Bitcoin: Resilient Internet Payment

I blogged six months ago about why Bitcoin matters. Since that time, I've developed some services with Bitcoin and had two of them shutdown by PayPal freezing my account. I've also sold thousands of dollars worth of Bitcoins in cash sales on the street. I've come to the conclusion that my earlier statement about Bitcoin being "resilient in the face of disaster" may be Bitcoin's most important attribute.

Features

Bitcoin has seven main features. Critics usually choose one feature, argue that it doesn't hold and conclude that Bitcoin will fail. I think any three of these features could fail simultaneously and the currency would still succeed. Consider it an architectural margin of safety. The seven features are:

1. Predictable supply
2. Anonymous payments
3. Permanent payments
4. Fast payments
5. Low transaction fees
6. Easy cross-border transfers
7. All purchases allowed

Most of these features are well documented elsewhere so I won't explain them further. Fast payments (#4) may need some clarification. When I accept a credit card payment, it clears in a couple seconds. That corresponds exactly to a Bitcoin transaction arriving. After 180 days the credit card payment is essentially permanent. For Bitcoin, permanence takes about 1 hour. In that sense, Bitcoin is faster than credit card networks.

Investors

The Bitcoin investors I've worked with care almost entirely about the limited, predictable supply. Some of them are gold bugs or real estate mavens. They've gotten rich on the limited supply of those commodities and see similar opportunities with Bitcoin. Nearly ever feature except the inflation caps could fail and they'd still be happy. A deflationary spiral is their dream come true.

As this demographic holds greater Bitcoin wealth, anonymous payments and easy cross-border transfers will become more important. Bitcoin has potential to become the Swiss numbered account of the future.

Online Retailers

For businesses selling goods and services online, predictable supply is arguably irrelevant. As long as there's no hyperinflation, they'll do fine. However, they care deeply about features 3-6. Fraud and payment processing fees are substantial costs to their business. I know of at least one Bitcoin vendor who offers a 5% discount for Bitcoin purchases because Bitcoin eliminates those two transaction costs.

I've bought and sold services with Bitcoin dozens of times with people outside the United States. In each case, the experience was more pleasant and less expensive than using PayPal or a credit card. Features 1, 2 and 7 were completely irrelevant to these transactions.

Unpopular Commerce

The Internet has been a boon for unpopular commerce such as pornography, gambling, electronic cigarettes and now illegal drugs. Because the commerce is unpopular, many buyers want their orders placed anonymously (feature #2). Pornography and gambling have substantially higher chargeback rates than other industries (#3). Many mainstream payment processors prohibit transactions for these services (#7). In all three cases, Bitcoin provides a solution.

Other Bitcoin features are icing on the cake. They could be removed without reducing Bitcoin's utility for unpopular commerce.

Dissidents

It now seems common for governments to control dissident groups through the financial system. Banks and payment providers are threatened with punishment if they handle funds on behalf of dissidents. Features 2, 3, 6-7 appeal to these groups. Other features could fail and Bitcoin would still be useful for WikiLeaks or LulzSec (both of which accept BTC donations) or funding underground churches in China.

Conclusion

I don't presume to know all groups which might benefit from Bitcoin. I suspect that each of them will want a subset of Bitcoin's possible features. As long as that's the case, Bitcoin has a good chance of succeeding.

Why Bitcoin Matters

E-commerce in 2008 amounted to $3.7 trillion dollars. That's 12% higher than 2007 while the entire economy increased only 5% during the same period. As online commerce increases, the fundamentals of electronic exchange become more important. Bitcoin is an electronic currency issued without a central bank. It has remarkable properties making it important for an age of electronic commerce.

Transaction Fees Set by a Competitive Market

If all 2008 online commerce had been paid for with PayPal, the fees would have been $62 billion (Amazon and Google charge identical fees). Payment processors provide some additional value but it's largely an expensive system for subtracting numbers in a database.

The Bitcoin network essentially charges no transaction fees. Participants can pay to expedite their transactions, but it's not mandatory. Any network participant is welcome to process any transaction on the network. This makes Bitcoin transaction processing a commodity whose price is likely to remain permanently low.

No central point of failure

Recent attacks against PayPal, MasterCard and Visa remind us how centralized electronic payment processing is. A single PayPal outage can cost 25-30% of an online retailer's sales. It seems unwise to put so many economic eggs in so few baskets.

When was the last time you heard of a BitTorrent outage? Despite the U.S. government, the recording industry and various ISPs trying to destroy it, the BitTorrent network has prospered. Bitcoin's peer-to-peer network is similarly resilient. Failing components are quickly ignored and the network continues processing payments without a hitch.

No chargebacks

Credit card fraud is a challenging problem for large businesses who spend much effort building fraud detection systems. Small businesses can't justify such expensive systems. For them, a bad weekend of fraud can mean a missed payroll. The net effect is to increase the barrier to entry for online commerce which decreases competition and innovation and increases prices.

Bitcoin payments are not reversible by a third party. Just like cash given to a street vendor, Bitcoin payments can't be contested after the hotdog is eaten. If a buyer wants a refund, he must persuade the vendor. This places a greater burden on buyers to beware, but in an era of ubiquitous product and vendor reviews, it's easier for a consumer to find the reputation of a vendor than vice versa.

No long-term inflation

Bitcoin's money supply is strictly limited by the protocol. The total number of bitcoins available approaches 21 million over time. The currency's first decades allow for limited, predictable inflation. Automatic, bi-weekly adjustments recalibrate the system toward these goals.

Mr. Bernanke's helicopter full of cash has highlighted how dangerous a centralized, unpredictable money supply can be. As long as the power exists to inflate a currency, it will be done.

Conclusion

Perhaps Bitcoin itself won't dominate the market, but certainly it shows the way toward a future of low-cost, predictable, digital currencies resilient in the face of disaster.