Bit By Bit By Bitcoin

During our Nov. 20 hour on the buzzy, big world of bitcoin, we fielded a great number of calls from listeners wondering just what, exactly, the digital currency really is.

We tackled some of the finer points in the early part of the hour, but our guest, Stanford University Graduate School of Business Economics Professor Susan Athey, provided a helpful crib sheet on the finer points of bitcoin regulation.

So far we’ve been discussing the use of bitcoin for illegal activities, and this week a lot of discussion of bitcoin as a speculative investment or a store of value.   But some argue that bitcoin has a lot of legitimate uses that have gotten less airtime.  What is your take on bitcoin?  When I look at math-based currencies, I see a revolutionary technology that allows one individual to send money to another individual instantly, securely, and without a middle man.  Current methods for sending money are archaic—if I want to send money from my Bank of America account to my Fidelity account, BOA will charge me $3 for 3-day delivery, $10 for next day, and $25 for a wire.  I still have to wait for my funds to be available on the other end.  It costs $45 to wire internationally, and there are also delays.  I’m a premium customer.  Really?  In the year 2013?  Math-based currencies offer an alternative payment rail that is instant, secure, and cheap.

You might ask, if all math-based currencies are is a payment method, why do you need new currencies at all?  The answer is that the currency is an integral part of the technology.  I can’t literally beam a physical dollar to you.  The currency is the way you keep track of who has what, and who sent how much to whom, all on a public, secure ledger.  You can call it a chit, a coin, a mark in a book—some thing has to move from me to you in the ledger, and that thing is called a bitcoin or a unit of a math-based currency.  Some next-generation math-based currencies, such as that built by a company called Ripple Labs (disclosure: I’m an advisor there), completely abstract from the underlying currency in the user experience.  A U.S. user with a dollar balance in a U.S. bank sends yen to the Japanese bank account of a Japanese customer.  The virtual currency operates behind the scenes.

What are the use cases for virtual currency?  One that I’m very interested is the developing world, where most citizens don’t have bank accounts.  You might think it is strange to consider something so technologically advanced for the world’s poor, but you have to remember that cell phone coverage is better in many African countries than in Palo Alto, CA.  In addition, countries like Kenya are actually on the cutting edge of using technology for payments.  A full one third of commerce in Kenya takes place using cell phone credits as a medium of exchange.  It works great, as anyone with a cell phone can store money there, and people send credits from phone to phone.  The problem is that the fees are large: cashing out can cost as much as 20-25%.  That’s not so great for people in poverty.

Another big use case is remittances.  Remittances are estimated to be $4-500 billion dollars a year, and are a double-digit share of GDP for a range of poor countries—Ghana, Nigeria, Nicaragua, and so on.  Yet fees are large—published estimates vary, but put fees in the 7-9% range.  Math-based currencies can be used by remitting agents and receiving banks to provide an instantaneous and low-cost way to move money across borders.  If we get to a point where retail establishments offer to change local currency to virtual in remitting and receiving cities, individual consumers could send their remittances directly to their families via mobile phone, with the only remaining fees being those charged by the local exchanges.  Since money is sometimes needed urgently at home, this can provide great benefits.

Math-based currencies also enable more electronic commerce.  Today, there’s no cost-effective way to buy hand-crafted items from most developing countries the way I can on eBay or etsy in the U.S.  And firms in Kenya with things to sell have no way to, say, buy advertising from Google in Kenyan Shillings.  So you can look at the internet from all over the world, but you can’t transact.  Math-based currencies let you send funds as easily as email.

Are there uses within a firm?  Rather than accumulate potential trades throughout the day and clear at the end to save fees, a multinational firm can send money to itself many times a day over the low-cost math-based currency rails, reducing the need to hold large balances within each country and increasing efficiency.

Hasn’t Paypal already solved this problem?  You can look to what Paypal has enabled—people can send money to each other easily within the U.S., allowing for easier fundraising and allowing e-commerce to work for individuals or small businesses who can’t afford credit card services.  But, Paypal is an institution, a middle man, that charges a fee.  Math-based currencies take that to the next level, allowing one individual to send to another using a protocol that is architected to operate without a toll collector in the middle.  The on-ramps and off-ramps for getting local currency in and out of the system do charge fees, however.

What do you think about the bitcoin price increases recently?  Well, if you expect the volume of transactions to grow a lot, then the exchange rate from dollars to bitcoins has to grow too, because each bitcoin can only be used so many times per day.  The market value of all bitcoins has to be enough to support transaction volume.  You could interpret the price increases as reflecting increased optimism about the future volume of transactions, driven by China implicitly signaling that it will allow bitcoins to be used for commerce there.

What about the extreme volatility?  Volatility is bad because it increases frictions—if I just want to send you $100, the exchange rate might change between when I buy the bitcoins and send them to you, and when you receive and cash them out.  That creates risk and frictions. But the level of the exchange rate is irrelevant for the efficiency of the payment rail—if I knew it would be $1000/bitcoin all day long, or $100/bitcoin, either way I can buy bitcoins, send them to you, and you can sell them, while avoiding paying exorbitant bank fees.  You still incur some fees when getting money in and out, but those are relatively low and should fall over time with competition.

It’s also worth checking out The Guardian’s simple, easy to read explainer on the ins-and-outs of the crypto-currency.

The apparent boom in bitcoin’s actual, bitcoin-to-dollar conversion ratio is also readily apparent in the chart below, tracing the currency’s quiet start at around $2 a share to the dizzying heights of $900 per share during this Monday’s Senate hearing on the future of digital currency.



What do you make of the bitcoin buzz? Is it a bubble? A criminal currency? Or the future of monetary exchange? Leave your thoughts below, or on Facebook, Tumblr and @OnPointRadio.

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