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What is the tipping point for Bitcoin adoption?

Bitcoin "coin" with other currency

I had the pleasure of participating in a debate on the merits of Bitcoin—the increasingly popular open-source, peer-to-peer, digital currency—on Russia Today’s Crosstalk last week. One of the guests on the show was dismissive of Bitcoin and basically called it a nerd’s fantasy that would never amount to anything. I understand why some people might think this. First, whether fair or not, Bitcoin has gotten a somewhat sullied reputation because of its use for illicit transactions, such as the online black market Silk Road. Second, the stability of Bitcoin has been called into question in recent months by the somewhat volatile exchange rates whose fluctuations have been driven by speculators. Third, previous efforts in this area—such as the start-ups DigiCash and e-gold—never amounted to anything. Finally, government regulators may try to shut it down—either directly or indirectly. Last month the U.S. Department of Treasury’s Financial Crimes Enforcement Network (FinCEN) issued new guidelines on virtual currencies which resulted in three U.S. exchanges for Bitcoin shutting down.

However, there are legitimate responses to each of these criticisms. Yes, Bitcoin is used for illegal transactions, but so are fiat currencies (and in much larger quantities) and this doesn’t prevent them from being used for legal transactions. And while it’s true that the price of Bitcoins has fluctuated quite a bit because of speculators, this happens to many other commodities where investors put their money. What about the failure of start-ups like DigiCash? First, many dot-com failures like have  since seen entrepreneurs develop successful reincarnations of an earlier business as the economics of e-commerce have changed in the past decade. Moreover, start-ups during the dot-com era are not comparable to Bitcoin because Bitcoin is not a company—it is just a non-proprietary protocol, much like TCP/IP. Finally, although U.S.-regulators have taken a hard line against Bitcoin, other countries may be more tolerant—the Financial Transactions and Reports Analysis Centre of Canada (FINTRAC) told Canadian Bitcoin exchanges that they are exempt from the country’s money-laundering laws.

While it is impossible to predict if Bitcoin itself will be around in 50 years much less 5 years or 5 months, it is reasonable to expect some type of digital currency—whether it is Bitcoin or something else—to eventually take off. Not all consumers are clamoring for the ability to conduct anonymous cash transactions online, but new electronic payment systems such as Square and Google Wallet have shown that innovation in this area is still rewarded. Moreover, many merchants will likely be willing to accept Bitcoin if it means they can reduce the amount of fees they pay now to payment processors.

With this in mind, it’s worth asking how well Bitcoin is doing today. First it’s clear that while Bitcoin may be a game changer someday, it certainly isn’t there yet (for a fun read, check out Kashmir Hill’s attempt to live on Bitcoin for a week). Right now Bitcoin is a drop in the bucket compared to larger payment systems. There are about 150 million transactions every day that use Visa’s electronic payment processing network; there are only around 50,000 per day on Bitcoin. There are 2 million ATMs worldwide that accept Visa; as of May 2, 2013, there was one Bitcoin ATM. Because of the system architecture, it’s difficult to estimate the number of Bitcoin users, but it is likely in the tens of thousands—significantly lower than the 110 million PayPal users or over a billion Visa cardholders worldwide. Similarly, we don’t know the number of merchants who accept Bitcoin, but it’s likely in the thousands, rather than the millions who accept credit cards (or cash).

Using other metrics, Bitcoin looks more impressive. As of this month, the total market capitalization of Bitcoins (the number of Bitcoins in circulation x the exchange rate) was approximately $1.4 billion USD. To put this in comparison, this is larger than the stock of broad money of 33 national currencies (behind Togo) and larger than the stock of narrow money of 53 national currencies (behind Macedonia). This puts Bitcoin ahead of currencies like the Belize dollar, the Malawian Kwacha, and the Maldivian rufiyaa. Of course, this ranking changes depending on the exchange rate. At its peak in April 2013, the total value of Bitcoins in circulation was around $2.6 billion. Still, this is a long way off from major currencies like the Chinese Renminbi ($15.5 trillion USD), Japanese Yen ($13.1 trillion USD) or U.S. dollar (13.0 trillion USD).

Bitcoin versus other currencies

All currencies must be both trustworthy and useful to succeed. Every day that goes by where Bitcoin doesn’t get hacked, the level of trust in the system will increase. So if the security works, then the major focus of Bitcoin proponents should be on growing the level of adoption and use of the digital currency. This will both enhance its overall utility to users and increase the stability of the currency. As with all currencies, Bitcoin benefits from the network effect—the value of using it grows as the number of users increases. If it continues to grow, eventually it should reach a tipping point where the value of using Bitcoin becomes so great that consumers and businesses are compelled to use it. This is true now of many of the most popular paper-based fiat currencies in use today. Unlike paper currencies, the switching costs for Bitcoin users is low so if a better alternative comes around, Bitcoin may become the next Friendster rather than the next Facebook.

In short, Bitcoin has reached an impressive size in terms of overall market value, but Bitcoin will not likely be supplanting other major international currencies or payment systems in the immediate future unless it grows significantly larger than it is today. It is still far from certain that Bitcoin will become the de facto digital currency, but it is highly probable that one will eventually emerge. Given this, policymakers must start coming to grips with the implications associated with a decentralized digital currency. In addition, countries may want to start thinking about whether they too can have more “innovation” in their currencies or whether this is something they will cede entirely to the private sector.

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