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2/26/2014
09:16 AM
Jasmine  McTigue
Jasmine McTigue
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Why We Should All Hope Bitcoins Go Mainstream

Cryptocurrencies aren't problem-free, as Mt. Gox's travails show. But I want the concept to survive, thrive -- and eventually break credit card processors' stranglehold.

Mark Karpeles, CEO of Mt. Gox, resigned from the Bitcoin board of directors on February 24 after halting withdrawals. Then, news dropped of breaches and the site being shut down, possibly headed for an acquisition. These are just the latest twists in the cryptocurrency’s fortunes. We’ve seen meteoric rises -- including a 400% increase in value in about 15 days last October -- along with drops tied to reports of security flaws. There's even a scandal involving a Harvard researcher.

It’s easy to write off Bitcoin and other emerging cryptocurrencies as too risky or unproven for mainstream use. But the real risk is in the status quo.

To recap, a crytocurrency is managed by a decentralized network of individual, peer-hosted currency wallets, unbacked by any governmental entity. That peer network, in theory, keeps each transaction honest. The convenience, however, is anything but theoretical. In a global economy, Bitcoin makes international transactions easy and nearly instantantaneous. You can carry on your phone, encrypted, a Bitcoin wallet that’s as good as cash anywhere in the world yet not prone to theft like paper money. With just an Internet connection, you can transfer money to anyone, anywhere, without giving a third party rights to your transaction history -- something that’s becoming more important as reports emerge of rampant corruption in federal surveillance programs. Exchanges can swap Bitcoins for a currency of a buyer’s or seller’s choice in a matter of moments and perform deposits and withdrawals via bank transfers or cash payouts at an ever-increasing number of locations.

Bitcoin is a trading currency, not a reserve currency. A reserve currency functions by providing enough volume to spread tens of billions of units among organizations and nations in a complicated international web of interdependent fiscal promises. Think bonds, stocks, and business and national agreements: They all use large sums of extant reserve currency to secure relations and stabilize trade.

Bitcoin isn't about a reserve or financial hedging. It’s about two people exchanging goods or services. Before we invented the global economy, we traded in gold, silver, even cattle. We backed paper notes with real commodities because we hadn’t yet invented the tangled web we call “international finance” that requires huge sums to sustain. Commodity-backed notes were a trade currency, and that’s the difference between Bitcoin and the dollar, euro, pound, or yen.

Bitcoin, and cryptocurrencies in general, signal the return of a genuine trade currency that's accepted worldwide.

But perhaps the most valuable and compelling aspect of a cybercurrency transaction is this: It almost completely eliminates payment processing fees for buyers and sellers of goods and services. Right now, the credit card is consumers' medium of choice. Consider international purchases. We buy goods in a foreign currency, say pounds, and our credit card company pays the person far away and converts our dollars to pounds at an exchange rate just a tad below market prime.

It’s so low a margin, and cards are so convenient (for now, anyway) that we don’t get irked when processors make a few cents off our transactions. But the cents from those billions of transactions add up -- we’re talking a fortune in exchange rate manipulation alone. 

But what should really get us riled up are the fees for accepting plastic in the first place. Small vendors pay $1 plus 3.5% of the total purchase for every credit card transaction. The restaurant you visited last night and paid by plastic? That small-business owner had to charge more for your sandwich to pay the MasterCard piper. For big retailers, this fee is smaller, around 2% of the transaction total. Still, like exchange fees, they add up.

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Here’s the billion-dollar question: Why haven’t these fees dropped as a result of nimble card provider startups entering the fray, or in response to completely new ways to pay for that sandwich? In a free-market economy, competition should ensure that fees are competitive. Your local deli owner ought to be able to figure a way around that $1 plus 3.5%, besides insisting on cash only.

On the surface, there is competition among Visa, MasterCard, American Express, and Discover. Yet fees haven't budged in years. Why?

The short answer is, the system is structured to make it incredibly difficult for new card entities to get in the mix. Discover and Amex are grudgingly allowed -- sometimes. We've all seen ads for venues where only Visa is accepted. New, independent card offerers can't get into the game, even if they could afford the prohibitive capital outlay. That's the stick.

The carrot is that Visa and MasterCard are franchisers. Like a Dunkin Donuts, you can buy into their system and offer Visa- or MasterCard-branded services. You make your money on interest rates, penalty fees, and other stipulations of the cardholder agreement. But Visa and MasterCard, or a few trusted business partners, control the processing of transactions. And it’s those organizations that impose the 3.5% vigorish on small businesses.

American Express and Discover Card are independent. They issue their own cards and are responsible for their own transaction processing, so they could exert downward pressure, right?

In theory, but not in practice. With only four players in the market, it’s not difficult to imagine an unstated “gentleman’s agreement” to hold steady on rates, regardless of other competitive efforts. It’s all very neat and contractual, but the bottom line is that by keeping credit card processing fees static, everyone makes their money, and no single organization is vulnerable to antitrust. It’s a great deal for credit card processors, but it’s bad for businesses and by extension customers. It’s why so many shops and restaurants impose a minimum purchase on cards (to cover the $1 fee) and/or offer discounts for cash purchases. And don’t even get me started on the costs for PCI compliance.

And that’s the real promise of Bitcoin and other emerging cryptocurrencies. They cut the middleman credit card processors out of the picture. Bitcoin opens the market again to competition and innovation. And suddenly, its value is crystal clear. 

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Jasmine McTigue is principal and lead analyst of McTigue Analytics and an InformationWeek and Network Computing contributor, specializing in emergent technology, automation/orchestration, virtualization of the entire stack, and the conglomerate we call cloud. She also has ... View Full Bio

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J-Moreno
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J-Moreno,
User Rank: Apprentice
2/27/2014 | 9:52:59 AM
Re: Nothing backs Bitcoin
Dandrick,

I agree that the government's greatest concern regarding Bitcoin is the lack of regulation. While Bitcoin may provide anonymity and ease to the honest consumer, it will become the financial method of choice for the elite to hide wealth from taxation, and a haven for terroroists and criminals to finance their activities.
moarsauce123
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moarsauce123,
User Rank: Ninja
2/26/2014 | 6:52:52 PM
Backed by what?
The problem with these made up currencies is that they are backed only by virtual hype and nothing else. As quickly as this money from the land of makeblieve appears as quickly - poof - is it gone into digital nothing.
dandrick601
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dandrick601,
User Rank: Apprentice
2/26/2014 | 6:06:57 PM
Re: Nothing backs Bitcoin
Thanks for the response. I agree that international transaction fees are especially egregious. Given global terrorism, money laundering and tax evasion laws, I don't see governments sitting Bitcoin out in the name of competition.  I could be wrong - I didn't see Durbin amendment coming.

I do understand the merchant side of this - wanting lower costs for their operation. However for domestic (e.g. mundane) payments, what's in it for the consumer?  Going back to Loran Garey's recent blog, what is going to be easy for the consumer that will overcome inertia?  I don't see it in Bitcoin yet.
JasmineMcTigue
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JasmineMcTigue,
User Rank: Strategist
2/26/2014 | 4:29:15 PM
Re: Nothing backs Bitcoin
Excellent Response Dandrick!

The issue is partly the monopoly status of the main payment networks, but more so the ease with which international transactions are completed in Bitcoin. I'll give you a real world example: 

I sometimes buy commodity computer hardware from China for my evaluation lab or for other purposes like iPhone repair. Until the advent of cryptocurrency, I typically used Western Union for these transactions, which while effective, imposes an even harsher vigorish than credit card processing transactions. 

I don't fully understand the hostile microeconomic climate in other nations that drives them to use services like western union over credit card payments, but the feedback I get is that these vendors have a very difficult time dealing with fees and security measures that seem trivial to US customers, so they use privatized currency exchanges with large fees rather than just accept my card. Yet these same vendors would, before the recent collapse in value, accept Bitcoin happily. Chinese acceptance of Bitcoin is skyrocketing, and a part of that has got to be the underdeveloped or individually inaccessible nature of payment processing networks, even in economically robust countries like China, never mind developing nations in the third world. 

The world is getting smaller economically, and while existing international financial frameworks work acceptably for big businesses who can shoulder the fees, responsibilities and obligations of accepting international payments, the small company or individual continues to work against signficiant difficulty in conducting legitimate business worldwide in the context of our existing financial framework. Nevermind transactional anonymity, the present discussion is about usability and global trade. 

The Euro, problems inclusive, has done wonders for facilitating commerce in EU countries, but as we move toward an increasingly global economy, we need payment frameworks that allow individuals to deal with one another on a fair basis, without pejorative fees, anywhere in the world. This is my hope for Bitcoin and other cryptocurrencies: that they will come to fill a much needed niche in international trade economics not just between organizations but between individuals. This is also why I see intrinsic value to the idea of Bitcoin, even while maintaining concerns about the widespread adoption and regulation of cryptocurrencies in general. 

To your point about competition, I am also enthused by the idea that Bitcoin may shake up credit processing frameworks. As a small business owner, I cringe at the transaction fees paypal assesses when I collect invoices electronically. Other small businesses for whom I consult feel similarly: the cost of credit processing transactions is "perfect" from a payment processor standpoint: it's high enough that they make excellent money handling transactions and just barely low enough that small businesses will grudgingly swallow the losses. The credit card payment processing market is stagnant and well controlled by a small group of insiders, unorthodox value structures like Bitcoin challenge our assumptions about how transactions must be conducted and inject vital competition into a stagnant market.

Bitcoin asks us to think: are we happy with these structures? Are these organizations adding value? Could we do this differently? And in that respect it provides a much needed catalyst for innovation in a needy and immature international market. 

Nobody can assert that Bitcoin doesn't have a long way to go in satisfying the needs of a robust, global, ubiquitous and secured trading currency. But Bitcoin is just the first iteration of a government agnostic, international, value based trade currency. Even if Bitcoin fails to survive as a viable international currency or to lower payment processing rates domestically, it has still shown the world that the way we do things today isn't the only way, and that there is most certainly room for improvement. 
dandrick601
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dandrick601,
User Rank: Apprentice
2/26/2014 | 3:54:51 PM
Re: Nothing backs Bitcoin
In full disclosure, I do not own Bitcoins and have worked in/around the payemnts space for over two decades.  I also believe we are lacking in the 21st is a good P2P system in the US which numerous entities are attacking.  Without rehashing some of the issues, I'm curious about your closing statement on this article. 

As a capitalist, I believe in competition.  Challengers always force market leaders to re-evaluate their business models - sometimes they win, often not - but it does typically drive change.  Is your issue the cost of processing a payment or the lack of innovation in the market?  If cost is the issue, why is it an issue?  Or is it the near monopoly status of the main networks?

The original premise for charge/credit cards was that people spent more at a merchant when they didn't pay by cash.  So extra revenue.  However merchants weren't/aren't willing to take on the cost (e.g. transaction processing, statementing, collections, fraud, plastics) associated with that payment method.  Some of those costs may go away with a digital currency, but not all.  As a former fraud manager, I also know all payments have risk.  And those costs will have to be funded by someone.

While good at grabbing headlines, I content:

1) the volitility and lack of ubiquity for Bitcoins will keep the "masses" away

2) Once adaption reaches "critical mass", governments who haven't banned it, will regulate it, thus stripping some of the desired cost reductions and anonymity

 
JasmineMcTigue
IW Pick
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JasmineMcTigue,
User Rank: Strategist
2/26/2014 | 3:27:26 PM
Re: Nothing backs Bitcoin
The major concern is that cryptocurrency will be used to fund illicit activities, and ultimately, some form of multi-government oversight is probably going to be required if the currency is to become a legitimate trade currency. The bitcoin protocol does have security vulnerabilities which I'm not going to get into here, except to say that the network depends on peer validation of transactions and that a large enough network of peers could theoretically manipulate transactions. 

But even if Bitcoin fails, others like Litecoin are ready to take up the mantle. And like all trading currencies, Bitcoin remains valuable because of scarcity. In the same way that diamonds are only scarce because DeBeers controls international supply, Bitcoin is scarce and therefore valuable because the network only allows a certain amount to be generated, proportionate to the effort of the "miners" who solve each new equation. Scarcity and value are well established partners, the fact that the backing commodity exists in the form of a consensus network of transactions does not make it any less real than the dollar, a currency which is no longer commodity backed, and exists only in electronic ledgers, the sum of which far exceed the value of gold bars in the federal mint. 

Right now, we haven't established what the real value of Bitcoin ought to be, but as cryptocurrencies mature and existing players begin to offer financial services built around them, currencies like Bitcoin and Litecoin may come to fill a much needed role in facilitating inexpensive, reliable and instant transactions in our increasingly global world marketplace. And maybe, shake up the competition a little on the way through. 
JS88
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JS88,
User Rank: Apprentice
2/26/2014 | 3:10:05 PM
Re: Big, big money
Coinbase and other payment companies take on that risk. When the business accepts bitcoin, it instantly transfers it to USD, eliminating all of the risk. The business gets the USD and coinbase/etc gets the bitcoin. There is, as far as I can see, absolutely no risk for a small business to accept business under these circumstances and they get free publicity plus tap into a new market. I would much rather visit an establishment that is accepting bitcoin.
Lorna Garey
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Lorna Garey,
User Rank: Author
2/26/2014 | 3:03:22 PM
Re: Nothing backs Bitcoin
Governments certainly seem to see cybercurrency as a threat, above and beyond the possibilities for illegal activity. The US and Japan are investigating Mt. Gox and will, I imagine, do what they can to maintain the status quo.
JasmineMcTigue
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JasmineMcTigue,
User Rank: Strategist
2/26/2014 | 1:56:56 PM
Re: Nothing backs Bitcoin
DDURBIN1, 

You've made an excellent point, and one of the important things that credit card companies and processors provide in exchange for their fees is also transactional security. If someone hacks your bitcoin wallet and spends lavishly, no one will step in and soak those charges for you. 

This leaves an interesting niche to fill in cryptocurrency: who will provide financial services that indemnify consumers against fraud and protect assets? 
DDURBIN1
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DDURBIN1,
User Rank: Ninja
2/26/2014 | 1:14:14 PM
Nothing backs Bitcoin
"Think bonds, stocks, and business and national agreements: They all use large sums of extant reserve currency to secure relations and stabilize trade."  If you believe a Bitcoin is in this category you are very mistaken.  There is much more than just "extant reserve currency" behind these to secure them.  For example, bonds support public works project backed by governments.   Stocks support business endeavors backed by assets and captial.  What backs Bitcoin in a similar manor?  Nothing. 
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