Monday, November 30, 2015

Bitcoin double “double trouble”

Two of the main hurdle for large scale Bitcoin adoption as an everyday payment method are :
  1. Any payment for a physical good at a brick and mortar shop require the equivalent of a double foreign exchange transaction by all the party involved.
  2. This type of payment are also exposed to double spending attack. Where the buyer fool the seller into thinking that the transaction occurred while it get invalidated at a later date but not before the buyer left with the goods.
These problems can potentially generate a significant overhead (as in fees) due to the risk associated with each operations. These uncertainties are major roadblocks on the democratisation of Bitcoin as an alternative currency for common transaction.

Double fee problem :

So what is the double fee issue ? It is the need for both party involved to convert the currency for paying / getting payed into another one due to the lack of widespread Bitcoin use coupled with the need to pay or get payed in the official currency of the country of residence. To put it simply it is as if Alice is selling the good while living in US (dollar), but is getting paid for them in Euro, by Bob from in China (yuan).
They will be exposed to this problem unless the consumer and the end-to-end product value chain ( supply and demand chain) relies only on Bitcoin currency for all their monetary transaction. By only relying on Bitcoin, I also implies that tax, salaries etc.. are in paid Bitcoins. In extenso, this implies a blanket replacement of the “traditional” currency for any operations associated with the sell/buy. Without these conditions fulfilled, all the parties involved expose themselves to double fee problem.
I will now explore some of the sub problem associated with the double “FX” fee problem : price conversion tracking and long term fluctuation risk. 

Price Conversion tracking:

Alice buys her goods in dollars, and sell in Dollars or Bitcoins. To avoid losing on the conversion due to the fluctuating Bitcoin exchange rate, Alice needs to update daily (at least) the goods price. While, this is not a major hurdle for online shops, it is quite a tedious process for brick and mortars one. Obviously, this could be done at the till on the spot however this implies that there would be no possibility to dual pricing sticker with the items.

Long term fluctuation risk :

After Bob pays Alice in Bitcoin, Alice will not convert the payment immediately in order to avoid paying a large amount of exchange Fees for each transaction. Ideally, Alice want to batch the conversion of her Bitcoins in order to reduce the transaction overhead. However, the lengthier the retention, the higher the risk of loss due to drop in Bitcoin price. Naturally if the price goes up Alice would have made a profit on the exchange rate, but this is equivalent to trading of the foreign exchange rate. This can be perceived as a significant risk by merchants, banks, accountant. Moreover, it is not really clear how this needs to be treated under accounting rules and how tax needs to be paid. 
One can advocate that Alice does not have to convert her Bitcoin and keep using them within a self contains market ecosystem. However, this is rather impractical or near impossible to achieve as Alice still needs to pay tax and salaries in the local currency. It is only possible if the Bitcoin’s transaction are marginal compared to the overall amount of transactions the business does.
On Bob’s side, the risk is more limited as it is almost the same as the one of a Tourist buying currency in advance of its trip. 

Next we will be looking at another consequence of the use of Bitcoin in everyday transaction : fraud by double spending attack.

Transaction delay and double spending :

The average confirmation time of a Bitcoin transaction is ~7 minutes. As a result, it is clear that brick and mortar vendors, such as vending machines and take-away stores, cannot rely on transaction confirmation when accepting Bitcoin payments. We cannot really see the cashier asking the client to wait 7 mns to get the transaction acknowledgement. It is even worse for fee less transaction. You would be lucky to get it done within 24h and it can take much longer. To address that, Bitcoin encourages vendors to accept fast Bitcoin payments with zero confirmations as soon as the vendor receives a transaction from the network transferring the correct amount of BTCs to one of its addresses.
However, this opens up the whole process to potential fraud via double spending techniques. In our case Bob needs to trick Alice into accepting a Bitcoin transaction that Alice will not be able to redeem subsequently. Basically Bob issue a transaction toward on of its own addresses for the same Bitcoin used for the payments of Alice goods. If both transactions are sent at the same time, and Bob’s transaction is acknowledge before Alice one (can use a higher fee, or other tricks), Alice transaction will be cancelled. By this time of course, in a fast transaction, Alice has already released the goods.

This beg the question, how Bitcoin debit card provider handle this issue? And what insurance and accounting solution they have in place to prevent abuse and protect from malicious operations. This is a huge risk as well as trial by fire for these companies. They not only risk the future of their company but also the trust in Bitcoin as a trade currency. Maybe Insurance companies might be able to offer a partial solution here as it might not be 100% possible to cull such attacks. However, this would make Bitcoin impractical for small due to excessive fees associated with insurance premium.

To conclude Bitcoin has a really bright future as the overlay virtual currency on top of the blockchain technology. However, its potential reach within the everyday financial transactions system might be greatly overestimated. There is a lot of complex problem to be solved in order to establish trust as well as cost efficient system for brick and mortar shops. And like anything happening in the real world, the spread of new technology is often slow, just look how long it took to get NFC payment out. And don't get me started on the chip and pin system which is not even widely used in USA yet.