Evangelists and skeptics alike tend to frame digital currency protocols and state fiat currencies in stark conflict, but the promising moderate view sees them coexist as mutual optimizations of one another.
Bitcoin doesn’t need to replace fiat currencies in order to be successful – it merely needs to optimize away the pain of (and expose new value in) transferring currency.
Conversely, fiat currencies don’t need bitcoin to fail or see it regulated into the shadows in order to ensure continued sovereign coin sustainability; traditional economies can instead assimilate digital currency protocols to grow a stronger, safer, less expensive and more valuable hybrid economy.
Optimizing traditional currency
Despite the complexities of cryptographic trust and the protocol’s potential beyond transfers alone, the payments advantage is simple: more of our money reaches its destination, safely and without exchange of personal information, quickly and without potential for future reversals. We have more control over our own money.
For a digital age, sending money remains unreasonably expensive, slow and insecure. Fraught with risk, the payments path is policed by gateways that levy tolls at each tightly controlled yet still insecure step along the way.
Banks levy fees for transfers cleared by a central bank; mere access to the closed network rails requires a fee. The ‘APIs’ and ‘protocols’ to accommodate these transfers usually equate to batch uploads of files via SFTP — welcome to the 1970s, ripe for protocol overhaul.
Meanwhile, credit card networks levy interchange fees for authorizing and executing debits from issuing banks — which themselves also exact a toll – on top of the tolls required by payment processing gateways and intermediary services. Most of the fees exist not for value-add, but, a) to compensate for authorization and administrative fraud, and, b) for access to private card network rails. The distributed trust protocols of the bitcoin system eliminate both altogether.
Adam Shapiro of Promontory Financial Group illustrated that sending $1,000 USD to a merchant requiring that equivalent in euros would cost $50 via credit card and as much as $80 via bank wire, while the same payment would cost around $15 if exchanged in/out of bitcoin at both ends of the transaction.
Even in scenarios in which consumers don’t see such fees directly, merchants could be given incentive to pass along transaction savings to those customers. Mainstreamers would then flock to digital currency’s viral utility, low cost and security, rather than to make a deliberate political statement or speculative investment. That benefits everyone in the ecosystem, even those advocates who look at bitcoin very differently.
While the existing clearing houses may see short-term threat in losing these fees, they stand to gain far more in the long term through new business opportunities. Greater value exists in innovation above the network layer, and the cost of operating the network layer itself should diminish. The new protocols and distributed ledger want to do far more than merely transfer numbers, which presents opportunity for companies old and new alike.
In light of recent breaches, the security and push model is worth highlighting: Consumers do not need to provide personal information (let alone keys or card numbers) to a merchant, and the merchant does not need to hold it. You can’t hack or steal what isn’t there in the first place.
Further, note that in Shapiro’s scenario, the same KYC and AML (Know Your Customer and Anti-Money Laundering) policing would be just as possible for bitcoin as it would be for traditional credit or wire transactions, given the use of bitcoin for only one transaction between two gateways in that example (assuming the gateways, as banks or as money services backed by banks, comply with those regulations).
In some ways, this is a typical and predictable Internet story. The days are numbered for exacting a toll merely for access to network rails used to move information from one place to another.
In domains of content, communication and media, business process automation, search and so many others, the Internet wants access to the network to be free, or very close to free. We don’t expect to pay a fee for sending an email, for example. This is not so true in the domains of finance and payments, yet.
That is now changing, and it’s inevitable that fees move to value-added layers above the rails, to layers that expose new opportunities from payments to smart contracts to programmable money and more. That innovation starts with optimizing the transfer of money, not by replacing state money altogether.
Optimizing digital currency
Fiat currency optimizes digital currency as well, even beyond the obvious case of enabling payments to merchants who don’t (or won’t) accept digital currency:
Traditional currencies offer a volatility solution for merchants more concerned with payment for goods and services than speculative investment.
Bitcoin currently trades at low volume through a handful of exchanges, similar to a single small-cap stock, so it’s natural for volatility to exist. This should improve, but for the purpose of payments specifically, a merchant can nearly ignore volatility by trading out of bitcoin into fiat at pegged value. Most bitcoin merchant services shelter their clients from intra-day bitcoin volatility so long as they trade back into fiat by close of business.
Taxation and supporting communal nation-state schools and infrastructure is another obvious value that state currencies provide, and this includes taxation on earnings related to bitcoin as well.
Any definition of bitcoin as a protocol, a payment vehicle, a currency or an asset must be fluid in order to be accurate, as the definition varies by context and time. As a protocol-currency-asset, however, it can, if held, result in material gains (or losses) subject to taxation.
Gateways into fiat offer a simple means of applying tax at exchange points rather than attaching tax complexity to the protocol itself. Instead of attempting to apply taxation to a world of digital currency, existing taxation on the fiat side might account for digital currency as part of money flowing through the hybrid economy.
