Source: David McBee

Bitcoin analysis part 3: can it be a useful medium of exchange?

The cryptocurrency would need a radical upgrade to become a widely-used payment method. It offers some benefits for illicit transactions, but these are unsustainable.

This is the third article in a series analysing Bitcoin. The other posts are linked at the bottom of this piece.

Bitcoin was supposed to be a faster, cheaper way to move money anywhere in the world — a superior alternative to stodgy payment providers like banks and PayPal.

But to date, barely anyone uses Bitcoin for everyday purchases of goods and services. Of the 500 leading internet sellers, just three accept Bitcoin, down from five last year. This month, Steam, the video games platform, stopped accepting Bitcoin because of “high fees and volatility”.

As I explained in my previous post, the fact that no-one uses Bitcoin as a unit of account — a common measure to set prices—severely limits its potential as a medium of exchange. Nonetheless, Bitcoin could in theory become a useful payment method in some circumstances.

Let’s examine Bitcoin’s potential in two segments:

  • Illegal payments
  • Legal payments

For each segment, I’ll provide the facts to date and my view of what the future holds.


Illegal payments

People have undoubtedly found Bitcoin useful for evading the law. For example, Silk Road, the first successful darknet marketplace for illegal drugs, couldn’t have existed without Bitcoin. When the US government took down Silk Road in 2013, it seized more than 140,000 bitcoins, which at the time had a market value of $48m.

In addition to buying contraband, Bitcoin has also been used for the following illicit activities:

  • Money-laundering
  • Hiding wealth from the government
  • Circumventing capital controls in countries such as China
  • Extracting payments from victims of computer hacking (“ransomware”)

Criminals use Bitcoin because it allows them to make transactions that are not tied to their real identity. Unlike banks, Bitcoin’s peer-to-peer network doesn’t require users to register their personal details. Anyone can create a Bitcoin address — a random string of letters and numbers — and use it to send or receive funds to other addresses in the network.

Some Bitcoiners think that increasing demand to use the cryptocurrency for illegal transactions will support its price. I doubt it. The more that Bitcoin is used to evade the law, the more aggressively that governments will respond. Bitcoin isn’t immune to regulation.

Lifting Bitcoin’s veil of secrecy

Governments are already starting to enforce know-your-customer regulations at Bitcoin exchanges, the companies that allow people to swap cryptocurrency for widely-used currencies like the dollar, pound or euro. This means that the authorities can obtain the names of an exchange’s customers and link them to specific Bitcoin addresses.

When a Bitcoin user is “deanonymised”, they’re extremely exposed. That’s because every Bitcoin transaction ever made is publicly recorded on the blockchain. Anyone can look at the blockchain to see where any user sent their Bitcoin. In other words, Bitcoin isn’t great for anonymity. This lack of privacy isn’t just a problem for criminals, of course: few people would like their spending habits to be a matter of public record.

With Bitcoin coming under growing scrutiny from government authorities, I expect that people will increasingly lose confidence in using it for illegal transactions. People who value anonymity are likely to switch to other cryptocurrencies, such as Monero and Zcash, that are designed to offer superior privacy protection.


Legal payments

One of the main reasons that hardly anyone uses Bitcoin for payments is that its price swings wildly relative to the common unit of account. In other words, Bitcoin isn’t a stable store of value. This aspect of Bitcoin is so important that I’ll deal with it separately later in this series.

In this post, I’ll focus on two other attributes by which we can judge a medium of exchange:

  • Transaction speed
  • Transaction costs

Bitcoin transactions are expensive

Users must include a fee with their transaction to ensure that the transaction is processed by Bitcoin “miners”, computers that validate transactions on the network. These fees have surged over the last year to almost $20, as shown in the chart below. As a result the Bitcoin network is prohibitively expensive for small transactions.

