Credit cards vs. Bitcoin (Part Two).

[Continued from Part One]

If Bitcoin can’t beat credit cards based on transaction costs alone, then what can it do?

At this point we’ll pull back from the microeconomics of transactional efficiency and take a 30,000 ft. macroeconomic view.

Bitcoin’s greatest strength is that it has many strengths. But this can sometimes make its message confusing. Is it a currency? It is a payment system? Is it an ownership ledger? Is it a commodity? The answer to all of these questions is “maybe.” It really depends on what happens in the future – what people make of it. Similarly, take an ordinary piece of cloth and ask if it is a blanket, a dress, a sack, or a sail. It certainly could be. It could even be all four. But what is it best at being? Nobody knows yet. People have different opinions, but only the future holds the definitive answer.

Possibility 1: Bitcoin begins acting like a currency.

If Bitcoin fulfills its promise as a means of exchange and a store of value, then it can get an adoption boost by merchants who will discount their prices even further than the transaction cost savings because they expect Bitcoin to rise in value.

The advantage of this dynamic is that it doesn’t matter whether fiat currencies are falling, or Bitcoin is rising. All that matters is the differential. As long as Bitcoin undergoes a steady and prolonged increase in value vs. the dollar, euro, yen, etc., it will be immaterial whether these currencies are falling precipitously against goods and services, staying steady, or even increasing in value.

Possibility 2: Global recession pressures slaughter the credit companies’ cash cow.

Depending on your economic world view, you may believe that the world is teetering on the brink of collapse, or in the early stages of a full blown recovery. Regardless of which scenario you find most likely, it always helps to at least acknowledge the historical precedence for sharp corrections in stock markets, bonds markets, and currency markets.

In particular, some worrisome developments are that the largest banks are about 30% bigger than they were before the 2008 recession – creating the possibility of very large systemic risks, debt to GDP ratios have increased in almost every Western nation, and global stock markets are near all time highs at the same time as underemployment figures – indicating a disconnect between valuation and production.

If the world undergoes a new recession, it may very well be a sovereign debt crisis. At the very least, the “good” credit card customer pool will certainly be diminished, perhaps dramatically so. As a result, in the same way that banks slowly eliminated the interest paid on regular bank deposits from 5%+ to almost 0% over the last 15 years, credit card companies will feel the squeeze and see their earnings become more reflective of transaction revenues than revolving debt. Essentially, the rewards programs will vanish, along with the competitive edge that credit cards have over Bitcoin as a means of payment.

Possibility 3: The only way to beat a credit card company is with another credit card company that uses Bitcoin.

Even if the above two scenarios do not pan out – i.e. Bitcoin doesn’t grow into a proper currency and the world chugs along without hyperinflation – there is still the remaining fact that credit card companies are very sensitive to cost, and that using the legacy ACH/SWIFT banking “tubes” generates a lot of unnecessary overhead.

So this brings us back to the transactional efficiency of Bitcoin. If you can’t beat them, join them. A credit card company that properly integrated the Bitcoin payment mechanism into its business could reduce many underlying costs that it currently takes for granted. As a result, it could pass these cost savings on to its customers in the form of even more generous rewards. If you thought that 1% or 2% was a good deal, how would you feel about 7% cash back?

Surprisingly, in this respect it may not be the merchants, nor the consumer who would benefit the most from Bitcoin, but rather the credit card companies that seem so obviously at odds with the world’s favorite fledgling crypto currency. And once one company executes correctly, the others will have to follow suit to keep up.

Conclusion: Whatever its going to be, it’s going to take a while.

Every day brings us closer to figuring out what Bitcoin will grow up to be. But progress takes time, code takes coding, and business takes building. Wherever Bitcoin ends up in 10 years, I’m sure it will surprise us all (hopefully in a good way).

Credit cards vs. Bitcoin (Part One).

Doing a head-to-head comparison between Bitcoin and credit cards may seem to be a reasonable exercise. At the till, given the choice between the two, what would you use?

Because Bitcoin can enable cheap transfers, merchants have an incentive to accept it over credit cards. On the front end, they are the parties who eat the 1.5-3% commission + $0.xx flat fee (for small transactions), and see it on their balance sheets. So naturally, merchants would be intrigued by a payment option which cuts these fees off at the knees: specifically, a 1% solution from Coinbase or Bitpay, or a ~0% solution using native Bitcoin, but with the associated volatility risk of bitcoin.

