How to Profit in Bitcoin: Chaos And Order (Part 2: Payment Protocols)

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By Vin Armani

Author’s note: In this article, the term “Bitcoin” refers to any cryptocurrency network running a version of the consensus protocol described by Satoshi Nakamoto in the Bitcoin White Paper. This includes, but is not limited to: Bitcoin (BTC), Bitcoin Cash, Litecoin, Dash, ZCash, and Decred.

This article is the second in a two-part series exploring how to leverage the economic self-interest of individuals and businesses seeking profit in Bitcoin, to enable a self-sustaining cycle of Bitcoin adoption. In the first part of this series, I explored the the Visa digital payment network. Visa’s first CEO (and now CEO Emeritus), Dee Hock, refers to Visa’s organizational structure as a “chaord” – a portmanteau of “chaos” and “order.” The Visa network is made up of member banks that both compete (chaos) and cooperate (order) to exchange economic value to the tune of more than $7 trillion US every year. Hock considers Visa to be a “global currency” as well as a payment network. In this way, Visa shares enough in common with Bitcoin that wisdom would dictate the value of an examination of how Visa has been able to sustain and grow over the decades since it was introduced. Although there are important differences between the Visa payment network and Bitcoin, there are lessons that those seeking profit in Bitcoin should draw from Visa.

There are two critical axioms to consider when trying to understand how to leverage Bitcoin profit-seeking as the foundation for mass adoption. The first Bitcoin truth is that the purpose of Bitcoin is to be a form of digital currency devoid of centralized custodians of funds, final authorities, like governments and banks, that can censor financial transactions. I think that some in the Bitcoin community have drawn this axiom out farther than Satoshi Nakamoto intended, saying that the purpose of Bitcoin is to eliminate all trusted third parties in all contexts. I think that notion is simply wrong. Financial services providers are going to be a reality in any established economy. Such businesses simply emerge in the market due to consumer need. So long as utilization of third parties is optional and done voluntarily, Bitcoin is still serving its purpose. Not everyone will want to roll their own node from code they audited and compiled themselves. So long as that is a viable option for gaining access to a Bitcoin network, however, then Bitcoin remains permissionless and decentralized by design. This is not the case with the Visa network. Only member banks (in tight collusion with governments) are able to access the Visa network directly.

The second Bitcoin truth is that Bitcoin transactions are fundamentally different, in their structure, from any payment method that existed prior to Bitcoin. Bitcoin transactions are made up of one or more inputs (value amounts already in existence on the blockchain and associated with some address), that will be spending funds, and one or more outputs (addresses and amounts to be received), that will receive funds. I will refer to this model as the Unspent Transaction Output (UTXO) model.

Until Bitcoin, the financial world had operated on a different model, which we can call the “balance model.” If you look at any bank statement, a traditional financial ledger, you are seeing the balance model. On each line of the ledger, there is either a credit or a debit – money has either been added to or subtracted from a running balance. Many bank statements will even have a field showing the running balance of the account as it exists at the time of each credit or debit. Each credit that you receive, in the balance model, is given its own line item. Three separate digital credits to your account will show as three line items, each with their own identifier within the system. The same can be said of debits. Paying three separate, unaffiliated entities using your debit card requires that you make three separate transactions. This is not the case within Bitcoin’s UTXO model – an important distinction in the context of profit-seeking.

If you use a Bitcoin wallet which has, as its backup mechanism, a mnemonic phrase (a group of 12 or more words), then you are using a hierarchical deterministic (HD) wallet. When using this wallet, you may have noticed that the receive address your wallet provides to you will change quite often. And yet, funds sent to those many different addresses all seem to show up and display as your total balance. HD wallets take advantage of Bitcoin’s UTXO model. A transaction can be constructed with source funds from dozens (or even hundreds) of addresses, so long as the person(s) creating the transaction has access to the private keys for those addresses and can properly sign the transaction.

Similarly, the funds from those inputs can be dispersed, in a single transaction, to many different addresses as well. Unlike in the balance model, in Bitcoin, you can make payments to many, many unaffiliated entities (i.e. pay your electricity, phone, water, gym, and cable bill) in a single transaction. Most HD wallets construct transactions with multiple outputs by default, sending any “change” to a brand new address controlled by the sender’s wallet. The UTXO model has not been fully deployed for the purpose of Bitcoin profit-seeking. That must change if we want mass adoption.

The Visa network is a set of protocols and systems that allow member banks to communicate with one another. Although it is in a bank’s best interest to participate in the network, it is not mandatory that a bank do so. Some banks choose competing networks such as Mastercard. There are other protocols that are simultaneously at play for other transfers between banks, such as SWIFT and Zelle. In the case of Visa, by agreeing to use the same communication protocol, banks are cooperating.

It is because of this cooperation, however, that they are able to fiercely compete with each other for market share of network users (both merchants and consumers). This competition is valuable because the bank at either end of the transaction (card issuer or merchant services) earns revenue for that transaction. The more transactions, the more revenue. What is Bitcoin’s analog to Visa’s “chaordic” environment?

CoinText, a company I co-founded, is a Non-Custodial Financial Services (NFS) provider. We allow users to construct and broadcast transactions via our SMS infrastructure in exchange for an additional output being added to any transaction done using our platform. Users do not have to use CoinText to move funds to or from their CoinText address. We provide users access to their private key (via our PRIVATEKEY command), which they can sweep into another wallet or use as they please on any platform which supports importing of private keys.

