesn't pay any interest on balances held in the Starbucks app or gift cards. You, the loyal customer, are providing the company with free debt.

Starbucks isn't the only firm to get free lending from its customers. So does PayPal. That's right, customers who hold PayPal balances are effectively acting as PayPal's creditors. Customer loans to PayPal currently amount to over $20 billion. Like Starbucks, PayPal doesn't pay its customers a shred of interest. But Starbucks's gig is way better than PayPal's. PayPal is required to store customer's funds in a segregated account at a bank, or invest them in government bonds (see tweet below). So unfortunately for PayPal, it earns a paltry amount of interest on the funds that customers have lent it.

PayPal is a good example of a modern 'narrow bank'. Customers have deposited ~US$20 billion at PayPal. And PayPal invests these funds in very boring things listed below, like bank deposits, time deposits, government debt etc.

Source: https://t.co/snJel203QM pic.twitter.com/EDfMA2Wkux

— JP Koning (@jp_koning) August 21, 2019

Starbucks, on the other hand, doesn't have to keep customer funds in a low yielding segregated account or government bonds. Why is that? PayPal allows people to cash-out of PayPal dollars into regular dollars, so for regulatory purposes it must keep an adequate reserve on hand to facilitate redemptions. But the only way to cash out of Starbucks balances is to buy a coffee--a promise that Starbucks can always keep! And so Starbucks can immediately put its customer loans to work in higher-yielding opportunities like funding its operations and expansion.

In addition to borrowing from its customers, Starbucks also borrows from professional investors. Here's a list Starbucks's long-term debt:

Starbucks is paying an interest to bond and note-holders that ranges as low as 0.46% (on its yen notes maturing in 2024) to 4.5% (on its 2048 notes). You can see why borrowing from customers in the form of stored value card liabilities is the better option. By expanding its borrowing from its non-professional lenders and using the proceeds to cancel its debts to professional lenders, Starbucks can make an immediate profit.

But there's more. As I pointed out in the following tweet, don't forget breakage. Bond and note holders are pros. They don't forget about debts. But customers aren't so exact. They are sloppy, or busy, or forgetful, which means that many gift cards and balances will go unspent:

Few companies can get that much free financing. But don't forget breakage—balances that will never be redeemed. In 2018 Starbucks recorded breakage of $155 million,~10% of all card balances.

So the true rate at which customers are lending to Starbucks is probably closer to -10%. pic.twitter.com/hRaN7LGoEf

— JP Koning (@jp_koning) August 11, 2019

Each year Starbucks recognizes that a portion of its stored value liabilities will be permanently lost. This is known as breakage. Starbucks recognizes this amount as profit. In 2018 the company recognized $155 million in breakage, around 10% of all stored value balances. Wow! Starbucks already pays just 0% on its debts to customers, but add in breakage and that equates to a roughly -10% interest rate!

On Twitter, Wayne points out to me that I need to add back the impact of Starbucks rewards. App users receive stars on each purchase which can be saved up for free coffee. This functions as a form of implicit interest that Starbucks pays to its customers.

I earn about 50% equivalent interest per year on my Starbucks card. 2 Americanos per week earns me a free one about once every 3 months. Roughly $12 per year in free purchases. I keep between $10-$25 balance on the card. Earning $12/year on a $25 investment is a good return.

— Wayne Culbreth (@wayne_culbreth) August 11, 2019

That's a good point. But if were going to bring rewards into our calculation, then there are other non-pecuniary flows that need to be added in too. Keep in mind that each payment made through the Starbucks app is a payment that isn't made by credit card. Since each credit card payment will cost Starbucks 1-2% in interchange fees paid to the card networks and banks, the company saves a lot of money by guiding customers to its payments app. As for Wayne, while he may earn an implicit interest return in the form of Starbucks points, by forgoing a card payment he's giving up on the associated cash-back or airline points.

Another flow that needs to be accounted for is data. By capturing the customer's wallet, Starbucks is getting loads of free but valuable personal information that would otherwise be lost, or for which it would have to pay. Any customer who pays with cash forgoes rewards, but at least they get to retain their information. 

Adding all of this up, (0% interest + breakage - rewards + interchange savings + customer information), Starbucks's stored value liabilities are a terrific liability to have.

More generally, I think this calculation demonstrates how providing financial services to a retail customer base is a great business. Retail customers don't seem to be too fussy about the return they get. And they are busy and distracted and sloppy and forgetful. Take central banking, for instance, which serves a retail clientele. People are pretty happy to hold banknotes that pay 0%. But you never see businesses or professional investors hoarding banknotes. They quickly return the cash they take in during the course of the day to their bank so that they can harvest interest. Commercial banking is also a good example. Like Starbucks, banks are able to borrow from their retail customers at a measly rate approaching 0%. But professionals who lend to banks by purchasing their bonds require a much higher rate. To top it off, retail customers unnecessarily sign up for high-fee products and avoid changing banks when there is a cheaper option.  

Why doesn't every retail chain try get into this game? By borrowing as much as they can from the non-professional public, they'd steal plenty of profitable business from central banks and retail banks. Well they do. Gift cards are a big business. And if you think about it, retailers are perfect candidates for providing monetary services to the masses. Like banks, they already have a network of physical stores. But none of them have been successful at it as Starbucks. Walmart is much bigger than Starbucks, for instance, but it has just as many gift card balances outstanding:

Starbucks is really good at harvesting seigniorage.

Walmart's annual sales are 20x larger than Starbucks sales (~$500b vs $25b). But Walmart only has $1.9 billion in unredeemed gift card balances, not much more than Starbucks. Source: https://t.co/LBs6DE1cGq pic.twitter.com/wtJltMt26L

— JP Koning (@jp_koning) August 11, 2019

Perhaps Starbucks's success has to do with the regularity and homogeneity of Starbucks purchases? And so customers are willing to preload a dedicated account? I'm not sure.

In any case, there are probably a few Starbucks executives who'd love to grow the amount of negative yielding liabilities that the firm issues. Why stop at $1.6 billion in stored value liabilities? Why not grow the program to $5 billion, $10 billion, or $100 billion? It would be a terrific business line to get into.

The problem here is that Starbucks only sells coffee. Coffee is great, but the demand for dollars that are only useful for buying coffee will always be limited. To really grow the amount of stored value liabilities it issues, Starbucks would have to increase the usefulness of Starbucks dollars. One way to do this would be to open up the Starbucks app up to other stores. If consumers could also buy Big Macs with the balances on Starbucks App, this would increase the demand for Starbucks balances. To secure McDonald's cooperation, Starbucks would have to share the savings, breakage, and data. Maybe companies like Home Depot and Costco would join the Starbucks-McDonald's alliance. (And other chains, say Kroger and Burger King, might join the competing Walmart Pay alliance).

Sure, each of these companies could simply pursue their own independent stored-value liability programs. But wouldn't an alliance be better? From the customer's perspective, balances held in a single payments app that can be spent at Starbucks, McDonald's, Home Hardware, or Costco would be far more useful then dollars held in four separate and walled-off apps. And so collectively these stores should be able to get the public to hold more stored value card liabilities than they could individually. Which means more breakage, free loans, and data for everyone (and less for the banks, card networks, and central banks).

Who knows if it would be successful. And it might not even be possible from a regulatory perspective. But it would be tempting, no? In a world where most debtors have to pay interest, being  a debtor who earns interest is pretty hard to beat.

---

*I believe that current portion of deferred revenue is equal to around $174 million. This comes courtesy of the current portion of an up front royalty payment from Nestlé. So the stored value card liability is actually closer to $1.46 billion. Still pretty high. 

Stigmatized money

Some payments systems are so awkward they scare away the average user. The only people with the patience to stick around must have a motivation for doing so. These include ideologues with an ax to grind, hobbyists who happily embrace complicated features, and criminals/weirdos who are shut out of everything else.

Here are a few examples of awkward payments systems:

-Local Exchange Trading Systems, or LETS
-Bitcoin/Dogecoin
-Labor notes
-Stamp scrip

When usage of a payments system is confined to a narrow group of like-minded individuals, this may stigmatize these systems, scaring away mainstream users. Stigmatization only compounds the initial awkwardness. After all, if fewer venues accept the stigmatized payments option then it becomes harder for the small band of users to make purchases. A vicious circle has been created. Initial awkwardness leads to stigma which leads to more awkwardness etc.

While this vicious circle is the death knell for a payments system, it is less of a problem for other products. You can make a decent living by targeting a small niche of consumers, say communists who eat vegan food. Every big city needs a communist vegan restaurant. But a payments network is only as good as the size of the payments pathways that it facilitates. A payments entrepreneur won't get very far by building a platform that only allows communist vegans to pay other communist vegans. 

How to evade the awkwardness-stigma spiral? What is needed is a frictionless, non-awkward payments system. With little to learn, everyone—not just nerds and those with an ax to grind—can quickly start using it. Think M-Pesa or Visa or Octopus.

Even the haters will get onboarded. Gold bugs and bitcoiners may rail against banks and fiat money. But because everyone else is using these relatively simple systems, the bugs and the bits have no choice but to go along. By bringing the vast hoard of normies on board along with the weirdos, these systems avoid all connotation. They are safe for broad consumption. No stigma can attach to them. And so the vicious awkwardness-stigma circle I described gets sidestepped.

I'd argue that LETS are an example of a system that suffer from the awkwardness-stigma spiral. LETS are a pain to use. This article on the famous Comox LETS and its founder Michael Linton, an earlier proponent of LETS, explains some of the problems. And so the only people who use LETS will be those willing to put up with the awkwardness: folks who self-identify as leftist with anarchic views. Those who don't share those views might feel weird joining a LETS. So LETS remain small and fragile, or as Linton says, they're like "sandcastles on the beach."

You see the same awkwardness-stigma cycle at play in bitcoin. Bitcoin is an awkward payments medium. The stuff is so volatile that retailers don't like to accept it. Risk averse consumers don't want to hold it. So only a subset of the population will ever feel comfortable using bitcoins for payments.

This subset has developed its own norms and codes. Bitcoin steak dinners are a good example. A large group of predominately male bitcoiners will get together to eat meat while avoiding vegetables, then broadcast it on Twitter:

Thank you @pierre_rochard for organizing the Bitcoin Steak Dinner last night! It was a pleasure and a blast meeting with so many bitcoiners! Tag yourselves so we can connect on Twitter 😎☇ pic.twitter.com/UzD40SNqF6

— Gustavo J. Flores E. (@GustavoJ_Flores) March 10, 2019

I'm sure it's a lot of fun. But these sorts of traditions will inevitably be perceived as weird by the majority. And so the majority will go out of their way to avoid bitcoins for fear of being tarred as an oddball. Other niche groups who can't sympathize with male carnivores, say lesbian vegans, will avoid bitcoin payments on principal. This stigma cuts down on the potential pool of bitcoin payees, which only makes bitcoin more annoying to use.

Mastercarders don't have their own set of traditions. For instance, you won't see Mastercard users setting up meetups to eat organic food and talk about the latest development in tokenization technology. The Mastercard/Visa user-bases are devoid of culture and character. This lack of a class consciousness is one of the features that makes them such effective  payments networks. Systems without norms and traditions never face the risk of falling into the stigmatization hole.

Facebook's Libra has attracted plenty of attention over the last few months. But Libra risk encountering the same awkwardness-stigma cycle as Bitcoin and LETS. Unlike other social media-based  payments tools (Wechat, Kakao, Line etc), Libra's architects have chosen to create a new unit of account rather than marrying Libra tokens to existing units like the dollar or euro.

But as I suggested in a previous post, it's a pain to learn a new unit of account, just like it's a hassle to learn a new language. So only a certain type of motivated person will bother using Libra, just like only motivated people—language nerds—learn Esperanto. This weirdo factor could stigmatize the system. Hey, look at those Libra-using elitists! What snobs! By crowding out normies (and the massive number of potential payment pathways they bring to the table) Libra runs the risk of never self-actualizing as a payments system. Better to take the safe and boring route of linking Libra to dollars and yen and whatnot. 

The vicious awkwardness-stigma cycle has already started to hit cash. In places like Sweden, cash is being stigmatized. When the middle and upper class are convinced that only the poor and criminals use coins and banknotes, many of them will go out of their way to avoid using cash. Cash becomes "grungy and unsexy," as Brett Scott puts it. Unfortunately, an ever narrower base of cash users will only make the stuff more expensive for retailers to handle, leading to a rise in cashless stores (especially ones that cater to the rich), leading to more awkwardness and stigma, leading to less users, etc.

David Birch has an interesting parable from William Gibson's Count Zero that illustrates what happens when this stigmatization is brought to its logical conclusion. Basically, cash is still around in Gibson's imagined future, but it has disappeared from "polite society". And so the story's protagonist, Bobby Newmark, describes it as unspendable:

William Gibson imagined a future where 'polite society' won't accept cash. From 'Count Zero' ht @dgwbirch pic.twitter.com/Bh9ZKVDmJz

— JP Koning (@jp_koning) October 3, 2016

If cash is to avoid a Gibsonian future, it needs to be de-stigmatized. But this requires that it re-attracts many of the people and businesses that have deserted it because it is no longer convenient. In a post  at the Sound Money Project (and earlier on this blog) I suggested paying interest on cash. Thus individuals and businesses would be compensated for the relative inconvenience of note storage and handling. And with a wider range of people using notes, any stigma that they have attracted would dissipate.

Stigma is dangerous for a payments system. A system will become stigmatized if it attracts a clique rather than a broad group of users. Cliques kill a payments system since they suppress the system's connectiveness. To avoid the potential for clique-ization, systems should try to be as easy to use and accessible as possible.

Prepaid debit cards. The other anonymous payments method

When it comes to financial privacy, good old fashioned banknotes and privacy cryptocurrencies like Zcash & Monero get all the attention. But as I recently wrote for the Sound Money Project, let's not forget about prepaid debit cards.

Having written a bunch of posts over the last two years about financial privacy, I recently decided that it was time to step up my own personal financial privacy game. A few months ago I walked into my local pharmacy and bought my first non-reloadable prepaid debit card (i.e. gift card), a Vanilla card.

You've probably seen the rack of prepaid cards near the front of pharmacies and department stores. Some of them are closed-loop cards. They can only be used to buy things at the issuer, say Tim Horton's or Starbucks. But some of them, like my new Vanilla Prepaid card, are open-loop cards. That means they can be used wherever Visa or MasterCard are accepted. In Canada, Vanilla cards are sold in denominations from $25 to $250.

The Vanilla card that I bought doesn't have my name on it, nor did I have to show any ID to buy it. I paid for it in cash. This means that whenever I use my card, my identity won't be associated with the purchase. My card is backed by dollars held in a pooled account at Peoples Trust Company, a Canadian bank. It gives me the right to anonymously route my portion of the pooled funds along the MasterCard network to a retailer who operates a MasterCard terminal.

Given that authorities and banks have spend decades constructing a vast financial surveillance apparatus (the Bank Secrecy Act, FATF, AML, CFT, suspicious transaction reporting etc), it seems odd that this small window for accessing the digital payments system anonymously would have remained intact. To comply with Canadian anti-money laundering requirements, card-issuing banks require that the prepaid card seller (my pharmacy) collect the buyer's personal information if the face value of the card exceeds $1000. For amounts below that, due diligence is waived. The same practice is followed in the U.S. This regulatory exemption is why I didn't have to give up my anonymity when I bought my card.

The idea motivating the sub-$1000 exemption is that small amounts of anonymity can't easily facilitate criminal activity, but larger amounts can. (Note that I can convert my non-reloadable Vanilla card into reloadable format—i.e. a card that I'll be able to add money after the first batch is used up—but I'll have to register and forfeit my information. Only non-reloadable cards below the $1000 cap are exempt from due diligence.)

I'm not obsessed with privacy. I still use my information-laden credit card for a big chunk of my day-to-day purchases. But from time-to-time I want to have the option of shielding my data from outside observers. Cash is good for that. I already use banknotes and coins to pay for about half of my face-to-face purchases. This is usually for the sake of convenience, but sometimes it's because I'd prefer not to give up too many of my personal details to the retailer (especially small shops I've never been to before).

By adding a non-reloadable prepaid debit card to my wallet, I've gained an extra degree of protection. Say that I've used up all of the cash in my wallet, or I need to make a purchase in a place that doesn't accept cash, or I want to buy something online—well, a prepaid gift card offers me a way to make a transaction while still protecting my data.   

Law abiding citizens who are conscious of their financial privacy are a pretty small demographic. Sellers of non-reloadable prepaid cards have much larger markets in mind, specifically: 1) people looking to buy convenient gifts for friends and family or; 2) the unbanked and underbanked, i.e. those who don't have bank accounts or have them but don't use them. By allowing people to buy prepaid cards without identification, those without formal credentials such as driver's licenses, social insurance numbers, or credit scores can still make digital payments. Think the homeless, children and teenagers, immigrants, and refugees.

The post-9/11 brigade of security-at-all-costs zealots would love for regulators to shut the prepaid anonymity window. They worry that terrorists and money launderers will abuse prepaid cards. The anonymous prepaid window has only stayed open because these zealots have been countered by a collection of banking lobbyists who want to keep doing business with the unbanked and politicians who care about the disadvantaged.

I'm neither unbanked nor underbanked. I've got several bank accounts that I often use. Nor am I buying these cards as gifts. So I'm not really the target market for non-reloadable debit cards. My ability to get anonymous access the digital payments system is really just a by-product of the wider effort to make it easy for the unbanked to plug in. This is a precarious position for a privacy-conscious individual to be. In the U.S., where only ~93% of the population is banked, the constituency for anonymous prepaid access is relatively large. But in places where the banked population is approaching 100% (Canada, Finland, Germany, Netherlands, Denmark, Belgium, Sweden, UK), there is probably diminishing political support for providing anonymous access to the banking system.

In Europe, for instance, the window for anonymous access to digital payments seems to be closing. When the EU's 4th Anti-money laundering directive was passed in 2015, up to €250 in electronic money (the EU's term for prepaid instruments that reside on a device, say a card or a phone) could be bought without being asked to give up personal information. With the passage of the 5th Anti-money laundering directive in 2018, this amount has been reduced to just €150. And a new ceiling on online purchases of €50 was introduced. As I wrote in my recent Breakermag article, such a tiny amount of anonymity just isn't that useful.

One thing I've noticed about prepaid financial anonymity is that it is expensive. My first Vanilla card had a face value of $25. But I had to pay an onerous $3.95 to activate it. Buying higher value cards defrays this expense, but it still costs $7.50 to activate a card with a face value of $250. That's a 3% levy. Keep in mind that when I use an anonymous prepaid card not only am I paying the activation fee, I am also forgoing 2% cash back that my not-so anonymous credit card would otherwise provide me with.

Think about it this way. Let's say I decide to buy my groceries anonymously using a prepaid card. My $250 only gets me $242.50 worth of goods ($250 less the $7.50 activation fee). With my credit card, I can get $255 worth of food ($250 plus $5 cash back). That's an extra $12.50 in spending power if I decide to go the non-anonymous route. Sure, by using a prepaid card I've prevented my grocery store from being able to collect information about my eating habits. But is the $12.50 I've given up worth it? (Incidentally, this calculation also indicates how costly it is to be unbanked!)

While prepaid anonymity is handicapped by a low ceiling and high fees, the drawbacks don't stop there. Non-reloadable prepaid debit cards are great for buyers who want small amounts of privacy, but they don't help out retailers who want to shield themselves. In a recent article, privacy advocate Timothy May made a great distinction between buyer privacy and seller privacy:    

I like the distinction that Tim May draws between "buyer anonymity" and "seller anonymity."

As consumers we tend to focus on the former. But anyone who is selling a controversial product (i.e. birth control information) also needs protection from tracking https://t.co/2cFguzsn6G pic.twitter.com/6NHf3x46zf

— JP Koning (@jp_koning) October 20, 2018

If someone is selling a controversial product (May uses birth control information as an example), they must always be wary of snitches who make a purchase only to "out" the seller, either by reporting the transaction to the authorities or posting it to social media. Controversy-wary payments providers will quickly cut the seller off. To protect themselves, sellers need a payments method that doesn't leave a paper trail. They also need a payments system from which they can't be censored. Cash is a good example—it doesn't leave a paper trail and is censorship resistant. So are privacy-friendly cryptocurrencies. But prepaid cards don't cut it. The seller can easily be reported to the network and banished.

The last drawback of non-reloadable prepaid debit cards is that they can't be used to make anonymous person-to-person payments. As far as I know, there is no technical reason that I shouldn't be able to use my Vanilla debit card to anonymously send $100 to anyone else with a Visa card, just by inputting their card number and clicking send on a website. In theory, this payment should get pushed across the Visa network.

But there are regulatory reasons that I can't do so. In the U.S., the Financial Crimes Enforcement Network (FinCEN) prohibits anonymous debit cards from offering person-to-person capabilities, and I believe the same rule applies in Canada. Meanwhile, cash and privacy-friendly cryptocurrencies do allow for anonymous person-to-person payments.

In sum, non-reloadable prepaid debit cards allow for a small extension of one's financial privacy. But in an age where the ability to make payments without someone snooping is getting increasingly rare, I suppose we have to take whatever crumbs we can get.

Swish > cash and bitcoin

Ok, another Sweden post. I keep returning to Sweden because no country has gone further down the road to being cash-free. Since all of us seem to be following the same trajectory, we should probably be paying attention.

Lucky for us, every two years the Riksbank—Sweden's central bank—-carries out a payments survey and puts the data up on its website. One of the most interesting questions that is asked is "which of the following payments methods have you used in the last month?"

I plotted out some of the data and tweeted the result:

Sweden is at the forefront of digital payments. I made this chart with data from the Riksbank payments survey: https://t.co/WTZlFYOl2Y:
1. Debit cards are universal, beating out credit
2. Cash use is plunging but still high
3. Swish adoption is exploding
4. Not much bitcoin usage pic.twitter.com/fal0pfYdMz

— JP Koning (@jp_koning) February 20, 2019

What follows are a few observations.

Swish beats cash

Only 61% of Swedes used cash in the last month, down from 94% just eight years ago. But 62% now use a service called Swish. Swish is a mobile payments app that Swedes use to pay each other in real-time and on the weekend. Think Venmo or Zelle in the US, or Interac e-Transfer in Canada. These sort of payments options are not really used much at the point-of-sale. They're a person-to-person (P2P) payments technology.

Swish was developed by Sweden's banks, not by an upstart tech company. Incidentally, both Zelle and Interac e-Transfer are also owned by banks. (Venmo is owned by PayPal, a fintech). Which goes to show that banks aren't always the slow moving monoliths that a lot of people make them out to be. They'll protect their turf.

Swish was introduced in 2012, around the time that Sweden's legacy banknotes were all being scheduled to be replaced by a new issue of notes. By any measure, the timetable that the Riksbank selected for the switch over was inconvenient for cash-users. Rather than allowing for permanent note switches (like we do in Canada and the US) or a long window (like Sweden did in the 1980s and 1990s), the Riksbank gave Swedes only a year or two to make the swap. In the case of the 1000 kroner note, they'd have to do two swaps in five years. Due to the inconvenience of the changeover, many more Swedes chose to go cashless than would otherwise have been the case. I make this point in an earlier post which I called Swedish betrayal.

The Riksbank chose this timetable because it was recommended to them in 2012 by a collection of private financial institutions including Sweden's big banks. This was at the same time that the banks were introducing Swish. Since Swish and banknotes are direct competitors in the P2P payments space, an inconvenient note switch would have given banks quite the helpful tail-wind.

So Swish's success (at the expense of cash) probably isn't solely a function of enlightened consumer choice--it also benefited from a gentle nudge from the Riksbank (and the private sector, who advised the central bank). 

Debit card way more popular than credit cards

Canada is the land of credit cards. According to a recent Bank of Canada survey, around 39% of all retail payments are made with credit, or 56% of all value spent. Debit is a distant 26%. While debit is more popular in the U.S., credit cards aren't far behind.

So why is debit card usage so popular in Sweden? I'd guess low interchange fees. An interchange fee is how much a retailer must pay for each transaction that a customer makes using a card. In Sweden, interchange fees for credit cards are set at 0.3% while debit is 0.2%. In Canada, credit card interchange fees vary between 1%-2.5% compared. For debit, they are set at 0.25%.

Canadian banks can use the income from credit card interchange fees to fund handsome reward programs and 2% cash back. Swedish banks can't because credit card interchange fees are so low. So from a Canadian shopper's perspective, why use you debit card to buy $100 in groceries when you can use you credit card to get the same groceries and also get $2 cash back? Swedes don't face this same payments calculus—low mandated interchange fees mean that credit card can't come equipped with massive amounts of rewards. So buying 1000 kronor worth of groceries with a credit card doesn't provide any advantages to a debit card.


