What Happens in A Cash Transaction?

There is an increasing amount of information on the web about Bitcoin.  Macro information, how it’s an online ledger, how it’s a platform, how it’s a medium of exchange.  But, it can be overwhelming to people that have trouble grasping the concept.

One way to try and understand Bitcoin is to try and break it down into micro ideas so people can see similarities and understand what’s really going on when they use paper currency.  I will try to do that in a series of blog posts.

First off, everyone in the world is conditioned to using a currency that is backed by a government entity.  It’s important to understand the historical roots of our accepted practices.  There are reasons currency exists. The Chinese had currency in the 10th century.  The ancient Greeks and Romans had coins that represented values.  Having a generally accepted value for a paper note or coin helps commerce flow faster.

Suppose we had no medium of exchange.  As a shopkeeper, I would have to analyze and accept all kinds of good or services in exchange for my goods.  Barter is very hard to quantify, and is not good at aligning supply and demand market forces. In the words of an economist, “There is a lot of dead weight loss in the economy” with barter.

Until 1971, government currency was backed by gold or silver.   Milton Friedman showed how the gold standard was one of the contributing forces to the Great DepressionAfter 1971, currencies were allowed to float in value.  That float in value is the real time rebalancing of supply and demand forces in the world wide economy for the currency.  A US dollar is only worth what the market says it is worth.  There is risk in holding government currencies, and there are markets that help holders mitigate that risk.  Anyone that has travelled to another country and exchanged their currency for another country’s currency has felt the effects of that risk through the currency exchange.   The difference between what the exchange will buy and sell currency is one reflection of that value risk.

Here is what happens in a simple straight cash transaction:

Customer comes in, finds a good or service they want to buy.  They go to the shopkeeper and exchange currency for that good.

But, what’s happening behind the scenes?

Customer has risk of carrying cash.   They could get robbed.  They could lose it.  If it’s in coins, it can be heavy.  If they are going to several countries in the same day, they might have to carry several different currencies-and because of exchange rates, they are subject to losing value in the different currencies.   If there is no receipt, the customer could have a difficult time returning the item or trying to get the other side to perform a service.

What about the flip side?

The shopkeeper has risk with cash too.  They could get robbed.  They have to transport the cash to their bank, and could lose it.  They only take one currency, so there is some risk in holding it-but not a lot.  They run the risk of the cash being counterfeit.  If they accept cash, and it’s not real, there is no recourse for them and they lose all their profit. Under RICO statutes in the US, if the cash is ill gotten, the government can seize it.

How does the straight cash transaction change if we substituted Bitcoin for traditional government backed currency?

Person comes in and buys good/service with Bitcoin.

How is it executed, and what’s happening behind the scenes?  Does Bitcoin change the risk parameters?  Does it make the purchase more or less efficient?

From the customer perspective:

Since Bitcoin is virtual, I carry it on my phone.  My risk is getting robbed for my phone and not having enough built in security programmed in.  Bitcoin does fluctuate in value relative to government currency, so there is risk.  But eventually the risk will be no different than holding any government currency.

From the shopkeeper perspective:

Taking Bitcoin instead of currency isn’t a lot different-except I have no risk of getting robbed or losing it.  I have exchange rate risk, but it’s similar to the risk my customer has.  I don’t worry about the government seizing Bitcoin, since I can automatically trace exactly where the currency came from.  I also can check automatically if my customer can pay, since the general ledger is transparent.

Bitcoin is just as efficient as straight cash.  It might be slightly more risk free, because of the transportation problem with cash.  The risk today with Bitcoin is that it is highly volatile in value.  There is no market to hedge the risk of holding Bitcoin.  The owner of Bitcoin assumes 100% of the risk.

This is for a simple cash transaction.  As we examine other transactions, the mechanics behind them get a lot more complex.

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