Friday, June 5, 2015
Why bitcoin has failed to achieve liftoff as a medium of exchange
It's pretty simple, really. For any medium of exchange to displace another as a means for buying stuff, users need come out ahead. And this isn't happening with bitcoin.
We can break any exchange medium's user base into consumers and sellers. Now we know that sellers love bitcoin—they've been adopting it at a blistering pace, from Amazon to Microsoft to CVS. No wonder when we consider the cost savings they enjoy. A merchant is required to pay around 1.5-2.0% for each credit card transaction. Bitcoin payment processors like Coinbase, Bitnet, and Bitpay charge just 0.5% while simultaneously absorbing all of merchant's forex risk. A retailer with $1 million in sales that converts all of its shoppers from Visa/Mastercard payments to bitcoin has just earned themselves $10,000. It's a no-brainer.
While sellers are jubilant, consumers aren't. Tim Swanson shows that bitcoin payments haven't budged in over a year with bitcoin processor Bitpay's transactions volume amounting to a piddling $57.5 million or so in 2014 (not including precious metals and mining). Bitpay controls at least a third of the payments market. That's what failure looks like, folks.
I think that this aborted takeoff can be blamed on the fact that the dominant consumer payments medium, the credit card, leaves the consumer with significantly more resources after each payment than bitcoin does. Consider the fact that consumers are always paid in U.S. dollars (or whatever their respective national currency happens to be). At the same time, sellers price their wares in dollars and accept payment in that unit, the dollar being both the dominant unit of account and medium of exchange. This is highly convenient to consumers. If someone wants to buy an annotated hard cover edition of War & Peace for $100, they never have to leave the dollar ecosystem.
Paying in bitcoin, however, means that the consumer must endure the cost of exiting the dollar ecosystem and entering the bitcoin ecosystem. One portion of this cost is comprised of the fixed non-recurring expense of learning how to set up the dollar-to-bitcoin portal. The next portion has to do with the commission that a bitcoin exchange will extract from the consumer for buying bitcoin, around 0.5%. At the same time, a consumer will have to pay an additional cost as they reach across the spread between the bid and ask price in order to amass the requisite bitcoin. Finally, consumers must bear the cost of coping with the incredible volatility of the stuff. In order to preserve the U.S. dollar purchasing power of the bitcoin up to the point of purchasing the $100 edition of War & Peace, the consumer needs to buy insurance. Either that or bear ghastly bitcoin exchange rate risk.
You can see why credit cards come out ahead. They are easy for the consumer to setup, they do not extract a foreign exchange commission, nor do they force users to bear any exchange rate risk. Let's work out the numbers. If a consumer earns $100 in salary and want to buy War & Peace for $100, a credit card provides them with enough purchasing power to consummate the deal. However, if they try to buy that same item with bitcoin, they won't be able to afford it. Assuming it costs 50 cents to buy bitcoin and 50 cents to hedge the price risk until the point of consummation, they need to earn at least $101 to afford War & Peace. It's out of reach.
There are ways to modify this setup so that War & Peace is brought back into the reach of the bitcoin paying consumer. Let's assume that bitcoin advocates are right and that the total resource cost of maintaining a bitcoin-based payments network is cheaper than running the credit card network by a significant wedge. The above calculations show us that, at the moment, consumers don't enjoy any of this wedge. In order to induce consumers to make the leap from credit cards, bitcoin sellers and payments processors have to share the savings with them.
Sellers can provide part of this inducement by introducing a lower U.S. dollar sticker price for bitcoin payments. Here's how it works. Our seller maintains their offer to sell War & Peace at $100 for credit card users but drops the price by seventy-five cents to $99.25 for bitcoin users. Let's further assume that the seller pays $2.00 in fees to the credit card network but only 50 cents to its bitcoin payments provider. Despite having discounted War & Peace's bitcoin price, the seller still comes out ahead for each switch from from credit card to bitcoin payments. Each bitcoin sales nets them $98.75 ($99.25 minus 50 cents), but each credit card payment only nets them $98.00 ($100 minus $2). Since they earn an extra 75 cents if they use the bitcoin payments ecosystem, sellers still have an incentive to adopt bitcoin payment.