What happened to the bitcoin payments revolution?

If you want an example of a payments revolution, Swish is it—not bitcoin. Only six out of 2011 Swedes surveyed by the Riksbank used bitcoin to make a payment over the course of the month. That's an adoption rate of just 0.3%.

That being said, it's not as if bitcoin is unpopular in Sweden. Stockholm's Nasdaq/OMX exchange has the distinction of listing Bitcoin Tracker One, the world's first (and one of its only) exchange-traded bitcoin financial products. Bitcoin Tracker One is one of the exchange's most active tracking certificates. At the peak of the bitcoin bull market in December 2017, assets under management ballooned to $600 million.

These statistics illustrate the odd nature of bitcoin's success. Bitcoin was supposed to be a payments, or monetary technology. But this vision has never panned out. Rather, bitcoin has taken off as a great way for Swedes (and everyone else) to gamble. I took up this theme in a recent article for the Sound Money Project:

"Forget online payments; Bitcoin has become the most successful gambling technology to be invented since Henry Orenstein introduced the poker pocket cam in 1999. The pocket cam allowed viewers to see players' cards, revolutionizing the way people watched the game of poker and launching the 2000s poker frenzy.

In what sense did Bitcoin succeed as a gambling technology? At its core, Bitcoin is a pure Keynesian beauty contest. People try to guess what other people guess other people guess Bitcoin's value will be. The price that results from this contest is incredibly unsteady. But these explosive rises and stunning falls provide a fun, challenging, and addictive bet for casual gamblers and deep-pocketed professional speculators alike."

With bitcoin's first and primary function being gambling, a small minority of Swedes (six out of 2011) have been able to piggy back off it and use it for payments. An analogy can be made to other products that have alternative uses, say like how tooth paste's primary use case is to clean teeth, but a few people might use it to remove carpet stains.

The problem is that the very feature that makes bitcoin such a great gamble—its beauty contest nature—interferes with its serviceability as a payments system. I don't think this problem is solvable. Which is unfortunate because in theory at least, bitcoin seemed to have several features that would have made it a decent replacement for cash. 

Are Argentinians paying for Uber rides with bitcoins?

Earlier this month the following tweet elbowed its way onto my Twitter timeline:

The tweet comes from Anthony Pompliano, aka Pomp, who works at Morgan Creek Digital Asset where he runs a cryptocurrency fund.

So, have I been wrong all along about bitcoin? As anyone who has been reading me for a while will know, I've been skeptical of the bitcoin-as-money story. Rather than fulfilling Satoshi Nakamoto's vision as being a next generation medium of exchange, bitcoin has gone mainstream as a new type of gambling technology—an exciting decentralized zero-sum financial game. This is a somewhat useful role, but let's face it, it's not quite as revolutionary as digital cash.

But if Argentinians are indeed hailing rides and paying drivers directly with bitcoins, as Pompliano seems to be saying, then maybe I've been too quick to dismiss the bitcoin-as-money scenario. Paying for stuff is exactly what Satoshi Nakamoto intended bitcoin to do, right? So I dug further into the tweet.

Twitter: Couldn't find anything in the news about this. Anyone got a solid source?
Pomp: https://cointelegraph.com/news/uber-switches-to-bitcoin-in-argentina-after-govt-blocks-uber-credit-cards
Twitter: Pomp that was 2 years ago
Pomp: Does that make it less important?

And that's how Pomp left things. So it looks like I've got some work to do.

Here's the fine print. In 2016, the City of Buenos Aires ordered the major credit card companies to block Uber's App. Stanford Law School's WILmap project has a detailed post on this. So Argentinians suddenly found that while their MasterCard and Visa cards worked for everything else, they could no longer be used to get an Uber ride.

Contra Pompliano, Uber did not respond by allowing users to purchase rides with bitcoin. Rather, the company pointed out that anyone who had a certain type of pre-paid debit card could sneak by the Uber embargo.

To carry out the hack, the first thing that an Argentinian had to do was to apply for a prepaid debit card from any of Entropay, EcoPayz, Payoneer, or ZapZap. These are non-Argentinean payments companies. Entropay, for instance, is based in Europe and issues Visa-branded debit cards in partnership with a Malta-based bank, Bank of Valletta. Once Entropay had approved an Argentinean for an account, either a physical debit card would be sent by mail to the applicant's address in Argentina or a virtual card would be instantly created. An Argentinean could then log on to Entropay's website and use their local credit card, the same one that had had been neutered by the Uber embargo, to top up the Entropay prepaid debit card. With the debit card now funded, it could be used locally to pay for Uber rides.

Under the hood, prepaid cards issued by Entropay are really just regular Visa cards. So when an Uber ride was requested in Buenos Aires, an Entropay card would have used the same Visa rails that a regular Argentinean credit card used. Why would an Entropay Visa card be accepted but a regular Visa card denied?

The nub seems to be this: the ban seems to only have applied to payments instigated by domestically-issued cards. When payments to Uber originated from Entropay or any of the cards listed above, they were earmarked as originating internationally, in Entropay's case probably from Malta-based Bank of Valetta, and so Entropay payments were able to squeak by. Voila, by swapping domestic cards with international ones, Argentinians could avoid the blockade.

A number of bitcoin debit cards also enabled the hack, including Xapo and Satoshi Tango. Maybe this is what Pomp is referring to in his tweet. But it would be wrong to say that these cards allowed Argentinians to "purchase rides with Bitcoin," as he claims.

Prior to paying for an Uber ride, an Argentinian had to load U.S. dollars onto the bitcoin debit card by selling bitcoins for dollars on a bitcoin exchange. Either the card owner did this manually, or the card provider rapidly sold bitcoin in the very same instant that the payment was requested. In either case, bitcoins weren't flowing from the card holder to Uber. A fiat currency had been pre-loaded onto the card, and everything after that was just a  regular transfer over the Visa or MasterCard network.

These bitcoin debit cards are really no different from gold-based debit cards. Nor are they any different from the cheque-writing and debit card privileges provided by some U.S. money market mutual funds. Neither bitcoins nor gold not mutual fund units are being transferred from the card holder to the seller. Rather, each item is being quickly sold and turned into fiat, then processed along the same rails as any other payment.

In theory, all sorts of assets might be debit card-ized in this way. Buy a coffee with your Facebook debit card, for instance, and underneath the transaction's hood your Facebook share(s) are being quickly sold on the stock market for dollars, those dollars being the medium that ultimately settles the payment between you and the cafe. Complicating matters is that Facebook shares, which trade at $165, can't be cut into fractions, unlike bitcoins or fractions of a gold bar, so paying for a $3 coffee might get a bit awkward.

So returning to the tweet, recall that Pomp proclaimed that "more companies will begin using Bitcoin to fight back against corruption." But this wasn't the case with Uber. As you can see from the above, the company fought back by pointing to a neat hack of the existing credit card networks. The reason that Xapo and Satoshi Tango bitcoin cards were able to enable Uber purchases in Argentina wasn't because of their unique bitcoin nature. In Xapo's case, the card was issued by Wave Crest Holdings, a Gibraltar-based company. Like a regular fiat-based Entropay card, the incoming Xapo card payment was classified as an international one, and thus it escaped the domestic blockade.

Most bitcoin debit cards are no longer functional. Wave Crest, the card provider through which most bitcoin firms partnered, was suspended by Visa for non-compliance with Visa's rules in early 2018. If you go to VoyEnUber.com, an independent Argentinean website that reports on Uber, you'll see that it has delisted Xapo and Satoshi Tango from its list of ways to pay for Uber. The non-bitcoin prepaid debit cards are still there. So Pomp's tweet is twice wrong: 1) not only were Argentinians not using bitcoin to pay for Uber rides in 2016, but; 2) by the time of his tweet, they are not even making Xapo card payments, since Visa has cut that option off.

In addition to using foreign cards to pay for Uber rides, it seems that people in Buenos Aires are also paying with cash. According to the article, when riders pay with banknotes, there is no way for Uber to collect its 25% commission, so driver's are increasingly indebting themselves to the company. Or put differently, drivers are accepting cash, then paying Uber with a personal IOU. The irony here is that a combination of old fashioned fiat banknotes and trust-based IOUs—not bitcoin—are being used to "fight back against corruption."

So be careful what you read, folks. This sort of reminds me of the Zimbabwe bitcoin story from last year, which was seen as a crystallization of the long-held dream that bitcoin would help unbanked Africans. I rebutted that particular myth here.

