The Green Sheet Online Edition

February 24, 2014 • Issue 14:02:02

Bitcoin bubble: Risks to the payment system

By Edward Barton
G2 Web Services

Bitcoin is a decentralized digital currency that provides the ability to send payment over the Internet or through other electronic media. While bitcoin has many perceived advantages to traditional electronic payment methods, it introduces significant risks to the payment system, as well as to merchants and acquirers that accept bitcoin as a form of payment.

Additionally, bitcoin has all the trappings of a "bubble" that threatens to burst in the near future.

Bitcoin advantages

Bitcoins have perceived advantages to traditional electronic payment methods, including:

Bitcoins can be transferred person to person without going through an exchange or bank. Because they are digital, bitcoins can be used and accepted globally. Due to the fact that they are decentralized, bitcoins cannot be easily seized or frozen by law enforcement. The combination of the three advantages just listed keeps a high level of anonymity for the user – similar to paying with traditional paper currency.

Bitcoin is merely one of a number of digital currencies, including litecoin and nibble, among others. As of November 2013, my colleagues and I had identified more than 75 variants of digital currencies; we continue to identify such currencies and monitor their use.

How are bitcoins made?

Bitcoins are "mined" by servers performing complex calculations. The design of the currency limits bitcoin to 21 million units, which will be mined between now and the year 2140.

The complex mining process ensures that the supply of bitcoin will remain reasonably predictable, while serving as a counter to inflation common with traditional "fiat" currencies. (Fiat money is defined in several ways. It can be money that is: declared to be legal tender by a government; state-issued, cannot be converted to anything else and cannot be fixed in value according to an objective standard; or that has no intrinsic value.)

Bitcoin bubble?

In 1637, the Dutch experienced a phenomenon known as "Tulipmania." The introduction of the tulip to the Netherlands from Turkey created a frenzy, and the demand for tulip bulbs far outstripped the intrinsic value of the underlying asset. The resulting "bubble" in tulip bulb prices and the subsequent market correction were well documented at the time, and such bubbles and corrections have oft been repeated throughout financial history. The two most recent cases are the Internet stock bubble of 1999 to 2001 and the real estate bubble in the United States from 2005 to 2008.

Bitcoin is following the same historical bubble pattern of volatile and irrational prices in response to publicity, assumed features and perceived scarcity. Bitcoin also has significant disadvantages that limit its usefulness as a medium of value. This will likely result in a bitcoin bubble burst in the near future.

Those disadvantages are:

• Bitcoin enables fraud and other criminal activities, which likely will attract regulation and law enforcement efforts against legitimate exchanges. We have already seen this in the People's Republic of China, where restrictions on bitcoin resulted in dramatic shifts in the value of the currency.
• Bitcoin has no intrinsic value. The mining process creates a digitally encrypted data set that was created from nothing, continues to be nothing, and has no use or underlying asset value. Even fiat currencies, such as the U.S. dollar, are backed by government and central banks. Bitcoin is entirely ephemeral.
• Bitcoin's anonymous nature – similar to currency – has a similar challenge. Bitcoin can be easily stolen or lost. The advantage of perceived anonymity creates an opportunity to steal with impunity. There are two famous stories exemplifying this. One is of the journalist whose bitcoin was stolen on the air during a December 2013 Bloomberg TV broadcast. This happened when the quick response code containing the private key for a bitcoin gift certificate was displayed for 10 seconds, during which one viewer scanned the image and redeemed the gift himself. The full story is at rt.com/usa/bloomberg-anchor-robbed-bitcoin-747/.
• The second widely reported incident involved a British man who threw out a hard drive that contained 7,500 bitcoins he had mined using a laptop computer in 2010. The computer became damaged, and he eventually threw it out. He didn't realize his mistake until it was too late to retrieve the device. At the time the story broke in 2013, the estimated value of his bitcoin was more than $7.5 million. Further details are at http://worldnews.nbcnews.com/_news/2013/11/28/21654552-it-worker-throws-out-hard-drive-loses-75-million-bitcoin-fortune?lite.
• Bitcoin has no competitive advantage. Because there is no central bank or exchange, and there are no rules, the 21 million limit on the supply is arbitrary. There are no appreciable barriers to entry, as can be seen by the explosion of copycat cryptocurrencies such as litecoin, dogecoin and numerous others.

Managing payment system risks with bitcoin

While bitcoin and its competitors may have fatal flaws, the market conditions that gave rise to the bitcoin movement are likely here to stay. There will always be a desire, for both legitimate and illegitimate reasons, to access bitcoin's perceived advantages of anonymity and ease of transfer. For merchants or merchant acquirers looking at accepting or underwriting cryptocurrencies for payment, the risks may significantly outweigh the rewards of the incremental business to be gained. Running afoul of law enforcement or being on the wrong side of a transaction when the bubble bursts can leave a business open to significant reputational and financial risks.

I have seen an increasing number of acquiring bank clients monitoring their merchant portfolios for indicators that merchants are accepting cryptocurrencies, both at underwriting and during ongoing monitoring, and incorporating that higher risk profile into their merchant risk management activities. The increased risk associated with merely accepting an extremely volatile cryptocurrency in and of itself may result in a different credit risk profile for merchants in the eyes of their lenders or acquirers.

Like the Internet bubble of the early part of this century, the bitcoin phenomenon is likely an indicator of where payment systems will head over the next several years. However, like the Internet bubble, the cryptocurrency business models have significant flaws and risks that need to be mapped and carefully navigated by the stakeholders and users.

Edward Barton, CFA, CPA, JD, is the President of G2 Web Services, a leading provider of merchant risk management services including merchant website monitoring, fraud prevention, and merchant boarding risk analysis. For more information about G2 Web Services, or to request a complimentary risk review of your merchant portfolio, visit www.g2webservices.com.

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