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.