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Bitcoin Is Money … It’s Just Terrible At It

Yahoo! Finance
The Exchange

By Robert MacGregor

“So, is Bitcoin actually money?”

It’s a fair question and, with the intense scrutiny directed at the “crypto-currency” of late, an increasingly common one. But the real question is not whether Bitcoin functions as money today, nor whether Bitcoins themselves are a good speculative investment. The real question – and the only important question when considering whether Bitcoin could be a viable alternative currency – is, “can Bitcoin ever function well enough as money to matter?

And that answer, I fear, is no.

Whether something is “money” has nothing to do with the source of production, whether it’s issued by a government or a private company or spontaneously generated by a community, whether it’s minted or mined or printed or issued electronically.

Money is … well, money … to the degree to which it enables transactions, to the degree that you can use it to purchase things. No matter how efficient or liquid a market is, unless it can be used to purchase things, it’s not money; it’s a commodity.

By that measure, Bitcoin is unquestionably money.

It just happens to be terrible at it.

Where's the marketplace?

Even the most vocal supporter of the system acknowledges that the number of merchants accepting Bitcoins is miniscule and the number of large merchants embracing it is almost nil.

But is that unfair, or at least premature?

Perhaps it’s just a question of time, business development, marketing … of scale. One hears the term “critical mass” a great deal when this question is posed, the implication being that the ecosystem just needs enough merchants to buy in for Bitcoin to become useful as money and to become self-sustaining.

But it is not quite so simple.

To understand why, the system must first be viewed as a product: look to the value proposition versus existing payment options and then at the barriers to adoption. If the problems with Bitcoin as money are a lack of participants, Bitcoin must be viewed form the perspective of a merchant.

Consider the debate from the perspective of Tom Szkutak, Amazon.com’s CFO.

To accept credit cards, Amazon pays hundreds of millions of dollars in transaction fees and credit card fraud, in addition to the costs of related systems and personnel. While processing costs vary, typical rates for online merchants hover in the 2-3% range. At first blush, implementing Bitcoins as a payment option seems compelling – potentially eliminating entire categories of fraud and risk. From a payments risk perspective, it’s relatable to being paid cash over the counter on a worldwide scale.

So why aren’t large merchants like Amazon flocking to Bitcoin’s banner?

Liquidity

Companies like Amazon (AMZN) don’t pay staff or operational expenses in Bitcoin, so to accept them as payment they must be assured of the ability to convert Bitcoins to “real” currencies at will, in any amount, and at a predictable price.

However, Bitcoin liquidity is limited, the system itself guaranteeing that at some point total supply of Bitcoins will be capped at around 21 million.

Like a commodity, Bitcoin trades on exchanges and limited liquidity means that merchants cannot be comfortable that their large sell orders will be executed at a known or predictable price, or filled at all. Worse, in a transparent market with constrained liquidity, a sizable sell order has the potential to itself drive the Bitcoin price sharply downwards.

The very act of disposing of them may, in effect, devalue them.

And, if they cannot be sold at will, Amazon will be forced to sit on a large and unpredictable FX exposure until they can be flushed from the system. And that’s bad.

Legal Risk

I often hear that because the Bitcoin network is technically distributed and that there is no centralized authority to be targeted, it is beyond the effective reach of existing law enforcement and regulatory structures.

Of course, this is utter nonsense and deeply, dangerously naïve.

If a virtual currency is to grow beyond a technical curio and function as money, an infrastructure must exist to enable interaction between the existing banking and financial system and the virtual ecosystem. Participants in the virtual system must integrate with banks, payment processors, digital wallets and card networks, all of which are highly regulated. Banks are risk adverse - they are creatures of regulation and compliance and, ultimately, risk mitigation.

This is not speculation. The field is littered with Bitcoin wallets, exchanges and businesses that were choked off because their processing partners and banks consider the regulatory risk unacceptably high. And what appears to be a Department of Justice Grand Jury investigation in Maryland into Mt. Gox, the world’s largest Bitcoin exchange, will do nothing to assure confidence.

Without a means of moving “real” money into and out of a virtual economy, the system becomes a closed loop, eventually driven underground and into a death spiral of reputational risk. Unless legal clarity can be achieved, key financial institutions that are critical to the survival of a virtual economy will, quite understandably, remain wary and on the sidelines until the fog of war clears.

Volatility

Bitcoin prices oscillate wildly, driven largely by market perception of potential long-term utility of Bitcoins as money and by the attitudes and perceptions of speculative investors.

However, inventory and operational costs are in “real” currency, so holding any appreciable amount of Bitcoins for long brings non-trivial FX exposure. Combined with the liquidity problem, this means a merchant’s product pricing needs to be dynamic, updated daily or hourly, creating an operational, customer service and communication nightmare.

Reputational Risk

Beyond speculative investors, one of the most obvious, early value propositions of Bitcoin was the pseudo-anonymity of transactions. Predictably, this attracted early adopters for whom this was considered a feature. As such, Bitcoin lurched into the limelight in association with the Silk Road, a site whereupon everything from heroin to weaponry can be purchased using Bitcoins. Subsequently, other virtual currencies have been implicated and indictments have issued in the US alleging bank fraud and money laundering.

Unless the legal and tax questions can be resolved definitively and with regulatory blessing, adopting Bitcoins as deposit method brings potential associations with criminal activity.

Tax Exposure

Many proponents argue Bitcoin is not a financial instrument but rather a digital token, a virtual commodity. Torturous legal arguments are constructed with the obvious intention of avoiding existing regulation. Such positions may prove to be correct, but they should take care, as they may wish they weren’t.

It is increasingly clear that purchasing and selling Bitcoins as a commodity will likely attract capital gains or income tax for the speculator. Transactions where Bitcoins are used to “purchase” goods or services will likely be taxed as barter transactions – essentially a trade of a digital commodity for a physical one.

But here’s where it gets ugly.

If a Bitcoin does not qualify as a regulated financial instrument, then it is likely a digital commodity indistinguishable for tax purposes from an ebook or piece of downloaded software – attracting a sales tax in most jurisdictions.

Note that this is a tax applied to the purchase of the Bitcoins themselves. Similarly to a European paying 12% VAT when purchasing Bitcoins, the online purchase is treated as a taxable barter transaction, and the merchant who wishes to dispose of the Bitcoins must charge sales tax upon disposal. Such treatment of Bitcoin as a digital good rather than a financial instrument could trigger an implosion of any mainstream use as commercial basis for adoption would be annihilated overnight.

In short, the superficial value proposition to merchants appears compelling, but it must be tempered with reality. Local retailers may be able to ignore these issues, but large merchants cannot.

The potential financial, operational and reputational exposure of adopting Bitcoins as a payment method will likely dwarf the benefits for the foreseeable future, and indeed may never be overcome.

A technology and alternative payments lawyer, Robert MacGregor is the founder and CEO and founder of nTrust, a regulated global peer-to-peer money transfer platform.

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