The dollarization of bitcoin

Bitcoin was supposed to result in the bitcoinization of the world; instead, I'd argue that the world of bitcoin is being dollarized.

A successful medium of exchange will be used by four types of actors: retailers, consumers, financial intermediaries, and speculators. In bitcoin's case, the inherent volatility of the cryptocurrency militates against its adoption by anyone other than speculators, leaving dollars as the default option.

Let's start with the first bit of the equation; retailers, or merchants. Entrepreneurs who have been trying to bring bitcoin to the mainstream have discovered that while merchants like the idea of allowing consumers to pay with bitcoin, the merchants themselves refuse to deal in the stuff. Instead, upon receipt of bitcoin, a merchant's bitcoin payments processors—usually an intermediary like Bitpay or Coinbase—will instantly convert bitcoin into U.S. dollars on behalf of the merchant. Retailers choose to dollarize rather than bitcoinize because they are afraid of bitcoin's volatility, and justifiably so.

The next bit of the equation is the consumer. I argued in my previous post that it is dubious whether paying in bitcoin offers mainstream consumers any benefits relative to dollar payments. People who buy with bitcoin must incur added costs in the form of trading fees if they wish to move from dollars into bitcoin. They must also bear the burden of bitcoin's volatility until the moment of making a purchase.

To drive mainstream consumer adoption of bitcoin, those intermediaries who are servicing buyers will have to begin offering the same sort of volatility-shielding services that bitcoin payments providers currently offer to merchants. A permanently shielded wallet, for instance, would allow consumers who want to make a purchase the opportunity to store value in U.S. dollar terms until the very last moment, at which point the intermediary takes on the bitcoin risk and consummates the deal. Of course, this only pivots things further towards dollarization, not bitcoinization.

The inevitable product that emerges will be a just-in-time bitcoin solution. Buyers have the benefits of holding dollars up until the moment at which they press the Buy Now button, at which point the intermediary takes over and sells their dollars for bitcoin. The switching of the payment from the dollar rails onto the bitcoin rails is only momentary. Upon receipt of the bitcoin payment an instant later, the merchant's payments provider will immediately sell the bitcoin and deliver dollars to the merchant. With both buyer and seller choosing to dollarize, neither has to suffer from bitcoin's volatility. However, they still get to enjoy whatever cost savings are provided by rapid just-in-time usage of the bitcoin rails. Only speculators and intermediaries, who have now taken on the responsibility of dealing in bitcoin from consumer and retailers, have avoided dollarization.

But hold on. If all parties to the transaction only want dollars, why not just cut bitcoin entirely out of the equation? Instead of a just-in-time swap of bitcoin, the intermediaries involved—the buyers' bitcoin wallet provider and the merchant's bitcoin payments processor—can get together and agree to exchange a dollar IOU instead, saving them the hassle of dealing in bitcoin. Gone are the exchange fees, the obligation to pay bitcoin's bid-ask spread, and slippage that might occur if bitcoin's price weaves dramatically as the transaction is going through. To spare readers the gritty details, the footnote below describes how bitcoin intermediaries might fashion a U.S. dollar IOU trading network.

This puts these bitcoin intermediaries in the rather odd position of no longer being part of the bitcoin universe. Instead, intermediaries have become like interlinked Paypals, offering U.S. dollar accounts to consumers and U.S. payment solutions to merchants.

Thus, in an effort to promote mass adoption of bitcoin, we've somewhat perversely arrived at the opposite, an all-out dollarization of what was supposed to be a bitcoin retail payments network. Buyer and merchant hold only dollars, and so-called bitcoin intermediaries like wallets and payments processors no longer deal in the stuff. That leaves only speculators to hold the bitcoin bag. This system of individual PayPals will be built on top of the very infrastructure that bitcoin was designed to tear down, namely the existing dollar rails run by incumbent banks and underpinned by the Federal Reserve.

This isn't to say that bitcoin is a failure as a retail payments option. But I have troubles seeing it ever going mainstream.  Even if bitcoin continues to exist as an arcane niche payments system for a community of like minded consumers and retailers, that's still constitutes quite a success, albeit one that has not lived up to many people's dreams.

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In writing this, I stumbled on an earlier post by Guan that already arrived at a similar conclusion. If you've already read his post, my apologies for wasting your time and making you read mine.

The gritty details: Rather than trading bitcoin to settle payments between consumers and retailers, intermediaries can simply trade dollar IOUs. Costs should be lower than settling in bitcoin. To begin with, bitcoin intermediaries will have to maintain U.S. dollar clearing accounts with all the other bitcoin intermediaries. Over the course of a trading period, dollar payments will flow into an out of these clearing accounts. At the end of the day, each intermediary's account will be netted and cleared against all other intermediaries' accounts. The result is that some intermediaries will be owed dollars, others will owe. These balances will all be settled that very evening on the books of an underlying commercial bank, say Citi, where all intermediaries also maintain accounts. Since accounts are settled on the books of Citi, intermediaries needn't incur expensive inter-bank wire transfer fees. Citi has, in effect, become the central bank for a bitcoin based payments system, sans the bitcoin.