Viewpoint: Bitcoin Payment Services: Challenges, Opportunities and the Role of Regulation

 By Adam Vaziri, Diacle Ltd, a member of the Neopay Group

Did you know SWIFT, invented in 1973, the backbone of the current bank transfer system still uses telegraph to transmit payment information? Really! To me, that’s not too dissimilar from using pigeons as messengers rather than email. Maybe it’s time to upgrade our payment systems.

Today, payments are electronic, but the costs in the market for individual consumers—who may need foreign currency for holidays or to send to their home countries—still can be high and the speed is still slow. A bank-to-bank international transfer can take up to a week to clear. And, between the consumer paying money and the beneficiary receiving the funds, a number of middlemen collect their fees. Businesses also are affected by friction on international payments—their suppliers may be international, they may be running an international payroll—so the need for tight spreads and lower transaction costs become imperative for all.

Here comes Bitcoin.

What on Earth is Bitcoin?

A quick overview: Users, whether individuals or businesses, create electronic Bitcoin addresses, known as “wallets,” where they store and send their bitcoins. They buy their bitcoins from bitcoin exchanges, which are peer-to-peer markets for the sale and purchase of bitcoins. The system is fundamentally underpinned by three features: a P2P network, “mining” and a public ledger of all bitcoin transactions called the blockchain. The network is a Web of all bitcoin users—the key point with this is that there are no centralized clearing banks, no card schemes or otherwise. Mining is a process of confirming that transactions are valid and adding the transactions to the blockchain.

On first view, Bitcoin appears to be able to reduce friction on the costs of payments both domestically and abroad.

A Bitcoin Transaction under the Microscope

Because the blockchain is a public ledger, we can find some extraordinary examples of transactions for illustrative purposes. On Feb. 10, 2014, a payment was made from one Bitcoin address to two other addresses for BTC41,200. The value at the time of the transaction was around US$28 million. Have a look here.

The first point is that it really makes absolutely no difference if the counterparties in the transaction are in the same town, country or continent—the transaction fee remains the same.

And what is that transaction fee? Every transaction currently costs BTC0.0001. This money goes to the “miners” or, in other words, persons in the Bitcoin network who process the transactions.

So, at today’s rates, it costs 64 cents USD to transfer the astronomical value of US$28 million using bitcoin.

More startlingly, the standard transaction fee will decrease 10-fold in the next release of the Bitcoin protocol (the original software program devised by Satoshi Nakamoto and other founders of the digital currency).

By contrast, if you’ve ever tried to make an international bank-to-bank transfer from the U.S. to the U.K., for example, your minimum fees will be US$10, and the bank will control the spread to its own advantage on the USD to GBP exchange rate. Separately, money remitters’ fees can be levied as a percentage amount of the value of the transaction, which for a high-value transaction is totally unfeasible.

At a high level, bitcoin, therefore, appears to present itself as the new payment service on the block—full of promise and potential to reduce payment friction for all.

To test this hypothesis, let’s look at two payment models built on bitcoin: bitcoin value remittance and bitcoin processing.

Bitcoin Value Remittance

First off, bitcoin value remittance. Please bear with me as I explain this process using Tom and Jane as characters. (Please note: The figures quoted are for illustration purposes only, as charges may vary.)

Tom from the U.S. wants to send US$3,000 to his sister Jane who ran out of money in the U.K. on her gap-year trip. The question is how many more pounds will Jane receive if she takes the payment via bitcoin or via traditional remittance channels? (Gosh it almost sounds like a school mathematics question!)

Buying the bitcoins

Tom goes to a local U.S. bitcoin exchange, let’s say Coinbase, and deposits US$3,000 with the exchange. Tom then sends an order in the market to sell his dollars for bitcoin. At today’s rate on Coinbase, his offer is matched at around US$625 per bitcoin, so he’ll be able to buy around BTC4.8 on the exchange. Coinbase will charge a transaction fee of about 1 percent, so knock off BTC0.04 from the BTC4.8., Tom will walk away with BTC4.76. He then transfers from Coinbase to his own bitcoin wallet the BTC4.76 (this takes about 15 minutes) and asks Jane to set up a wallet.

