| Originally published on TheBusinessofBitcoin.com on January 29, 2014 |
As mentioned in my frameworks post, one of Bitcoin’s key applications is its role in facilitating consumer/merchant payments. In fact, many are judging its success, rightly or wrongly, by how much it’s being used in day-to-day B2C transactions. So this begs the question: what will drive adoption among both merchants and consumers?
The most obvious driver is to lower merchant fees. If merchants can stop paying transaction fees, why wouldn’t they adopt Bitcoin as a payment option? Many Bitcoin supporters point to many retailers’ thin margins and how these could be significantly boosted by a reduction in transaction fees.
However, such a broad statement ignores some important nuances:
1) Fee details
To fully understand the implications, it’s useful to briefly review how the current payments system works, who makes the money and how much they each take. It’s a complex and non-transparent system and the following parties all take a piece of the pie:
- Acquiring bank (merchant’s bank)
- MSP/ISO (entity that “sold” and has the merchant relationship)
- Payment processor (company that does the actual processing)
- Card network (name on the card, i.e., Visa, Mastercard)
- Issuing bank (consumer’s bank)
(Note: I’m ignoring Amex as it works a bit differently. Numbers are similar, but somewhat higher.)
Most merchants pay somewhere between 2 and 3% in credit card transaction fees, with the exact fee depending on a number of items. However, the biggest determinant of how much the merchant pays comes down to how big and sophisticated they are, which translates into how well they can negotiate down fees.
Of the 2-3%, the largest piece (called “interchange”, roughly 1.5%) goes to the issuing bank, with smaller pieces (ranging from 0.1 to 0.35%) going to everyone else. By the way, pretty much everyone pays interchange, even someone as big as Walmart. It is the other pieces that are up for negotiation.
Now, the idea behind Bitcoin is that you can do decentralized transactions, cutting out unnecessary third parties and reducing costs. Can we just assume that by moving a transaction from credit cards to Bitcoin, the merchant will save ~2% in fees? Sadly, it’s not that simple.
Who can we cut out? Let’s look at each player in turn.
Issuing banks – Since the issuing bank takes the biggest piece, let’s start there. Can we get rid of that entire 1.5%? As it happens, a big chunk of that fee is given back to consumers via rewards. Rewards cards are very common and give consumers back amounts that are often at 1% of spend or higher. So while it’s possible you could take out the full amount, you really have to think about how this will impact the consumer (see below).
MSPs – These companies do the legwork of signing up and managing the relationship with individual merchants. Can you eliminate them? Maybe, if the merchant in question is sophisticated and will find a processor and set things up themselves. But many merchants, especially smaller bricks and mortar ones, will need guidance/support. That costs money and there will have to be some fees to cover this.
Payment processors – In the Bitcoin world, processing is done by the miners. So you can eliminate a 3rd party for this role, but you still have to assume that you’ll need to give miners some transaction fee. Due to how Bitcoin works, transaction fees will become more important for miners in the long term. It is probably safe to assume the necessary fee for this role will be lower than today’s, but since fees have not “stabilized” it is unclear by how much.
Card network – This role may disappear, but this is not a given over the longer term. Let’s say Coinbase (one of the leading Bitcoin processors today) decides to brand their consumer and merchant services. Let’s even say there are good reasons to do this: for example, the brand gives both sides piece of mind and keeping transactions inside the Coinbase network (i.e., Coinbase wallet and Coinbase merchant) results in faster confirmations. Coinbase now becomes a network on top of Bitcoin, and it would be reasonable for them to charge some amount in exchange for the value they provide.
Acquiring bank – Today this role exists to manage the merchant’s money as it comes in (i.e., direct it to the merchant’s bank) and to absorb the risk that the merchant will go out of business. How so? Well, imagine that a merchant receives orders (and payments) for 10 widgets and is supposed to ship them to the buyers over the next week. But before it ships the widgets, the merchant goes out of business. In today’s world, the consumers will go to their banks (the issuing banks) and ask for their money back. The issuing banks will promptly issue “chargebacks” and give the money back to the consumers. Someone has to pay for those chargebacks – and if the merchant is gone, it will be the acquiring bank. Can we eliminate this role? It’s unclear. In the Bitcoin world there are no chargebacks per se, so there is no latent risk in that sense. However, consumers have a say in this. If they feel they are running more risk by paying in Bitcoin, they may choose not to do so. So here you once again have to think about consumer implications (see below).
So where does this leave us? It’s impossible to come up with an exact number for how much fees will go down by. I personally believe they will go down, but it’s clear from the above discussion that they cannot disappear.
2) Consumer implications
In the previous section it became clear that consumers have a say in at least two areas: rewards and their acceptance of merchant risk. In a world where consumers do not care about rewards and are willing to absorb the risk of a merchant going out of business, you can eliminate the relevant merchant fees. But that is not the world we live in. Most likely, you will have to give consumers incentives via some form of rewards (which you probably would want to do anyway to encourage Bitcoin uptake) and you will have to give them some piece of mind around merchant going-out-of-business risk.
3) Pricing dynamics
This is an even more amorphous category, but it’s worth discussing briefly. Today, it is likely that at least some of the credit card fees are being passed on to consumers through higher prices. I seem to remember there was a study from Australia that showed this behavior, but I haven’t been able to find it as I’m writing this post.
So what happens when some of those fees go away? Well, some merchants may reduce their price to better compete (which in turn may cause similar moves from other merchants). Alternatively, they may keep prices the same, but may give certain incentives to consumers to pay in Bitcoin. Either way, the end result is the same: the potential margin gains to the merchant from accepting Bitcoin are reduced.
To be clear, this outcome is a net positive for the merchant/consumer system. But it’s worth making the point because the current promise of higher merchant margins is not the obvious outcome.
4) Volatility and currency exchange
These two items are non-issues for merchants today (at least domestic ones) but they become issues when handling Bitcoin payments. Since Bitcoin volatility is very high today (and probably will still be for some time) few merchants can take the exchange risk this entails. This means that they need to trade their Bitcoins for dollars (or their local currency) as they come in. Coinbase does this for merchants, but this is not a trivial or riskless exercise and they are currently charging merchants for this service (1% + $0.15 ).
In fact, even in situations where the merchant is willing to keep Bitcoins and take on some risk, they will eventually need to exchange some of them for dollars because we live in a world where most things are bought/sold in dollars. At that point they will likely incur some exchange fees (currently on the order of 1%).
So what can we conclude from all this? It’s actually very hard to draw any exact conclusions. The fact that a processor like Coinbase is currently charging “0%” (except for instant exchange) is indicative of the current “land grab” environment (and ample VC funding), not of the longer term steady-state fees.
To be clear, I believe merchant transaction fees with Bitcoin will be lower than what we have today, short and long term. And even if they weren’t lower, Bitcoin introduces advantages and efficiencies that make it more desirable than today’s system. I’ll cover these and other aspects of B2C Bitcoin payments in coming posts.