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How Bitcoin Makes Transactions Cheaper

(@johnehenderson) | Published on January 18, 2014 at 14:30 GMT

There are many reasons to be excited about bitcoin: it could enable totally new business and technology models; it resembles the internet in the early ‘90s in the sense that it is a network that no-one owns and everyone can contribute to; it could revolutionise legal concepts of ownership; it could disrupt the payments industry; it could even become a tax haven. It could also flop.

In an earlier post, I described the thinking behind my first angel investment in the digital currency space: CoinDesk. In this post, I discuss what first got me excited about bitcoin — the solution to the so-called “double spending problem” — and why this could drastically reduce the cost of non-cash transactions.

The double spending problem: why it costs so much to transact electronically

The double spending problem is the risk that a person could pay for two different things with the same unit of currency. This problem really only arises if you want to make a purchase electronically (i.e. with something other than cash).

Say I make t-shirts and you want to buy one. In the offline world, we could transact with cash. You give me a $20 bill, and I give you a t-shirt. As I’m now in physical possession of the $20 bill, I can be certain that you won’t spend it on something else. My only risk is that you’re a professional counterfeiter, but that’s pretty unlikely… Now, say you want to buy one of the t-shirts from my online e-store. As it happens, my shop is overseas.

Wouldn’t it be cool if we could replicate the offline experience by you simply sending me a digital version of a $20 bill? Until recently you couldn’t: you needed at least one financial institution involved and either you or I (or both of us) had to pay them a fee to facilitate things. A credit card payment is a good example. You would send me your card details and, in order to process it, I would involve the credit card provider, a merchant services company and my bank.

credit card transaction

We needed the financial institutions because, unlike physical bills, digital information is super easy to copy. If you try to send me a unit of digital money directly, how can I know that it is real — or that you haven’t sent the same thing to someone else? To be certain, I’d need to access your bank account to check that your balance actually decreased. And there’s no way you’d give access to your bank account to someone selling you a t-shirt!

The role financial institutions play here is to serve as a trusted third party to identify you and me, to ensure that the money is spent only once, and to process the payment. In order to retain their trusted status, financial institutions also become involved if there is a dispute between us. This takes time and resources, for which financial institutions charge fees.

In the example of the t-shirt sale, I (the merchant) would incur a cost of 0.5-2.5% to process the credit card. You (the purchaser) would probably be charged a currency conversion fee by your credit card provider (who would no doubt make additional money by giving you a crappy exchange rate). These fees and charges add up. Some smart management consultants I used to work with estimated that transaction-specific fees amounted to nearly $140bn in 2012.

Bitcoin’s fundamental innovation is to obviate the need for a 3rd party to be involved in the transaction. It allows you to securely and anonymously transfer money to anyone, anywhere in the world. Going back to the t-shirt example: if you had paid me in bitcoin, I would have paid much much less than the c. 2.5% it cost me to process your credit card. And you would have paid no currency conversion fee whatsoever.

How does bitcoin deal with the double spending problem?

I can sense your skepticism. How does bitcoin cut out the financial middlemen? Bitcoin is a “purely peer-to-peer version of electronic cash”. It allows you to securely send money directly to me. The bitcoin network is decentralised, which means there is no central financial body overseeing things. That sounds bad, right? Well, actually no — bitcoin’s inventor developed a clever mechanism to ensure that bitcoins couldn’t be copied and spent more than once.

Each bitcoin has a history attached to it — essentially a log of digital signatures showing the transactions it has been involved in. In bitcoin-speak, these logs are called ‘blocks’ and, when you put them all together, they form the ‘block chain’. The block chain contains a record of all the transactions ever made using bitcoin.

$140bn in transaction fees is a big pie, and bitcoin has the potential to take a large slice.

But what if someone alters a block? Couldn’t they ‘erase’ a transaction and spend a coin twice? The nifty thing about bitcoin is that the blockchain is publicly available. Anyone on the internet can see it (don’t worry — the names of the parties to specific transactions remain hidden).

There is a huge amount of computer power that goes into recording transactions and verifying the blockchain. This is what all the computers mining bitcoins around the world are doing and its why bitcoin transactions take an average of 10 minutes to complete. (To incentivise miners to undertake this work, they can ‘earn’ bitcoins along the way — but mining is a story for another post ...)

If someone were to alter a block, all the other computers on the bitcoin network would notice it and ‘vote’ to reject that alteration. In short, in order to hack the system and spend a coin twice, you’d need more computer power than everyone else on the whole bitcoin network combined. And that’s virtually impossible nowadays.

So should I start buying things online with bitcoin?

You might not want to just yet. At the moment, not many merchants accept bitcoin and the huge price volatility outweighs the benefits of lower transaction costs. However, this is likely to change as the bitcoin ecosystem matures.

In the long term, the ability to securely transfer money on a peer-to-peer basis could be hugely disruptive. I’m not saying bitcoin will completely replace other methods of transacting money. It won’t. But $140 billion in transaction fees is a big pie, and bitcoin has the potential to take a large slice of it.

What’s more, there are many other pies out there. I’ll discuss some of them another time, but as an example just consider the potential impact on the $550bn remittance marketOriginally posted on Medium.com.

Follow John on Twitter @johnehenderson

Featured image via Shutterstock

RemittanceTransaction Fees

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