It hasn’t happened in earnest yet, but the next step in the puzzle is merchants recognizing that they can afford to offer a discount to Bitcoin-paying customers. But how much is needed before they can compete with credit cards? The unfortunate truth is that it may actually be impossible for Bitcoin to beat credit cards relying on its cheap transaction costs alone.

The headwinds that Bitcoin is pushing against are customer rewards programs. 1% cash back is completely standard nowadays, and depending on an individual’s card usage, or the location of their expenditures, 5% cash back is quite common too. But here we encounter an apparent paradox. For the 5% cash back on Walmart gasoline, even if the merchant is being charged a full 3%, where does the extra 2% come from? Surely the credit card companies can’t afford to take a loss in this manner.

The answer is somewhat complicated, and a bit obscured on purpose by credit card companies that don’t necessarily want to divulge their secret sauce. But the basic answer is that there are three types of customers whom credit card companies serve: good, bad, and risky.

Good customers are the bread and butter of credit card companies. These are people with steady jobs, and decent cash-flow, but who also have a tendency to carry a balance on their credit cards, or to use credit cards when cash is tight to get them through tough spots. This Goldie Locks customer is just right: not too reckless, not too responsible.

Counterintuitively, bad customers are actually those who have great credit. They take advantage of sign up bonuses, pay attention to limited-time cash-back offers, and pay their balance in full every month. In the industry, these people are known as freeloaders, because in the long run, they receive a net-positive financial benefit from the use of credit cards.

Risky customers are the ones who might actually generate substantial losses for credit card companies. These include chronic late payers, people about to undergo personal bankruptcy, and outright scammers and fraudsters. The money and time that credit card companies spend to keep these people away is well worth the money saved.

So now that we understand a bit more about a credit card company’s business model, let’s have a look at the revenue sources. Remember that transaction fees are just one source of revenue for the entire business, and it generally accounts for about 1/3rd of total revenue (depending on the company, of course). The remaining 2/3rds is generated through annual fees, late fees, balance transfer fees, over-limit fees, merchant promotions, and the mother-lode of credit profit: interest charged on balances, which averages 13-24% annually.

At this juncture, our comparison between Bitcoin and credit cards reaches an impasse because we are no longer evaluating apples with apples. If credit card companies made all of their money off of transaction fees, then Bitcoin might have a fighting chance. But in reality, all of the “good” customers are subsidizing the very generous cash-back and rewards programs which incentivize more and more people to use credit cards whenever and wherever they can.

This means that merchants accepting Bitcoin could theoretically pass on the entire amount that they would save in transaction fees as a discount to their customers, and it still wouldn’t beat the cost to consumers of credit cards. That is because the merchant isn’t picking up the whole tab. The remainder is mostly coming from consumers who maintain a revolving credit balance every month.

In part two of “Credit cards vs. Bitcoin” we’ll have a look at how Bitcoin might still be able to create an edge against credit cards in the long run.

[Continued in Part Two]

Why you need dollars

Common among the question posed by those introduced to Bitcoin is that of need.

Why do I need Bitcoin? What benefit does it offer me?

While most Bitcoin enthusiasts embark on a multi-faceted adventure of how Bitcoin may provide benefits in payment costs, or perhaps as a speculative investment, few flip the question on its head and ask why people need dollars (for this exercise, please replace “dollars” with the fiat currency of your choice).

At face value, dollars are needed to operate. It doesn’t really matter whether the transfer costs are low, or the methods are convenient. People accept dollars predominantly, but more importantly, they need dollars to meet their financial obligations. Even more importantly, they need dollars to pay their debts.

Without digressing into monetary semantics, I’ll claim that most currency in circulation arrived on this earth through the issuance of debt. To a layman this may not be clear, but anybody with banking experience, or who has done their research, can confirm that money enters the system as a debt obligation.

What this means is that every (almost every, I’ll admit, but most indeed) dollar in existence has an invisible rubber band attached to it that pulls it back to its issuer. Consider the implication. Even though you may have eliminated your personal debt, and accumulated $10,000, this concept still applies. Somebody, somewhere, owes those dollars to someone. This is not a conspiracy notion. This is a fact.

As a result, we observe a proliferation of debt in our society. Whether an individual suffers from $5,000 in credit card debt, $50,000 in student loans, or $300,000 in mortgage debt, the paradigm is the same. All dollars are debt. And all dollars are owed.

Ergo (and I do hate that word, but it carries the message), the number one reason that people need dollars is to pay off debt, period.

It would be nice if everybody could shift blithely from a dollar system to a digital currency, but that simply won’t happen until the dollar begins to misbehave. Tethered to the dollar is a grand society of people, earners, makers, fathers, mothers, brothers, sisters, and others born into a world of infinite promise, but harsh reality. They toil in earnest, and it breaks my heart.

This debt will never be repaid. I don’t say this as an opinion. This is a mathematical fact. The debt obligations of the world exceed the amount of currency that circulates. Simple. There is not enough currency to pay the debt, because the currency is the debt.

The bad news is that this has happened countless times before, but rarely with a currency so proliferate as the US dollar. The good news is that the world always seems to move on after a currency crisis, picking up the pieces, reevaluating their assets, and carrying forward.

The worse news is that these crises can take decades to wash out. So unfortunately, a Bitcoin enthusiast in 10 years may still have to answer the question: why do I need Bitcoin, when I REALLY need dollars?

Merchants are already currency speculators. They just don’t know it yet.

Along the Bitcoin success roadmap, among the regulatory potholes and IT growing pains, lies an essential piece in the puzzle: merchant acceptance of Bitcoin.

Although the author disagrees with those who claim that Bitcoin must be widely used and accepted to gain universal traction (case in point: the $7T of extant gold which nobody seems to own nor use to buy things), he does agree that a digital currency such as Bitcoin would undoubtedly benefit from merchant adoption as well.

The main selling point that companies such as BitPay and Coinbase use to convince new merchants to accept magic internet money is that they can remove the dreaded volatility factor, and conveniently convert any proffered bitcoins in the form of fiat currency such as dollars, euros, or yen.

When asked why they prefer to go through these financial intermediaries instead of accepting bitcoin outright, most companies reply that they are in the business of “x” and not currency speculation. “x,” of course, can be anything: selling tires, installing electrical outlets, transporting goats. Regardless of the industry, business owners prefer to stick to their personal expertise, which does not include speculating on currency.

This week, the Venezuelan government tacitly admitted that its currency is in free fall. Close to triple figure inflation year-on-year is dissolving the savings of the country while simultaneously wreaking political and financial havoc.

This example reminds us that merchants are not just goods and services output machines, but rather, that they are traders. The engine of economic activity is the trade, whereby one individual who can produce something at a lower marginal cost offers it to another, in exchange for something of perceived value.

In reality, all merchants are also currency speculators as well. Given a relatively stable currency, a merchant may have the luxury of forgetting this essential half of the equation, and convincing him or herself that the money they accept is some kind of universal constant. But a quick page turn back into recent history reveals the plight of merchants as they struggle to survive, forced to be shrewd in both their business practices as well as the medium of exchange which they choose to accept in return.

The author recalls visiting Zimbabwe in the early 2000’s, and finding himself in need of a camera battery. Having already accumulated a stash of Zimbabwean dollars at the official rate (which was about 4x more expensive than the black market rate), and being currency agnostic, he found a vendor in the streets who was willing to sell him the necessary battery, but who discounted heavily the price in USD, even beyond the black market rate. He was so terrified of the value loss he would incur from accepting Zimbabwean dollars, that he was willing to take what appeared to be a financial hit, but in reality, allowed him the self-indulgence to simply go home at the end of the day, rather than speculating once more by converting his Zimbabwean dollars into something with a greater potential to preserve value (Rice? Bread?). He certainly didn’t want to hang on to it too long. The cost of goods in stores at this point was being updated multiple times per day.

Our favorite camera battery seller in Zimbabwe didn’t want to be a currency speculator. But chances are that if he moved to New York he’d make a better Wall Street analyst than bodega vendor. Such is the plight of the merchant, who must spin what often feels to be an ever-increasing number of fragile plates.

Bringing this back to the developed world, the message might fall flat at first, but the fact that people who sell things must also decide what is an acceptable exchange medium is all-embracing. To the merchants of the world, take note. You are already speculating on currency. You accept it, you save it, you spend it, and if you are lucky you put aside some for your daughter’s education. You should care about the inflation rate, whether 2%, 200%, or -5%.

