Here is a recent Bitcoin transaction:
It stands out for several reasons. First is the number of inputs into the transaction: while most transactions spends funds from a handful of other transactions, this one is aggregating from dozens. More interesting is that it moved an astonishing 217500 bitcoins total, valued at roughly 81 million dollars based on the exchange rate at the time of this transaction. That figure stands in sharp contrast to another one: the total commission (or “miners-fee” as the terminology goes in Bitcoin) paid for moving this amount: one-ten-thousandth of a Bitcoin which comes out to about 4¢ or less than 0.000001% of the transaction cost. Where nuclear energy once promised “electricity too cheap to meter,” Bitcoin seems to hold out the possibility of funds movement with negligible fees.
That rosy picture changes quickly once we look at fees charged for more typical transactions, which are often mediated by third-party payment processors, rather than going through the blockchain directly. For example Coinbase— one of the more prominent Bitcoin payment processing services— does not take any commission for accepting Bitcoin, but charges 1% to merchants who choose to convert their funds to fiat currency. (It is a safe bet that this is what most large merchants are doing, since the problem of vaulting Bitcoin is unfamiliar.) That rate is several orders of magnitude above the rate achievable using the blockchain directly. What accounts for such high margins? That may be the wrong question to ask. Perhaps a better approach is to look at garden-variety payment systems and ask what justifies their fee schedule.
- Credit cards: A fixed cost on the order of 30-40 US cents, plus a per valor amount ranging from 2-3% of the transaction depending on the type of card. For example American Express has historically had highest processing fees than Visa or MasterCard. Similarly rewards cards tend to have higher fees. Large merchants such as Walmart have better leverage with card networks for negotiating fees— although not enough to stop being disgruntled about it— while smaller businesses tend to pay higher effective rates.
- Debit networks: 2010 Durbin amendment ushered in a steep drop in debit fees. While small community banks were exempted from the regulation, for the majority of large banks in the US debit transactions now have a minimal transaction fee of 0.05% plus roughly a quarter. There is a different fee schedule with higher rate for “small-ticket” purchases less than $15 but for amounts in that range both formulas converge to similar amounts.
- Square: Square handles credit-card processing for the long-tail of small businesses, except that the “merchant of record” as far as the network goes is Square itself. Meanwhile the actual retailer transacting with the customer pays Square a flat 2.75% for swipe transactions regardless of the type of card used. (Keyed-in cards— Square analog for card-not-present transactions incur a higher 3.5% rate.)
- Paypal: Anywhere from 2.2% to 2.9% of transaction based on monthly volume, plus a small fixed cost. Higher rates and currency-conversion fees apply for international transactions.
- Western Union: Complex schedule based on amount, funding source (credit-card vs bank account) and whether the funds are sent online, from mobile-app or in-person. Two sample data points along the spectrum: sending $100 to New York by credit-card costs $12 for a staggering 12% rate. But sending ten-times as much to the same zip-code funded by a bank account costs less at an effective 1% fee.
These numbers are all over the place, but one can explain at least why the orders of magnitude are stacked this way. For example, in the case of a credit card transaction, the fee is split between acquiring bank, the issuing bank— the one that gave the customer their credit-card— and the network itself. (In the case of Discover and AmEx, “issuer” can be same entity as the network.) Of these three parties, most notable is the issuer taking risk of consumer credit. The cardholder can spend the money but never pay back the issuer for the charges. There are additional costs the issuer must contend width— dealing with disputes, absorbing the cost of fraud in case of charge-backs, reissuing cards etc.— but credit risk is by far the most significant one, hence the triumvirate of credit-reporting bureaus compiling massive dossiers to estimate the creditworthiness of every American. There are also large operational expense for the issuer: rewards programs. Those frequent-flier miles, cash-back awards and airline status upgrades all cost money, which the issuer hopes to recoup from its share of the transaction fees along with interest earned on customers carrying balances.
The absence of such frills explains why PIN-debit networks are able to operate with much lower overhead. A debit transaction only clears if customer has funds present in their bank account. There is no credit extended with the expectation of future payment. Second, debit cards also have nominally better security compared to plastic cards: entering PIN at the point-of-sale terminal is required for spending and there is no “card-not-present” model where simply entering in a number and expiration into a website— easily compromised— allows debit transactions. This is why debit-card skimmers have to both capture magnetic stripe and PIN entry. Debit transactions can also be reversed and disputed, but the process and timelines associated are different from credit cards.
What about Square? Square pays one transaction fee to Visa/MasterCard/AmEx while charing the merchant a different one, presumably profiting from the difference. That means profitability for is critically dependent on the actual mix of funds that customers are using and transaction amounts. If every customer of a Square merchant spent a few dollars only and paid with their American Express card, Square margins would be completely squeezed out, potentially putting the company into the red on each transaction. (In the extreme, this reduces to the time-honored dot-com business model: “We lose money on every transaction, but we make up for it in volume.”)
Returning to the problem of processing Bitcoin transactions for merchants, there is no “issuing bank”, nor is there an“acquirer.” Closest analog to the network are the Bitcoin miners competing to produce the next block in the public ledger that records all transactions, but their fees are nominal— dramatically illustrated by the $80M transaction above. So what is the risk that Coinbase is taking? There is no dispute resolution or fraud investigation to speak of: Bitcoin transactions are famously irreversible. It is the ultimate in self-reliance where your cryptographic keys are your funds: lose control over the key, there is no bank to call, no 1-800 number to report, no FDIC insurance to cover losses. There is no notion of charge-back or penalties levied by the network for having too many transactions reversed. There is some currency risk, considering most merchants seem to prefer getting paid in US dollars immediately instead of vaulting Bitcoin— likely due to the lack of expertise in storing and handling cryptocurrency. That means whenever there is a precipitous drop in the Bitcoin-to-USD exchange rate, Coinbase is left holding the bag, having acquired Bitcoins from the customer while paying out fiat currency to the merchant. And there are certainly no lavish vacations or frequent-flier status upgrades being awarded to anybody: Coinbase does not have any relationship with the consumer. (While Coinbase also provides a consumer wallet service, there is no guarantee that an incoming Bitcoin remittance is originating from one of these.)
In short, there is little reason to expect that merchant processing fees for Bitcoin should be in the 1% range- including currency exchange- as they are today. These rates are more likely to be a reflection of a nascent market, high volatility in exchange rates, lack of merchant expertise in directly handling Bitcoin and first-mover advantage enjoyed by initial participants, that is likely to face downward competitive pressure as the risk-models mature.