Is there a future for in-store cryptocurrency payments?
Blockchain and other distributed ledger technologies (DLTs) are rapidly changing the landscape of many industries, as evidenced by the surge of interest seen in 2017 that continues to skyrocket. In the financial industry, banks are taking notice - what will these new technologies mean for the future of their business? Do they need to adapt to this evolving sector, and if so, how?
In this blog post we will consider a relatively established idea around distributed ledger technology: using cryptocurrencies for in-store payments. Having shown much promise in the past; the time has come to assess whether any of the expectations for crypto payments have materialized, and whether in-store cryptocurrency payments have a future. These are questions we strive to answer in this blog post. We will start with an introduction to cryptocurrencies, and show how they compare to more traditional means of payment. This will then lead to an outlook of the future of in-store cryptocurrency payments.
Basics of cryptocurrencies
Bitcoin (BTC) is by far the most widely recognized cryptocurrency, having a market cap of more than 185 billion US dollars at time of writing; however, there are well-established and also recently introduced cryptocurrencies that are proving to be worthy contenders. As of January 2018, over 1400 cryptocurrencies have been created. Some of these are based upon blockchain technology, but there are hundreds of others whose core foundation relies upon different Distributed Ledger Technologies (DLTs).
Figure 1. Popularity of search term “bitcoin” versus “credit card” on Google. Via trends.google.com.
So what is distributed ledger? Simply put, it is a consensus of replicated, shared, and synchronized data, such as transactions. As opposed to a centralized database of information, it relies upon a decentralized network of users with no central authority. With no single entity of control, it has no single point of failure. In the case of the Bitcoin blockchain, transactions are public and easily verifiable as part of a shared database which is continuously reconciled every ten minutes in intervals referred to as ‘blocks’. Blockchain technology has seen a rising interest in the past few years, as compared to the steadily declining interest in traditional database technology, as illustrated in figure 1.
There are four key concepts that are crucial to the understanding of cryptocurrencies:
- Distributed ledgers are the decentralized, shared databases that hold all transactions and/or value of cryptocurrencies. Typically, a transaction consists of moving value between two or more addresses. As opposed to a centralized database of information, it relies upon a decentralized network of users with no central authority. With no single entity of control, it has no single point of failure. In the case of the Bitcoin blockchain, transactions are public and easily verifiable as part of a shared database which is continuously reconciled every ten minutes in intervals referred to as ‘blocks’.
- Miners are the people or companies that confirm transactions in the blockchain, and thereby secure it. For most cryptocurrencies, this is done by calculating the answer to a mathematically difficult problem, thereby reducing the likelihood of attackers re-calculating the existing transactions and changing the blockchain in their favor. For every transactions that miners manage to confirm, they receive a small fee, incentivizing them to spend resources on their mining operations.
- Wallets provide a means for storage of cryptocurrencies by handling cryptographic key management. A private key is stored that can be used by the owner or a trustee to ‘unlock’ the value of the specific cryptocurrency that is stored on the distributed ledger. There are two types of wallets:
- Software wallets are applications on desktop, mobile, or online that store the private keys. These are very widely used because of their wide availability and ease of use, but are regarded to be less secure than hardware wallets. Software wallet security depends on the developer having taken proper security measures. Both desktop and mobile wallets have been targeted by malware that tries to steal private keys. Online wallets can pose an even higher risk, as the user must trust a third party to properly store the private keys. Mainly because the cryptocurrency market is still in its infancy and is largely unregulated, incompetence and malevolence have resulted in lost and stolen coins from software wallets.
- Hardware wallets are physical devices with a secure element that stores the private key. An authorization mechanism such as a pin code is used so that if the hardware is lost or stolen, the private key and therefore the balance, is safe. Restoration of access can be obtained on a new device by using a passphrase.
