August 19, 2016
Bitcoin: Bubble to Bedrock?
A case could be made that Bitcoin—its rise and fall and rise again—was the payments story of 2013. But in the early stages of 2014, the debate has shifted. While attention still is being paid to its volatility as an investment, increasingly, the focus is on merchant acceptance and navigating what could be a thorny regulatory environment. CardNotPresent.com presents a three-part series on Bitcoin and its spasmodic progress toward legitimacy. In Part I, we present a pessimistic view that has endured despite the hype. Will Bitcoin’s volatile changes in value hinder its effectiveness as an online currency?
Part I – Determining the Value of Bitcoin as Currency
A CardNotPresent.com Editorial
Although Bitcoin is primarily a form of currency, providing a source of value used as a medium of exchange within a transaction, people have a number of interests in Bitcoin that extend beyond this use. However, for the card-not-present payments industry, the question is can we extract the value of Bitcoin that comes from these secondary uses of the product, subsequently allowing an analysis of Bitcoin’s value that is derived purely from its use in monetary transactions?
Beyond payments, Bitcoin has two major sources of value. The first is as an investment. Speculation in currency is certainly nothing new, but the rapid rises and crashes in the price of a Bitcoin has made this a particularly interesting investment. Recently, Bitcoin hit an all-time high, each selling at just over $1,200. When compared to its value only 12 months ago—under $15—it is easy to see why Bitcoin’s investment potential has garnered such attention. However, while it is certainly possible to argue that this increase in price is based on Bitcoin’s value as currency for payment, CardNotPresent.com is interested in the source of that value, not the result. Whether or not buying and holding Bitcoins is a sound investment is irrelevant to us and to the e-commerce industry in general. Rather, we are focused on the value of buying and using Bitcoins.
The other use of Bitcoin beyond payments is its use for currency conversion. As anyone who has traveled abroad is likely aware, converting one country’s currency to another is not free. In general, fee’s tend to hover around 2 percent, and are often higher when the exchange takes place outside of a bank. Because Bitcoins are traded without fee, it is possible to exchange one country’s currency for Bitcoin, then that Bitcoin for a second country’s currency, thus avoiding any exchange fees. This is without question a beneficial use of Bitcoin, but as it does not involve the exchange of money for goods and services, it is also outside the scope of this examination.
Once, these two sources of value are removed, what remains is Bitcoin’s inherent value as a method of payment. As such, Bitcoin has a number of both strengths and weaknesses.
Bitcoin supporters generally point to three significant strengths related to Bitcoin as a form of currency: anonymity, a lack of discount fees, and versatility during international transactions. But just how valuable are these characteristics?
The fact that Bitcoin payments can be made without a paper trail may appeal to people who are uncomfortable with the level of information that card networks and financial institutions are able to generate from their transaction data. There are a number of people who hold this opinion because they feel the collection of such data violates their civil liberties. Unfortunately, there are also a number of people who don’t want to produce transaction data because they are engaging in illegal activities, such as drug trade and gambling. Whether criminal activity represents the majority of Bitcoin activity or barely any of it, this is the type of transaction that has and will continue to attract the most attention. Every time Bitcoin is linked to Silk Road, or the CEO of a Bitcoin exchange is arrested on suspicion of money laundering, Bitcoin becomes increasingly associated with illegal activity. The stronger this reputation becomes, the less likely Bitcoin is to be adopted by the mainstream.
In addition, many Bitcoin advocates have touted that Bitcoin represents the end of discount fees and interchange, thus appealing to merchants for the potential cost savings in accepting electronic transactions. However, although it may feel this way sometimes, it’s important to remember that card networks use interchange to do more than just extract profits as a third party in transactions. Networks and financial institutions use the revenues they generate from discount fees to provide a number of services that support the transaction. Among these services, one of the most significant is security: card networks have developed secure systems that ensure funds are transferred reliably and in their entirety. Because Bitcoin does not charge for the service of making payments with Bitcoin, the security involved in the process is minimal. While the actual transactions tend to be secure, the exchanges have been an all too frequent source of theft. Obviously, this creates a risk in holding Bitcoins, however, when these thefts are sizable enough, they cause the value of Bitcoin to crash. This means that Bitcoin theft not only affects those who lose their Bitcoins, but in fact affects all Bitcoin holders. This only adds to the volatility of the currency, making it less likely to become a reliable base for transactions.
The final strength cited for Bitcoin is that it simplifies international commerce. Essentially, because all countries use the same “Bitcoin”, an American purchasing an item from France can complete the transaction without going through the often costly process of currency exchange. That said, while this does provide an opportunity to reduce transaction costs, eliminating the 2-3 percent fee for currency exchange would be most valuable for transactions involving low-margin, commoditized products. Generally, when a consumer is forced to seek out a product in a foreign country, that product is anything but a commodity. So while Bitcoin does provide a level of value for these transactions, that level is unlikely to be sufficiently significant to inspire changed habits.
Clearly, the oft-cited strengths of Bitcoin are marginal at best. But more than any of this, the most glaring weakness of Bitcoin is its inherent volatility. There is no gold standard backing up the value of a Bitcoin, meaning that its value is whatever Bitcoin users claim it to be at any given moment, resulting in rapid rises in value followed by similar declines. Admittedly, the US dollar is also no longer tied to the value of gold, and hasn’t been for more than 40 years. However, unlike the U.S. dollar, the entire economy of a nation is not based on Bitcoin. This creates a catch 22: Bitcoin is too volatile to achieve significant adoption, but it can’t reduce its volatility until it is adopted by a significant number of consumers.
While there are certainly benefits that can be extracted from Bitcoins, it is not certain that a more effective transaction process is one of them. At the moment, Bitcoin is not poised to replace the US dollar, nor will it become the dominant currency for international transactions any time soon. From a payments perspective, until these issues can be addressed—if, indeed, they can—the Bitcoin craze is more fad than a harbinger of things to come.
But what if we’re wrong? What if what seems like the inevitable wave of regulation pointed at Bitcoin does more good than harm—what if it quiets markets and smooths out the bumps? Many companies are betting on that already. Look for Part II of our series, in which we examine what these companies are doing to legitimize Bitcoin as an accepted and trusted online payment method—how they are getting ahead of and trying to work with regulators.