Are Digital Currencies payments-ready?

Not for routine, domestic consumer payments, but they could serve edge cases

Key insights in this post

• Digital Currencies (DCs) come in three flavors: Crypto, Stablecoins, and Central Bank Digital Currencies (CBDCs). The US does not yet have a CBDC

• While promoters claim DCs are payment methods, they are rarely used this way and are instead treated like asset classes, for investment & speculation

• DCs are debit payment methods whose costs should not be compared to Credit Cards which offer grace periods, rewards, and revolving credit

• As debit payment methods, they have similar characteristics to Instant Payments (FedNow & TCH RTP) which are themselves having trouble gaining traction relative to cards, ACH & Zelle despite a low cost of acceptance

• A key challenge is that DCs require the consumer to store value outside their core transaction account just to do payments. For Crypto, that value fluctuates

• DCs are unlikely to become mainstream domestic payment methods in any high-volume use case, but could serve edge cases leveraging their unique characteristics:

  • They are global without much of the cross-border friction in other methods

  • They are infinitely divisible, and therefore suitable for micropayments

  • The payments can be contingent on embedded logic (“Smart Contracts”)

• To get traction, DCs need to pioneer uses cases where these advantages are required. These will be small initially, but could grow quickly once they launch

Introduction

I admit to a luddite tendency, but I am not crypto phobic. I submitted a patent application for using a blockchain in Floor Plan Lending. I helped ideate the use of blockchains in several JPM use cases, including early thinking on their “Liink” offering. I also encouraged TCH to analyze blockchain technology for what became RTP – it wouldn’t have worked at the time, but was worth considering. On the other hand, I have never owned any crypto and probably never will.

In my early JPM days, entrepreneurs promoted crypto as a payment method. They made many of the same arguments you hear today for A2A payments, and they are back again promoting Stable Coins or CBDCs (Central Bank Digital Currencies). Note: I will use “Digital Currencies” (DCS) as an umbrella term for crypto, stablecoins & CBDCs.

Digital Currencies could work in some niche use cases, but not in routine, domestic consumer payments. B2B is even less likely. This post will discuss why.

How are digital currencies different from incumbent payment methods?

The Digital Currency argument, then and now, is about acceptance savings relative to incumbent payment methods — especially Credit Cards. You can count on the promoter to compare the cost of DCs to the cost of Credit at ~3%. But DCs are a debit method, so the cost savings argument is always overstated since regulated debit costs ~25¢ per transaction. DCs can be less expensive than Debit, but the gap is narrow — and ACH is even less expensive.

If Credit Cards was the comparison, the bulk of that 3% is returned to the consumer as rewards. DCs also lack credit and the grace period – which most cardholders value. Displacing Credit Cards may seem good to merchants, but it is a net loss to Credit-using consumers.

Most domestic consumer payments use cases for DCs are not practical:

• For C2B commerce, DCs lack consumer protection features compliant with Regs Z & E. If the consumer can’t do a legitimate chargeback or a return, it really doesn’t matter how inexpensive the original transaction fee is, because the regulatory fines would consume all the savings. If they add those protections, the cost-to-process DCs will go up, eroding any cost advantage

• For C2B bill pay, low-cost ACH is the competitor. Yes, ACH can bounce, creating exception costs, but even end-to-end, ACH is a hard cost-benefit to beat

• For P2P, Zelle is free to consumers and as Zelle scales, bank transaction costs are dropping. Further the funds end up in the consumer’s primary transaction account rather than an illiquid, stored-value method like DCs. It is hard to see how DCs muscle their way into P2P.

• In B2C (disbursements), the incumbents are ACH and Push-to-Card, which are both low cost and ubiquitous. The downside of these methods is onboarding a long, complicated account number, but Open Banking is making that much easier

The apples-to-apples comparison should not be cards at all but to Instant Payments (TCH RTP & FedNow). These methods are real-time, push-only, irrevocable, fully digital and authenticated – just like DCs. And like DCs, none of these methods offer credit. The network fee for an instant payment is 4-5¢ with bank fees on top of that. Even if digital currencies were completely free, aggregate savings are not material except at very high volumes.

If the above analysis sounds familiar, it should. I explained all this in the Instant Payments post a few weeks ago. Instant is only slowly displacing incumbent methods in any use case. Compared to Instant Payments, DCs have unique drawbacks that make them a harder sell.

Key disadvantages of Digital Currencies

Digital Currencies come in three broad flavors: Crypto, Stablecoins, and CBDCs. In the US, we don’t have CBDCs yet, but the Fed is exploring the topic. Other countries do have them.

All DCs capture value outside the consumer’s primary transaction account. That means fiat currency must be moved into a DC before an economic transaction can occur. The reverse movement must happen at the receive end, i.e., DC to DDA. Only then can it be used with more ubiquitous payment methods. If DCs ever became ubiquitous, this challenge might go away, but that day is well into the future.

You can see an equivalent phenomenon in Venmo. The consumer needs to fund their Venmo account to do P2P and then move any cash back to their DDA to use received funds for regular commerce. Pay with Venmo (PwV) can use a balance for Commerce, but take-up is modest and acceptance is spotty. When I was at JPM I found that Venmo users tended to repatriate funds once the balance exceeded $200. That doesn’t leave much balance for PwV transactions. DCs are no different today.

Crypto has a unique disadvantage since it behaves like FX. The exchange rate from dollars to crypto can change between the time the consumer clicks a buy button and the time a merchant wants to trade their crypto in for fiat dollars. Either the buyer or the seller takes a small loss or a gain on the transaction. Some Fintechs step in to internalize that FX risk, but the fees they charge make the transaction more expensive.

The final point is who guarantees the funds. In all three, transactions are real-time, so the DC itself moves for sure. But are the funds as safe as Fiat? For CBDCs, they are guaranteed by the Central Bank, just like analog dollars. Stablecoins should be backed by Fiat sitting at a trustee, but there have been historical scandals on this dimension.

In contrast, Crypto is only backed by consumer confidence that it is worth something. So far, that has been a good bet. Bitcoin is even structured so that devaluations can’t happen from juicing supply – something that does happen to Fiat. One reason Crypto never became a payment method was because its value kept going up. I recall examples from the early days where someone bought a pizza with Bitcoin that would have been worth $1M a couple of years later. No one wants to be that person.

So for typical domestic consumer use cases, DCs are less attractive than Instant Payments which are in turn less attractive that ACH & Cards. That means only niche consumer use cases are attractive – just like Instant. But DCs are superior to Instant for at some consumer use cases.

Use cases where DCs have advantages

DCs can has a few clear advantages over Instant that can be exploited to create business cases:

1. DCs are global

Virtually all DDA-based consumer payment methods have drawbacks for cross-border transactions:

• Wires are available for cross-border payments but they are slow, the FX rates are not usually competitive, and the fees are high

• Instant Payments are domestic today, although Central Banks are slowly trying to link systems into a global network; don’t hold your breath

• Cards are global, but expensive. The networks impose “inter-regional” fees that raise costs. The exception is push-to-card which serve disbursements (B2C)

• Fintech solutions are global and digital, but lack deep pockets to backstop their performance. They are faster and cheaper than wires, but not cheap overall. Some also have relatively modest limits that can exclude high-value payments

• ACH is only interoperable in a few cross-border corridors

In contrast, DCs can be used anywhere there is an internet. In cross-border, the FX problem for Crypto is less onerous as a currency conversion must occur anyway. Crypto always booms in markets undergoing a currency crisis because it makes money movement quick and semi-anonymous. In those crises, countries often impose capital controls but Crypto can move around them. The WSJ published articles about this if you want to do some reading. Even without a crisis, Crypto has competitive FX rates given its structure and its fees are low, if not zero. There is still the fluctuation in value to consider, but Stablecoins can address that.

I doubt CBDCs will find a consumer use case in cross-border, but they are ideal to move money between institutions. Central Bank currency reserves are an ideal application. Interbank settlement for FX is another. The advantage here is that CBDCs are backed by a central bank and have no settlement risk.

2. Micropayments

All conventional payment methods are too expensive for real micropayments. In contrast, Bitcoin can go as small as a “Satoshi” – one-hundred millionth of a full Bitcoin. Other crypto methods have similar concepts without the snappy name.

Micropayments are a long-standing challenge for incumbent payments. The cost to run a transaction over most payment networks is at least a few cents, so payment costs can overwhelm the value of what is being purchased. This is solved in closed-loops with a stored value method: The buyer deposits a lump sum with the seller which is gradually drawn down to funds transactions. The Starbucks wallet works this way, as does EZPass, and “gold” wallets on gaming sites. All those transactions are low-value but not really “micro”.

It contrast DCs could be anyone to anyone. Over the years I have heard of interesting theoretical use cases for this. Two examples come to mind:

• Killing spam email. The proposal here is to charge a very low fee – a fraction of a cent – to send an email. For a typical consumer or business, the cumulative cost of this is minimal. But Spammers count on very high volumes with very low response rates. The costs of sending all those unsuccessful emails could generate a negative ROI for the spammer relative to the few that convert. If those micropayments accrue to the receiver, consumers might even welcome spam as it earns them money!

