By Ann Train
Capital investment in cryptocurrency companies is at an all-time high. During the first six months of 2015, funding in this sector reached $357 million, surpassing the $350 million record set for all of 2014, according to Wedbush Securities Inc. Cryptocurrency enterprises have brought in an estimated total of $832 million since 2009, when bitcoin, a decentralized digital currency, debuted.
Based on open source protocol, bitcoin was developed by an individual or group going by the pseudonym Satoshi Nakamoto. Most cryptocurrency investments have gone to bitcoin-related ventures. The largest to date $116 million, went to San Francisco-based startup 21 Inc. Led by Andreessen Horowitz partner Balaji Srinivasan and Matthew Pauker, who co-founded Voltage Security Inc, which Hewlett Packard Inc. acquired in February 2015, 21 Inc. plans to distribute an embeddable bitcoin mining chip called BitShare that can generate a continuous stream of digital currency.
A near-record $75 million investment landed at San Francisco-based Coinbase to expand the bitcoin exchange's merchant base and bitcoin wallet globally. Founded in 2012 by software engineer Brian Armstrong and former Goldman Sachs currency trader Fred Ehrsam, Coinbase competes with bitcoin wallets like Blockchain, Circle and Xapo, as well as the bitcoin exchanges Bitreserve, Bitstamp, Bitfinex, BTC-e, BTCChina, Cryptsy and Kraken.
Digital wallet-agnostic bitcoin payment processors have also received cash infusions. BitPay Inc. added $30 million to its coffers and is on track to exceed the $158 million it processed in bitcoin payments last year. Bitnet Technologies, led by former CyberSource Head of Business Development John McDonnell, secured $14.5 million to deliver a secure, enterprise-level bitcoin platform for large retailers.
Cryptocurrency has recently gained payments industry support from First Data Corp., Global Payments Inc., NCR Corp., Stripe and Square Inc., among others. The Digital Currency Council estimates that each week about 1,000 new merchants begin accepting bitcoin payments. Even the New York Stock Exchange is on board. It launched the bitcoin price index (NYXBT) in May. Bitcoin users can now follow the daily value of bitcoin in U.S. dollars.
Despite price volatility and a spate of reputation damaging events, including the debacle involving bitcoin-based online drug trafficker Silk Road in 2013, the collapse of Japanese bitcoin exchange Mt. Gox in 2014 and the fall of bitcoin marketplace Buttercoin in 2015, most analysts agree cryptocurrencies are here to stay.
Some view bitcoin and its associated blockchain technology as having the potential to disrupt the existing financial infrastructure. "We see the scope of the disruption as substantial considering 20 percent of U.S. GDP is generated by industries whose main function is as a trusted third party," wrote co-authors Gil Luria and Aaron Turner in a Bitcoin Investment Trust report for Wedbush.
Both Ripple Labs Inc., supported by Google Inc., and Hyperledger, acquired in June by Digital Asset Holdings, hope to improve financial institution inclusion in blockchain technology as a potential replacement for legacy systems.
Mercator Advisory Group Analyst Nikhil Joseph described the key difference between the way bitcoin and payment card networks operate is that the former does not appoint a trusted central authority to validate and facilitate payments.
When an issuing bank receives through a card network a payment authorization request from a merchant acquirer, it reviews the ledger of accounts maintained for all its customers to determine whether the cardholder has sufficient funds, then debits the account.
"In the case of bitcoin, all of these private ledgers maintained by trusted central authorities are replaced by a single, public global ledger also known as the blockchain," Joseph said. "The blockchain contains a history of all transactions, and the associated public addresses (analogous to account numbers) since the inception of bitcoin.
"In order for me to send some bitcoin to you, all I need is my public address containing the requisite bitcoins and a private key to that address. I then use my private key to sign off on a transaction that moves bitcoin from my address to yours," which lends itself to a number of payment scenarios.
Luria and Turner believe much of the demand for bitcoin will come from payment applications enabling bitcoin to offer significant benefits over alternatives, such as online payments (especially cross-border), global remittances and micro-payments. Both analysts predict that by 2025, the bitcoin network could support $595 billion in online payment volume, $744 billion in global remittances and $184 billion in micro-transactions.