Trust is a sensitive topic. On the digital currency side, trust is strong and decentralized for transactions, but that doesn’t mean trust of specific parties is altogether absent.
Whether it’s trust of the peer review and open development meritocracy of the core implementation code, or trust of a custodial service to manage keys, or trust of a piece of local software to manage wallets, or trust of an exchange service to protect fiat gateway and personal information; except for the actual transaction validation and confirmation, some trust of strangers is still implied, even in bitcoin.
When it comes to trust of such parties in the world of state, a long line of laws and regulations is designed to protect consumers. Although large institutions have famously breached that trust, formal consumer protections more often than not do protect consumers from fraudulent charges and provide a ‘lender of last resort’.
The same is not quite true of digital currency, as the loss or theft of keys is more akin to the loss of cash than to a fraudulent charge.
It’s not a simple matter of whether to trust digital currency vs traditional banks or card networks, but a matter of which one to trust, for what specific purpose, at what time and for what amount. Taking control of our own money involves making responsible decisions about trust.
Digital currency’s push model, identity protection features, decentralized transaction clearing and easily-audited open ledger make it trustworthy for payments, especially as its transaction throughput increases.
At the same time, custodial implications for exchanges, service providers and software developers can make traditional institutions trustworthy partners for other kinds of asset storage for mainstream users. Money can happily flow between both.
Gateways to a new world
Gateways throttle the flow. In a hybrid economy, customers and merchants alike must be able to get into and out of digital currency quickly, easily and securely.
In a pure payment scenario, a customer wants to acquire bitcoins using fiat instantly, execute a payment immediately after acquiring them, and, at some point shortly thereafter, the merchant wants to acquire fiat in exchange for those bitcoins. This is not the only valid scenario, but it’s helpful as a lens for discussion.
A gateway enabling that scenario must meet several challenges. For mainstream users, the gateway cannot be a trading desk, exposing an order book and price spikes to users through a bid/ask metaphor; the transition must feel seamless in design.
This entails some short-term credit risk for the gateways. Bitcoins credited to customers immediately can be spent and never recovered, while the credit card charges used to acquire the bitcoins can be reversed.
Also, in a scenario in which fiat is traded for bitcoins, bitcoins are transferred from one address to another, and then immediately traded back into fiat – bitcoin is not always much of an optimization because the one transaction may not always be sufficient to overcome the fees at the two gateways.
The threshold at which paying digitally becomes valuable fluctuates across use cases for different domains, and for different goods and services within domains.
When multiple bitcoin transactions occur before trading back into fiat, the optimization increases. The more transactions introduced into the digital chain before exchange into a gateway, the greater the increase in value of bitcoin (as for any full reserve model applied to increasing transaction velocity against a finite resource) and the greater the optimization through fee avoidance — but the AML risks also increase.
Moreover, if the gateway holds fiat on behalf of customers, then the gateway must be a bank. If the gateway merely transfers and does not hold fiat funds, then the gateway must have a banking partner.
Partnering with a bank is no trivial task. Bank risk departments can be far more conservative than state regulators. Transacting bitcoin from one address to another, whether for remittance purposes or for the exchange of goods and services, cannot always enforce KYC, AML or anti-fraud rules. Banking partners are either comfortable with these cash-like traits or they’re not. These days they’re mostly not, and this hinders gateway innovation considerably.
So mainstream gateways will need to manage short-term credit risk, potentially on a per-individual basis, while also simplifying the forex trading function, optimizing gateway fees, satisfying a banking partner and addressing AML policies – all while speeding up exchange and transaction throughput. A tall order. Capable, responsible, experienced innovators required.
Although the challenges for such a gateway are great, the reward is even greater: transform disparate economies into a global hybrid economy and grow digital currency into lasting evolution rather than shadowy revolution.
It will require some time, and in the end it’s possible that bitcoin may prove to be more like NCSA Mosaic is to Google’s Chrome, an early informative breakthrough instead of what we’re all actually using 20 years later, but that would still equate to smashing success and world-changing innovation, and it’s illogical and unwise to bet against innovation.
The leader in news and information on cryptocurrency, digital assets and the future of money, CoinDesk is a media outlet that strives for the highest journalistic standards and abides by a strict set of editorial policies. CoinDesk is an independent operating subsidiary of Digital Currency Group, which invests in cryptocurrencies and blockchain startups. As part of their compensation, certain CoinDesk employees, including editorial employees, may receive exposure to DCG equity in the form of stock appreciation rights, which vest over a multi-year period. CoinDesk journalists are not allowed to purchase stock outright in DCG.
Learn more about Consensus 2023, CoinDesk’s longest-running and most influential event that brings together all sides of crypto, blockchain and Web3. Head to consensus.coindesk.com to register and buy your pass now.