- Exchanges are used for buying, selling and trading cryptocurrencies for other cryptocurrencies and/or fiat money, enabling liquidity as well as a means for evaluating their worth. Typically, transactions between currencies that are traded on exchanges are not recorded on the respective distributed ledger. An exchange typically pools together the balance of its users in a single or a few wallets.
Comparison to Conventional Payments
So how do payments with cryptocurrencies work? Asymmetric cryptography keys are the basic protocol for making or receiving a crypto payment. Each user has a public and a private key: the public key is shared in order to receive payment, and the private key is used to prove ownership of the account. The protection of the user’s balance, which is stored on the distributed ledger, is contingent upon them properly safeguarding their private key.
To put crypto payments in the context of current payment methods, we will compare them visually. One of the simplest cases is the 3-corner model that is employed by some credit card schemes (figure 2a). Both the merchant and its customer have accounts with the scheme. After a card payment is done, an authorization is sent to the scheme and a confirmation is sent back. The funds are transferred to the merchants account, and the customer will be billed to his account, all within the control of the scheme.
Figure 2. Schematic representation of the three-corner model employed by payment schemes.
Conceptually, a crypto payment is similar to this model, with the distributed ledger taking the role of the scheme (figure 2b). However, the direction of the transaction flow is very different: the authorization is sent to the ledger directly by the customer, instead of via the merchant. Next, the funds are moved from the customer's address on the ledger to the merchant's address, after which the merchant receives a confirmation and goods can be exchanged. Here we touch upon a crucial difference between the card payment and this particularly 'pure' crypto payment: trust. There is no central authority that can immediately send a confirmation after receiving an authorization from a trusted card. The funds have to be transferred before the merchant can receive a confirmation and transfer the goods, making the performance of the ledger absolutely critical.
An alternative to the three-corner model is shown in figure 1c, where the merchant outsources the management of its crypto key(s) to an acquirer. This would provide possibilities for the confirmation to be sent before the transfer of funds is completed, although in that case the acquirer would need to manage the risk of unsuccessful transactions.
Most current card payments actually follow the 4-corner model (figure 3a). This model also has an equivalent in the crypto space, in the case where both the merchant and customer delegate the management of their keys to their respective banks (figure 3b). The problem remains that, unless there is a separate authorization system in place, a confirmation can only be sent to the merchant when the funds have moved on the ledger. A more feasible solution in the short term is actually one based on the existing 4-corner model, where only the exchange of funds between the issuer and acquirer is changed to a distributed ledger-based system. This way the current payment method does not change for the merchant and customer, and the banks can possibly benefit from a more efficient way of transferring funds using a distributed ledger system.
Figure 3. Schematic representation of most the four-corner model, which is most commonly used.
Alternatively, there are numerous options for loading cryptocurrency balances onto physical payment cards in the national currency of choice. The funds are added at the spot market price and do not fluctuate with the value of the coin. These cards function as conventional prepaid debit cards and as such are subject to the same regulations.
How does acceptance of cryptocurrency in-store work?
Bitcoin is the still most widely accepted form of crypto payment, however numerous platforms exist that enable the exchange of upwards of a hundred different types of cryptocurrencies. As the popularity of altcoins rises, so do the number of companies providing a means for exchanging them.
With thousands of altcoins in existence, using cryptocurrency to purchase goods or services in a brick and mortar store is not quite as straightforward as with more traditional means of payment. Only a handful of them are accepted by retailers as a form of payment.
The most common in-store transaction method involves the customer scanning a QR code displayed on the merchant’s POS device. The customer uses the QR reader in their mobile crypto-wallet of choice to scan a unique one-time code on the POS terminals screen that is embedded with the merchant’s public key. The payment amount can also be included in the QR code or the customer can manually enter it in the wallet, depending on the situation and merchant preference. Once the scan is complete, the address field for the merchant’s public key (and the amount if it is included in the QR code) will be populated. The customer then hits send to create the payment and broadcast it via the mobile wallet. The process for online payments works similarly; the consumer can simply scan an on-screen QR code to send funds for a purchase.