Jane Sets Up a Wallet

Setting up a wallet is pretty simple, assuming Jane has a computer or smartphone and an Internet connection. If she has a swish Mac laptop or a PC, she can download any number of wallets, including Hive, Blockchain or Multibit, for free onto her local drive, then give Tom her public address. In all, it may take her a few minutes to get a wallet set up. However, it might take more than two minutes for her to understand how to secure her wallet correctly. (Hopefully she won’t forget to lock her wallet with a password and back up her private key somewhere safe, in case her computer dies or someone steals her device.) Although wallets are becoming more user-friendly, there is still some work to do to improve the user experience.

Tom Transfers the bitcoins

“There are constantly new bitcoin exchanges popping up globally. For example, if Jane were visiting Aztec temples in Mexico, she would (in the coming months) be able to sell her bitcoins on MEXBT, a new bitcoin exchange, or if she wanted to do a tour of Victoria Island in Hong Kong, she could sell her bitcoins for HK$ on ANXBTC.”

Once Jane has set up her wallet, Tom sends the bitcoins to Jane. Jane receives the bitcoins in less than 15 minutes. Jane then goes to a local U.K. bitcoin exchange, such as Bitbargain.co.uk, and sells her bitcoins. At the time of writing, she can sell her bitcoins for about £395 per bitcoin. So, in total, she will receive GBP£1,880.2. Bitbargain charges 1 percent commission, so she would receive net GBP£1,692.13. If she uses Dealcoin then she can settle in person and pay no commission on the trade. If she goes for Dealcoin then she can opt to meet the buyer in person to receive cash, but that may take a few days depending on the availability of both traders. Alternatively, on Dealcoin she can opt to receive a bank-to-bank transfer from the buyer. If she wants a quick sell on Bitbargain, she just puts in the amount she wants to sell and usually the price is matched instantly and the trade is settled within 30 minutes.

Other Options: via Bank Transfer or Standard Remittance

If Tom wants to send the money to Jane via a bank transfer, the bank will charge a minimum of $10 for the transfer and then provide its own FX rate for the USD/GBP conversion. For a comparison of costs between bank transfers and other standard money remitters, we had a look at Fxcompared.com and, apparently, you can transfer online $3,000 in 1-3 days for GBP£1,783.78, as the best price.

So the cheapest way for Tom to remit the money to Jane is via an online transfer. If Tom pays US$3,000 Jane will receive GBP£1,783.78 versus if Tom uses bitcoin to do the remittance, Jane will end up with around GBP£1,692.13. Note that a bank-to-bank transfer, including online transfer, implies that Jane has a GBP account in the U.K., which may not be the case. And funds are not as immediately available. He could transfer funds to her American bank account, and she could access the funds—in a few days—using her debit card, but she’d be paying FX on her end. For a cash-based transfer from a Western Union or MoneyGram and immediate delivery to an agent location, Tom would pay a percentage commission on the amount transferred. The commission may well make bitcoin more appealing.

In most of the examples above it is, in fact, more expensive to use bitcoin as a vehicle to remit value internationally. However, there are a few points to bear in mind that are the current limitations of the Bitcoin system, but may very well become its biggest opportunities:

Access

As you can see, to make the bitcoin value remittance you need access to local bitcoin exchanges. Without local bitcoin exchanges spread evenly around the world, Jane won’t be able to “cash out” her bitcoins for local currency. If every country has a local bitcoin exchange, then Jane can cash out her bitcoin anywhere she travels, releasing only as much local currency as she needs for the duration of her stay in that country.

There are constantly new bitcoin exchanges popping up globally. For example, if Jane were visiting Aztec temples in Mexico, she would (in the coming months) be able to sell her bitcoins on MEXBT, a new bitcoin exchange, or if she wanted to do a tour of Victoria Island in Hong Kong, she could sell her bitcoins for HK$ on ANXBTC.