McDonnell, who now serves as Bitnet Chief Executive Officer, agrees that bitcoin will impact online payments, as well as enable the billions of people without credit cards who own mobile phones to transact on mobile devices. He added that as more retailers accept bitcoin online, consumers will come to expect it in stores as part of the omnichannel experience.
"One way to think about it is that the technology behind the bitcoin protocol has turned the public Internet into a secure payments network without banks, without interchange," McDonnell said. "ISOs still have a role, as do PSPs, in order to offer bitcoin acceptance alongside cards, direct debits and other alternative payments."
That is not to say banks won't play a role. "The conversion of the bitcoin into fiat currency is done at bitcoin exchanges, but then we need banks to move that dollar or euro back to the merchant's account," McDonnell said. "That triggers ACH fees. In Europe it's SEPA. Not huge fees, but at volume it can be quite interesting. In the aggregate we have banks that are pretty excited about the potential."
For card-not-present merchants – whose card processing costs can range from 250 to 400 basis points, once interchange, PCI compliance, chargeback management, fraud control, gateway and other costs are factored in – digital currency is an attractive proposition since the total transaction cost is less than 100 basis points, McDonnell noted.
"What we have done is create a service layer on top of bitcoin through a single API connection to our platform," McDonnell said. "We manage all aspects of digital currency acceptance for merchants. They get a guaranteed payout at a predetermined amount of time, at a guaranteed price, with no chargeback, in a currency of their choice for a processing fee that is a fraction of what they're paying for card-not-present transactions."
To facilitate bitcoin payments in retail spaces, an Internet protocol-enabled, screen-based POS terminal is required. "It needs to be capable of initiating an API call to us and then receiving a graphical image of a QR code," McDonnell said. "The consumer scans that QR code with their smartphone app, and embedded in that QR code is all the information that their app needs to push the payment over the bitcoin network to Bitnet."
Another company working to simplify bitcoin integration is Gem. "Gem is powering the infrastructure for any developer anywhere in the world to easily begin building on blockchain technlology," said Ken Miller Chief Operating Officer at Gem. "We are working with all types of payment and funds processors. By integrating our wallet functionality through our API, it gives them the ability to store or move digital currencies within their apps that their end businesses and individuals use."
Blockchain payment platform GoCoin recently merged with mobile wallet and loyalty program provider Ziftr to increase visibility for bitcoin by adding the loyalty element.
Initially the novelty of bitcoin was enough to attract customers to merchants, but in developed nations it has become a consumer-preferred, cash-like push payment. "Now there are customers who have bitcoin," said George Peabody, Partner at Glenbrook Partners LLC. "Those customers who have bitcoin tend to be an attractive demographic. For one, they tend to be well heeled. They tend to be tech forward. For certain kinds of merchants it makes sense to accept it."
CardinalCommerce, which offers a global cloud-based platform for card-not-present e-commerce merchants, recently teamed with Bitnet to integrate bitcoin payments. Within the first months, several trends started to emerge. "We have about four categories of merchants that use it," said Alasdair Rambaud, Senior Vice President of Merchant Services at CardinalCommerce."
The first category comprises travel merchants, who discovered they could capture early bitcoin adopters by offering them high-end travel incentives. "The companies that do it have told us that they're mostly customers they've never seen before," Rambaud noted.
High-end retailers, the second category, also saw a spike in online sales after introducing bitcoin payments. "I think you're going to see a lot of brick-and-click merchants accept bitcoin, because they want to capture that excess inventory," Rambaud said. "What we're seeing and will continue to see is big-box retail and luxury retail" going after bitcoin spenders.
The final two categories, online gaming and adult entertainment, coincided with the anonymous side of bitcoin, where privacy is valued. "The four retail categories are definitely catering to two different types of people, the anonymous type and those who have created excess wealth through early entry into bitcoin," Rambaud said.
Bitcoin ATMs don't connect with payment networks to validate bank funds availability, but they do resemble ATMs physically and come in a variety of sizes to accommodate location type. While an estimated 2.2 million cash ATMs are in use globally, fewer than 500 bitcoin ATMs have been deployed. Five manufacturers – Lamassu, GenesisCoin, BitAccess, Skyhook and General Bytes – dominate the bitcoin ATM market, according to recent reports.
