On-ramps & off-ramps: impact of Bitcoin payments on the regulatory landscape

Money serves three functions: store of value, unit of account and medium of exchange. Bitcoin has achieved a dubious hat-trick in drawing criticism in each category. It is claimed to be too volatile to act as a measure of economic value—how can merchants risk accepting BTC if the prices fluctuate drastically day to day? For that matter, why would consumers risk giving up an appreciating asset if it is likely to be worth a lot more tomorrow? (Recall the infamous Bitcoin pizza incident.) It has also attracted a chorus of skeptics arguing that it can not succeed as a popular payments, pointing to the intrinsic scaling limits and costs of transacting on the congested network. Blockchain space is scarce, topping out around 7 transactions per second worldwide, dwarfed by the throughput of existing centralized payment rails such as credit-card and PIN debit networks. Moreover transactions compete against each other for inclusion in every block by offering “fees” to miners, who are incentivized to include only those with highest fees into the next block. Counterintuitively, those fees depend not on the monetary value of the transaction but on the amount of space it takes up on the blockchain— akin to charging for check-processing based on thickness of the paper used instead of notional value printed on the check. Depending on demand on the network, this results in drastically varying efficiency. In 2014 it was possible to transfer $80M while paying a few cents—outshining every other system including wires in cost-effectiveness— while the late 2017 frenzy witnessed  users spending tens of dollars in fees to send amounts of the same order of magnitude, which is a staggering level of inefficiency comparable to Western Union for cross-border remittances.

After an initial period of exuberance where merchants raced to outmaneuver each other in claiming bitcoin support and scoring cheap PR points, it is clear that bitcoin is not currently working as a payment mechanism. Ethereum never focused on payments as a use-case, while other altcoins such as monero with aspirations to being a medium of exchange are optimizing for dubious black markets and criminal activity outside the mainstream. Jury is out on whether any of the scaling approaches proposed such as Lightning Network will provide a lasting solution. 

 But this is more than a question about technical merits or real-world feasibility: it will have repercussions for the regulatory landscape around cryptocurrency. Whether Bitcoin or another cryptocurrency succeeds as a widely used medium of exchange will determine which participants in the ecosystem become the focus points for regulatory influence. If conducting meaningful commercial activity requires converting into fiat, regulating cryptocurrency becomes a simple problem focused on existing, already regulated businesses which serve as on-ramps & off-ramps to blockchains for the majority of consumers. (This is true even when that conversion into fiat is hidden from consumers, as in the case of most merchants who claim to accept Bitcoin but are in fact relying on a third-party payment processor who accepts Bitcoin from the consumer while paying out in USD to the merchant, effectively absorbing both the exchange risk and information security challenges associated with storing bitcoin.)

The difference can be illustrated by imagining two alternative scenarios. In the first case, Bitcoin or some other cryptocurrency with better intrinsic scaling properties succeeds in becoming a ubiquitous payment mechanism, complete with a vibrant ecosystem of consumers and merchants rivaling that of existing payment networks. Average citizens purchase goods with Bitcoin from one another with the same ease as swiping a credit-card, with one crucial distinction: there is no middleman moderating the transaction. (More accurately, since blockchains are not made out of magic, the “middleman” has been replaced by a decentralized network of miners.) There is no reason to convert bitcoin into or out of USD— which is what happens today behind the scenes when most merchants rush to announce bitcoin support. Such cross-currency hops are not only unnecessary but they would introduce economic inefficiencies compared to transacting in bitcoin as a first-class, “native” currency.

In the second scenario, Bitcoin is relegated to a different role, serving primarily as store of value (or unit of measure, however implausible that appears from current levels of volatility.) In this word everyday retail transactions are not carried out over the bitcoin network, directly or indirectly through second-layer solutions such as Lightning Network. either because no viable scaling solution has emerged or because network fees are too high compared to existing payment rails, dissuading merchants from switching. BTC can still be competitive for niche scenarios, such as cross-border remittances or infrequent large transfers (such as settlements between commercial banks) where 24/7 reliability and speed is more important than saving a few basis points.

