How do Bitcoin payment processors work?

Yesterday there was a discussion on a listserve about Brian Kelly’s hypothesis’ regarding bitcoin exchange rates and below is an answer I used to discuss where payment processors fit into the ecosystem.

At their core BitPay is basically a forex company, a broker that matches merchants with liquidity providers.  Microsoft and some 44,000 merchants can convert bitcoins into fiat through them (and/or hold portions or all of the coins they receive too).  Some miners also use them to process BTC to USD.

To do this, they have built an exchange (you can also call a few of their team members to place block orders with), which effectively sorts the bid/asks among other exchanges and OTC providers (such as Buttercoin, Mirror, Xapo, Sator Square Partners, Bitfinex, Coinbase, etc.).  I tried describing some of how this plumbing system works in a article a couple months ago.

While I do not have the full details of other payment processors (like Coinsimple or Bitnet), they likely try to build similar relationships with liquidity providers.  And this is important because all payment processors — or really, forex brokers — are faced with the following three situations during an arbitrary 15 minute window:

1) order from merchant is canceled by payment processor
2) order from merchant is accepted and then sold to inventory partner (such as Buttercoin)
3) order from merchant is accepted but the coin is put on payment processor’s books

Payment processors ultimately want commerce to flow so they do their best to match up partners; so in practice there has to be partner on the other end with the same or greater demand for the coins being sold by the consumer/merchant.

I do not have exact numbers for how often #1 happens though I do understand it happens on a daily basis (again, the 15 minute window is to help lock in a price and the OTC demand from partners such as Coinbase may not be fast enough at times) or how often #3 happens (my understanding is US payment processors typically used to hold coins on their own books prior to the IRS ruling last year but have sold their inventory for tax purposes).  Obviously during a heavily volatile period like yesterday (or even today on the upside), there is a possibility that the coins could get placed on the payment processors’s books due to a lack of bids on the OTC partners side, but none of that is really public knowledge.

The point is however, that there has to be a demand side to absorb the sales of coins coming from merchants and payment processors have built some pretty good systems to handle that (incentivized in large part to limit their exposure to exchange rate volatility).  If these partners were to disappear or the coins they decide to purchase declines in aggregate, payment processors are then left with having to choose #1 or #3.  This doesn’t seem to be the case the last few days, the behavior seems to be on the exchanges themselves and not from merchants.

What does this mean in practice?

The current supply pressure on a daily basis: aside from a couple firms such as BitFury (which according to some sources has around a ~$180 total cost of production), miners as a whole end up having to sell the majority of coins each day (~2,000 – 3,000+ coins) and as a whole, merchants process about 5,000 – 6,000 coins a day.  So this means 10,000 coins x 365 days or 3,650,000 coins.  Thus, to maintain a $300 price with that sell pressure the market needs to have ~$1 billion a year in capital come into this space.  And to maintain a $1,200 price with the same merchant/miner behavior the market would need to have ~$4.4 billion.  Therefore it is likely that payment processors try to reduce the amount of exposure to #3, otherwise the coins would eat up the internal budget and increase the burn rate at these startups.

Note: what BitPay’s volume looks like in practice was recently summarized by analysis from Jorge Stolfi.

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