Masterpiece or Showpiece?

Why skepticism is setting in not just about Bitcoin but also about its underlying technology, the blockchain.

Like Beanie Babies and baseball cards, Bitcoin has become a collector’s item, curtailing its usefulness as the faster, cheaper consumer payment method it was developed to be.

Out of these adoption delays has come a tangential industry focusing on Bitcoin’s underlying technology, the blockchain, a distributed ledger of transactions. Many of these projects are based on exclusive, permissioned ledgers for enterprise use cases. And they’re operating in financial markets where heavy doses of competition and existing regulation could severely stunt their potential. Private blockchain initiatives hinge on collaboration from financial institutions, which have typically obscured their processes from competitors.

As all these private blockchains are still in beta testing or pilots, many in the Bitcoin community tout (correctly) Bitcoin as the only blockchain that’s proved fruitful for consumers. Indeed, Bitcoin enthusiasts have pinned their hopes for the cryptocurrency on promising applications like peer-to-peer transfers and micropayments. But these hopes appear to be faltering. Even remittances, a promising market, could prove to be tougher to crack than many figure.

The Bitcoin community needs to focus on bringing liquidity to the market, says Drew Weinstein, chief growth officer at HyperWallet, a payouts provider that built its enterprise platform for transacting high volumes of low-value payments for the gig economy all around the world. HyperWallet doesn’t currently utilize Bitcoin but it’s “carefully looking at the blockchain as the critical infrastructure to improve costs on the back end.”

“It’s great for me to accept Bitcoin, but if I can’t use it, well then I’m just collecting it,” he says, like coffee mugs, beer steins, and other collectibles.

Discussing the ability to use Bitcoin seems almost comical. A payment mechanism needs utility, and if it doesn’t have that, it fails. The technology suffers from the same old chicken-and-egg problem every new payment system confronts. You need both consumer and merchant adoption, but consumers don’t care to adopt a currency no merchant accepts and merchants don’t care to accept a currency no consumer has in their wallet.

But on its nearly eight-year ascent to the ultimate financial-services-industry buzzword, Bitcoin has more to prove than just its capability as a showpiece.

‘No One Has Figured Out P2P’

Bitcoin was introduced in 2008 by an individual or group of individuals going by the name Satoshi Nakamoto as a decentralized software protocol that allows for peer-to-peer (P2P) transactions based on its native digital cash-like asset, bitcoin (lower case b).

According to Nakamoto in the Bitcoin whitepaper: “What is needed is an electronic payment system based on cryptographic proof instead of trust, allowing any two willing parties to transact directly with each other without the need for a trusted third party.”

For Nakamoto, and now for a significant number of Bitcoin evangelists, the traditional payments system’s reliance on trusted third parties has a number of flaws for online commerce, including non-reversible transactions that lead to increased costs for fraud and mediation, leading further to limits on transaction size.

There’s no doubt Bitcoin was created for online consumer payments, such as P2P transfers. But banks and payment providers have tried for years to get P2P payments off the ground, with little success.

“No one has really figured out P2P,” says Lana Schwartz, a researcher at the Microsoft Research Social Media Collective and a professor at the University of Virginia.

“PayPal is probably the best we have, but there’s a reason why we have sites like paypalsucks.com,” she says, referring to a Web site that posts users’ complaints about PayPal.

‘A Superior Payment Method’

While open access and pseudonymity were always a part of Bitcoin’s claim to fame, originally the cryptocurrency was proclaimed a cheaper, faster online payment method than the traditional financial system has provided.

After a couple years of venture capitalists throwing money into consumer- and merchant-focused Bitcoin companies, all while regulators jumped on the opportunity to develop new rules for cryptocurrency, Bitcoin still hasn’t taken off in the consumer payments space like many thought it would.

Tim Sloane, vice president of payments innovation at Maynard, Mass.-based consultancy Mercator Advisory Group, compares Bitcoin’s struggle to lure consumers and merchants to the lackluster adoption of mobile payments in the U.S.

But it’s not all a tale of one faux pas after another.

“There is an audience for Bitcoin which is a very specific type of consumer, the consumer that is suspicious of the financial structures that currently exist and are a bit anti-government,” Sloane says. “Like in Utah, perhaps,” he adds, laughing.

