Bitcoin has an experienced an enormous rise in price in 2013, and thus attracted even greater interest. While some are interested in the virtual currency for ideological reasons -- as a means of resisting monetary policy imposed by central banks associated with nation-states, whose actions are perceived by some to be a form of economic warfare waged by the wealthy against the poor and what remains of the middle class -- others, particularly those investors and entrepreneurs in the Internet technology world, see Bitcoin as a potential payments solution for the web -- something that can disrupt Visa and Mastercard. That Bitcoin offers its own technology protocol and an entirely new way of operating causes some to see it as an enabling technology that can unlock new markets and unseat established incumbents of old markets. For these technologists, payments are the big promise Bitcoin holds.
The viewpoint put forth in this post is that the current crop of Bitcoin payment processors cannot live up to this promise; that they are setting themselves up for a big collapse. This post will illustrate that these processors face one of two outcomes:
To illustrate this point we will look at Bitpay, a market leader in Bitcoin payment processing, though the concept can be applied to most any Bitcoin payments company.
Bitpay enables merchants to accept Bitcoin anywhere in the world. They offer 1% transaction fees and guarantee loss avoidance due to exchange rate fluctuations. An example will illustrate what this means:
How is Bitpay doing this? There are a few options:
1. Bitpay is essentially buying Bitcoins from your customer and immediately selling them. The best route would be if they could sell them to another customer that Bitpay already has. In this way, they do not need to do any external recordkeeping. However, this assumes they have a customer who wants to buy Bitcoin, and wants to buy them immediately at the same price that Bitpay bought them from your customer.
2. Bitpay also has the option of going out into the larger market and selling Bitcoin there. Price can vary greatly based on which exchange is used. The chart below, courtesy of TheGenesisBlock, shows Bitcoin spreads have exceeded 12% on various exchanges. This does create arbitrage opportunities that may eliminate the gap in time, but for now, it illustrates the lack of efficient price discovery in the bitcoin market.
At this point the problem that Bitcoin payment processors face becomes clearer. While they must guarantee elimination of exchange rate risk to secure adoption from merchants, they can only do this to the degree that they are willing to accept exchange rate risk themselves. Companies like Bitpay do implicitly acknowledge this by capping transaction volume, and by stating that if they do not receive Bitcoins from the customers of merchants in sufficient time they will reject Bitcoin payment for transactions.
But ultimately, this issue must be dealt with if payment processors are to survive. While volatility in percentage terms is likely to decline, and while speculators are likely to erase arbitrage opportunities, the question remains whether Bitcoin can achieve the degree of price stability that make it viable for payment processors to conduct large scale transactions at rates that are superior to what incumbent payment processing companies use.
Personally, I don’t find the odds to be favorable for Bitcoin companies. Consider, for instance, the volatility that nation-state currencies face: the Euro/US dollar exchange rate fell by 0.8% in under 1 minute when the European Central Bank announced it was cutting interest rates on November 7, 2013. The chart below illustrates.
According to blockchain.info, on November 7, 2013, it took nearly 13 minutes for Bitcoin transactions to be confirmed.
The stage is set: one day, a Bitcoin payment processor is going to be caught holding the bag. A big event in the nation-state economy -- something completely unrelated to Bitcoin -- can set off a big and quick change in the exchange rate. At such times, transactions will take even longer to confirm, causing payment processors to either reject more transactions or expose themselves to greater exchange rate risk. If processors aren’t careful, they’ll find themselves wholly insolvent within minutes. Conversely, if they're too careful, then they won't be able to scale, as big transactions will pose too big of a risk for them.
Is there a solution? Yes. An ambitious processor could seek to dominate the Bitcoin economy, so that they own virtually all coins in existence. This is a tall task, given that many Bitcoin owners are not inclined to sell until prices are much, much higher. But a payment processor that has majority control over the exchange rate emerges, the processor may be able to effectively minimize exchange rate risk.
But, what such a processor is doing is taking an open protocol and closing it. This is sure to raise the ire of many Bitcoin enthusiasts, who will find such actions to be in violation of the Bitcoin spirit of liberty, anarchy, community, and openness.
As this process becomes more fully understood, the solution for a virtual currency and the disruption it promises will be clear: a central bank to ensure price stability, and perhaps other forms of security.
-- Simit Patel