Liquidity

The next issue is liquidity. If you have local exchanges with a small amount of trading activity, then it’s likely the spreads between bitcoin and the local currency would be higher; more liquidity equals better prices. Having more local exchanges would make it easier for Jane as she travels around the world, and greater liquidity would mean she would get a better rate in the local country. The increase of liquidity is linked to advent of regulation and consumer confidence; I’ll touch on the role of regulation later in this article.

Volatility

Lastly, the major challenge here is volatility. Bitcoin’s price goes up and down like a yo-yo. Before Mt. Gox went pop, the price of bitcoin went from US$700 to now US$600. This means Jane’s purchasing power would gradually reduce as she travelled in March 2014. Volatility levels out in major FX markets with derivatives trading—in particular options and futures. Access to derivatives in bitcoin is increasing but still restricted due to regulatory uncertainty.

Developed to Developing Markets

It’s noteworthy that the hypothetical transaction between Tom and Jane took place between the U.S. and U.K.—two developed and highly competitive markets, with a scaled banking system and competition between banks and other payment services providers.

Naturally, bitcoin value remittance may, therefore, have little impact in terms of price disruption between the U.S., EU and other developed markets.

However, in Africa, for example, the cost of sending money from overseas to Africa or within Africa can be unbearable. According to International Fund for Agricultural Development, the costs of sending money to Africa from a developed market ranges between 5 to 15 percent, and the costs of intra-African transfers range from 12 to 25 percent of the amount sent.

Here, there may be an obvious opportunity for bitcoin value remittance to lower the costs of intra-continent transfers and the costs of transfers into developing markets. For a snapshot at the potential of this market, have a look at what Bitpesa.co is up to.

Bitcoin Processing

Another role for bitcoin in the payments world is in relation to merchant processing.

Online merchants, selling anything from cars to tablets to magician’s clothing, charge in their local currency and yet can sell their products to the world at large. Why would you want your customers to buy your currency to then buy your product? This painful barrier may well affect your conversion rate.

“The future of bitcoin is in flux. … The endorsement of governments and the oversight of regulators are needed to enable the infrastructure to blossom and for volatility of the digital currency to be more controlled. The keys to unlock its potential are in lawfulness and regulation.”

Take a merchant, such as John Lewis, which sells to the world but prices in British pounds. It may sell a pair of brogues to a gentleman in Saudi Arabia for £90. The Saudi customer may have bitcoins, rather than pounds, in his wallet ready to spend (OK, I’m not sure Saudi Arabia has the biggest adoption rate for bitcoin. A better example would be Canada!). Now, let’s assume that the customer wants to pay in bitcoin, what’s the payment experience like?

Put simply, the customer clicks a link to a QR code, which loads the transaction on his bitcoin wallet. The price of the shoes is displayed in bitcoin, then the customer transfers the bitcoin to John Lewis. The transaction confirms within 15 minutes. No entering personal banking details into a form. In principle, no PCI compliance is needed for fast and verifiable payments, as the payment is shown on the public blockchain.

Third-party processors are emerging that provide this processing service, but what about costs? First, the customer will need to pay a transaction fee of BTC0.0001 (i.e., 64 cents USD). In addition, the processor will, on average, charge around 1 percent to the merchant for the processing fee. But, the merchant, rather than receiving bitcoin, can opt to receive its local currency. This enables the merchant to not take any currency risk in accepting bitcoin payments—John Lewis will still receive £90, less the processing fee and a 1 percent exchange fee, into its bank account, even though the payment was initiated in bitcoin.