Pompliano seems like a nice guy, so I'll just assume that excitement got the best of him. I normally try to avoid someone is wrong on the internet posts, but since he has over a 100,000 followers on twitter, and this particular meme has been retweeted over 2,000 times, I feel like it's my duty to try undo some of his error. The good thing with twitter is you can untweet retweets, feel free to go ahead and do that right now. :)

Bitcoin, drowning in a sea of credit card rewards

Satoshi Nakamoto kicked off his famous 2008 white paper with the line: "Commerce on the Internet has come to rely almost exclusively on financial institutions serving as trusted third parties to process electronic payments." He created Bitcoin, a form of decentralized cash, to deal with this problem. But as Meltem Demirors points out, Bitcoin adoption seems to have peaked. Eight years after Nakamoto published his paper, not many people are using the stuff as money.

Here's a way to get more people using bitcoins as money on the internet:

Commerce on the Internet has come to rely on a Visa/MasterCard pricing standard. Although a few online stores like Dell, Expedia, and Microsoft accept bitcoin payments, they still set their prices in terms of Visa/MasterCard dollars. Because the dominance of this pricing standard is preventing innovative money like bitcoin from emerging, it needs to be hacked.

The Visa/MasterCard standard

Credit card issuers aren't mere intermediaries. Along with their core payments offering, they sell a broad range of goods and services. This includes but is not limited to: 1) rewards in the form of points, air miles or cash back; 2) car rental and travel insurance; 3) warranty extensions; 4) coverage of goods purchased against loss/damage; and 5) price protection i.e. should the price of a good fall after you buy it, the card issuer refunds the difference.

Credit card issuers don't give all this stuff for free. Some of the costs are recouped by annual fees and interest on unpaid balances. But by far the biggest line item is something called 'interchange'. An interchange fee is a levy that merchants must pay to the credit card issuer each time a card is used. The better the card reward the larger the interchange fee. In Canada, for instance, the MasterCard World Elite interchange rate for internet transactions is 2.49%. Regular cards are docked interchange of just 1.61%. [source]

Retailers recoup interchange fees by passing them off to customers. The way they do this is to build interchange into sticker prices. In a world without credit cards, Dell accepts nothing less than $1000 for a laptop. But in an economy with credit cards Dell faces an average interchange rate of 2%, or $20 per laptop, reducing revenue-per-laptop to $980.

To recoup its costs, Dell marks laptop prices up to $1020.40. Of this amount, 2%, or $20.40, goes to the credit card issuer to cover the cost of the customer's rewards, insurance, warranty extensions, etc, leaving Dell once again with revenues of $1000/laptop. Dell doesn't actually tell us they are on-charging us for these things. They surreptitiously build this premium into the sticker price.

On the internet, every retail price has been marked up by around 2%. That's what it means to be on a Visa/MasterCard standard.

Bitcoin is being undervalued

The Visa/MasterCard standard has the effect of repelling bitcoin use.

Imagine Alice, a bitcoin user who wants to buy a laptop. In paying $1020.40 worth of bitcoin for a Dell, Alice effectively overpays. She gets the $1000 laptop but does not get the $20.40 in associated rewards, points, insurance, or price protection that are built into the laptop's sticker price. Rather, Dell gets to keep the $20.40 premium for itself, since it doesn't need to pay interchange on Alice's bitcoin payment.

Because retailers like Dell are undervaluing bitcoin, consumers like Alice are always better off using their credit card. The more rewards that credit card issuers add to their cards, the better the get at locking out bitcoin. This isn't just a problem with bitcoin and cryptocoins. The Visa/Mastercard standard has the potential to inhibit the adoption of other new media of exchange like mobile money.

No amount of code can hack the standard

If bitcoin could somehow be altered to pay rewards, cash back, and car rental insurance then it would be competitive with credit cards. This isn't a realistic option. Instead, the best fix is for retailers to offer bitcoin price discounts. If a Dell laptop retails online for $1020.40, bitcoin users should be charged just $1000 so that they aren't paying for points, rewards, car rental insurance and other benefits that they never get to enjoy. This would put bitcoin on an even playing field with credit cards.

How to convince retailers to offer bitcoin discounts? This isn't a problem that can be fixed by the bitcoin brain-trust making alterations to bitcoin source code. It's an interface problem: bitcoin hasn't been properly integrated into the real world, specifically into online shopping carts.

Cash has the same problem. The growing popularity of credit cards has led to the emergence of a Visa/MasterCard standard in the bricks & mortar economy. In a fully competitive economy retailers would compete to reduce their cash prices. However, retailers do not generally offer cash discounts, perhaps because they are worried about causing confusion, distrust, and delays at checkout counters (see discussion here). Alternatively, many retailers seem to believe that offering discounts is in contravention of Visa/MasterCard rules (it isn't.)

There is one big difference between cash and bitcoin. Cash lacks a community of users that can agitate for changes to the Visa/MasterCard standard. Central banks, which issue banknotes, don't really care that cash discounts aren't being offered because they lack a profit motive, and cash-using consumers, which tend to be poor or criminals, lack the means to organize. Lined up against cash is an incredibly powerful credit card lobby that has implemented all sorts of tricks (like prohibiting card surcharging) to prevent cash usage.

Unlike cash, Bitcoin boasts an active community of individuals and businesses with a strong interest in the success of the Bitcoin network. To hack the standard, this community needs to start agitating for discounts. Bitcoin payments providers Coinbase and Bitpay currently offer retailers the technology for setting bitcoin discounts. But Microsoft, Expedia, and Dell haven't taken them up on their offer, opting to keep the Visa/MasterCard standard in place. That's one place for activism to start. If the big three can be convinced to implement changes, this might be enough to kickstart an industry-wide practice of offering a 0.5 to 2% bitcoin discount. If the Bitcoin community succeeds in unbundling the Visa/MasterCard standard, it'll have leveled the playing field not only for itself but all subsequent forms of digital cash, whatever form they take.

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P.S. I wrote a similar piece in 2015 on Bitcoin and the VISA/MasterCard standard. That piece focused on the superior stability of credit cards and the fact that credit card users, unlike bitcoin users, needn't incur foreign exchange costs since they spend most of their lives in the dollar universe. This version is more explicit about the reward side of the equation. All facets need to be integrated to determine how large of a bitcoin discount to be applied by retailers.

In praise of anonymous money

A while back I was paying for gas at a nearby gas station when the clerk fumbled my credit card. When he bent down to pick it up he momentarily disappeared behind the counter. Because credit card transactions are always such repetitive affairs, this slight break from routine raised my hackles. Might the clerk have done something with my card while out of sight, perhaps taken a quick photo of it?

Credit and debit payments require the relay of personal information. But this information-richness is also their weakness, since valuable data can be "skimmed" and used to attack the payer later on. That's why an anonymous payments medium is so important; it provides buyers with a shield from everyone else involved in a transaction. The next time I payed for gas at the nearby station, I bought myself some peace of mind by handing the clerk a few $20 notes instead.

Like banknotes, bitcoin is a (near) anonymous payments medium. My gas station doesn't accept bitcoin, however, nor would I be able to pay for a tank of gas with bitcoin since I'm wary of holding more than a few dollars of the volatile stuff. There is no inherent reason that an anonymous digital money must be volatile. David Chaum's eCash, first proposed in the 1990s, was a monetary product that, unlike bitcoin, offered stability while still allowing for anonymity.

Here's a broad-brush description of how eCash worked. A customer would kick the process off by creating $x worth of digital coins, each with a unique serial number. The bank would in turn sign the coins and debit the customer's bank account for that amount. Thanks to Chaum's invention of blind signatures, the bank would not be able to see the serial numbers of the coins it had signed, and thus could not match those coins to a specific person. This 'blinding' provided a measure of anonymity.

What about the double spending problem that bedevils digital cash? Because digital coins can be copied ad infinitum, a mechanism must be introduced to prevent a dishonest actor from buying up the entire world. Chaum solved this by having the bank rig up a database of already-spent coins. When the customer spent $x at a merchant, the merchant would call up the bank and provide it with each coin's unique serial number. The bank would check the number against its database to ensure that the coins had not been spent. If they hadn't, the transaction was free to proceed. The merchant in turn had to return the $x to the bank to be redeemed.

Bitcoin's creator(s) Satoshi Nakamoto doesn't seem to have been a fan of Chaum's eCash. In his famous white paper, Nakamoto says (not referring to eCash in particular) that the "problem with this solution is that the fate of the entire money system depends on the company running the mint, with every transaction having to go through them, just like a bank." Later on in a forum post Nakamoto talks about the "old Chaumian central mint stuff," noting that:

a lot of people automatically dismiss e-currency as a lost cause because of all the companies that failed since the 1990s. I hope it's obvious that it was only the centrally controlled nature of those systems that doomed them. I think this is the first time we're trying a decentralized, non-trust-based system.

Nakamoto thus designed Bitcoin so that it had no central points of control. There is no third party database to record serial numbers; instead, the task of validating transactions is outsourced to a distributed network of anonymous miners and nodes. As for the money supply, there is no "Chaumian central mint" that issues and redeems tokens; rather, the evolution of bitcoin supply is set ahead of time by the Bitcoin protocol.

By sacrificing this last central point of control, Nakamoto condemned bitcoin to being a permanently volatile instrument. Unlike eCash, which is stable because the issuing bank pegs its price to that of bank deposits at a 1:1 rate, bitcoin's purchasing power is left entirely to the whims of market demand. Should market demand suddenly rise, bitcoin can double in price. Should it collapse, bitcoin will be worth $0.  

Sacrificing the Chaumian issuer/redeemer leads to another, more nuanced, trade-off. Because bitcoin is not pegged to the dollar, retail prices will always be expressed in dollars with the bitcoin equivalent bobbing up and down every few seconds or so. Put differently, bitcoin users must get accustomed to the unit of account and medium of exchange being divorced from each other.

Contrast this to eCash. Thanks to the peg, the two functions of money—unit of account and medium of exchange—are married. Anyone who owns eCash can relax knowing that they possess the same exact unit that all other economic actors are using to express prices. This provides eCash users with a degree of certainty. As a service to their customers, retailers tend to keep prices sticky in terms of the unit of account for days, even months. So if carrots are going for $2 today, an eCash owner knows that they'll be going for that same amount next week. This fixity makes planning one's life a much easier affair. Those who own bitcoins enjoy no such certainty. Carrots that cost 0.005 bitcoins today may cost 0.01 next week.

So these two monetary products provide users with a degree of anonymity while asking them to make very different sacrifices. Bitcoin foregoes both stability and the convenient marriage of unit of account and medium of exchange. Chaum's eCash retains both stability and a marriage but introduces several central points of control that might render it subject to attack. Pick your poison. My gut feeling, however, is that over the long term, the public will prefer to stomach some degree of centralization in return for a stable anonymity product that doesn't suffer from medium of exchange/unit of account divergence. But I could be wrong.

A Visa/MasterCard theory of recessions

Statistical agencies employ data collectors who walk up and down aisles with hand-held computers gathering sticker prices for things like frozen french fries and bicycles. The data they collect gets amalgamated into an index and passed on to central bankers who use it as the basis for rate change decisions. It seems simple enough, but what happens if the source material has been corrupted? Might central bankers be reacting to mere shadows on the wall?

Here's how prices might go bad. Start with the U.S. and Canadian payments systems. For each credit card payment, a North American merchant must pay 1-2% in fees to the card networks Visa and MasterCard. Retailers in both countries have very different strategies for coping with this burden. In the U.S., retailers are permitted to offload network fees onto customers by asking them to pay a surcharge on each credit card payment. Because Canadian retailers are prohibited from surcharging customers, they react by marking up every sticker price in their store by a percent or two, the extra margin they collect sufficient to cover the card network fees. (Canadian retailers almost never offer cash discounts.) For a more complete explanation, see here.

This arcane difference in payments habits has the potential to result in a divergent evolution of prices, vastly different monetary policies, and an uncoupling of North American economic growth.

Consider what happens when the Visa and MasterCard networks decide to offer North American customers a universal 5% cash back reward. The networks fund this bonus by requiring merchants to submit a 5% fee on each card transaction. U.S. retailers cope with this levy by boosting the surcharge they apply on each card transaction to 5% or so, forcing the card-paying customer to bear the cost. Those Americans who pay with cash i.e. banknotes continue to get the sticker price, which stays constant. Without the ability to surcharge, Canadian retailers cope by boosting sticker prices by 5%, thereby indirectly passing the costs of the cash-back bonus onto the customer.

Marching up and down the aisles, U.S price collectorsdon't notice a thing. As a result, the U.S. consumer price index stays the same and the Fed doesn't lift a thumb. Canadian price collectors, however, find that prices have risen. Upon reception of this data, the Bank of Canada anxiously raises rates. This is because Bank officials believe that the rapidly rising price level indicates that the economy-wide rate of return (the natural rate of interest) has risen above the Bank's market rate, breeding inflation. A rate hike is necessary to bring the two rates back in lane, thus choking off the incipient inflation that seems to be developing. The natural rate hasn't budged, of course. All that has changed is the card networks' fee policy. Instead of bringing the market rate of interest in line with the natural rate, the Bank of Canada has been fooled into moving the market rate of interest above the natural rate.

If the card networks again increase the cash back reward, say to 10%, Canadian prices will rise even more. U.S. prices stay flat. The Bank of Canada once again confuses the effects a new cash-back policy with a rise in the natural rate of interest, tightening while the Fed stays pat.

Assuming that prices react rapidly and fluidly to central bank policy, then the Bank of Canada's tightening will simply drive consumer prices back down and restore equality between the natural rate of interest and the market rate. But if changes in monetary policy have effects on the real economy, then we've got problems. It could be that certain prices are sticky downward so that markets can't clear, the result being inventories of goods going unsold. Or perhaps the fact that debts are nominally denominated creates a Fisherian debt deflation. If so, then the Bank of Canada could end up unnecessarily driving Canada into a recession. The Federal Reserve, reacting to the very same set of stimuli, does not.

Now of course I'm exaggerating things. In real life such large increases in cash-back policy are unlikely. Nevertheless, we have seen a progressive increase in network fees over the years, enough to have probably inspired Canadian retailers to ratchet up sticker prices. As a result, Canadian CPI may be slightly over-stating actual inflation. On the U.S. side, consider that American retailers only recently gained the power to surcharge credit cards. As U.S. retailers roll out surcharge policies and reduce sticker prices, CPI will be pressured down. This may fool Fed officials into believing that the economy is slowing and draw them into an unnecessary rate cut when in realtiy all that has changed is credit card pricing habits. One wonders if the monetary authorities take into account these arcane features of our payment system when they set their monetary policies.

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This answers a question I asked more than a year ago.

How monetary systems cope with a multitude of dollars

Over the last few decades, dollars have become incredibly heterogeneous. People can pay for stuff with traditional paper bank notes, debit cards, or a plethora of different credit cards. Each of these dollar brands comes with its own set of services and related costs. On the no frills side is cash. Paying with paper still incurs the lowest transaction costs, although at the same time it offers its owner no associated perks. On the fancy side is an American Express card, which costs around 3.5% per transaction but is twinned with a raft of benefits including reward points, the right to dispute a transaction, and insurance coverage. Mastercard and Visa come somewhere between. As you can see, spending one sort of dollar is very different from spending another sort.

The free banking era and the "multitude of dollars" problem

There's a precedent for this sort of dollar heterogeneity. During the U.S.'s so-called "free banking era" that lasted from the 1830s until 1863, hundreds of different types of banknotes circulated, each issued by a unique bank. Notes were universally redeemable in a certain quantity of gold. Varying physical distances between a note's final resting point and its birth at an issuing bank (often in another state) led to widely disparate redemption costs across note brands. A merchant in Philadelphia who was paid in local bank notes need only take a short walk in order to redeem the note. If that same merchant was paid in a note issued by a bank in Chicago, however, redemption was much more onerous due to the time and distance required to travel from Philadelphia to Chicago.

So in the same way that an American Express dollar is the most costly of the modern day dollars, a distant bank's notes were the most costly of the free banking era's dollars.

Here are two interesting problems. How can a merchant establish a single set of sticker prices while still accommodating a wide range of disparate dollar payments media? Second, consider the fact that shoppers paying with a premium card like American Express (or distant bank notes) enjoy the widest range of benefits, but should also face the highest costs. How can the system ensure that the person who enjoys the marginal benefits associated with a given payments medium also bears its marginal cost? Put differently, how is quid pro quo ensured?

