Bitcoin accepted here? Part 2: Getting the merchants on board

By John Enoch, UK

Part two of a six-part blog series exploring the history, potential and implications of virtual currencies as they become more widely accepted.

4. Regulatory inconsistency and uncertain definition

bitcoin2Some countries, such as Russia, Thailand and Vietnam, have banned the use of digital currency, while others, such as China and Iceland, have made it more difficult to use Bitcoin by preventing regular financial institutions from dealing with them.

Different countries also define Bitcoin differently. It may be '€˜property'€™ (US), a '€˜unit of account'€™ (Germany) or a '€˜commodity'€™ (Japan), for instance. China has declared what it is not '€” i.e. '€˜currency'€™. Denmark decided that it was '€˜like glass beads'€™ '€” i.e. valueless. The UK has flip-flopped. Initially, bitcoins were to be one-off vouchers, making them taxable, although this was later reversed. We are now waiting for the European Union to decide exactly what Bitcoin is.

Why does any of this matter? Three reasons, I think. The most obvious is legitimacy: currency holders would like to be sure that they are not falling foul of some government restrictions.

The second is taxation. I certainly do not want to go into the details of this but, depending on how Bitcoin is defined, transactions may be subject to no tax, income tax, capital gains tax, barter tax (don'€™t ask) or some complex hybrid. This may be of more concern to governments who are trying to collect the tax than to the consumers who don'€™t want to pay it, but the more that business is channelled through intermediary institutions such as exchanges or virtual banks, the easier it becomes for a government to try to impose some taxation. At present, with virtual currency transactions accounting for a tiny proportion of the total, the pressure from governments to give them a share of the cake is manageable. That may change as the volume of transactions multiplies in the future.

Finally, insurance. Boring, but it can be important. Bitcoin-holders and insurers have to know whether there is insurance coverage in place, and if so, of what exactly '€” theft, loss, software malfunction, majority attack, etc. (As an aside, some insurers may be covering Bitcoin without meaning to, because policy wordings were written before Bitcoin was invented and coverage is not excluded; it all depends on the definition'€¦.)

5. Finite supply

One of the things audiences generally ask about is the impact of the limit of 21 million bitcoins. The currency is, however, divisible to eight decimal places. That means that even if one Bitcoin were worth $1 million, you could still buy something for 1 cent. So, micro-transactions are hardly threatened by the limited supply. One theory is that, because economies will continue to grow but the Bitcoin supply will not, rational Bitcoin investors will hold the currency rather than spend it, with a deflationary effect. That might be the case if there were no substitutable alternatives, but it is unlikely to happen when consumers and retailers can switch to other virtual currencies which are not limited in the same way.

A more important consideration than a theoretical future economic impact of that sort lies in the progressively increasing cost of mining Bitcoin. In an increasingly environmentally conscious world (perhaps more so outside US than within it), the concept of expending ever-growing amounts of energy for completing tasks that are in essence pointless (other than mining the coin) may at some point encounter resistance. The effect has to date been counteracted through the development of more efficient, dedicated mining hardware, but there may be limits to the increases in efficiency that are possible in that regard.

Other virtual currencies have adopted different models '€” 42 million units, or a fixed rate of growth per year, for instance. There will probably be space for co-existence of different models. The macroeconomic impact on the economy of any country as a whole is likely to remain insignificant for quite some time.

6. Fragmentation

The fact that there are so many competing virtual currencies is a barrier to any parties, such as retailers, that may need to invest in systems to process (or promote) transactions in a virtual currency. Although Bitcoin is in, by far, the strongest position at present, it is not clear that it will end up the '€˜winner'€™. One might expect greater acceptance of the desirability of dealing with Bitcoin, or whatever ends up replacing it as a dominant virtual currency, once the risk of backing the wrong horse is reduced by the elimination of a lot of also-rans and the establishment of a pecking order of, probably, three or four mass-market long-term players. This is not to deny an ongoing role for small, niche players, but the mainstream requires no more than a small handful '€” more than that is simply unmanageable.

7. Processing systems

Processing systems will have to keep pace technologically and in volume terms with developments of virtual currency, but there is no reason why they should not be able to do so.

8. Merchant and consumer acceptance

Ultimately, this is the key consideration. If Bitcoin is to be successful, there must be a mass of consumers who want to use it and merchants who are willing to accept it. This is partly a chicken and egg situation. Mass retailers will not provide virtual currency facilities unless they perceive a demand for them, while consumers will not be interested in holding a currency that is not accepted by many of the retailers with whom they like to shop.

There is certainly nothing intrinsic to virtual currency that is stopping it from becoming fully accepted as a worldwide payment mechanism, except perhaps government disapproval of anything that is difficult to control, and big business disapproval of anything from which they cannot make enough profit. All currencies involve some measure of '€˜consensual hallucination'€™.

The Economist published a story about the island of Yap, in the South Pacific, which had little commerce or obvious financial resources, but where great store was set by ownership of the huge boulders that were scattered around the island. The largest item of expenditure that many islanders were likely to incur was the provision of a dowry to accompany their daughters when they were married. Apparently, the story goes, the father would formally declare that one or other large, immovable (and to all intents useless) rock now belonged to the bride'€™s father-in-law. Honour was satisfied and all parties were happy about the arrangement. Something has value if people accept it has value.

Bitcoin supporters point to the rapid growth in the overall number and size of daily transactions (the last estimate I had was $40m worth a day, but it may well be higher now), as well as the number of outlets accepting the currency, and that is fair enough. Virtual currencies in total, though, still account for a tiny fraction of all financial transactions. Once volumes grow to 1,000 times the present level, Bitcoin can start to be taken seriously in terms of acceptance and impact. That may well happen. The comparison is always drawn between virtual currencies and the internet, which has grown at exponential rates for 20 years or more. But it may take some time and we are not there yet.

Next week I'll look at the benefits of buying with bitcoins.