Source: Bitcoinfees.info

For large, international transfers, sending Bitcoin can sometimes be cheaper than using fiat currency — if the sender and the recipient are both happy to hold Bitcoin. However, most cross-border transfers involve sending one fiat currency and receiving another. Save On Send, a website that compares the prices charged by money transfer providers, has found that if all costs are taken into account, Bitcoin offers no advantages over established payment mechanisms for cross-border remittances.

Bitcoin transactions are slow

The chart below shows the median time taken for a Bitcoin transaction to be confirmed on the blockchain, for transactions that include a fee. The average is a bit above 10 minutes. That’s not great when compared with the world’s most commonly-used payment systems such as Visa, MasterCard, or PayPal, which enable instant transactions.

If a user doesn’t include a transaction fee, their transaction can take days or may never be confirmed.

Source: Blockchain.info

Bitcoin is faster than some payment methods, such as international bank-to-bank transfers, which can take days. Yet Bitcoin can’t beat specialist payment providers like Moneygram or Western Union, which can make cross-border transfers almost immediately.

Bitcoin transaction volumes are limited

The Bitcoin network can’t handle large transaction volumes. At present, the network can process a maximum of 7 transactions per second. By contrast, Visa handles an average of 2,000 transactions per second.

Bitcoin is inefficient and energy-intensive

As a decentralised network, Bitcoin is inherently less efficient than centralised networks. The peer-to-peer network requires computers around the world to simultaneously solve cryptographic calculations, requiring huge amounts of electricity. The electricity consumed per transaction is 244 KWh — enough to supply eight US households for a day. This is thousands of times the energy required to process transactions through traditional payment networks such as Visa.

Bitcoin would need to evolve radically to be a viable medium of exchange

Given that Bitcoin transactions are currently slow, expensive and cannot scale, the cryptocurrency can’t possibly become a popular medium of exchange in its current form.

But I can’t write it off completely, because Bitcoin can evolve. Developers are constantly thinking up new ways to improve the Bitcoin protocol, the code on which the network operates.

The protocol can be upgraded in one of two ways. In a so-called “soft fork”, the majority of users agree by consensus to upgrade the software they use to run the Bitcoin network. In a so-called “hard fork”, the network splits in two: one version of Bitcoin operates under the old protocol and the other operates under a new protocol.

It’s impossible to estimate how likely it is that Bitcoin will evolve to the extent needed for it to become a useful medium of exchange. But I’m confident that if Bitcoin’s transactions costs fell to near zero, and if its transaction speed was near instant, and if it became less volatile, then some people would find it useful for some purpose or other. To be clear, this is a highly-speculative scenario and there’s no reason to expect it to become reality.

The reason to be extremely sceptical about this possibility is that Bitcoin has evolved quite slowly since it was released in 2009. Warring factions in the Bitcoin community cannot agree on the best way to upgrade the network. So if history is any guide, Bitcoin will stagnate. In addition, Bitcoin faces tough competition. Hundreds of rival cryptocurrencies have sprung into existence in recent years and many more are on their way. Any one of them could steal Bitcoin’s crown.


Summary

  • Bitcoin’s most compelling use case to date has been for illicit transactions, as anyone can use the network without disclosing their real identity.
  • But this activity is unsustainable because of increased regulation. As authorities “deanonymize” Bitcoin users, people will increasingly shift into other cryptocurrencies that offer superior privacy.
  • Bitcoin is currently too slow, expensive and not scalable to be a widely-used medium of exchange for legal transactions.
  • The Bitcoin protocol would need a radical upgrade for the cryptocurrency to stand a chance of rivaling scalable systems like PayPal and Visa.
  • It’s theoretically possible that Bitcoin could evolve into a useful medium of exchange. But in recent years Bitcoin has improved more slowly than rival cryptocurrencies. It’s therefore extremely unlikely that Bitcoin will become a viable payment method.
  • Read my next post to understand why Bitcoin is a terrible store of value. This is one of the most important reasons why the cryptocurrency isn’t a useful medium of exchange.

Thanks for reading! If this has sparked some thoughts or if you think I’ve got something wrong, please let me know in the comments below.

Here’s the rest of the series: