Monday, September 15, 2014

The math behind why Bitcoin fees are understated

Quite often the biggest reason given that Bitcoin will be adopted by the masses is that it has very low transaction costs. This is simply untrue for most transactions that occur in everyday life. The reality right now is that the transaction costs of Bitcoin are commonly understated. Although there may be plenty of other reasons to use Bitcoin, low transactions costs isn't one of them. This may explain why you haven't cut up and thrown away your credit cards already.

Currently, the Bitcoin transaction mining fees can be anywhere from 5 to 15 cents regardless of the dollar value of the transaction. So it's is just as expensive to transfer $2 or $20 million. These are the only costs that are commonly referenced when claims are made that Bitcoin is cheap. Unfortunately, an implicit assumption made is that you are paid by your employer in Bitcoins, and whoever you pay for any products and services in Bitcoin will keep their money in Bitcoin.

Let's look at why Bitcoin isn't cheap by looking at the steps needed to buy a cup of coffee at a coffee shop using Bitcoin -

  1. Customer transfers dollars to a Bitcoin Exchange or broker to convert Bitcoin to dollars
  2. Customer buys Bitcoin at the exchange
  3. Customer transfers Bitcoin to his/her smartphone wallet at least once
  4. Customer purchases a coffee with Bitcoin from merchant
  5. Bitcoin is converted immediately to dollars by the merchant (to avoid currency fluctuations) 
  6. Coffee is delivered to customer
Now let us first look at all the fees related to this transaction -
  1. Wire-transfer or ACH fee to a Bitcoin Exchange for transferring dollars
  2. Bid-Ask spread costs when converting dollars to Bitcoin
  3. Exchange Fees incurred by the customer for buying Bitcoin
  4. Mining Fee for transferring the Bitcoin to the merchant
  5. Bid-Ask spread costs when the coffee shop converts Bitcoin to dollars
  6. Exchange Fees incurred by coffee shop for selling Bitcoin
  7. Any additional Wire-transfer/ACH fees to transfer dollars to the coffee shop's bank account.
This problem is further complicated by additional international wire transfer fees (which can be around $50 per transaction) if you don't have a lot of money in your bank to negotiate lower fees. The biggest Bitcoin Exchanges are abroad and that's where you can typically get the cheapest rates (i.e. smallest Bid-Ask spread and lowest Exchange Fees). 

Let's do a sample transaction using optimistic real world numbers and an American Bitcoin marketmaker, I am going to use because they are the largest Bitcoin seller in the US and because I can ignore wire transfer costs since they are an American company. Let's see how much money is paid in fees if I start off with $100 .

As of this writing, sells 1 Bitcoin (BTC) for $626.41 and buys for $612.60.  That means the Bid-Ask spread equals $626.41 less $612.60, or $13.81.  The buyer pays $6.905 in Bid-Ask spread/Exchange Fees and thus pays a total amount of $626.41 and receives 1 BTC and the seller pays $6.905 in Bid-Ask spread/Exchange Fees and receives $612.60 for selling 1 BTC. [Note: rolls in Exchange Fees with the Bid-Ask spread.]

Converting the Bid-Ask spread/Exchange Fees of $13.81 to a percentage would give us a Bid-Ask spread/Exchange Fee rate of about 2.2%. So if I purchase Bitcoin with $100, after the Bid-Ask spread/ Exchange Fees, we are left with $97.80. There should be, at a minimum one mining fee, so let's subtract $0.10, which takes our money down to $97.70. This means that combined the customer and the coffee shop pay about 2.3% in fees for this transaction.

Now 2.3% isn't terribly expensive, but it isn't "cheap" either. If you are doing transactions that are of a much smaller value, the mining fee has a greater impact thereby raising this number significantly. The number is approximately in line with what most credit cards charge. Although by using a credit card, the buyer gets insurance that any lost or stolen charges aren't the buyers responsibility. Most importantly, the seller is the one incurring all the credit card fees! It's not rational for the buyer to incur Bid-Ask spread and mining charges if instead the buyer can make the seller incur these charges by using a credit card.

I completely acknowledge that the math can change drastically in unusual circumstances. For example, if you are visiting a foreign country, you will need to pay foreign exchange fees to make purchases with a credit card or cash. In such cases, Bitcoin suddenly becomes the cheapest option to do business. 

Although, for most of the transactions done in a day, 2.3% in fees is not cheap. As a result, for Bitcoin to gain widespread adoption, the retailers will need to offer a discount for customers paying with Bitcoin, similar to how some retailers now offer a cash discount. This is currently not a common practice and it will probably take time for retailers to realize the other benefits of Bitcoin which warrant such a discount. Until such time, these fees may keep Bitcoin from gaining widespread traction at most retailers, and will continue exist as a currency of choice for its anonymous quality and other benefits.

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