Also, bitcoin machines essentially come in two flavors: one-way and two-way. Peter Klamka, President of Bitcoin Direct, who strategically places bitcoin ATMs at high-traffic retail, restaurant and hospitality locations nationwide, said college students and travelers are frequent users and tend to spend money at retailers who offer bitcoin ATMs.
According to Klamka, bitcoin is electronically uploaded into the machines, on the order of $100,000 to $200,000 per month. "A customer puts in cash and they get bitcoin sent to their bitcoin wallet or their phone," he said. "They hold up their phone, there is a QR code that gets scanned, and a few seconds later that amount of bitcoin, less a fee, winds up on their phone."
Two-way machines additionally allow bitcoin users to hold up a QR code that has bitcoin value loaded onto it for redemption of the fiat currency of choice. Because demand for two-way machines is limited and regulations for them are more stringent, Klamka does not place them. He said certain states such as California, Michigan, New Hampshire, Nevada and Texas tend to be more bitcoin regulatory-friendly.
"When you are selling your own bitcoin from a machine, you are in the vending business," Klamka said. "When you are buying U.S. currency for digital currency, you are a money transmitter." That distinction makes operating two-way machines an expensive, time-consuming proposition, since individual money transmitter licenses must be obtained in the 48 states that require them.
Aware of the foothold virtual currencies are gaining in mainstream commerce, federal and state regulators are stepping in. Money services businesses and, in many instances, virtual currency businesses must now register with the U.S. Department of the Treasury through the Financial Crimes Enforcement Network (FinCEN) or face possible penalties.
In a precedent-setting case in May 2015, Ripple Labs was assessed a $700,000 civil penalty by FinCEN for its failure to register as a money services business as a seller of virtual currency and allegedly failing to implement and maintain an adequate anti-money laundering program.
In June, the New York State Department of Financial Services released the final framework for a bitlicense to regulate virtual currency firms operating in that state. It contains key consumer protection, anti-money laundering compliance and cyber-security rules now applicable to cryptocurrency companies. California, Connecticut, New Jersey, New Hampshire, Texas and Wyoming are considering similar guidelines.
"If the law of New York, and California's draft law are any indication, the scope of application of state licensing laws to virtual currency businesses is wide," said payments attorney Adam Atlas. "Consequently, if an ISO is to become a reseller for a virtual currency processor, for example, the ISO should ask whether or not the processor has the necessary licenses to operate in the states where the ISO wishes to sell the product." He added that the processor should also indemnify the ISO for any claims the ISO may face if the processor is deemed to be inadequately licensed.
The ISO should also make an effort to understand virtual currency itself and explain the risks inherent in it to merchants. "Merchants who accept virtual currency as payment should also be told to consult with their accountants as to how to report that income," Atlas said. "I think it is incumbent on all in the payments industry to be familiar with virtual currency as it is likely to occupy a real part of the economy sooner or later."
Taking action well ahead of the curve, IdentityMind Global began offering anti-money laundering and know-your-customer management services to virtual currency businesses several years ago and now has more than 30 digital currency clients globally.
"What we do is provide technology for those companies to execute specifically their transaction monitoring and KYC," said Jose Caldera, Vice President of Marketing and Products at IdentityMind. "Almost every country has some form of regulation when it comes to money laundering, and those regulations need to be followed." He noted that movement of digital currency in the United States, Canada, China and Western Europe is increasing, but it will take time for volume to reach full potential.
Internationally, the climate for cryptocurrency is changing. In July, virtual currency dodged a bullet when the European Union's Court of Justice Advocate exempted bitcoin trading from Europe's value-added tax. As the world continues to grapple with the decentralized trust inherent in cryptocurrency, it could boil down to convincing enough people that "in math we trust" might be the right choice, according to McDonnell.
Following the launch of bitcoin, the world's first decentralized currency system, more than 150 cryptocurrencies have emerged. Collectively referred to as altcoins, following are some of the more popular alternatives to bitcoin in use today.
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