Seeking Alpha

Christopher Gon...'s  Instablog

Christopher Gonsalves
Send Message
Studied Economics at SUNY Purchase. Currently living in NYC studying for my Series 7 license. LinkedIn: http://www.linkedin.com/profile/view?id=161886908&trk=tab_pro
My book:
The Road To Serfdom
View Christopher Gonsalves' Instablogs on:
  • The Economics Of Bitcoin

    Every second, hundreds of thousands of transactions are happening across the web. The Internet has streamlined the process of purchasing goods, making it painless to order virtually anything from inside the comfort of your home. Even while on the go, anybody with a connected device has full access to this robust online marketplace. However, a bank account or credit card is required to make purchases as you cannot just jam money into your computer. Because we mainly use credit cards to make payments, it's becoming increasingly common to never have to deal with cash. We have evolved into a digital age where most of our transactions are now done without using paper money.

    From China to Argentina to the United States, money is what facilitates our daily interactions. What was once limited to just being a physical asset has grown into and flourished as a virtual one. Digital currency, a form of virtual currency, is a type of money that is electronically created and stored. It has existed for decades, but has only started to gain mainstream recognition in recent times. One of the major critiques of early iterations of virtual currency was that it was not secure. Easily exploitable flaws in the architecture rendered these initial virtual currencies inadequate for real-world use. Eventually, a new technique was implemented that addressed this issue. This new addition was called public key cryptography. Consisting of a set of equations, algorithms, and arcane mathematics, public key cryptography is an essential technology that's used every day for preserving computer privacy. It allows two parties to set up a secure connection without ever having to meet beforehand. It's used every time your phone talks to your bank. Without it, there would be no privacy over the internet.

    Public key cryptography's first known use was in the mid-70's. The NSA, who is credited as the technology's inventor, used it to command and arm nuclear weapons. It was independently invented again in the late 90's by academic cryptographers. This was the first time it was used to experiment with virtual currencies. The primary concern that prevented digital currencies from ever going mainstream back then was referred to as "the double spending problem". Double spending is the result of successfully spending money more than once. Because of this glitch, nothing could stop users from paying two people simultaneously and getting away with it. The idea of a digital currency was a novel one, but it was rejected in its current form due to its impractical use.

    For years, mathematicians, cryptologists, and computer programmers continued to work on a more secure way to transfer money digitally. In 2009, Satoshi Nakamoto released the first version of a payment software that he dubbed "The Bitcoin Protocol". This payment system protected against double spending by verifying each transaction added to the ledger to ensure that inputs for the transaction had not previously already been spent. He had created a decentralized way to transfer money that solved the double spending problem. It's now five years later and The Bitcoin Protocol has garnered a tremendous amount of media attention. It has caught the eye of some of the biggest players on Wall Street as well as top venture capitalist firms. The Bitcoin Protocol answers a crucial question that has plagued cryptologists for years: Can a group of people who don't trust each other all agree on when something happens so precisely that it can be used to securely transfer value? The Bitcoin Protocol, which I will now refer to just as Bitcoin, indeed makes this possible.

    To be clear, Bitcoin is not a company. Just as E-mail is mail for the Internet, Bitcoin is cash for the Internet. It's a computer protocol that nobody owns, the same way nobody owns the technology behind E-mail or the Internet. The distinguishing characteristic that separates it from conventional money is that it's completely decentralized. This means that no single institution controls it. Bitcoin uses a decentralized system, where a consensus among "miners" following the same protocol is substituted for a central authority. As a result, this system enables anybody with an internet connection to transfer money without the help of a traditional financial institution. Bitcoin doesn't have a CEO or a Federal Reserve and it's not tied to any country. It operates using a peer-to-peer network, much like when downloading torrent files on your computer. To sum it up in one sentence: Using bitcoin, anyone can securely transfer money to anybody in the world, at any time, for effectively no cost.

    At first glance, bitcoin is just digital money, but as one looks closer, it becomes apparent that that's just one of the applications enabled by an underlying network. The heart of any bank, surprisingly, is not their vault. It's their ledger. Most banks would rather have you empty their vault than gain access to their ledger. A bank's ledger is what controls everything. You could delete entire accounts or add some zeroes to your own. The beauty of the bitcoin network is that it allows a distributed system of computers to build a global assets ledger. This ledger is called the Blockchain, and it truly is a public system. It acts as a viewable list of all the bitcoin transactions for the entire world. It shows who owns what bitcoin, at what time, and where they got it. The fundamental advantage of using the bitcoin system is that it allows computers to transfer money without the need for traditional financial institutions to serve as a middleman.

    That being said, there are pros and cons to any such novel institution. Prominent economists, like Nobel Laureate winner Robert Shiller, have sounded off on bitcoin with varying opinions. Shiller opposes bitcoin, and while he sees it as a computer science inspiration, he ultimately believes that it's a bubble that's destined to pop. According to Shiller, "The central problem with Bitcoin in its current form is that it doesn't really solve any economic problem." Contrary to Shiller's belief, I believe there is a host of ways bitcoin can bring economic good to billions of people in impoverished countries. Moreover, the subsequent reduction in transaction fees that it brings with it could revolutionize the financial services industry. With attractive characteristics like 24/7 worldwide access and virtually no transfer fees, bitcoin has the potential to positively impact every individual that wants to save and send money, regardless of their geographical limitations. The Bitcoin Protocol, and its associated technology represent a potentially game-changing disruption to our covered payment companies and the way money is transferred around the world.

    What's driving interest?

    There are three main factors that have driven interest in bitcoin throughout the past five years. Different people have been attracted to bitcoin at different points in time by different elements of these three characteristics. The first factor is its decentralized structure. Many of the early adopters were certainly drawn in by this aspect. Many of them were probably tech savvy libertarians who didn't like the idea of a central governing body of their currency. This kind of passion, which stems from these ideological grounds, was the first step in making bitcoin more than just a social experiment. In contrast with banks, individuals who display bad ethics have no bearing on the system's overall integrity. A handful of corrupt CEOs cannot jeopardize the entire system. Bitcoin's decentralized nature is without question its most alluring quality.

    The second attractor was its anonymity. In large part, the people who were attracted to this characteristic were probably doing something online that they didn't want to be associated with. Things like selling drugs or just something more mundane like online gambling. Silk Road is a black market website that has been widely used for selling products that have been made illegal by various governments. You can buy anything from forged documents to methamphetamine. Many pundits indicate this shady website as a reason why bitcoin can never fully go mainstream. Bitcoin should be understood as a tool. It's a useful tool that can be used by anyone who finds it useful. Similar to how irresponsible people will use their cell phones while driving, criminals will use bitcoin for nefarious acts. It's an inevitable side effect, but not one that's significant enough to disregard its underlying value to billions of law-abiding citizens.

    The previous two groups of people by themselves were not large enough to make bitcoin have a real impact. There isn't that many people who are passionate enough about their politics who are willing to adopt a new currency and there also isn't that many people breaking the law. The third characteristic however, the reduction in transaction costs, appeals to a large number of people. This is likely the most compelling real reason for businesses and Wall Street to get involved. The majority of online payments are made through Amazon and PayPal. Both charge businesses $0.30 + 2.7% for each payment processed. These fees, when added up across the entire retail industry, cost businesses hundreds of billions of dollars every year. In a recent report by Goldman Sachs, it was concluded that the adoption of Bitcoin could result in a $210 billion dollar reduction in retail and e-commerce fees. That would be a tremendous amount of cost being taken out of the system.

    Savings that significant are becoming increasingly harder for economists and business owners to ignore. Admittedly, embracing a new technology like bitcoin is currently not very easy. As the ecosystem gets built out further, more people will feel comfortable integrating it, but at the moment it can be quite confusing to the average consumer. Right now the top two bitcoin payment processors, Coinbase and BitPay, charge 1% to process each transaction. Even with such low rates, these companies are still able to make a profit due to the efficiency of bitcoin's engineering. This is compared to the $0.30 + 2.7% that PayPal charges. Once a business starts accepting bitcoin, they're saving 2% on processing costs. For a 5% margin business, that's a 40% increase in net profit for all bitcoin purchases. That is a non-negligible cost-savings.

    As opposed to taking multiple business days when using a credit card, bitcoin payments are typically confirmed within an hour. Generally, payments are immediately converted into fiat as soon as they're received by a business. This avoids any risk that could occur from price volatility. Furthermore, because all transactions must be mathematically proven legitimate by bitcoin miners before going through, there is no chance of fraud or chargeback. The miners can be thought of as competitive bookkeepers for the network. They're incentivized to keep the ledger updated and legitimate. Miners are paid by the network itself, in newly produced coins, which makes the whole system self sustaining. This allows companies like Coinbase to charge less than traditional processors can afford to and still stay in business.

    Undoubtedly the single largest investor in bitcoin startups today is American entrepreneur, Brock Pierce. I had a chance to meet him and see him speak at the cryptocurrency convention in NYC and I could tell his interest was genuine. Brock sees long term promise for the digital currency for many reasons, but primary because of its fixed money supply. Bitcoin is unlike fiat currency in that its supply is limited. There are approximately 12 million bitcoins in circulation today and there will only ever be 21 million made. 150 are produced every hour and that number gets cut in half every four years. This unique component makes bitcoin a deflationary system. Over time, some bitcoin holders will inevitably lose their external hard drives that have bitcoins stored on them(i.e. dropped in the ocean) which will further add to the deflation. As the price of each coin goes up, the amount being distributed goes down. This means there won't be inflationary pressure like the kind we experience in our current system of money. Taking the printing press out of the equation really differentiates bitcoin from traditional money. It creates a transparent environment that can't be manipulated or corrupted.

    Bitcoin puzzles a lot of economists who would not have predicted you could start from something with no intrinsic value and have it grow into a successful payment system. Paul Krugman, Op-Ed columnist for The New York Times, has been very vocal about his disdain for the digital currency. He believes it's not a stable store of value. So far, Dr. Krugman is correct. Bitcoin's spectacular growth has subsequently made it an extremely volatile asset. I expect that this volatility will continue to exist for years to come. The thing is, though, bitcoin's volatility is something you see over the span of a day or a week. Over longer periods of time, like 6 months or a year, bitcoin has been in a clear uptrend. It has increased from $100 per coin a year ago to $440 today. Two years ago, it was about $5 per coin and three years ago, when hardly anyone knew what it was, the price under $1. A year has yet to pass when bitcoin hasn't vastly outperformed the stock market. Considering its effective use as a payment processor as well as its value as a speculative asset, bitcoin's price will likely continue to rise so as to reflect its increased demand.

    In his NYT article Krugman states that "Bitcoin is only used because of people's lust for a pristine monetary standard, untouched by human frailty." While this may have been the case for its earliest adopters, it is now just an added benefit of being decentralized. In the beginning, bitcoin was sort of a social experiment, however they have been trading for real money for years now and tens of thousands of merchants are accepting them. Krugman also believes that "Bitcoins derive their value purely from self-fulfilling prophecy, the belief that other people will accept them as payment." While it's true that many speculate bitcoin's price will be much higher in the future due to growing adoption, it's not the primary reason why merchants have become so intrigued. People who confidently reject all the innovation bitcoin offers are on the wrong side of history. Krugman assumes bitcoin has no real world application beyond just getting away from spending Federal Reserve notes. He uses its volatility to discredit it, but as a payment system it works great regardless of sporadic volatility.

    Mainstream Adoption

    Since the beginning of 2014, over $100 million has been invested into bitcoin startups. As the infrastructure develops it will be much easier for consumers and merchants to use bitcoin. The objective is to feasibly be able to present bitcoin to someone, even someone like my mom whose never seen it before, and have her reasonably be able to use it. PayPal, along with major banks should even feel comfortable getting involved. While big banks likely loathed bitcoin at first due to its competing use as a store of value, many have started to change their attitude. Xapo is a bitcoin wallet provider that recently received $20 million in venture capital funding. They store their bitcoins in multiple continents, offline, which keeps them out of the reach of hackers. The vaults are underground and each have multiple armed guards. More recently, they've started taking pre-orders for the first ever bitcoin debit card. The card will be usable though MasterCard's existing network making it possible to use in the 28,000,000 locations that MasterCard works. You can even walk up to an existing ATM and withdraw cash. This implementation of a transitionary technology is a big step forward for the ecosystem. It shows that bitcoin can coexist with the mainstream financial services industry.

    Innovation in technology is one of the recent causes of economic shift. It has affected the economy as a whole. New ways of conducting business have resulted in greater convenience for the parties involved. Large corporations, like Overstock.com, one of the world's largest online retailers, have welcomed the digital currency. "It can make our money more robust," say their CEO, Patrick Bryne, a disciple of the Austrian school of economics. Bryne has always been an unorthodox thinker and he took a big risk being the first big public company to start accepting bitcoins. It's turning out to be a very savvy business decision as Overstock passed $1 million in bitcoin sales in less than two months. Not only are bitcoin sales showing up their bottom line, but they're also attracting new customers. Overstock is seeing increased engagement while simultaneously avoiding saving on transaction fees. 60% of bitcoin sales are coming from new customers who are also spending more than average. Other prominent companies such as Victoria's Secret, Zynga, Cheapflights, the Sacramento Kings basketball team, and dozens of others have all starting accepting bitcoin in 2014. The exponential growth in merchant adoption is a further sign that the ecosystem is maturing.

    For the average business, bitcoin is a way to attract new customers and decrease the cost of processing transactions. For the billions of unbanked adults in developing countries, bitcoin can be utilized to bring them financial freedom. The world's unbanked population is over 2.5 billion, most of whom live in Asia, Africa, and South America. Historically, about every 7 years, one of the South American economies completely collapses. High rates of inflation result and many innocent people lose their savings. Although, many of them don't have any savings to begin with. Not having access to a bank account makes it extremely difficult to save and thus make investments. An economy without savings results in decreased standard of living and lower GDP. While only available to some currently, the demand could be enormous once bitcoins are readily accessible to a large percentage of people in developing countries. People who are excluded from the traditional banking system will have a means to greatly improve their financial situation.

    When Zimbabwe was at the peak of its hyperinflation, prices were increasing 79,600,000,000% per month. Bitcoin can be particularly useful in countries like this that use value so fast. In 2009, the government in Zimbabwe legalized transactions in foreign currencies and the Zimbabwe dollar effectively ceased to exist. In reality, citizens of Zimbabwe could've, and still can, theoretically adopt bitcoin as their national currency. If we expect demand for bitcoins to steadily rise over time as it has been, then we can conclude that the price of each bitcoin will continue to increase due to the law of demand. While this is admittedly a very radical idea, it would, in retrospect, have been a better choice for the nation than adopting any other currency.

    Citizens of Argentina, many of whom in fact do have banks accounts, are also seeing their currency rapidly devalued from mass inflation. Bank accounts are often frozen and in many cases even seized by the local government. Families have repeatedly had their balances hijacked, forcing them start over with nothing. Countries such as these two, as well as Nigeria and Venezuela, currently represent bitcoin's biggest addressable market. Individuals living in these countries simply cannot afford to chance putting their money in the bank. They have no place to safely store their savings. $1.00 in Argentina today is estimated to be worth approximately $0.50 a year from now. With currencies as volatile as this, taking advantage of store of value like bitcoin can gives them a statistically better chance of preserving their wealth.

    Remittances

    Another area where bitcoin can significantly reduce transaction costs and preserve wealth is with remittances. Remittance is the transfer of money by a foreign worker to an individual in his or her home country. Immigrants in any given country are often unbanked, but still need a way to send money back home. The families receiving remittances often cannot survive without some sort of financial assistance. Money sent by these immigrant workers competes with international aid as some of the largest financial inflows to developing countries. In 2009, Global remittances totaled $414 billion. Out of that, $316 billion went to developing countries, mostly in China, India, and Africa. The Philippines saw the 3rd largest inflow that year, with $21 billion sent back home. That $21 billion, without counting transaction fees and commissions, accounted for an astonishing 9% of their total GDP.

    In 7 Latin American & Caribbean countries, remittances account for over 10% of GDP. It exceeds the dollar flows of the largest export product in almost every country in the region. Annual remittances have grown to $529 billion in 2012. This is a 300% increase since the year 2000. Most of these payments are handled by the conventional channel of agents, most commonly Western Union and Moneygram. Referred to as money transfer agents, or MTOs, these companies provide an indispensable service to families in developing countries. These remittances make up over 50% of recipient's household income and in some cases as much as 80%. These figures would be even higher if not for the steep prices MTOs are able to charge for sending money.

    To send $200 to the Philippines from the US, Western Union charges $22, or about 11%. Not to mention that Western Union sustains operating margin of over 50% while Moneygram is more profitable than average fortune 500 companies. Furthermore, MoneyGram has repeatedly been fined for money laundering and other criminal activity. Most recently, in 2012, Moneygram forfeited $100 million after admitting to criminally aiding and abetting wire fraud as well as failing to maintain an effective anti-money laundering program. They purposely looked the other way as scam artists used their services to commit fraudulent schemes targeting the elderly. As additional punishment, MoneyGram must have a corporate monitor until 2017 that will report to the Justice Department. This type of toxic corporate culture is what creates demand for a more decentralized way for people to transfer funds.

    With no other alternative to get money back home to their families, MTOs are able to charge senders exorbitant fees for their services. Assuming an average transfer fee of 9% around the world, receiving families are losing over $47 billion annually to MTOs in fees. Additionally, there are frequently changing foreign exchange rate spreads, which act as a form of hidden foreign exchange commission. According to a 2005 assessment of remittance fee pricing, these spreads were concluded to be "too high and not transparent to the sender." Total commissions for sending and receiving agents are in the range of 40% to 60% of the remittance fee. In the end, a tremendous amount of value is being lost to MTOs. Utilizing a decentralized payment technology like bitcoin, families could save billions of dollars in remittances that are currently going into the pockets of highly profitable MTOs.

    Microtransactions

    Probably the most unexpected opportunity for bitcoin will be in micro transactions. The 2010 Haiti earthquake, which killed over 230,000 people, was the only time in history when the payment processors collectively waived their fees. The Red Cross had a campaign where you could donate $1.00 via text message and 100% of that $1.00 went to Haiti. In any other case, payment processors deduct $0.30 plus 2.7% of your donation. This means, if you were to donate $1.00 to a charity of your choice today, $0.32 would be going to the payment processor. Only $0.68 cents of your $1.00 donation is actually going to the cause you intended. This is not a very efficient way to do things. Bitcoin has the potential to bring about new business models that are simply just not possible today.

    If I wanted to transfer someone $0.25 over the Internet today, it wouldn't be impossible. The prohibitive $0.30 base-fee on credit card transactions would lose the charity $0.05, inhibiting them from taking such small donations. Alternately, transferring money in bitcoin has an predetermined transfer fee coded into the system that will always be approximately $0.05, no matter what the price of one bitcoin is. This gives business's more flexibility as well as giving charities more donation options. Imagine if every time a terrible natural disaster occurred, millions of people each donated $0.25. It would become so much easier to help those in need. Another example could be a business model that is "Pay $0.01 to read the rest of this article." Once the proper infrastructure is in place, the possible applications are endless. As bitcoin's adoption grows, entrepreneurs will continue to come up with amazing uses that we can't even imagine today.

    The history of fiat currencies has a bad track record of breaching the trust that our financial system inherently relies on. After generations of repeated credit bubbles and a banking system plagued with moral hazard problems, many economists are calling for an alternative to this unstable system. Despite some high-profile collapses such as Mt. Gox's bankruptcy, it seems like every major venture capitalist fund wants at least one bet in the space in the event it does succeed. The economic liberty bitcoin's decentralized system can bring to billions of people around the world is staggering. Individuals that have had their bank accounts routinely seized cannot trust their own financial institutions. They are in desperate need of a place to store the fruits of their labor. Families of immigrants are losing billions of dollars in potential income every year to immoral MTOs. The potential value bitcoin can deliver to the world is immeasurable.

    Ten years from now, it's reasonable to predict that the bitcoin protocol will have disappeared. Most things that are new tend to fail. Trading bitcoins could be made illegal. It's also feasible that the entire system will fail, simply because governments regulate it into the ground, thus extracting all its value. A critical security flaw could conceivably be discovered deep within the code, rendering the whole thing completely useless. Bitcoin's price could inexplicably crash, effectively crushing all confidence people have in the network. On the other hand, if by some chance bitcoin hasn't fallen apart in ten years time, and continues to grow, it will likely have taken over much of the world's financial system.

    Disclosure: I am long BITCN.

    Additional disclosure: I own 12 Bitcoins total at an average price of about 550. I store the majority of them with Xapo. I also own 1,000,000 Dogecoins

    May 19 12:23 PM | Link | 3 Comments
Full index of posts »
Latest Followers

StockTalks

More »

Latest Comments


Most Commented
  1. The Economics Of Bitcoin (3 Comments)
Posts by Themes
Instablogs are Seeking Alpha's free blogging platform customized for finance, with instant set up and exposure to millions of readers interested in the financial markets. Publish your own instablog in minutes.