The Promise of Bitcoin Payments (#22)
Explores the utility, challenges, and the likely road ahead for Bitcoin
The last few months have ushered in a new phase for Bitcoin. I say that not because it has gone from $10K in October to ~$35K while I type this. Neither because the search trends for the term are off the charts. This is most expected with the run that Bitcoin has had. Especially when it is something as fundamental to the human condition as a temptation to create wealth fast.
This growth and interest are all too familiar for long-term investors. 2013, 2017, and 2019. All of these years saw periods where Bitcoin grew more than 400%. There is a similar script to the rhetoric that follows as well. The sceptics bring out the parallels to the dot-com bubble or the Tulip mania, rubbing their hands in anticipation of a big crash to shout “I told you so”. The bulls look onwards with sparkling eyes. And a belief that this time, it will be different.
But, is it?
I think so. Two reasons support the claim.
Institutional Interest: last year was truly one where bitcoin went institutional. Asset managers, banks, and companies such as Square have been vocally optimistic about Bitcoin holdings and Bitcoin’s prospects. This is likely a result of low-interest rates, continuous success of the bitcoin protocol to support transactions, and the utility of short-term volatility and the protocol allows.
Regulations: aiding the sentiment are the regulations that are gradually allowing financial institutions to partake in cryptocurrency management. For example, OCC recently drew out guidelines for banks allow banks to access public chains and to run nodes for public chains. The regulations have allowed bitcoin to gain legitimisation in people’s consciousness.
The institutional support also lends voice to the notion that Bitcoin is worth something and not nothing, which is often the conundrum in the crypto world. It also pushes people to trust investing a small portion of their portfolio in Bitcoin. If you follow the space well, you have likely done the same.
But this also uncovers a harsh reality. That most people today are investing in the optimism of others more popular, and hardly on what Bitcoin stands for. In other words, the retail money entering the asset is largely hot money. On the other side, a small group of long-time supporters of bitcoin cares little about the daily price changes. They believe in the future where bitcoin will be part of our everyday life. For institutions, an opportunity to hedge might be powering their belief.
Regardless, whatever side you pick in this debate, you are likely to make a better bet with more knowledge. And the way to that enlightenment is to understand what Bitcoin stands for. This article attempts to cover exactly this.
So, what is bitcoin? A little history before that.
Bitcoin: A Peer-to-Peer Electronic Cash System
This was the title of what is now the seminal paper for bitcoin. Released in 2008 by Satoshi Nakamoto, which was likely a pseudonym for a group of people, the paper neatly lays down the protocol that governs the bitcoin payment system.
The work suggested replacing the legacy currency systems that rely on trust with the Bitcoin payment system, a decentralised P2P electronic cash system that would instead use cryptography. I will explain this in more detail.
The premise, quite true, is that conventional currency systems require a lot of trust to work, which makes them costly, opaque, and weak. For example, the reliance on centralised commercial and central banks leaves an opportunity for systematic failures. Similarly, it gives power to the central organisations to confiscate your balances and accounts. And the payment intermediaries to a transaction may refuse to process payments. More importantly, financial institutions gain complete control over transaction management (transfer) and money issuance (creation).
These processes have evolved enough to offer great success in a high percentage of transactions, but the system continues to deal with trust-based costs. These include costs in terms of mediating the transactions, of reversing them in times of fraud – accepted as part of payment systems today - and of being at the mercy of few financial institutions, which use the almost-monopolistic power to price even the simplest transfer services for profit.
These inefficiencies of trust, among others in our payment systems, is what Bitcoin solves.
How does Bitcoin work?
Bitcoin payment system solves the problem of trust by establishing a protocol wherein the system relies on cryptographic proof instead of trusted third parties to transact. As technical as it may sound, understand importantly that there is no central or commercial bank in the system to print new money or to track transactions.
Instead, these roles are distributed to the network itself.
Tracking transactions
Electronic payment systems such as FedWire, PayPal function as a record of accounts themselves. Each account in the system is associated with a user. And the user can access it to check their balance and make transfers. This pushes the responsibility of bookkeeping on a single trusted authority.
Under Bitcoin, the ledger with all transactions is maintained by a collection of computer servers, called miners, and is made available on a public database called the blockchain. The incoming transactions are broadcasted to all nodes handled by miners, and each node time stamps the new transactions to a block. The nodes then work to find a proof-of-work, which on a high-level is the process of confirming the transaction through proof of computational effort. This step is important to ensure that it would not be easy for a malicious node to take over as they would require incredible computation power to override multiple confirmations.
Once the proof-of-work is established first by a node, the block with the transaction is broadcasted to all other nodes. The acceptance of the block in the existing block-chain is only done when all the transactions in it are proved valid, which adds security to the system. Finally, once the block is added, the nodes express their acceptance by working on the next block of transactions using the hash (say, ID number) of the previous block.
In the entire process, there are two other features of note:
The selection of the block is randomly distributed, independent of the aggregate computing power of the miner – the randomness implies a lower chance of block manipulation by a single node
Also, each block has only a limited capacity, which limits the transaction-processing capacity of a single block and thus the possibility of a large set of fraudulent transactions to be accepted
Printing bitcoins
In market economies today, the function of printing money is particularly reserved for central banks. The central banks, as the authority for guiding monetary policy, are often tasked with maintaining inflation through acts of printing fiat currency and to interfere in times of need.
In the decentralised monetary system with no central bank, the protocol under bitcoin guides the pricing and printing of bitcoins. Miners, who are required to add transactions to the block-chain, are provided incentives for this resource-intensive work.
Bitcoins are created and awarded to miners each time a block is created. By design, the number of bitcoins generated per block is halved every 210,000 blocks to limit the supply. While initially in 2009, each block rewarded 50 bitcoins, the figure is down to 6.25 now. Halving allows the lifetime supply of bitcoins to be limited to only 21 million. The purpose was partly to ensure that bitcoins are not created in excess to introduce inflation, and mainly to match the price with the fiat currencies. That is, Satoshi thought that limiting the supply is likely to push the price of Bitcoin above and closer to parity with USD or EUR as the demand catches up. This calculation proved quite inaccurate with the value of even a 0.0001 bitcoin above ~3.5X USD today.
In addition to bitcoins, the miners are awarded transaction fees (or minor fees) from the users for including the transaction in the block. As the number of bitcoins per block reduces and tends towards zero, the incentives for miners will shift towards transaction fees. And eventually, once all the bitcoins are mined, it will purely be this incentive driving the miners to continue printing blocks. For the consumers, the good news is that the transaction fees are little affected by the monopoly of processing companies and the fees are instead dependent on the size of block size, which is expected to change little.
These processes provide a high-level view of how the money issuance and transaction management in the decentralised monetary system work without the trusted third party. By doing so, the bitcoin payment system significantly reduces the transaction costs and makes the system more transparent without compromising on security.
But, is solving for the trust costs the only major benefit?
Solving for high trust costs is a huge benefit in itself. But it is certainly not the only improvement of the system. The following are some others:
No storage costs: much like gold, bitcoins provide the quality of natural scarcity and fungibility to be regarded as a medium of exchange. However, unlike gold, bitcoins have little to no storage costs, which make them easier to secure and transfer.
Low-cost alternative: particularly for difficult and high-cost payments incl. cross-border transactions such as remittances, bitcoin provides a cheaper alternative with the property of being borderless and permissionless. These transactions would simply require a transfer of bitcoins from one wallet to another - similar to sending a slack message across the world, with no intermediary to please. Further innovations are being suggested for lowering the network costs.
Anonymity: although broadcasted to all nodes, the bitcoin transactions provide discretion the same way stock markets do – by hiding the identity of the broadcasted transaction. They are not completely untraceable unless users maintain a certain decorum, but are safer compared to the traditional electronic transfers.
No censorship: no organization can block or freeze a transaction or account, however, the crypto exchanges do have the liberty to counter suspicious activity
Irreversibility to counter double-spend: the entire protocol of mining, proof-of-work, etc. exists to hard code the transactions into a chain of blocks – making the transactions computationally irreversible. As the transaction is confirmed, the money cannot possibly be spent again and the transaction is all but impossible to modify. This is a key element of the system to protect it from fraud.
These properties of the decentralised bitcoin payment system allow users higher autonomy of their digital transactions than the fiat currency, at least in theory.
Does this mean that Bitcoin is destined to be successful?
Bitcoin proposes a new monetary system that improves the inefficiencies of the legacy ones, but without the large scale use cases – to a great extent, the notion is still untested. More importantly, there are legal and economic considerations that Bitcoin must overcome to be accepted on a global scale.
High switching costs
William Luther highlights, and makes a valid point, about the incumbent-monies problem that Bitcoin faces. That is, the decision to an extent to adopt bitcoin is a decision to stop using the incumbent money. A behaviour that can take decades to shift. These switching costs of consumer behaviour and the network effects invariably favour the widely-accepted status quo systems.
More so, it becomes important to then understand that whether Bitcoin can act as good a store of value as the fiat currency. Given the present volatility, Bitcoin is highly unlikely to be justified as a direct substitute. And with the switching costs of removing the infrastructure such as routing machines, ATMs, etc., the benefits for incumbents must surely be large enough to justify the costs.
Going against the Government-Sponsored money
The proposition of a decentralised currency is less appealing to the governments that give fiat the legal-tender status and sponsor it. The fiat currencies, although somewhat inefficient, give the government the benefit of managing the monetary policy and of generating revenue through positive seigniorage.
So long as bitcoin goes against the government benefits, persuading the regulators and policymakers will remain a challenge. The speculative nature of bitcoin purchases and the lack of price stability supports this scepticism and draws bitcoin away from the commodities that it is compared with.
The common rhetoric is instead to focus on digital currencies that are centrally backed. CBDCs are fundamentally different from bitcoins, given that they are centrally backed. It is, however, not surprising that central banks would first want to experiment with fiat-backed digital currencies before allowing bitcoin complete acceptance.
Marketability and First-Mover Advantage
We realise that bitcoin has money-like properties, incl. portability, durability, fungibility, scarcity, security, and divisibility. To add, its ability to function as money without the need of third parties makes it highly marketable among users.
These points highlight the utility of bitcoin, but for success, it needs public acceptance more than anything else. As Austrian free-money economics argues, no money really holds any intrinsic value, and the value is all but derived from humans themselves.
To this extent, bitcoin stands to benefit among decentralised currencies with its first-mover advantage. Making up more than 80% value of all cryptocurrencies, bitcoin has benefited from the network effects generated from being first-to-market. The wide usage makes it more likely to be accepted by new buyers of cryptocurrencies, forming a positive feedback loop.
Despite the oversight and regulatory hurdles that bitcoin is likely to face, the support from institutions and the consequential belief of the public in the currency can force pressure on governments around the world to allow bitcoin to exist.
Even Milton Friedman has long propagated the need for e-cash that limits government overreach, while Hayek has gone on record to say that the old monetary system can’t be violently taken out from the hands of the government, but instead, we must slyly find a way to introduce something that they can’t stop.
Now, can the governments stop Bitcoin?
Lack of Intrinsic Value and Use Cases
The traditionalists’ whimper of the lack of intrinsic value, of no cash flows to discount, and of the obvious change to a digital asset. Change is difficult, of course, and the lack of any physical asset to back bitcoin and cash flows do make the valuations a hyperbole.
But the argument is hardly sound. Bitcoin was built on the premise of building a system that allowed an exchange of value, the value that people associate with it. The intrinsic value then it derives is then from the blockchain protocol. As the system builds the blockchain by embedding more transaction messages, the value of a bitcoin grows. Moreover, the proponents also argue that assets such as Gold – although with industrial uses – are worth way less based on their intrinsic value alone than they are presently on the market.
Bitcoin, however, seriously needs to answer the doubts on its real-life use cases. The features of the system suggest utility. But, we must carefully keep an eye for the adoption of the currency to prevent fraud for merchants, to lower costs for high-transfer fee payments, among other examples. These will require patience to gauge the success of, and an attitude from businesses and consumers alike to treat bitcoin as a medium of exchange as much as an investment asset. The challenge here will remain the volatility of the currency due to its limited supply and ever-changing market sentiments.
Predicting the Future of Bitcoin
Forecasting the evolution of digital payment systems is an open field today. Anyone can take a shot, and we are all likely to be equally wrong. Needless, there is an attempt in order.
The competition of bitcoin is less from the other alt-coins and more from the legacy payment systems. Given the headwinds of some regulatory and institutional support, the adoption is likely to be hastened in the more developed corners of the world amongst the early adopters. My guess is that bitcoin will evolve across three phases:
Proof-of-concept phase: The next year or two will continue to convey bitcoin as a speculative asset, but increasingly more retail and institutional investors will treat it as a store of long-term value. Peer to peer balance settlements will likely be the first big use case with platforms such as BitPay, PayPal leading the use. We can also expect more major store chains and small businesses to start accepting payments in bitcoin, primarily to save on transaction costs and to benefit from sales from early bitcoin adopters.
Sophistication in Big Use Cases: As the proof of concept is established in public, more platforms and products will focus on the distribution of the software to remote locations with poor financial infrastructures. Eventually, I believe that the biggest use for bitcoin will be more in replacing cash more than any other monetary system. This will start with developing nations that see interest in the new asset. Today, Nigeria is already one of the biggest proponents of bitcoin. Expect the use cases on remittances, e-cash for financial inclusion to build over the following four-five years.
Niche community adoption: Eventually, as the concept and use cases prove successful, there are likely to be strong small communities of businesses and consumers that will primarily depend on bitcoin for most transactions. This will possibly be the case for the financially backward and technologically advanced communities. However, I do believe that the legacy systems with the addition of state-backed digital currencies will continue to grow and dominate for at least this decade. If even 5-10% of the transactions in North Americans or any developing countries are in Bitcoin by 2030, it would be a great success.
These are all based on some heavy underlying assumptions. For all we know, some insider news might lead bitcoin to crash tomorrow, investors to lose faith, regulators to tighten the screws, and leave the prediction in tatters. But, isn’t that part of the fun?
Final few thoughts
The article was meant to help me and the people reading this understand the finer aspects of bitcoin, but there is an incredible amount of literature that this read does not cover. As I plan to, I would also encourage all readers to learn more about bitcoin for the payment system that it is and less for the charts.
In case you started reading this for a suggestion on whether to invest in Bitcoin, I have little to offer. For all we know, bitcoin might be valued 10X more today than it should be, or 10X less. So read, invest, and count your luck!
Other interesting (and highly recommended!) reads on the topic:
On bitcoin and the future of digital payments by William J. Luther in The Independent Review
On the economic analysis of the Bitcoin Payment System by Gur, Jacob, and Ciamac
On the controlled supply model of Bitcoin in Bitcoin wiki
On the network effects in Bitcoin by Paras Chopra in Inverted Passion
On why Bitcoin is worth anything at all by William Foxley in Coindesk
On the growing optimism for crypto by Simon Taylor in Fintech Brain Food
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