Speaking of Utah, Cottonwood Heights, Utah-based online retailer, Overstock.com was one of the early merchant adopters of Bitcoin. Overstock’s chief executive, Patrick Byrne, is an outspoken skeptic of the U.S. government, so Bitcoin aligned nicely with his political views. And the company has seen success, offering early Bitcoin adopters a place to send their earnings since the currency’s price has jumped from mere cents to more than $1,200 in November 2013 and has since flattened out to around $500 to $600 per coin.

‘A Big Bite’

This price volatility has led to a great degree of speculation within the Bitcoin and greater cryptocurrency space. Most people using Bitcoin today are traders or see the currency as a store of value for investment.

“It’s a 70/30 split,” says Adam White, vice president of business development and strategy at Coinbase, the Silicon Valley-based digital-asset exchange, trading platform, consumer wallet and merchant services platform. “Roughly 70% of transactions on our platform is for investment purposes, Bitcoin as a speculative investment. And in 30% of our daily conversions Bitcoin is being used as a transactional payment medium.”

Those consumer payments include paying for products or services from a merchant or paying friends and family either for fun or for remittance, White says.

“Bitcoin is a more efficient means for transferring value online,” says White. “It’s just a superior payment method over the others in the market today.”

Payment cards are cumbersome for consumers to use online. And cards also come with significant fees (2% to 3% plus a flat fee) for merchants. Plus merchants bear a certain amount of fraud, which is factored into their prices.

“When you add all these together, the actual fee to accept a credit card is not just the 2.9%,” White says. “When you add chargebacks and fraud and a team to mitigate these risks, the actual fee is around 5% or 6%, which is a big bite out of a merchant’s margin.”

Coinbase, on the other hand, charges a 1% flat fee for conversion services, such as buying Bitcoin with U.S. dollars or cashing out Bitcoin in Euros. The company offers merchants the first $1 million processed for free.

And because Bitcoin transactions are irreversible, merchants can rest easy knowing the risk of chargeback fraud is eliminated.

Living off Venture Capital

But consumers sometimes don’t fare well in this situation. For instance, consumers have had their digital wallets hacked and their Bitcoin stolen, or have dealt with merchant fraud without recourse.

Many industry analysts believe the Consumer Financial Protection Bureau (CFPB) might require third-party providers of Bitcoin wallets to offer insurance and other protections consumers get with traditional providers.

White thinks that’s a fair point, but encourages people to think of Bitcoin as cash, a bearer instrument whose ownership liability is on the individual. “Users, for better or worse, are completely in control of their funds,” he says. “And Bitcoin users think that makes a fair financial system.”

According to White, about 40,000 merchants use Coinbase to accept Bitcoin. Altogether, there are around 100,000 merchants that accept Bitcoin through various merchant payment processors, such as BitPay, GoCoin. and Stripe.

While Coinbase’s customers still see they’re using Bitcoin, another Bitcoin startup, Circle Internet Financial, has obscured its use of Bitcoin for payments, developing a mobile app similar to PayPal’s Venmo P2P app but with private messages instead of Venmo’s public newsfeed style.

In the U.S. and Europe, Circle customers can send money to others using their local currency (dollars, pounds, euros), even across currencies, using Bitcoin. If a customer sends dollars to someone in another part of the world, the recipient receives Bitcoin. The Circle app is currently available in 150 countries.

“The high-level concept is, from a consumer’s perspective, money should work the same way the rest of the Internet does—instant, global, and free,” says Jeremy Allaire, chief executive and founder of Circle. “That moves us into a world where the economies of the world become more integrated and not worry about what payment methods providers accept.”

In Allaire’s mind, the world is moving into an era where mobile phones are the payment instruments; where banking and payments are just a software problem; and fraud mitigation through cloud computing, machine learning, and artificial intelligence allow companies to operate the services of a traditional bank at a radical fraction of the cost.

“We made a very big bet on AI and machine learning for risk management,” Allaire says. “So we don’t have so much overhead. We’re about 100 people with Macbooks.”

This is completely opposite the mentality of large banks and payment providers, such as JPMorgan Chase & Co. and The Western Union Co., both of whose chief executives boasted recently about the significant number of people they’ve hired for risk management.