• Funding AI services. I read about this recently. The theory is that AIs will eventually specialize in knowledge domains or services. They would rely on each other to solve complex problems. But how would the AIs be incented to work together? If each AI charges a micropayment to other AIs that use its services, a business case emerges. No human needs to get in the middle of this as the DC would simply flow between AIs as needed.

  The goal of each AI becomes creating more value-add than it consumes. If it provides more services to other AIs it will earn a surplus and if it doesn’t it will run a deficit. It all runs on auto-pilot. Higher value AIs can raise prices and lower-value AIs can reduce them to create more demand. It works just like the neoclassical model we all learned in Economics 101!

3. Escrow using “smart contracts”

“Smart contracts” are code embedded in a DC transaction to govern how the transaction executes. Think of an auction transaction: The buyer only wants to pay if the goods meet whatever terms were agreed to. It could be something like clear title on a car or condition on a trading card. The buyer’s funds are held until the transaction meets the condition and only then are those funds released to the seller.

We are all familiar with applications like this is the analog world, for instance Life Insurance: you generally have to show a death certificate before getting a payout. In the DC world, these kinds of if-then deals are embedded in code and linked directly to the payment transaction.

The problem of course is having an independent, honorable party to trigger contract execution. In blockchain-speak, these third-parties are know an “Oracles”. In the DMV & Death Certificate cases, the Oracle could be a government entity with digital access. But for trading cards, it would have to be a certified, independent appraiser who physically inspects the card. That analog solution slows everything down.

Today, even the DMV & Death Certificate cases are analog, despite the data being digitally available. You often must present physical copies of such documents to execute transactions. Think of the last time you bought or sold a car or a house. Things like Titles and Deeds are why we need in-person closings.

A DC-based solution using Smart Contracts and real-time integrations to digital Oracles would reduce time and cost for all parties. Of course, lawyers and title companies may not like that.

Overhead advantages of Digital Currencies

All these use cases work because DCs leverage the public internet and a distributed, consensus governance model. In other words, they are a network without network overheads. Think of the standard hub-and-spoke network diagram … without the hub! That allows DCs to be more agile and lower cost:

• They have no physical infrastructure because they rely on the public internet. This contrasts with any incumbent network with gigantic fail-safe data centers and telecom networks. That gives DCs a big cost advantage and, arguably, more resiliency

• Their rules are not established by a central body. Network rules generally change slowly because the network rightly wants their smallest members to keep pace. But DC rules can be embedded in smart contracts between any two or more parties. No central governance is required. All parties can innovate a solution on top of the public capability

Without a hub to fund, DCs don’t need switch fees. Think of our cross-border discussion above: One reason that DCs and Fintechs can underprice card networks is that the card networks impose “inter-regional” fees for cross-border transactions; roughly a third of network revenue is from these cross-border revenue streams. In DCs, such fees are not needed as there is no Network entity to fund – especially with public shareholders to satisfy.

Even incumbents networks demonstrate the advantage of this model -- contrast ACH with Credit Card Networks and Debit Card networks post-Durbin:

• ACH has two interoperable network utilities (TCH & Fed) that are governed by a thinly staffed third-party: NACHA. The two switches compete for volume, driving switch fees down. At volume, ACH can cost under a penny a transaction

• Credit card networks control all transactions carrying their brand even though all transactions use the same 8583 message format. The networks’ public ownership has led them to drive switch fees up (“assessments” in card-speak) rather than down, despite rising scale

• Debit Card networks compete for volume like ACH networks, driven by the Durbin Amendment. This drove debit switch fees down. For a one-sided view of how the card networks tried to preserve credit-card switching economics in debit cards, just read the DOJ lawsuit

At roughly the same time as Durbin, Visa & MasterCard launched their Push-to-Card running on debit rails; it is not a coincidence that this kind of innovation happened when routine switching became competitive.

So DCs are structurally lower cost and more agile than incumbents. But the same incentives push DCs the other way on compliance which is why KYC & AML remain challenges. Think of the currency crisis use case, where DCs circumvent capital controls. You can sympathize with the consumers while still recognizing they are breaking the law. Incumbent networks all blocked such traffic.

All the niche use cases I outline above leverage very low cost and greater agility. The challenge for high-volume use cases is that debit and ACH are low cost enough and innovation is constrained by regulation and inertia. To get traction, DCs need to pioneer uses cases where extreme low cost is required. They are particularly advantaged in Cross-border. Over time, these niches can grow to material volume, but that takes patience.