Wednesday, October 12, 2016

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.

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.


  1. The lack of stability and cost of conversion would undermine any discount though, what is the bitcoin/dollar exchange spread? Cash also has its benefits, anonymity and unreportable, and costs, counting and handling costs and errors, counterfeiting, pilfering, and robbery.

    1. Yep, good point. See my footnote. Even if Dell offers a discount, it may not be big enough to make bitcoin transactions profitable for the consumer, since consumers must hedge against volatility and pay the dollar-to-bitcoin exchange rate.

      Also, Bitpay and Coinbase currently charge retailers 1% for protection from bitcoin exchange rate volatility, which limits the size of the discount that Dell can offer.

  2. Are you sure VISA/MasterCard don't impose rules in their contracts? I live in eastern Canada. There is a gas station 15 miles outside of my city that offers a 2% discount if you pay cash or debit. People flock to it. Everybody knows about it and people stop there when they happen to be in the area. There are often lineups there. Once they ran out of regular gas while I was pumping (they then offered premium at the price of regular).

    Just across the street there is another gas station that doesn't offer that deal and it looks like they only serve crickets over there (maybe they capture some overflow from the other one?).

    I always thought that the one that offered the deal, which is a smaller independent business, just flaunted the rules in their contract and hoped that credit card companies wouldn't notice. They are the only gas station I know that offers that deal. Why wouldn't others do it, especially the one across the street which surely must notice where are their potential customers are going. This one is however a big chain so the decision must be made elsewhere.

    1. Benoit, nice anecdote.

      "Are you sure VISA/MasterCard don't impose rules in their contracts? I live in eastern Canada."

      In Canada, Visa and MasterCard prohibit card surcharges. They have never prevented cash discounts, however, which is why the gas station you describe can do what it does. In the U.S., retailers were recently granted the ability to surcharge credit cards, although not in all states. In Australia, surcharges have been allowed since the early 2000s.

      Here is a recent article on the topic:

      Why don't all gas stations provide cash discounts? Good question. Here are a few academic papers on the topic:

      Tell me if you find them convincing.

  3. JP, you and most of your fellow economists don't understand code, including monetary code, in a physics / evolution / complexity context.

    This omission crushes the philosophic orientation of most of economics ... and will soon come for your and my descendants.

    Here's one way to distill it:
    Looking at the multitude of human bodies to feast on, a bacterium asked, "What the hell happened here?"
    "They tried to do natural selection with monetary code."

    The Price Is Wrong: