Launched in 2009 and growing in popularity, Bitcoin is an unbacked digital currency.

Unlike traditional electronic payments, which require a bank or clearinghouse to process transactions, Bitcoin relies on a distributed network of users known as “miners.” When a transaction is made, miners compete to solve a complicated cryptography problem that ensures the transfer of funds is legitimate. The first miner to confirm a new block of transactions is awarded Bitcoin by the system. (These users are known as miners because, in processing transactions, they generate new coins in much the same way as actual miners dig up new reserves in a commodity money regime.)

The long-run success of Bitcoin will depend on whether anyone wants to use it. And the decision to use Bitcoin is, at least to some extent, a decision to switch from the local currencies we are already using. In other words, Bitcoin is battling entrenched incumbents.

Switching from an entrenched incumbent is costly since most merchants and consumers are not set up to accept and make payments in Bitcoin. Bitcoin need not only be better than local currencies to achieve widespread adoption, it must be sufficiently better to warrant the costs of switching.

Fortunately for fans of Bitcoin, the switching costs appear to be low. Xapo, a Bitcoin payment service provider, recently announced that it would introduce a debit card for its e-wallet users. The debit card costs the user a one-time fee of $15. As with other debit cards, merchants are charged fees per transaction. Since the debit card makes use of traditional terminals, there is no need for merchants to purchase new point-of-sale infrastructure to accept Bitcoin.

Similarly, although most consumers are not carrying around a balance of Bitcoin at present, many already have the technology to do so. By downloading an app, one can transform an existing smart phone into a Bitcoin payment device.  

Insofar as Bitcoin makes use of the existing technology already in place, switching costs are quite low. The bigger problem is what economists call network effects. A network effect results when the value of a product or service depends on the number of others using it. A telephone would not be of much use if you were the only person to have one. Similarly, no one wants to be the only person in their trading network using Bitcoin. With relatively few people using it at the moment, the incentive for others to switch to Bitcoin remains small.

Payment-service providers in the Bitcoin network, like Coinbase, BitPay, and Xapo, are working hard to erode the network-effects problem. In particular, they enable retailers to accept Bitcoin without having to receive Bitcoin. When consumers pay with Bitcoin, the payment service provider accepts Bitcoin on behalf of the seller and transfers local currency to the seller at the current market exchange rate. Since prices are posted in the local currency—or Bitcoin at the current exchange rate—sellers need not have any specific knowledge about Bitcoin or its value and are not subject to exchange risk. By facilitating transactions in this manner, payment-service providers effectively increase the size of the Bitcoin network and make it more attractive for others to use.

Given the challenges, one might wonder why some merchants like go through the trouble of accepting Bitcoin. Simply put: it is cheaper. Coinbase charges merchants a 1 percent transaction fee to process payments in Bitcoin. Compared with traditional merchant accounts, which charge 2 to 6 percent, this seems like a deal. Indeed, for low-margin businesses like, a few percentage points might mean the difference between success and failure.

Will Bitcoin survive? It is probably still too early to tell.

If the distributed-payment processing technology is sufficiently cheaper than the traditional clearinghouse model (and it seems to be), we should expect firms to adapt and adopt.

Bitcoin advocates will note that, as the world’s original cryptocurrency, it has a first-mover advantage. Bitcoin skeptics will point out that large financial firms like Visa and Mastercard could just as easily adopt the technology while allowing retail users to continue making and receiving payments with their preferred local currencies. In either case, a future with lower transaction fees seems probable. That, in and of itself, means we will probably be talking about Bitcoin for some time to come.

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