The holy grail of financial transactions is removing as many intermediaries as possible and offering faster, cheaper, frictionless payments. Cryptocurrencies aim to solve these issues via cryptocurrency payment gateways. Nevertheless, we are still not there yet. Several factors have hindered crypto adoption for retail payments. These include:
volatility, which imposes risk on any party required to hold and settle cryptocurrency into fiat;
the unwillingness of users to pay in a currency that is appreciating;
scalability and transaction throughput;
increasing regulatory challenges;
ubiquitous acceptance;
fees and settlement times.
If we can solve these issues, cryptocurrency will be recognised as a better payment method than traditional payment rails, because it aims to return the sovereignty of money to individuals and merchants, plus it removes the need for multiple parties to mediate transactions and charge fees.
Crypto payment gateways enable businesses to accept cryptocurrencies as a form of payment, in contrast to traditional ‘fiat’ currencies such as the USD, EUR, and others. These gateways can be ‘crypto to fiat’ and ‘crypto to crypto’.
a crypto-to-fiat payment gateway is a financial transaction service that accepts cryptocurrencies and converts them into fiat currencies for payout to the merchant's bank account – most of today’s currencies can be considered fiat. They are any currency that is backed by a government and issued by them.
a crypto-to-crypto payment gateway is a transaction tool used to either transfer crypto payments across one another or purchase different cryptocurrencies for payout to the merchant’s wallet.
Cryptocurrency payment gateways are not mandatory or necessary to carry out digital currency transactions. Users can also utilise their wallets to accept cryptocurrency payments. Still, gateways offload merchants of the extra work of exchanging cryptocurrency in real-time and managing a wallet. Moreover, they remove much of the anxiety, confusion, disinformation, and speculation that can come from a decentralised and unregulated source of value.
These gateways can be:
Off-chain payments – are facilitated by custodial services similar to traditional online and mobile payments. Those custodial services normally provide a list of accepted cryptocurrencies and act as settlement agent who bears the volatility and counterparty risks. Off-chain payments are not fully trustless (unlike the Bitcoin network), as the user depends on a custodian agent to use their services.
On-chain (layer 1) payments – these types of payments happen on-chain, meaning that the user pays their crypto directly from their wallet to the merchant’s wallet. The blockchain network validates the transaction. As a result, on-chain (layer 1) payments work like non-custodial crypto wallets, where the merchant is assigned an address to receive payment. The payment platform’s role is to integrate tools like APIs or UI plugins for those merchants who wish to offer crypto as a payment method. Worth mentioning here is that, according to Crypto.com’s Macro Report, merchants accepting crypto might charge a higher fee (> 0.5.% of transaction volume) to compensate for their operational costs, in addition to the liquidity and volatility risks that come with handling cryptocurrencies. For retail users, the UX of making crypto payments should be like making a transfer over the blockchain network such as withdrawing money from an exchange to a wallet.
On-chain (layer 2) payments – to settle transactions must faster, these kinds of payments will temporarily move some transactions off-chain. Only when transactions in off-chain channels are finished, they will be broadcasted to the whole on-chain network. An example of an off-chain payment is the Lightning Network which operates on top of the (layer 1) Bitcoin network. As we previously explained, the Lightning Network is a layer 2 payment channel established between two parties who want to transact. All transactions taking place within the channel are off-chain, and a global (level 1) consensus is not required. Because of this, these transactions execute quickly via a smart contract, with lower fees, and almost instantaneously.
A typical payment channel has three phases:
Both buyer and seller establish a channel by signing and funding it;
Because both are now findable, a payment path can be found to clear this peer-to-peer transaction through this payment channel;
Once one of the parties closes the channel, the balance is broadcasted to the Bitcoin (level 1) blockchain.
The speed and cost savings come from the fact that not every transaction is registered in the slower and more costly Level 1 chain and the aggregates of transactions (balances) that can be settled in batches. To draw a parallel with the current payment systems, it works similarly to how Automated Clearing House works in the high volume/low-value transactions of the fiat world.
Two significant factors differentiate crypto gateways from traditional payment processing.
A customer pays via a crypto wallet, not a debit/credit card, or a bank account;
The customer pays in cryptocurrencies, not in physical currencies.
Once the crypto payment gateway accepts a crypto payment, the merchant’s payment processor will execute the transaction. But let’s see how the payment flow is:
The merchant installs an open-source plugin that provides an interface to a Bitcoin/crypto wallet.
The customer chooses to pay in Bitcoin/crypto.
The conversion rate between Bitcoin/crypto and fiat is retrieved from an oracle1.
The price of the goods is displayed in Bitcoin/crypto and fiat.
The customer transfers Bitcoin/crypto to the merchant wallet.
The cryptocurrency payment service instantly converts the payment into the currency the merchant chooses.
The money is added to the merchant account with the provider; it is deposited to their designated bank account in intervals decided on in their service contract.
Usually for step 6. merchants choose to convert the crypto they receive from their customers into stablecoins. Once the transaction is confirmed, the Bitcoin/crypto is sent to an exchange where it is liquidated into a stablecoin. These will allow merchants to accept cryptocurrency as payment without exposure to market risks or reliance on any third parties. Stablecoins are a critical component in enabling, among other things, fully-decentralised payment gateways. The merchant can decide at what interval to convert the stablecoins into fiat and can do so through a service that deposits fiat directly into their bank account.
For merchants, the benefits of processing payments via stablecoins spring from the fact that they can put them at work for yield in protocols (putting fiat at work has become more difficult and costly in a low-interested environment). Therefore, PSPs could give merchants yields for delaying payout into fiat by providing liquidity in automated lending pools e.g., Uniswap, Compound, Sushiswap, Liquidity, and various options. However, this option might be riskier, because regulation is limited, and there is no government protection (FDIC insurance in the US).
Merchants can also do this themselves, without middlemen, but not many will do this because this is not their core business. Some experts agree that once the merchants will perceive all the true benefits brought by crypto (and even then, they might decide not to take advantage), regular PSPs will re-plumb their back ends toward crypto. This is caused by the ability to offer more options and better propositions to merchants – de-commoditise online payments. The complexity of crypto is shielded from the merchant, adding new pockets of value to PSPs propositions.
From what we learned so far, verification and validation transactions on blockchain incur energy and computational power consumption. Transaction validators are paid in small increments in the cryptocurrency transaction they validate, from which they pay their cost and make a profit. These fees are passed to the crypto payments provider that might charge them to the merchants they are working with so that they can continue operating and offering their services.
Crypto gateways remove the anonymity (due to KYC requirements) of who you’re dealing with while maintaining your customer's preference for it. Also, they reduce the volatility risk by paying you the market rate for the tokens at the time the transaction was conducted. Also, you receive the funds in the account with your provider, who transfers them to you, and you don't have to worry about or attempt to understand cryptocurrency.
Nevertheless, a payment gateway is a third party, which cryptocurrencies were originally designed to bypass. This means that you pay small transaction fees when you use receive; you pay an additional fee when you use a cryptocurrency payment gateway, to take away the complexities. And related to security, if the payment gateway is hacked, you'll lose any funds you have in your account with the provider while you're waiting for them to be transferred. You need to be sure that your service provider can be trusted. Thanks to its decentralised nature and its reliance on cryptography, blockchain technology is completely trustless. In contrast, crypto payment gateways are centralised entities, meaning that it is trustful, capable of providing quality service, and secure enough to resist potential cyber-attacks as well as fallible human behaviour.
This editorial was initially published in our Crypto Payments and Web 3.0 For Banks, Merchants, and PSPs Report. The first edition of our report aims to provide a go-to payment resource of crypto terms and concepts for those interested to understand the basics of crypto payments and their long-term impact. Furthermore, it shares practical examples of cryptocurrency-enabled ecommerce and banking services and presents the latest developments in the regulatory landscape. Also, it reveals what are the most innovative companies in this space, that are building the crypto rails.
About Mirela Ciobanu
Mirela Ciobanu is a Lead Editor of the Banking and Fintech domain at The Paypers. She is actively involved in drafting industry reports, carrying out interviews, and writing about the digital assets industry, the regtech space, digital identity, fraud prevention, and payment innovation. Mirela is passionate about finding the latest news on crypto, blockchain, DeFi, and fincrime investigations and is an advocate of the need to keep our online data/presence protected. As a writer, she aims to always get the best obtainable version of the truth. She can be reached at mirelac@thepaypers.com or via LinkedIn.
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