A couple of points to note. Again, this system relies heavily on access to bitcoin exchanges. The processor takes the bitcoin and goes to an exchange to buy the output currency to pay the merchant. The volatility risk is reduced as the bitcoin price is only shown at the last minute, and the processor automatically exchanges the bitcoin for settlement to the merchant. Another point is the irreversibility of transactions in bitcoin. In other words, with bitcoin, there is no concept of chargebacks, which may be good for the merchant but may not be so great for the customer. Another obvious setback for bitcoin processing is that not everyone has a bitcoin wallet yet, so bitcoin merchant acceptance will be relevant only for a minority of customers.

Regulation

The future of bitcoin is in flux. The viability of bitcoin value remittance and bitcoin processing depends on mass adoption, liquidity and access, which itself depends on consumer confidence in bitcoin and that of the market at large. The endorsement of governments and the oversight of regulators are needed to enable the infrastructure to blossom and for volatility of the digital currency to be more controlled. The keys to unlock its potential are in lawfulness and regulation.

Lawfulness means the use of bitcoin is not made illegal; regulation means bitcoin value remitters and processors come under the oversight and scrutiny of credible regulators. Of course, there are concerns about consumer protection, especially in view of the disaster surrounding the demise of Mt Gox. With regulation the issue of consumer protection should be, to some extent, addressed, however; it is also for the industry representatives to step up and contribute. We set up the UK Digital Currency Association to ensure not only that the industry would be represented but also to ensure that digital currency businesses meet certain standards, including ensuring the protection of client assets. What’s more, the industry group Digital Asset Transfer Authority, which was formed last July, already is making headway with the creation of standards for digital currency businesses.

In the U.K., payment services laws derive from the Payment Services Directive. As yet, the EU does not have a harmonized position on what bitcoin is (i.e., a currency or commodity or financial instrument) and how it should be regulated. Speaking with the U.K. Financial Conduct Authority (FCA) and Her Majesty’s Treasury, the view from the FCA is that bitcoin falls outside of its remit while the Treasury is looking into it.

Interestingly, the tide is changing with regulation in the U.K. and Her Majesty’s Revenue and Customs has shifted its position with bitcoin, from considering it a taxable supply to a non-VATable virtual currency.

At present, the UK Digital Currency Association is lobbying the FCA about a similar re-interpretation under the Payment Services regulations to bring bitcoin processors and exchanges in as regulated payment institutions. This is done by recognizing that intermediary services provided by a bitcoin exchange or bitcoin processors are “service[s] for the transmission of money (or any representation of monetary value)”.^[1]

In any event, better protection is required for consumers and, without question, better protection is needed of client monies. More than US$300 million went missing when Mt. Gox fell apart. With lawfulness and regulation, bitcoin can evolve its ecosystem and create more competition within in the wider payment services market.

Conclusion

In all, bitcoin value remittance has the potential to reduce cost friction but relies on three assumptions: better access to local bitcoin exchanges, better liquidity on those exchanges and less volatility. Bitcoin processing assumes that customers first have wallets with bitcoins that they want to spend and that merchants see the sense in accepting bitcoin payments. If bitcoin overcomes the regulatory hurdles then its potential will crystalize rapidly.

So, the last question is, “What should I do if I am an existing payments provider?” I think now is the opportunity for incumbents to join in. Start doing R&D on a bitcoin project now, so when the regulatory landscape clears, you are good to go to market. Think about what’s behind bitcoin itself; look at the blockchain as a cost-effective accessible payment system on a par with SWIFT, BACs or other payment schemes. Have a look at Ripple, a federated value transfer system, similar to bitcoin but more centralized and controlled. Or if you really want to be left-field, create your own digital currency for your payment service, imagine PayPal Coins! If you want to trial bitcoin processing as part of your offering, then link up with the guys at Cryptopay or Gocoin.

Adam Vaziri is director of Diacle, a fintech regulation consultancy based in London and part of the Neopay Group. Diacle assists digital currency, crowdfunding and P2P businesses with their setup, licensing and compliance obligations. Adam has developed a compliance workflow management tool to maximize operational compliance consistency for money remittance agents. He is also an interim board member of the UK Digital Currency Association. He may be reached at [email protected].