What is Bitcoin and How Does it Work?
As bitcoin steps into legitimacy, it behooves our clients and friends to better understand exactly what is bitcoin and how does it work. We would encourage you to also read “Current State of Bitcoin Acceptance” in this edition of the Navigator.
What is bitcoin?
- Bitcoin is one of the first “cryptocurrencies,” a medium of exchange which uses advanced mathematics to securely exchange information.
- No financial institution, bank, or company controls bitcoin.
- Bitcoins are digital and are stored online or locally on electronic devices (computers, mobiles, USB sticks) rather than in accounts managed by authorities or institutions. Like cash, once lost (i.e., by a computer crashing), the bitcoins can never be recovered.
- Bitcoins are transferred instantly to anyone anywhere in the world via addresses (i.e., 3J98t1WpEZ73CNmQviecrnyiWrnqRhWNLy). No other information is exchanged, so address owners are anonymous.
- Bitcoins are sent directly from one party to another without being routed through an authority or institution.
- Bitcoin transactions are irreversible.
- It is impossible to duplicate a bitcoin or spend a single bitcoin twice, as all transactions are verified by the bitcoin network, a process known as “mining.”
- There are a finite amount of bitcoins; only 21 million will ever be generated.
Figure 1: How Bitcoin Works
Initially bitcoin was viewed as a speculative commodity but as its price volatility is decreasing, its use as an alternative payment method is increasing. Today, there are more than 5 million consumers using bitcoin as a payment method worldwide, up from less than 1 million a year ago.1
For a consumer to pay with bitcoin, he or she will need a personal bitcoin wallet either online, or on a computer, tablet, or mobile device. The consumer will get an address or QR code from the merchant and send bitcoins using their wallet. Many sites pass cost savings relative to traditional card processing onto consumers in the form of discounts.
Figure 2: Comparison of Bitcoin Economics vs. Cards
Merchants that would like to begin accepting bitcoin have two options:
- Create a bitcoin wallet, post the wallet address or QR code and ask customers to send bitcoin to the wallet address in exchange for services. The merchant will need to manually match payments to orders to confirm payment, and take the full risk of bitcoin volatility.
- Partner with a bitcoin acquirer like Coinbase or BitPay that allows merchants to accept bitcoin payments like any other payment method. These acquirers offer APIs and shopping cart integrations that enable a bitcoin checkout option. The acquirer handles conversion, pricing, and risk, settling in USD or EUR within 3 business days. This leaves the merchant with little or no actual contact with bitcoin. Fees are low or nonexistent; Coinbase offers free transactions for the first $1 million processed, increasing to 1% of sales volume thereafter. BitPay offers free transactions, using FX conversion spread as its source of revenue.
As described in further detail in our “Current State of Bitcoin Acceptance” article, more than 75,000 merchants worldwide accept bitcoin, 90% are e-commerce merchants. Market leading PSPs and acquirers are showing interest in working with bitcoin including Braintree, Global Payments, and Digital River, which already work with bitcoin acquirers Coinbase or BitPay to enable and bitcoin acceptance.
Fraud is currently not a problem with bitcoins, which are arguably more technically secure than most other payment methods. But like cash, bitcoins can be lost or stolen. Their built-in anonymity means that verifying the true owner of a bitcoin is impossible, so it is easy for merchants to potentially accept stolen currency. The anonymity and structure does not create fraud risk for merchants so long as they use a bitcoin acquirer such as BitPay or Coinbase as there is no chargeback system for bitcoin and payment settlement is guaranteed via the bitcoin acquirers (so long as they remain financially positioned to honor this guarantee). Without a chargeback system in place, there is potential for tension between merchants and consumers.
In addition to its function as a payment network, the bitcoin network can be used to securely transfer other digital documents such as contracts, securities, and votes. There are startups working on these and other bitcoin-based applications such as remittance. Funding in bitcoin startups is growing, with $168 million invested to date in 2014, while only $2 million in funding was recorded for the whole of 2012.2
Bitcoin has the potential to shake up the $440 billion global remittance market given that by nature, bitcoin is designed to be fully digital and global with streamlined value-chain processes (i.e., does not involve banks, schemes, processors, physical distribution points, etc.). Bitcoin technology could challenge traditional forms of remittance by potentially reducing costs and increasing the ease and speed of remittances. No one in the market has yet created an effective under-banked wrapper to enable this type of potential.
Regulation of bitcoin will be a key driver of success or failure of the system. Regulators around the world remain cautious and interested to regulate bitcoin in some shape or form, although few have explicitly legalized and regulated (Canada) or outlawed (Russia) the form of payment.
Figure 3: Legality of Bitcoin by Country
Despite growing acceptance by consumers and merchants, there are barriers and uncertainties as to widespread bitcoin adoption:
- Bitcoin is still unknown or perceived as unsafe by the majority of consumers.
- High volatility relative to flat currencies makes holding bitcoin financially risky.
- There have been a number of high profile bitcoin thefts and exchange bankruptcies, further eroding consumer confidence in the currency.
- Most people don’t have any idea how to buy a bitcoin because it is perceived as being too complicated.
- There are genuine concerns about bitcoin scalability. Right now, the bitcoin system can only process a tiny fraction of the amount of transactions compared to Visa or MasterCard.
- There is a growing amount of government legislation around bitcoin, creating uncertainty.
- There are other virtual currencies in the marketplace, though none close in stature to bitcoin.
1 Reuters Article “Bitcoin shows staying power as online merchants chase digital sparkle” by Gertrude Chavez-Dreyfuss.
For more information, please contact Chris Dickey, Associate, specializing in Credit Card Issuing,
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