“The average cost for a retail bank to support a customer is $400 just because of the overhead of the company,” says Allaire. “Our cost is $10 to $15 to support a customer.” But many financial industry analysts think this might change for many Bitcoin providers as adoption increases.

Currently, consumers do not assume any fees on Circle. So how does the company make money? “The short answer is, we don’t,” says Allaire, laughing. That part comes later. Right now, Circle is living off its venture capital, the startup way.

“Philosophically we just believe that storing money and exchanging value is going to be free,” Allaire says. “But if we can build a global consumer base that uses us for personal payments, that puts us in a place to offer other products that generate meaningful revenue in the future.” As an example, Allaire says Circle might help people find places to spend or invest their money.

‘From Hobby to Industry’

Most consumers using Circle today are purchasing digital content such as game upgrades or downloadable music and movies. These products tend to be priced low, meaning that credit card fees really cut into revenue. This is why many digital-content providers, such as Apple with iTunes purchases, batch transactions at the end of the day.

Bitcoin, with its 10-minute settlement time, could solve for real-time payments, according to many early supporters. Only a couple years ago, there were several initiatives testing Bitcoin for pay-per-view within online publications or blogs instead of subscription-based models. In February 2014, the Chicago Sun Times experimented with a microtransaction Bitcoin paywall, and while the publication initially saw success, it’s no longer running the initiative.

That’s because it’s become obvious that Bitcoin is actually a poor tool for micropayments. To understand why, you have to look at the current state of affairs below the surface of the Bitcoin economy, at a little-understood business called Bitcoin mining.

Because interest in Bitcoin has exploded, it now takes a considerable amount of money to mine Bitcoin. Keeping the Bitcoin network secure and accurate is based on mining, or authenticating blocks of transactions to be time-stamped to the blockchain. This process involves solving for proof-of-work algorithms, a routine that now takes vast amounts of computing power.

Whereas originally, individuals could mine Bitcoin as a hobby, Bitcoin mining has become an industry of enterprises with warehouses full of computers or mining pools.

Miners then get rewards for their work. The miner or mining pool that verifies a block of transactions gets a reward from the protocol itself. That reward is currently 25 Bitcoins (about $14,500 as of June 10) but, as a rule of the protocol, that reward halves every 210,000 blocks. A halving will happen some time in July, bringing the mining reward down to 12.5 Bitcoins. The first halving happened in November 2012, decreasing the reward from 50 to 25.

As this reward decreases (and if the price remains where it is today), mining firms will have a hard time recouping their costs and staying in business. And it’s already begun. In May, Bitcoin mining firm KnCMiner, which raised $32 million in venture capital, declared bankruptcy.

Sam Cole, KnC’s chief executive, told industry newsletter Coindesk in May: “Effectively, our cost of coin—how much we produce the coins for—will be over the market price. The price is now [roughly] $480. With all of our overhead, after July, the cost will be over $480. All of the liabilities we’ll have after that time will be too high.”

Many have speculated that miners will turn to per-transaction fees to make up. Currently, users are allowed to attach a fee to transactions to motivate miners to verify or prioritize their transactions.

This is why many companies that transfer small amounts of Bitcoin on behalf of their customers do so off blockchain—in other words, without having miners verify those transactions. For instance, transactions from one Coinbase user to another are instantaneous and free.

But this then makes those features nothing more than a traditional closed-loop payment network. “Over time, Bitcoin has become so popular, it has become a victim of its own success,” Coinbase’s White says.

Political Limitations

But others, like Daniel Cawrey, former chief operating officer at Bitcoin-tipping service ZapChain and now working at Velocity, a derivatives platform based on a separate digital currency called Ethereum, are still hopeful there’s a sweet spot for microtransactions, especially with some of the engineering and technical solutions being discussed within the community.

Examples of these solutions are the Lightening Network and side chains that verify transactions on linked but separate, less costly blockchains.

Plus there are separate projects, such as Steemit and Synereo, focused on developing next-generation social-networking platforms that come with their own digital currency. These companies expect the cryptocurrencies will be used to “vote” on content through micropayments.