You may not want to hold bitcoin today, but keep a close eye on your currency of choice. You are a currency speculator whether you like it or not, and you owe it to yourself to be proficient in money matters. In time, you might even find it prudent to keep 10%, 20%, or more of the bitcoin you accept. You may not be a hedge fund, but this choice is potentially in your interest and – more importantly – certainly within your purview.

The issue of currency is a current event, and how much is issued is your concern too.

Bitcoin is already backed by gold… sort of

Common among economic misunderstanding is the concept of “backing.” Somehow, the word “backing” signifies a final, and perplexingly, in my opinion, acceptable point.

Among all things that ever occurred in the history of the world during the entire existence of humans, the only thing which could ever be, or needed to be, backed, was a promise.

Somebody could accept a favor and “back” it with the promise to pay their debtor back in the future, in the form of something valuable to the lender. A coconut for a crab, or vice versa, perhaps.

Fiat currency is so pervasive today, that many people have little perspective on the concept of value. Historically, we are in uncharted territory. Never before have so many nations been so intricately tied together by a global monetary system. And yet, to the layman, the one who toils aways to make a living for a family, this seems normal.

It is not normal.

The main chink in the Keynsian armor is that monetarists ignore a central concept known as the subjective theory of value. If you read a modern macroeconomic textbook on the matter, you will encounter this term, but it tends to be buried and ignored. However, the implications are significant.

Why should anybody call for the “backing” of anything? The answer lies in a subtle observation of the subjective theory of value. For instance, if you make hats, you may very well be as excited about your 100th cap as you were about the first, for your own consumption, but you probably weren’t. In essence, the value to which you ascribe your 100th is light years behind the value that an undoffed individual might enjoy.

In such a world, where un-had things are better than many-had things, one might search for a more objective measure of value. After all, if the value of all things is subjective, how can we trade amongst one another without resorting to barter? When two individuals wish to trade, it helps to employ a medium of exchange which deviates as little as possible compared to the whims of their endeavors.

And what is the number one factor that determines objective value? There are many contenders, but the absolute winner in the equation is scarcity.

When the US was on a gold standard, the implication was that any individual could walk into a bank, proffer about $20 worth of paper currency, and receive gold in exchange. This was the gold-backed currency of yestercentury. But why was gold chosen?

Despite what many gold enthusiasts may claim today, it had nothing to do with gold’s industrial uses. In fact, the lack of industrial uses contributed to its status as a store of value. Sure, you can wear gold, but more people hid it away in safes than plastered it to their wrists.

Gold is scarce. However, even this term is often misunderstood. Because gold is highly divisible, scarcity isn’t really the best term to use. Gold is limited, or at least highly limited. What you know when you hold a gold coin in your hand is that is may indeed lose value, but not because somebody made more of it over the weekend. In you hand you hold a piece of hard work, labored over precisely because gold is limited.

So why is Bitcoin backed by gold? Admittedly, it isn’t. “Backing” requires a “backer,” somebody who will redeem a promise with a limited item, a token of posterity, an objective measure of value, or at least, as close as you can get to such a thing.

This is why those who claim that Bitcoin is backed by nothing are misunderstanding why backings occur in the first place. The only thing that can be backed is a promise, and the best backing possible is a universally accepted, limited, measure of value. Bitcoin is no such promise. It is gold unto itself. Bitcoin is the backing.

And for the adventurous mind, pairing gold to Bitcoin is quite easy. With a total valuation of about $8T of gold, and a total valuation of $7B of Bitcoin, Bitcoin comes out at about ~1,000x undervalued. That puts Bitcoin around ~$500,000 per coin if you equate 1 ounce of gold to the equivalent portion of outstanding bitcoins.

Of course, this valuation is crazy. After all, the world would never adopt a frictionless, honest, and limited store of value as their backing article of choice if it happened to be digital too… right?

When will the hash rate level out?

What goes up must come down.

Despite the vicissitudes of the bitcoin price during the last 5 years, the hash rate of the network, the measure of brute force levered against the protocol to secure the fidelity of the consensual ledger, has risen by about 15% per month.

Bafflingly so, the hash rate continues to rise. Currently, the network is uncovering north of 50 million gigahashes per second. To put it in more digestible terms, collectively, Bitcoin miners, rather than seeking a needle in a haystack, are applying the equivalent of the power of the world’s 500 most powerful supercomputers to blow-torch a haystack the size of mount everest in their quest to uncover a needle-sized block reward.

There is a relevant term known as the “miner’s fallacy” which posits that a purchase of mining equipment is inferior to an outright purchase of bitcoin if the expected mining potential of a “rig” is less than the quantity of bitcoins which can be obtained for the same price. Nevertheless, the arms race of acquiring mining equipment entices both the adept and the average. In short, most miners will lose money.

However, the miner, although stuck with his rig (if he received it in the first place), now faces a new economic reality. Despite any disparity between buying bitcoin or mining equipment, the decision which determines whether to not to mine boils down to a simple equation: mining revenue vs. electricity cost.

This implies that an individual who spent 1,000 BTC on a 1TH mining outfit, who may only see 50 BTC over the course of his rig’s life, will continue to mine, provided that his monthly electricity cost is less than his BTC earnings (denominated in fiat). 

Only recently has the increased network difficulty risen to a level which pinches this ultimate barrier. Over the last 12 months many individuals have rued their acquisition of mining equipment instead of simply buying the world’s favorite crypto currency, but have continued to mine because it brought in more money than it costed.

It is difficult to call the top, but it will come. At current bitcoin prices we are certainly close. Electricity costs per kilowatt hour trend ever closer to the pooled mining rewards. The author personally knows an individual who plans to shut down a 30-rack of 10 GH mining units in the next 3 months. After all, they are noisy, and hot.

Absent a rise in the price of bitcoin, the attrition of borderline mining rigs will accelerate. Whether this manifests as a gradual decline or an acute one, its effects should be interesting to witness. Although the Bitcoin community has become accustomed to relatively fast transaction confirmations, it should prepare itself for the possibility of a steady march downwards in hashing power. Even though the difficulty will adjust accordingly, it will do so more slowly than it adjusts upwards.

That said, a downward trend in hashing power, although imminent, will probably be temporary. After all, we’re on a trip to the moon.

For Bitcoin to succeed, the money that people use must rot. Coincidentally, it will.

Many people focus on the benefits of Bitcoin to the merchant and the customer as reasons for the ultimate success of the world’s favorite crypto currency.

Technically, it’s true, that by using Bitcoin properly, people can save money on transaction costs whether buying a sofa at Overtock.com or sending money to relatives in Mexico.

But practically, it’s not enough. Over time, a more efficient method of payment should find purchase, and succeed on its own merits, incrementally, but surely. 1% on revenue is a lot of money, particularly for intermediaries such as Amazon who play within the single digit profit percentages. Going from a 4% margin to a 3% margin is a big deal. And yet, somehow we are still uninspired.

The last 5 years has seen an explosion is payment processing innovation. From the handheld convenience of Square to the fee-less email transactions between Bank of America accounts, the world is making it easier and cheaper to send and receive money.

But the payment mechanism of Bitcoin is only half of the equation. The singular advantage that Bitcoin has over its contemporaries is that it uses a new and honest currency.

Regardless of how convenient, or fast, or fee-less, that companies can strive for, they are all at a large disadvantage: the currencies that they use are faulty.

Almost poetically, all of the world’s fiat currencies are already nearly 100% digital. There is little more than simple ledger accounting taking place as people sweat and toil to earn a higher number in their bank account, and equally so as it diminishes with each purchase of a car, or a roll of paper towels.

So as far as payment networks are concerned, Bitcoin faces stiff competition. Most of the infrastructures in place are expensive precisely because they haven’t had any competitive pressure to be inexpensive, but that tide has turned, and the consumer is benefiting from a collective race to the bottom of transaction fees.

The magic of Bitcoin won’t be truly recognized until these currencies start to misbehave. I speak specifically of the US dollar, the Euro, and the Yen. Even if prices remain constant, consumers are being robbed through inflation. Individual productivity has gone up dramatically over the past 50 years, and yet wages struggle to follow suit. Absent inflation, the prices of the common goods we all buy would have gone down: milk, petrol, electricity, copper. To the average consumer, this would have been a good thing.

Inflation hides the benefits of increased productivity and punishes the people who work every day to live, save, and provide for themselves and their families. Unfortunately, and insidiously, it steals from their wallets without taking out any bills.

Bitcoin may fail, but if it doesn’t, it won’t be because of incremental and steady progress due to its low-cost payment network. If Bitcoin succeeds, it will be amidst financial and monetary crises, providing a safe haven for those who have finally woken up and realized that the money they work for is shiny on the outside, but rotten to the core.

Like ashes in the fire, the illusion of debt-based money can disintegrate very quickly.