The subsidy provided by the retailer reduces the consumer's overall cost of using the bitcoin ecosystem. As before, our consumer earns $100. Given the reduced $99.25 sticker price, a 50 cent fee to buy bitcoin, and a 50 cent fee to buy insurance, their net cost has fallen to $100.25 from $101. Its still out of their reach, but not by as much.
The bitcoin payments processor can join the merchant in providing consumers with an inducement. Say that for each transaction the processor pays the consumer a cash reward of 25 cents out of the 50 cents they earn from the retailer in fees. Let's rework the numbers. Given the $99.25 sticker price, a 50 cent fee to buy bitcoin, a 50 cent fee to buy insurance, and a 25 cent rebate, the consumer's net cost has fallen to $100. Paying for War & Peace with bitcoin is now competitive with a credit card. Only now does it makes sense for a consumer to make a leap from the credit card rails onto the bitcoin rail. If merchant and processor can afford to add even more inducements, consumers will switch to bitcoin all the faster.
As an aside, some readers may have noticed I haven't included credit card rewards (i.e. points, air miles, and cash back) into my calculation. I'm making what I think is a pretty fair assumption that no one gets something for nothing. Those running the credit card system fund the rewards they pay to consumers by charging merchants a higher fee. To preserver margins, merchants will build this fee into the U.S. dollar price of the products they sell. This means that the value of rewards that the average card payer earns is entirely canceled by the higher price premium, effectively driving their benefit to zero.
Back to bitcoin. Inducing participation from the consumer isn't a technical problem, it's coordination problem, one that bitcoin entrepreneurs haven't seemed to figure out yet. As far as I can tell, retailers are not providing visible bitcoin price discounts in U.S. dollar terms, nor are payments processors like Bitpay and Coinbase providing consumer's with rewards. By focusing on offering merchants a superior product and omitting the consumer side of the equation, bitcoin entrepreneurs are trying to lure the cat into the door whereas a true tipping point requires going after the tiger.
Alternatively, they may not be going after the tiger because they can't. The ability of bitcoin payments processors and retailers to induce participation from consumers depends on the size of the wedge. If a bitcoin payment system does not provide any resource cost savings, then there is no kitty from which to buy consumer participation. In which case, long live Visa and Mastercard.
There is a misguided view out there that the problem of coaxing consumers into the bitcoin loop will solve itself as bitcoin's volatility disappears and trading costs fall, thus reducing the average consumers' costs of engaging with the cryptocurrency. See the founders of Coinbase here, for instance. This view is wrong. Take trading costs. Even if bitcoin trading commissions fall to zero, there will always be a bid ask spread that consumers will have to endure in order to get bitcoin, and therefore some disincentive to switch away from cards.
As for volatility, the only way bitcoin will ever shake it's toing and froeing is if it is pegged to the dollar by some powerful organization. Not likely. Nor will increased participation flatten out bitcoin's screaming ups and downs. Unlike stocks, gold, or U.S. dollars, bitcoin lacks a non-monetary stabilizer (see here and here). Put differently, its price is indeterminate. More buyers and sellers participating in bitcoin markets will not change this fundamental fact. So contrary to hopes that Bitcoin will become more cuddly, its future is destined to be a frenzied one. Unless consumers are compensated for bearing this volatility, or shielded from it, they'll keep using cards. If they can, retailers and payments processors should be trying their best to subsidize these costs. Without such subsidies, bitcoin is unlikely to ever achieve liftoff.
I started to write this post a few days ago. This is a snippet of the original: "Bitcoin's inability to achieve mass consumer adoption is a good indicator that it will never take off." So you can see that I've changed my mind in writing this post.