In 1999, professor Milton Friedman, a Nobel-Prize winner in economics stated:
“I think the internet is going to be one of the major forces… The one thing that’s missing but that will soon be developed is a reliable e-cash.”
E-cash, or digital currency, was first introduced in 2008 when Satoshi Nakamoto published a white-paper called “Bitcoin: A Peer-to-Peer Electronic Cash System”. Satoshi Nakamoto describes the cost-saving benefit of digital currency as it allows funds to be transferred from account to account digitally, without needing to pass through a central institution (bank), which significantly reduces transaction costs. In 2010 on May 22nd, the first real world (albeit expensive) transaction was made with Bitcoin. A Bitcoin programmer traded 10.000 bitcoin with another programmer for two large pizzas; a transaction worth $20 million today. Back then, Bitcoin wasn’t widely used or recognized, which meant it had little to no real world value. Fast forward to today, and there are over 700 different digital currencies, each promising a different feature (programmed transactions, anonymous transactions, faster transactions). The entire market value of all digital currencies surged in value recently, growing from about USD 17 billion to more than USD 75 billion since the start of 2017. The recent surge in value has on the one hand raised concerns regarding a valuation bubble, and on the other hand it has piqued the interest of individuals and businesses looking to understand the benefits that digital currency promises. Although digital currency can be used for a number of activities, the most fundamental use that digital currency has is low-cost transactions, which is why digital currency has the potential to shake up the payment industry. The Financial Times image below shows how a digital currency transaction works.
The technology behind digital currency
One of the core reasons that digital currency is regarded as revolutionary is because it’s based on blockchain, which provides security and transparency to the network. A blockchain is a publicly available database of transactions. Some refer to blockchain as “the spreadsheet in the sky”. Transactions are verified and bundled together into a block, which is subsequently added to the blockchain after following a specific protocol. Once a transaction is added to the blockchain, it’s permanently saved, creating a transparent financial system. The miners, or computer programs that run all day to verify these transactions are rewarded in digital currency (transaction fee) for verifying and adding transactions to the blockchain. The mining environment is highly competitive, requiring significant investments in computer hardware. The competitiveness of the mining industry incentivizes miners to work quickly to verify transactions, which benefits digital currency users. Due to the strict protocol that miners follow, double-spending coins and fraud is nearly impossible. A study done by WiseGuyReports suggests the market for blockchain technology will grow at a compound annual growth rate (CAGR) of 55.9% until 2021. A different report by MarketReports suggests the blockchain technology market will grow at a CAGR of 61.5% until 2021. The image below shows what the Bitcoin blockchain looks like (each block is a bundle of transactions).
International peer-to-peer transactions
According to a McKinsey report, USD 156 trillion is transferred per year in cross-border payments, earning banks USD 190 billion in revenue from transaction fees. Among cross-border payments, the effiency of remittance payments is highly significant for developing countries. A remittance payment is when an individual is working abroad and sends money home to family or friends. According to the World Bank, last year, international migrants sent USD 441 billion to developing countries, which is three times as much as these countries receive in development aid. Individuals in developing countries are at a disadvantage, as intermediary institutions charge significant fees to transfer money internationally. The market leaders facilitating remittance payments are Western Union and Moneygram. According to the World Bank, the global average transaction fee for transferring money across borders is 7.45% of the total amount, which means that last year about USD 33 billion didn’t reach developing countries due to intermediary institutions such as Western Union and Moneygram. Digital currency knows no borders, meaning it can reduce transaction fees to a minor fraction of what they currently are, as transactions can circumvent the numerous intermediary institutions that currently facilitate international transactions. Due to the large sums of money that developing countries aren’t receiving due to intermediary payment-institutions, developing countries have a greater incentive to start regulating the use of popular digital currencies for remittance payments. For this reason, the Philippines recently started regulating the use of Bitcoin. The table below shows the differences in costs between traditional methods and digital currency when sending $50 as a remittance payment. The figures are from the World Bank. [Bitcoin, Ethereum, and Litecoin are digital currencies].
Just as remittance payments can be costly for the individuals sending money, online payments can be costly for the merchants receiving the money. Users selling goods through online marketplaces such as Alibaba, Amazon, and eBay heavily rely on Paypal for international transactions. Paypal has no transaction fee for the party making the purchase, however, on international payments outside of the US, it charges 4.4% of the total amount, plus a fixed currency exchange fee to the merchant. For a purchase of $200 sellers pay about $9 in transaction fees to Paypal, which is quite high when compared to the low transaction fees of digital currency ($0.02-0.8 per transaction). In online marketplaces it’s unlikely that intermediary institutions will be removed, due to their role in conflict resolution, but it’s likely that intermediary institutions will soon allow for payment to go via digital currency. For organizations that mainly receive funds such as charities, it’s likely that they will add digital currency payment options, decreasing international transaction fees, allowing for more money to make its way to the charity or non-profit organization. Being the most dominant digital currency, Bitcoin is leading the way in adoption. Globally, over 100,000 retailers now accept Bitcoin, including Microsoft, Dell, Expedia, Home Depot, and CVS. It’s also the first digital currency to be officially accepted/regulated by major governments (Japan, the Philippines, and Australia). Besides Bitcoin, the second largest digital currency, Ethereum, is also making waves in the corporate world due its smart-contract features. Ethereum allows for smart-contracts, which are programmed transactions, meaning that if certain pre-determined conditions are met (e.g. goods arriving at a certain GPS location) a payment is automatically sent from one party to the other. This has the potential to shake up a number of industries due to the administration cost savings that programmed transactions can bring. The Enterprise Ethereum Alliance has recently been formed to standardize smart contracts so that they can be incorporated into business processes. The Enterprise Ethereum Alliance has 100+ members including Microsoft, Intel, Deloitte, J.P. Morgan, Accenture, Credit Suisse, UBS, Toyota and a number of other Fortune 500 corporates and tech companies. The image below shows how a smart-contract, based on digital currency Ethereum, works to cut down on administration costs by automating payments based on predetermined conditions.
Although there are significant cost-benefits, digital currency adoption will likely move slow, as governments want to understand the risks that blockchain technology and digital currency bring. Authorities will watch digital currency developments closely in Japan and Australia to set up their own blueprint for dealing with issues such as privacy and taxing digital currency. Following regulation, the use of digital currency will likely be driven by individuals making international peer-to-peer payments, as well as by businesses looking to streamline payments through process-automation and by paying lower transaction fees. Milton Friedman was right about an e-cash being developed, time will tell as to how long it will take for it to be globally adopted.
Written by YAG Alumnus Shaffy Roell