The solution: surcharging

In the free-banking era, the "multitude of dollars" problem was solved by a form of discriminatory surcharging. To begin with, merchants displayed their sticker prices in terms of a single unit; standard U.S. dollars (defined as 1.5 grams of gold). When the customer arrived at the till, the merchant determined what sort of surcharge to apply to each of the banknotes proffered according to its distance-to-redemption. With hundreds of note-issuing banks in existence, this was a cumbersome task. In order to speed up the process, the merchant would consult what was called a "bank note reporter." This handy publication, which was compiled by professional bank note analysts, provided merchants of a certain location, say Philadelphia, with the rates for all bank notes that circulated in Philadelphia adjusted for their shipping costs.

The image below is a section from Van Court's Bank Note Reporter and Counterfeit Detector, which I've snipped from Gary Gorton's introduction to the subject. It shows the the recommended price at which a merchant in Philadelphia should accept notes from Vermont, Maine, Pennsylvania, and elsewhere.

A page from  Van Court's Bank Note Reporter and Counterfeit Detector (1843), showing multiple prices for various dollars. Notation: do=ditto, same as above | par=no discount | 20 = 20% discount | 1 = 1% discount | no sale = 100% discount | fail'd=failed bank, 100% discount | clos'd=bank closed, 100% discount

After a merchant had consulted his bank note reporter and tacked on the appropriate surcharge, it was time to redeem the note. Merchants didn't actually ship the notes themselves but sold them to a local note broker at a discount to face value. In fact, the numbers that Van Court published would have been sourced from this broker market. The broker in turn shipped the note back to the issuer, getting full face value upon redemption. The gap between face value and the initial purchase price covered the broker's shipping costs.

Thus the "multitude of dollars" problem was solved. By surcharging relative to a benchmark dollar, merchants succeeded in setting a single array of prices while accommodating a much wider range of heterogeneous payments media. This also allowed them to efficiently pass the marginal cost of using distant notes onto those customers who chose to pay with them, while rewarding customers who used low-cost local notes by not applying such surcharges.

So why not implement this same technique of surcharging today?

Consider that in our modern era, credit card networks recoup much of the cost of the services they provide (which are many, but include perks like rewards and the right to dispute a transaction) by requiring that card accepting retailers collect a fee from customers on the network's behalf. This parallels the free banking era, in which banks required third-parties to bear the cost of transporting notes for redemption.

The best way for a modern retailer to establish prices in this heterogeneous dollar world would be to replicate the solution settled upon by their free banking ancestors: set sticker prices in terms of the most basic unit, paper dollars, and exact an appropriately-sized surcharge on each card transaction at the till.

Rather than an old-fashioned Van Court's Recorder, a merchant could go about this by installing card-reading software that would quickly determine both the card being used and the appropriate surcharge. Thus, consumers who paid with premium cards, those cards that offer the most bundled services per transaction (and therefore incur the highest costs), would have to bear the largest surcharge while those with bare bones cards would pay a minimal surcharge. Anyone paying in cash, much like those who payed with local banknotes during the free banking era, would not incur any surcharge whatsoever. This system would ensure that each customer bears the marginal cost of their chosen means of payment. The retailer, who routes all of the surcharges they collect back to the card network, doesn't eat any costs and therefore succeeds in preserving their margins.

If only things were that easy. Though surcharging would be a great way to deal with the "multitude of dollars" problem, card networks like Visa and Mastercard have typically "legislated" against surcharges.* The networks can successfully impose this no-surcharge obligation on retailers because as an oligopoly, Visa and Mastercard can banish offenders from the network, putting a huge dent in the offender's sales. Why prevent surcharges? One reason the card networks probably do this is because they don't want the card-paying public to feel that they are being penalized in any way. If the feel put off, consumers might choose alternatives like cash and debit that aren't subject to surcharge.

Another solution: discounting

The no surcharge rule puts retailers in a bind. They are obligated to collect fees on behalf of the card networks, but without the ability to surcharge they're left absorbing the costs imposed by the networks while the customer enjoys all the benefits.

There's a neat way that that retailers can get around this hurdle. All they need to do is to mark up all their sticker prices to the level of the highest cost credit card, and then offer discounts to everyone who uses lower cost credit cards, debit cards, or cash. Discounting allows the merchant to collect the appropriate fee from each customer, funneling these fees back to the networks. As before, a given set of prices can accommodate a wide range of dollar payments media. Each party who enjoys a given marginal benefit also bears its respective marginal cost.

So as not to leave our analogy hanging, if this solution had been chosen by free-banking era retailers (perhaps because the free banks insisted that merchants avoid bank note surcharges), then the price level in Philadelphia would have been marked up to the value of the most-distant bank notes in circulation, say those from Chicago. Those paying in less-distant bank notes, say New Jersey notes, would have received an appropriately-sized discount.

An anomaly: we don't see discounts

Having outlined how to solve the modern "multitude of dollars" problem without surcharging, what happens in the real world? An odd phenomena tends to play out. While retailers have certainly marked up prices to a premium card standard (or thereabouts) in order to cover their costs, for some reason they rarely offer their customers discounts on cheaper payment options. Try asking for a cash discount at Walmart the next time you visit. This means that anyone who purchases something with cash, debit, or a bare bones credit card is being forced to pay for a juicy set of benefits associated with usage of an American Express card, namely fancy rewards and dispute rights, without actually getting to enjoy those benefits. Put differently, the merchant is effectively overcharging their customers by collecting more network fees than the networks actually require, keeping this excess to pad their bottom line.

Why this predatory behavior? Briglevics and Shy note that merchants may be wary of discounting if it creates confusion and distrust among customers. Potential delays at checkout counters might impose an extra set of costs on all parties. They also point out that merchants may not find it profitable to offer a cash discount to consumers who would use low-cost payments anyway. Schuh, Shy, Stavins, and Triest report that merchants may lack complete information on the full and exact merchant discount fees for their customers’ credit cards, and therefore can't implement a policy of accurate discounting.

Could it be that the right set of tools to provide discounts hasn't yet been created? Perhaps we need a modern version of Van Court's Bank Note reporter. Such a technology would allow merchants to rapidly determine the proper discount to apply to each disparate dollar type and clearly inform customers about the saving they have enjoyed.

Lack of technology may explain why cheap credit cards don't receive discounts relative to expensive ones, but it doesn't explain why cash discounts has never been adopted by retailers. One theory is that even if certain retailers start to offer discounts, the public may be too overloaded with information to switch, thus allowing the practice of predatory pricing to remain the status quo. Supporting this view is the following observation: while discounting for cash and debit payments is rare in most sectors of the economy, it is quite common among gas stations, as the image below shows.

Why so? Gas stations sell one homogeneous, universally available, repetitively-purchased good. Gas consumers are by-and-large brand insensitive, gas from one station being just as good as gas from another. Repetitive trips to buy one simple commodity probably makes it easier for lethargic consumers to make dispassionate price comparisons across competing gas stations. From the gas station owner's viewpoint, the consumers' price sensitivity only increases the efficacy of a policy of price discounts on cash and debit. After all, a gas station that offers users of low-cost credit cards a 0.5% discount or a cash discount of 1% should be able to win business away from station across the street that doesn't offer any discount whatsoever.

Other retailers, say department stores, sell a wider variety of things than gas stations, many of these items only being purchased from time to time. This makes comparison shopping more costly. Brand loyalty only increases the hassles of switching. Department stores may find that a policy of cash discounts is simply not worth the effort as discounts get lost in the morass of data that a consumer is bombarded with on an hourly basis.

That being said, the online world's ability to provide faster cross-retailer comparisons than are possible in a bricks & mortar world could shake things up. Surely some smart fintech entrepreneur can create a way for online merchants to rapidly measure the appropriate discount (or surcharge in those jurisdictions that allow it) to apply to each card before consummation. This same tool would provide a user-friendly format for online shoppers to "see" competing card discounts across a number of merchants prior to hitting the buy now button. Just like they'll cross the street to hit the cheapest gas station, they may divert their purchase to the lowest cost website. If this sort of thing caught on, we'd see long forgotten free banking customs replicated in our modern era.

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*This is currently the case in Canada. In Australia, merchants have been allowed to surcharge since the early 2000s. US merchants recently won the right to surcharge, although it is probably too early to know what effect these rule changes will have.

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.

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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.