However, should a user choose to use CoinText’s infrastructure to construct, sign and broadcast a transaction, that user is agreeing to send CoinText a small fee in that very transaction. The more transactions that pass over the CoinText infrastructure, the more revenue CoinText earns, all while the end user retains complete control of his funds. CoinText is a clear proof of the NFS concept, but the possibilities for what can be done are myriad.

A Non-Custodial Financial Services provider is a business that enables some economic activity that a Bitcoin user is unable or unwilling to do himself. An NFS is an entity that enables better, faster, or cheaper financial transactions. An NFS is fundamentally a payment processor, but the scope of the services that can be provided will grow as new business models naturally emerge from this uncharted landscape. I believe the vehicles into this new financial paradigm are Payment Protocols.

Enter Non-Custodial Financial Services leveraging Bitcoin Payment Protocols.

Payment Protocols produce payment processor profits. It’s not just nice alliteration, it’s the truth. As reported right here on Coinvore, BitPay, the leading cryptocurrency processor, had a record year in 2018, processing over $1 billion USD in transaction volume. The company also set a record in the reduction of payment error rates. In December of 2017, 8% of total volume was lost to payment errors. This was reduced, to 1% by December 2018. Let’s run the numbers and get an idea of what a 7% reduction in volume loss (an increase in volume) means to BitPay.  Seven percent of $1 billion is $70 million in total transaction volume. At the 1% fee that BitPay charges merchants, that represents an additional $700,000 in revenue. Considering that there is actually less cost for BitPay for successful transactions than for errors (due in no part to customer service costs), this represents almost purely a profit increase for BitPay. If BitPay were doing similar volume to a payment processor like Square – at $68 billion USD per year – this reduction would mean an additional $48 million in profit. Not too shabby.

To what did BitPay owe this massive reduction in errors and increase in profits?

“The adoption of support for Payment Protocol wallets has made a big difference for our merchants,” said Sean Rolland, Head of Product of BitPay. “Merchants are now able to easily accept Bitcoin payments in a simple easy way without any support issues. This was our biggest request by our enterprise merchants.”

It was the pursuit of profit that made BitPay require that wallet applications institute Payment Protocols. Payment Protocols are, I believe, the true key to Bitcoin payment processor profits. BitPay, because they still operate in the traditional custodial model, aren’t even leveraging these powerful standards as will the first generation of NFCs. Those businesses will quickly outcompete BitPay and gain dominance via unleashed incentives to increase merchant adoption of Bitcoin in every corner of the globe. So, what are Payment Protocols and what makes them so special?

Payment Protocols are a set of standards – like the standards that comprise the Visa network – that allow parties in a financial transaction (i.e. buyer’s wallet and seller’s wallet) to communicate more data to each other than merely a single Bitcoin address and amount to be sent. BitPay was much maligned for requiring the use of Payment Protocols. I believe the criticism came mainly because there was a general feeling that “BitPay could do this without requiring the use of Payment Protocols.”

After all, BitPay was merely instructing the buyer’s wallet to send a specific amount to a single address. That is the absolute most basic use of Payment Protocols and yet it was still quite profitable for BitPay. The next level of use for these protocols is to instruct a buyer’s wallet to send funds to multiple addresses. This allows brokers, resellers, and affiliates to be paid, by the buyer, instantly, for every transaction they generated. The provider of the good or service will receive their payment (minus the affiliate fee) in the same transaction. Every good marketer knows the power of leveraging affiliates and resellers.

Up until now, one of the of the major differences between the traditional financial model and Bitcoin is that the buyer has been the one who pays the miner fee on a transaction. With the use of payment protocols, this no longer has to be the case. Because the seller can give the buyer’s wallet precise (down to the satoshi) instructions on how to construct the transaction, a seller can “eat” the miner fee (for an average sized transaction) simply by subtracting the requisite amount from the requested payment. This brings the user experience with Bitcoin more into line with Visa’s point-of-sale UX.

The back and forth communication also allows for custom extending of the payment protocol. There is adequate metadata space available in payment protocols at this time for buyers to be able to send details, such as size or color of a product as well as shipping information, within the Payment Protocol channel. This means that Bitcoin wallets can feel more like the Amazon or Netflix (because digital goods such as streaming video can be purchased in this way as well) mobile apps. Any wallet application that implements the standards can interact with any other application that implements the standards. Premium wallets can even add a fee output onto every transaction that the wallet creates that goes to the developers of the wallet. Wallet developers are incentivized to increase overall transaction volume through both cooperation and competition. Payment Protocols allow Bitcoin’s ecosystem to become a chaord.

I am currently building Payment Protocol platforms and engaging with other developers to begin the process of getting the most popular wallets compliant. I haven’t been as excited about Bitcoin since I first began developing on the network in 2014. I invite you to join me in this uncharted territory. Let’s imagine a new world of individuals whose financial sovereignty has been fully returned to them through the use of peer-to-peer electronic cash.

Vin Armani is the founder and CTO of CoinText, co-founder of Counter Markets, instructor for CodeFromGo beginner’s coding course, and the author of Self Ownership. Follow Vin on Twitter.

PREVIOUS ARTICLES by Vin Armani: 

Bitcoin Mass Adoption Through Chaos And Order (Part 1)
A Profit-Seeking Prophecy
The End (Goal) of Decentralization in Bitcoin