The payments sector is made up of companies that provide services for enabling crypto payments. These companies offer a range of services such as plugins for ecommerce, Point of Sale (POS) apps for merchant devices, currency conversions for bank deposits, direct deposit to banks, two-factor authentication, prepaid debit cards, etc.
Alternatively, NFC capable POS terminals are also being produced that can accept payments via mobile devices. For each of the methods described, if the payment provider allows for it, the merchant has the option of instantly converting the payment into national currency to reduce exposure to market volatility, or of adding it to their cryptocurrency balance. A confirmation of payment is then issued instantaneously. As opposed to traditional card payment acceptance, there is no requirement to comply with PCI standards using these methods.
Advantages versus Disadvantages
Having explored the basic concept and the current state of affairs of cryptocurrency payments, we can now come back to our initial question, and explore whether or not there is a future for in-store cryptocurrency payments. The answer to this question strongly depends on the payment model that is considered. When both the merchant’s and customer’s wallet are managed by their respective banks; a cryptocurrency payment is not that different to a traditional card payment (figure 3). When widespread adoption of a blockchain tech is achieved by banks; a transaction like this could possibly be performed at lower cost, especially in case of cross-border payments. A very strong advantage could be that settlement can be performed instantaneously, depending on the specific blockchain implementation.
There are arguments to be made to have the merchant and customer manage their own keys (figure 2b). This way there is no reliance on third parties for processing and settling the payment, and the payment can be performed at an even lower cost. Currently this is a difficult proposition however, as arguable the only possible candidate, bitcoin, has issues with a congested network and variable (up to $40 recently) transaction fees. Specifically in this model the congested network poses a problem, as the confirmation to the merchant has to come from the blockchain network. If there is more than a few seconds delay, this will delay the in-store transaction, making it completely impractical.
This, together with the elephant in the room, the huge price volatility, needs to be resolved before wide acceptance can be achieved. Currently, cryptocurrencies still need to prove the durability of their networks for large-scale use, and they do not possess the required price stability. In stable economies, this will understandably cause a reluctance to adopt a new type of currency with such uncertainty in value.
This scenario, an end-user fully responsible for their wallet, can pose other serious practical problems. When the cryptocurrency in the wallet is stolen due to a compromised private key or wallet software, when fraud occurs, or even when the user simply loses access to their wallet, there is no authority that can help to reclaim this balance. The question remains whether this is an acceptable risk to the end-user, and even whether he or she can properly assess these risks. Additionally, the fact that there is no know-your-customer requirements, and that cryptocurrency balances are not necessarily linked to a known identity, poses problems for authorities combating fraud, money laundering, etcetera. When widespread acceptance is on the table; large push-back from the authorities is expected.
As a parallel to the current market; where the merchant usually outsources its payment solution to a payment processor and/or acquirer, it is likely that this would be the preferred way as well when it comes to cryptocurrency payments. It seems likely that cryptocurrency, or blockchain technology, will be implemented in the payment sector in a more indirect way, with still a large role for intermediate parties as payment processors, acquirers and issuers.
It does not appear that cryptocurrencies are a passing fad that will dissipate into the realm of failed technologies. However, the most ‘pure’ form of cryptocurrency payments has some serious problems to overcome before being viable for widespread use for in-store payments. Of these problems, volatility might improve over time, and high or variable transaction fees and reliability issues can be addressed with improved technology. More fundamental problems have to do with the fact that the end users hold their own private keys, posing a large risk of loss, and no way of reclaiming money after loss or fraud. The fact that there are no identity requirements will also create pushback from authorities. We see cryptocurrencies or distributed ledger technology having more value when being applied in the settlement between issuers and acquirers, to reap the benefits of the faster and lower cost associated with blockchain transactions. The adoption of cryptocurrencies for in-store payments, with no involvement of third parties, will require improvement of the current technologies and a large mindshift of both customers and merchants.