The time for micropayments might be coming, coinciding with the disillusionment of advertising and a lack of control over personal data. “It’s still a ways out in terms of cryptocurrency, though,” says Cawrey. “The infrastructure needs to improve. But overall the cryptocurrency industry has pushed incumbents to rethink their business models; they’re talking a lot about blockchain.”

But Mercator’s Sloane remains skeptical, not because of technical limitations, but political ones.

Most of the startups that have tried to implement micropayments for the Web haven’t been able to make it work in part because there are huge companies built on existing architecture, Sloane says. “Having those companies move from advertising to micropayments is no small feat,” he adds. “A lot of these startups develop technology platforms for these companies to switch to, but they don’t think through how these companies do that while also protecting their revenue.”

Another industry that’s abuzz with blockchain idealism is the remittance industry, which for decades has been plagued by high fees and long settlement times.

“International remittance is one of the early success stories for Bitcoin,” says Gil Luria, head of technology research at Los Angeles-based Wedbush Securities, naming Abra and BitPagos as examples.

Many Bitcoin-based startups have gone after Western Union and MoneyGram International Inc. for those companies’ pricing models, but both companies have defended their models, saying fraud rates are higher than many expect and physical agent locations in hundreds of countries around the world raise overhead costs, as well.

“While these [Bitcoin] companies must keep an eye on fraud and compliance, they still could get to a price point that’s lower than the incumbents because at the very least they’ll be cutting out the foreign exchange,” Luria says.

The cost of remittance won’t be zero, says Luria. But using Bitcoin, providers can eliminate 2% to 3% on correspondent bank fees, and by taking advantage of mobile platforms they can reduce overhead costs.

There are inefficiencies that can be eliminated by updating core banking and payments systems with blockchain infrastructure, but Mercator’s Sloane says he would bet on private blockchain initiatives over the open-access Bitcoin network any day. And as more and more companies that were initially Bitcoin-based pivot to blockchain-agnostic business models, it looks like that position is supported.

Fundamental Flaws

The startups developing in this space are focused on private or permissioned blockchains, where access is limited to vetted organizations and individuals. Among the top startups in the space are Ripple, Eris Industries, Digital Asset Holdings, and R3. These companies focus their efforts on regulated financial institutions, hoping to create a transactional ledger secured by cryptography that allows banks to transfer information without the middlemen associated with traditional transfers.

Simon Taylor, co-founder and director of blockchain at 11fs, a new consulting and venture-capital fund targeted at blockchain for banks, thinks this shift to private blockchains is partly to do with Bitcoin’s tainted image, but more so to do with fundamental flaws in Bitcoin that make it less than useful for large enterprises.

One of those flaws is the idea that Bitcoin’s raison d’etre is “subverting currency controls as a service,” Taylor says. Many governments have issued guidance on virtual currency, raising concerns that these open-access, unregulated currencies could be used for terrorist financing and other money-laundering crimes, such as evading tax. The idea is that permissioned ledgers wouldn’t have the same problems since they’d have a network of trusted parties watching out for risks.

These initiatives are still in the very early stages, but have gained momentum. Ripple has 30 banks in pilot and R3 has more than 50 of the largest financial institutions collaborating on a permissioned distributed-ledger platform.

“Banks are very rarely at the forefront of technology. They understand it, but their ability to execute is lacking,” says Taylor, who prior to July had worked at Barclays for three years.

With distributed-ledger technology, though, banks have jumped at the opportunity quickly. But the first application will not likely be consumer payments. Instead, Taylor thinks many will focus on shared workflow, provenance, and identity.

Deflating Balloon

Of these, the biggest pain point of all for banks is know-your-customer and identity. “The idea of interoperating ledgers for data exchange is huge,” Taylor says.

He envisions a world where consumer data sits at a bunch of different places (the DMV, the utility company, etc.) and banks can request access to that data instead of having consumers bring in copies of that data that the banks then have to keep secure.

But there are hurdles here, too. Identity is a hard problem to solve because of the number of banks and government agencies that would need to cooperate with each other and share information.

Basically the financial-services and payments industry is just a difficult one to navigate. “The fintech balloon is slowly letting its air out,” says Sloane, “because of how regulated this market is and how hard it is to get a startup into the regulated environment to even make money.”