In both scenarios, the censorship resistance of the Bitcoin network is identical. While there are legitimate concerns around the geographic concentrations of mining pools in China and a software “monoculture” of one implementation running every node, it would require extraordinary effort to blacklist addresses or make arbitrary edits to the ledger to undo history or reverse payments. Where these scenarios differ is that such interventions are not required in the second case as a prerequisite to effectively regulating flow of funds.

If commercial transactions require converting cryptocurrency to/from fiat, existing authority to influence movement of that fiat currency also translates into influence on use of virtual currency in any meaningful commercial capacity. If consumers are constantly liquidating bitcoin as a prerequisite for most economic activity, one need only focus on regulating these so-called “on-ramps” and “off-ramps”— points in the ecosystem where bitcoin is exchanged for a native currency accepted in-real-life, such as US dollar. This a tractable problem. Dealing in fiat currency requires banking relationships and maintaining banking relationships involves following existing regulatory regime, which includes a functional compliance program among other components. (One need only look at the instructive example of Bitfinex to see what happens when those connections are severed.) It does not matter that payments within the bitcoin network can continue to flow freely because the balances recorded on that ledger, no matter how significant when converted into notional USD numbers, grant very little purchasing power unless the funds can be exchanged back into USD. If there are only a handful of such off-ramps to exit out of bitcoin and into old-fashioned but universally accepted currency necessary for meaningful commercial activity, there is an effective point to focus enforcement activities.

Consider the example of WikiLeaks. In 2011 the US government pressured credit networkings including Visa, MasterCard and Paypal to stop processing payments for the organization. This forced WikiLeaks to start accepting bitcoin. With the massive run-up in price against USD, WikiLeaks can paint a slightly revisionist picture of that forced move as a blessing in retrospect. But what about the cash-flow side of the equation? Even if all WikiLeaks personnel were volunteers resulting in zero labor costs, no salaries to pay etc. as soon as there are any expenses to account for— data-center hosting, advertising etc.— the question is whether those costs can be reimbursed in bitcoin. If the counter-party is not willing to accept bitcoin, WikiLeaks must find a way to convert their existing stash of bitcoin into old-school currency, interfacing with aspects of the financial system where stringent rules apply around which customers one can conduct business with. (Quite apart from access, this hypothetical scenario also raises the question of whether paying for expenses out of bitcoin—converted or not— was something to brag about in the first place: if the currency appreciated 50,000% since initial donation was made, having spent that on operational expenses to keep the lights on has echoes of the famous million-dollar pizza episode in bitcoin.)

Even overcoming the scaling challenges may not be enough to realize a world where consumers pay for their morning cup of coffee in bitcoin. Volatility may prove even more tricky, not being amenable to simple technological fixes. In the long-term, the belief that price of bitcoin will rise against USD means everyone will hoard their cryptocurrency, with no one willing to spend it on such pedestrian purchases as breakfast. (That brings a whole new meaning to the cliche that skipping a latte every day will compound into significant savings.) Meanwhile significant short-term fluctuation discourage merchants. Pricing goods in bitcoin requires hedging against the exchange risk. The path of least resistance for risk-averse merchants is to cash out to USD immediately after the transaction, which is exactly what most merchants who claim to accept bitcoin are doing: in reality their payment processor collects BTC from the buyer while delivering USD minus transaction fees to the merchant. That approach insulates the merchant from the risk of holding bitcoin long term, while superficially granting them an excuse to display the bitcoin logo on checkout pages and press releases. But bragging rights aside, the popularity of that model for merchants highlights the fragile nature of decentralization. The favored integration model for accepting bitcoin is in fact not using bitcoin as a peer-to-peer currency: there is a payment processor in the loop for converting bitcoin into fiat currency to make it more palatable to the merchant. That middleman is likely a regulated money transmitter and can be legally compelled to stop processing payments for specific clients. If cryptocurrency becomes a first-class, native payment system for online or brick-and-mortar transactions, it will require a fundamentally different regulatory approach focused on trying to impose order on unwieldy peer-to-peer networks. If instead the current trajectory continues, incremental approaches centered around on/off-ramps will be sufficient.