Friday, June 12, 2015

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.

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.


  1. Don´t you think that it depends more on having a use case for Bitcoin (besides Silk Road and speuclation) and that then there would be natural demand. None of the actors you list is there because of a use case and is just an operator in the Bitcoin market. My impression is that to create a more stable bitcoin you first need a natural use case that hopefully is big enough to then create a reason to hold Bitcoin beyond the traditional use cases.


    1. Hi Alex. To create a more stable coin, you need a use case. To create a use case, you need a stable coin. Its a circle that that can't be broken into. Having a coin that is stable from the outset, says like bitUSD, might be able to break the circularity problem.

    2. Hi JP, i tend to see this differently (but might be wrong). The reason why fiat money has demand is because it is legal tender and you need to pay your taxes with it and it legally exntinguishes debt. That creates a natural demand for fiat money. For Bitcoin there is nothing like that for the time being, to create it you need the decentralized databse of transactions that uses bitcoins as fuel to have a use case that then creates natural demand for bitcoins as a currency.Therefore for the time being I dont see the relationship you established, that circularity is not as strong as it might appear.

  2. The intermediares are bitcoin liquidity providers. Those that you have been seeking for years and failed to find. Just like forex markets provide liquidity to fiat and make it a better choice to hold, provide liquidity to the bitcoin market and make it a better choice to hold.

    Thanks to these liquidity providers, there is less and less reason to hold dollars (or in my case, euros). Just like when I travel to US or Canada, I don't need to hold dollars, I can keep paying with my euro-denominated debit card.

    There are also other costs of holding fiat which you do not mention. The fee you pay to the bank to maintain your current account, the fees your employer pays to the bank, the fees your employer pays to receive payments from the customers, and so on. For some types of businesses, this is more relevant than for others.

    The intermediaries are a logical step for a secondary medium of exchange. Complaining about them is like complaining that pawn shops are willing to buy gold and this dollarises gold. Whether they are sufficient is another thing.

    1. For the purposes of this post, I've defined intermediaries as payments providers and those who serve buyers, say wallet providers.

      But I'm curious, what do you mean by this? "Those that you have been seeking for years and failed to find."

    2. The provider can position themselves at any phase of the transaction, that is what makes Bitcoin great. For example, Cashila will settle SEPA payments on your behalf against Bitcoin. The payee does not even have to know that Bitcoin exists.

      The hedge providers do not necessarily increase the liquidity of dollar. Some mechanisms work without anyone having to hold dollars. For an overview of hedging mechanisms check out The Piachu's blog: . Adam Back also mentioned hedging as a possible use of sidechains.

      With such "dollarless" hedging mechanisms, there is no additional liquidity in dollars (euros/pounds), you just have a peg, which at least keeps the liquidity in cryptoassets. It also increases the perception of liquidity of bitcoin, because you know that at any time you can trade a bitcoin against a fiat-pegged cryptoasset, without the hassle of going into fiat.

      Just last week you wrote: "bitcoin lacks a non-monetary stabilizer (see here and here)". The intermediaries, by reducing transaction costs (and thus increasing liquidity), provide such a stabiliser. The problem with your argument, as I explained in my paper last year, is that you do not consider a reduction of transaction costs to be a source of non-monetary utility. This is a very tragic argument for an economist to make.

  3. Bit coin is a pyramid scheme

    1. I think it would be more correct to say that the world is a pyramid scheme.

  4. bitcoin/blockchain's value will be more clear once it is easier to use the 'programmable money' aspects. bitcoin is unlikely to become popular because it is superior store of value or unit of account.

    It will become useful because of multi-sig, proof of ownership, cryptographic signing, etc.

  5. I believe you are seeing speculation to get a gateway fee on bitcoin from providers to mitigate downward risks. This 'problem' is temporary and shortly to be solved with one of either sidechain, smart contracts, or secondary systems like Etherium or bitsharesX as you suggested bitusd...nubits etc. Bitcoin will dollarize presently because it has a profit to be made doing so and the dollar is presently showing strength. The process will reverse quite rapidly and bitcoins 'instability will be a temporary benefit for some while scripting/smart contracts will allow value to be maintained dynamically against a basket of currencies and commodities. IOUs (Ripple/Fed) invoke multiple layers of counterparty risks and the best use case of Bitcoin as a currency is that risk is totally eliminated.

  6. Still trying to learn about Bitcoin.

    Haven't had the courage to buy bitcoins yet.
    I fear the volatility, the fees, the tax consequences.

    I don't see the volatility when using dollars because merchants price things in dollars.
    Credit card companies have done a good job hiding the fees.
    I don't see tax consequences because the government treats dollars as currency.

    In your previous article you said merchants love bitcoins because the fees are less than the credit card companies charge.

    I was wondering if it would help get consumers, like me, to use bitcoins if merchants advertised the price of an item in bitcoins as well as dollars?

    Let's say a merchant wants to sell something and lists the price as either $250 or one bitcoin.

    It doesn't matter to me if a bitcoin was worth more or less than $250 as long as I could get the item for one bitcoin.

    I would be unhappy if the merchant just ran a script dynamically calculating $250 into the amount of bitcoin based on the moment to moment conversion price of dollars to bitcoins.

    I want a set price for an item in bitcoins just as I have a set price for an item in dollars.

    Would my request be good for merchants? Probably not. They would be assuming the volatility.

    Would my request be good for bitcoin? I think it would.

    Bitcoin seems to be nothing more than a medium of exchange between currencies with the purchasing of goods and services almost an afterthought.

    Before I get dinged I believe bitcoin was supposed to be a replacement for fiat currency for the purpose of buying and selling goods and services. I am guessing having bitcoin act as a medium of currency exchange was probably not a priority.

    I'm hoping my suggestion would get the use of bitcoin back to what I think was its intended purpose.

    For bitcoin to become the replacement, goods and services need to be priced in bitcoins.

    I will believe bitcoin has come of age when I walk into Walmart and see the price of an item listed in bitcoins as well as dollars.

    I still would have the impediment of converting dollars into bitcoins in the first place.
    Don't know what to suggest about that. Like most people, I am not paid in bitcoins.

    Don't know what to suggest about taxes.
    Wish bitcoins were treated as a currency and not as property subject to capital gains taxes.

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