The zero problem

The price of bitcoin is a capricious thing. Imagine that you've saved enough bitcoin to take your significant other out to a fancy restaurant. When the bill comes you discover to your horror that the price of bitcoin has crashed sometime between main course and desert. For the next few hours you're both stuck doing the restaurant's dishes. Far less embarrassing to choose dollars as your payment media at the outset given the unlikelihood of a dollar crash. This has always been one of bitcoin's main problems. The burden that a consumer must endure in absorbing bitcoin's incredible volatility until the time of payment outweighs any reduction in transaction fees that they might enjoy.

Or maybe not. Marc Andreessen recently posted a number of thoughts on twitter. The most interesting ones are #9 to 17, namely that bitcoin's fabled volatility needn't deter regular folks from using it as a cheap and fast payments mechanism.

15/For example, payment applications of BItcoin don't require users/merchants to hold BTC for any period of time. All benefits still gained.
— Marc Andreessen (@pmarca) January 5, 2015

In effect, it's possible to enjoy all of bitcoin's benefits without having to hold an inventory of the schizophrenic stuff. Consider that when merchants currently receive bitcoin in exchange for their product, their payments processor (say Bitpay or Coinbase) will instantaneously convert those coins into US dollars, thus sparing the merchant the risk of holding volatile bitcoin. As for shoppers, a service that allows them to purchase bitcoin in the instant prior to paying for a good would preclude them from having to bear the risk of a bitcoin crash. (1)

It's the "never-hold" approach to bitcoin. As long as just-in-time bitcoin purchases and sales are possible, shoppers and merchants can avoid bitcoin's worst feature, its volatility, while enjoying all of its best features, low fees and speed. These just-in-time services aren't free. Bitpay and Coinbase extract a fee for providing merchants with protection from bitcoin hyper-volatility, and a provider of shopper volatility protection would also expect to be compensated. Now I'm not sure how large these two fees would come out to. However, as long as the total cost is less than the fees levied by competing mechanisms like credit card networks, then bitcoin provides a net benefit to society. (2)

Touché, Andreessen. En Garde!

I've been talking about the potential for bitcoin to be displaced by stable-value cryptocoins as media of exchange for a while now. But if Andreessen is right (and I'm inclined to think he is) then who really cares if bitcoin suffers from +/-50% daily price changes? Whether it's worth $100 or $100,000, either way it serves regular folks as a superior last-second value transfer mechanism (subject to the above cost condition). We may not need stable-value cryptocoins after all.

But Andreessen is missing one of the larger points of the volatility criticism, which I'll call the zero value problem. Granted, we needn't care whether bitcoin is worth $100 or $100,000, but we do care if it is worth $0. While no categorical difference exists between any two given positive bitcoin prices, a categorical difference *does* exist between a positive price and a price of zero. Bitcoin works smoothly at any positive price, but it breaks down as value-transfer mechanism when it's worth nothing.

A key pillar of the volatility critique is that bitcoin's price earthquakes arise because the only players in the market are speculators. A more fancy way to say this is that bitcoin has no non-monetary demand. By non-monetary demand, I'm referring to that portion of an asset's total demand that would remain if prospective owners were notified that they could never sell that asset after purchasing it. Given this imposition, I sincerely doubt anyone would be willing to buy bitcoin. By and large, people only want the stuff because it can be got rid of in the future.

By way of comparison, gold has both monetary and non-monetary demand. There are consumers who will purchase the yellow metal knowing that they can never sell it again, say as jewelry or ornamentation. Same with an IOU like a stock or banknote. Because an IOU offers dividends (or a promise of cancellation at an attractive price), investors will be content to hold that IOU knowing that they can never resell it. This is the Warren Buffett approach to holding an asset, whereby one's favorite holding period is forever.

With the only folks holding bitcoin being future sellers, i.e. speculators, enter the zero value problem. An object whose value is purely speculative has no equilibrium price. In economics-speak, its price level is indeterminate. A $10,000 price is as good as a $10 price, or a $0 price. And that last price will inevitably arrive—maybe in 2015, maybe in 2020, maybe not till 2025—when for some reason or other speculators all begin to get antsy at the same time. It could be something as innocuous as the belief that everyone else is about to sell (because they expect everyone else to sell, because they expect everyone to sell, etc). When a reflexive process like this begins, the only way for the bitcoin market to accommodate everyone's desire for an exit is for the price of bitcoin to hit zero.

For illustrative purposes, gold isn't subject to the zero value problem because if a speculative panic begins, consumption demand kicks in to anchor gold's price at some lower level. The same goes for central bank money.

At $1, bitcoin still works. But at zero, bitcoin breaks down as a payment mechanism. Since bitcoin no longer has a positive purchasing power, regular shoppers can no longer make just-in-time bitcoin purchases in order to consummate a transaction. Merchants will quickly pull bitcoin price quotes from their websites, unwilling to trade something (their wares) for nothing (bitcoin). Since the financial reward to mining will have disappeared, the process for verifying the blockchain may become tenuous. All the hard work put into building a payments mechanism will be gone in a few moments of speculative fervour. And what happens to all of the other "use cases" that Andreessen describes, like bitcoin apps and sidechains, when bitcoin hits zero?

Even if bitcoin hits $0 for an hour or two, won't the inevitable dead cat bounce fix the problem? Not necessarily. The best theory for how bitcoin rose above zero back in 2009 is the 'bootstrapping theory.' A small clique of insiders conspired to trade what was then an intrinsically-useless token among each other, generating a long enough history of positive prices so that bitcoin began to be accepted by naive outsiders at a non-zero price. From nothing, otherwise worthless tokens had pulled themselves up by their own bootstraps. Andreessen admit as much in his eleventh tweet.

11/Bitcoin was specifically designed to use speculation early on to overcome the normal chicken/egg boostrapping problem for new networks.
— Marc Andreessen (@pmarca) January 5, 2015

The point I'm trying to make here is that if bitcoin were to fall to zero, a dead cat bounce isn't the natural next step. Rather, as in 2009, an outlay of time and resources would be required to fabricate a positive price. In essence, bitcoin would need to be re-boostrapped. But how to go about this process? Who would be willing to join the front line and risk their capital trying to trick the market into valuing bitcoin at a positive price again? Surely not all the former bitcoin millionaires. Keep in mind that it might take multiple efforts to jump start the system. And with bitcoin being so much more widely known than before, the re-bootstrapping process might take significantly more resources than it did in 2009. Finally, even if the system is successfully kickstarted after a few days, what about the damage that is incurred in the interim thanks to a period of inactivity? Could it do irreparable damage to bitcoin's reputation as a payments mechanism, in the same way that Visa would suffer if it went down for a few days?

How to overcome the zero problem

Luckily, there's a pretty easy fix to the zero problem. Set bitcoin's minimum price at US$1 so that it never has to go through a re-bootstrapping process.

To set a minimum price, bitcoin believers like Andreessen should consider donating US$21 million to a bitcoin stabilization fund. The fund will have a standing bid to purchase all bitcoin at $1. Since there will never be more than 21 million bitcoin in existence, the fund will have the financial resources to credibly support this price. In an extreme scenario in which all speculators run to the exits, the stabilization fund will be left holding 21 million bitcoin and no dollars. The good thing is that no harm will be done to bitcoin as a just-in-time value transfer system. The fund will make a market in bitcoin at $1, providing shoppers with an avenue to acquire the requisite bitcoin from the fund (say at $1.01) just prior to consummating a purchase, and providing merchants with a right to sell bitcoin at $1 in the moment after a sale.

The core idea here is that if speculators are for the moment unwilling to set a positive value for bitcoin, then someone else needs to. At some point after hitting the fund's $1 floor, speculators will likely gain enough confidence to once again take up the baton and drive bitcoin's price above $1. The roller coaster ride begins anew. If so, the stabilization fund's job is done, for the time being at least. It can start selling its hoard of bitcoin into the rally, replenishing its dollar reserves so that it can once again enforce the $1 floor should that necessity arise.

Think of the provisioning of a bitcoin stability fund as a public service. If bitcoin's promise is as enormous as folks like Andreessen believe, then the fund's $21 million price tag is a small cost to ensure that said promise isn't destroyed in a zero-value bitcoin scenario.

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(1) I was going to point out that I don't think anyone is offering this service, but now I see that one is: Cryptosigma.
(2) If the combined cost of merchant protection and shopper protection +  bitcoin transfer fees are higher than the costs that banks and the card networks earn on transactions, then bitcoin may not be the panacea that everyone makes it out to be.