This paper provides a pragmatic assessment of the future of crypto. As used here, crypto refers to public blockchains that rely on a cryptocurrency and the applications that use these blockchains to provide services to end users. Ether is an example of a public blockchain; it uses the ether cryptocurrency, and it supports applications such as Aave for lending and borrowing. Some blockchains, such as Onyx, which is owned by JPMorgan Chase, are private in that they are closed except to those who have permission to use them. Private blockchains are one of the potential competitors to public ones.
The paper considers the timeframe over which disruptive innovation could take place and substantial uncertainties about outcomes could be resolved. That is important for decision-makers — including businesses and regulators — who must decide how quickly to react to possible threats and opportunities posed by crypto.
The analysis is informed by the economics and experience of payment methods which is where we begin. Payments are one of the major applications for public blockchains and one that is necessary for supporting many proposed applications. The conclusions apply more broadly to other financial and transactional services.
Change Takes Place Slowly in Payments and It Is Tough For New Solutions to Get Critical Mass
Payment methods are two-sided. Senders and receivers of funds use the platforms to transact. There are strong indirect network effects. Senders value platforms that enable them to reach more receivers, and receivers value platforms that enable them to reach more senders. Inertia makes it hard to get participants, who use one method, to use another. People and businesses are accustomed to a method and collectively need a reason to change. They have made sunk cost investments in assets, such as software, and the time they have spent learning a method. They would have to incur those costs again. That makes indirect network effects sticky for incumbent methods and hard to overcome for new ones. These features help explain why changes takes place slowly in payments and why entirely new methods, such as public blockchains, have trouble securing widespread adoption.
Change Takes Place Very Slowly in Payments
Change does not literally occur at a glacial pace for payments, but from the perspective of the human lifespan it can seem that way. New high-level payment methods displace old ones very slowly, so much so that old payment methods remain in use for hundreds of years. Physical money started displacing barter about three millennia ago; paper checks did the same for physical money about 800 years ago, and digital methods started pushing both aside about 150 years ago. Within these high-level methods, new variants displace older ones but also slowly and often incompletely. Money went from coins to paper, but there are still coins.
The digital revolution has not upended these historical trends even though it has increased the pace quite a bit. Consider everyday transactions between consumers and merchants. General-purpose payment cards came into use in the early 1950s. By the early 1970s, private computer networks processed credit and debit transactions for consumers and merchants. The speed of these networks has increased dramatically over time to the point where a transaction takes place in a few seconds when a consumer waves a contactless card at a terminal or presses buy on an app or a website.
Yet cash persists in highly developed countries with all the necessary infrastructure for electronic payments. The European Central Bank did a survey of consumer payments covering 19 EU countries (accounting for 85% of EU GDP) in late 2019 and early 2020. It found that 73% of all transactions at the point of sale or between people were made with cash, which accounted for 48% of the value of these transactions. The percent of payments made with cash, cards, or eMoney in the EU-5 (France, Germany, Italy, Spain, Netherlands) declined from 57% in 2014 to 44% in 2020 based on the ECB’s Payments and Settlements Systems Statistics. Cash use is much lower in the U.S. but still significant. A 2020 Federal Reserve Survey found that cash accounted for 19% of consumer transactions and 6% of the value of these transactions. Cash has, as oft-noted, largely disappeared in Sweden but most countries have a long way to go for that to happen.
New Payment Methods Struggle to Gain Adoption
Given that even fundamental innovations in payment methods erode incumbent methods slowly, it should come as no surprise that lesser innovations struggle to gain traction at all. They must overcome a high degree of inertia for existing methods to get the critical mass necessary for survival much less growth. That has happened when there is a powerful reason for people to try something new. M-PESA, the mobile money scheme in Kenya, grew very rapidly. It served at least initially as a complement to cash: people could use cash to buy mobile money at physical (cash-in/cash-out) locations and send it to people who could redeem mobile money for cash at those locations. It mainly displaced physical methods for transporting cash with digital ones and took off during a period when civil war made transport unsafe and risky.
Apple Pay shows the challenge. Launched in 2014, Apple Pay made it very convenient for a consumer to register their card on their iPhone and then simply wave the phone at a contactless terminal to pay. It is very slick. Nevertheless, roughly 95% of iPhone users, who have Apple Pay installed, and are paying at a terminal where they could use it, do not. That has been the case, approximately, every year from 2014-2021. Other mobile payment solutions have been even less successful in the U.S. Even when people do use their mobile phones to pay, they are generally using a debit or credit card as the source of funds.
These methods are not being held back by sunk cost investments by consumers or merchants. People already have iPhones and merchants already have contactless terminals. The problem appears to be that it is easy for consumers to just wave or dip a card at a terminal, just like they have always done, and they do not see any reason to depart from that ingrained and efficient behavior. New payment methods that require senders and receivers of funds to make new investments of time or money face far greater obstacles.
These points concerning the inertia of payment systems apply to financial services more generally. Banks, businesses, and consumers have all made investments. They have embedded costs and learnings which make rapid change difficult for any of them. Getting all parties to move to new solutions is a challenge. This inertia certainly does not preclude innovative solutions from getting widespread adoption. But doing so is difficult and takes time in the best of circumstances.
Like Any New Technologies Crypto Has Flaws, But Has Less Flexibility for Fixing Fundamental Problems
It should come as no surprise then that crypto has gotten little traction as a general-purpose payment method thirteen years after its launch and after various well-publicized claims that it was about to go mainstream. It took five years before a major retailer, overstock.com which was led by a bitcoin evangelist, to accept bitcoin; three years later bitcoin accounted for 0.2% of payment volume there. Today, it is not possible to pay directly with crypto at most online sites or physical locations.
Following the run-up in crypto asset values, wealth accumulation and massive publicity, including by celebrities, more businesses have announced they would accept crypto. Some digital wallets, such as PayPal, support crypto, but it appears that this mainly provides a convenient way for buying and selling the asset for investment and speculation. El Salvador, population 6.5 million, made bitcoin legal tender alongside the U.S. dollar. Most people in that country do not want to hold, or use bitcoin, and now incur substantial transaction fees converting bitcoins to dollars.
Given the glacial change in payment methods, 13 years is a blink of an eye. There is no reason to discount crypto’s future, as a payment method, based on its limited success so far. Debit cards were available in the U.S., for example, by the early 1970s, but had scant adoption until the mid-1990s.
In their current form, though, the leading public blockchains have fundamental problems — they cannot be currencies because they do not have any mechanisms to make them stable, and they cannot be general-purpose payment systems because they cannot process large numbers of transactions efficiently. These are not the best of circumstances. The question is whether one or more could solve the instability and scalability problems, and gain enough traction, before they are crowded out by other sticky efficient alternatives.
The following discussion focuses on Bitcoin but applies more broadly.
Bitcoin Has No Mechanism to Ensure Price Stability Which Is a Necessary Condition for Being a Currency
A putative currency must be reasonably stable. If it is subject to rapid depreciation people do not want to receive it for payments, and if subject to rapid appreciation people do not want to spend it and thereby lose their gain. Bitcoin does not have any mechanism for ensuring a stable currency. It has a hardwired, algorithmically driven, supply curve that reaches an asymptote of 21 million bitcoins. It cannot adjust supply to ensure either that the…
Read More: A Pragmatic Guide to the Future of Crypto