Marijuana and Bitcoin: A Match Made in Cryptocurrency Heaven or a Digital Nightmare?

A hemp farmer pruning his crop.

The marijuana industry has been a seemingly unstoppable force for years, and investors have taken notice. Within just the past year, most marijuana stocks have skyrocketed in value, leaving the broader market indexes in the dust.

According to cannabis research firm ArcView, North American sales of legal weed surged to $6.9 billion in 2016 and remain on track to hit more than $22 billion by 2021, implying an annualized growth rate of nearly 27%. With an estimated $46.4 billion in black market North American pot sales last year, there appears to be a large pool of consumers which the legal industry can attempt to court in the years to come.

The marijuana industry faces a number of competitive disadvantages

However, that doesn't mean life will be easy for the marijuana industry, or even marijuana stock investors. Despite medical cannabis now being legal in 28 states, and recreational pot having been legalized via vote in eight states, the industry faces no shortage of disadvantages .

To start with, the federal government still lists marijuana as a schedule I substance, putting it on par with LSD and heroin. As a schedule I substance, weed has no recognized medical benefits, and it's illegal in all forms. Therefore, there's always the risk that the U.S. Drug Enforcement Agency or Congress could choose to reinforce federal law, superseding states' rights to legalize cannabis. In February, White House press secretary Sean Spicer intimated that the Trump administration would get tougher on the marijuana industry than the Obama administration, which has some within the industry on edge.

There are some major competitive disadvantages as well. Internal Revenue Service tax code 280E disallows businesses that sell illegal substances, which includes marijuana, from taking normal corporate income-tax deductions. This dooms pot-based businesses to pay exorbitantly higher tax rates than so-called "normal" businesses.

Likewise, marijuana businesses usually have little or no access to basic banking services, which includes everything from access to lines of credit or loans to something as simple as a checking account. A vast majority of banking institutions report to the Federal Deposit Insurance Corporation (FDIC), which is a federally created entity. Since the federal government lists marijuana as a schedule I substance, providing banking services to weed-based businesses could, under a strict interpretation of the law, be viewed as money laundering and result in criminal charges and/or fines. Thus, most marijuana businesses, particularly retail dispensaries, are forced to deal only in cash, which is a growth inhibitor and a security concern.

Bitcoin could bridge the gap between marijuana businesses and banks

However, as reported last week by Bloomberg Technology , a solution to the marijuana industry's banking woes could very well be within reach. Within Washington State, digital cryptocurrency bitcoin is being used as an intermediary that's allowing consumers with bank-issued debit and credit cards to legally purchase marijuana in dispensaries.

Once a consumer has decided what he or she wants to buy, the consumer has a choice of using cash or bitcoin to pay for the transaction. If the consumer chooses bitcoin, POSaBIT, one of the companies behind the intermediary technology that Bloomberg discusses, charges the customer's credit card via a kiosk for a desired amount of bitcoin. The bitcoin can then be exchanged within the dispensary for cannabis products, with the intermediary company then exchanging the store's bitcoin for U.S. dollars. For its trouble, POSaBIT nets a $2 service transaction fee, while marijuana businesses get to expand beyond relying solely on cash. This is especially notable since credit customers tends to spend more than cash customers, per Bloomberg.

POSaBIT is also doing its part to stay in the good graces of state and federal governments. The company requires consumers to present a valid ID that's scanned, encrypted, and stored. It also has a nine-point fraud detection program that includes requiring its retail customers to have a bank account. Lastly, buyers are capped at purchasing no more than $150 in bitcoin in an effort to prevent money laundering.

If Congress provides no alternatives for the pot industry, it's not out of the question that bitcoin could grow as a bridge between the consumer and weed industry.

Plenty of risks remain

Unfortunately, the only bridge available to the weed industry comes with a number of risks of its own.

Arguably the biggest risk is that state or federal governments could choose to crack down on bitcoin. The anonymity that bitcoin users and investors enjoy so much is also a means by which criminals can gain access to the digital currency. The recent WannaCry ransomware attack that locked up users' computers until they paid a ransom in bitcoin is a perfect example of how criminals can use bitcoin and its anonymity to their advantage. There's little stopping the federal government from placing regulations on bitcoin if it chooses.

Building on the first point, security is also a pretty notable concern. Just this past week CNBC reported that two popular bitcoin exchanges were the targets of cyberattacks. This follows perhaps the greatest implosion of all time, Mt. Gox, which four years ago was handling approximately 70% of bitcoin's transactions. Hackers wound up taking, per a bankruptcy filing in 2014, about 850,000 bitcoins and $27 million in Mt. Gox's cash. Despite POSaBIT's safeguards, history suggests bitcoin exchanges just aren't that secure.

There may also be a lot of resistance to using the digital currency given that few business owners understand how it works.

Here's what might happen

The irony of the situation is that the move toward using bitcoin as a bridge currency might prompt the federal government to act by providing a legal workaround for banks to provide financial services to the pot industry. The federal government can control that which it can see, so it would much prefer loans, lines of credit, and checking accounts for marijuana businesses remain with banks backed by the FDIC rather than passed through an intermediary like bitcoin, which it currently has little to no control over.

However, that doesn't necessarily mean that the pot industry is destined for success. Even if weed businesses gain access to banking solutions, they'll still be facing tax disadvantages and be dealing with a schedule I status at the federal level. I'd be willing to bet that far more marijuana stocks would remain unprofitable than profitable, even with regulatory changes at the federal level for financial institutions when dealing with weed businesses.

For the time being, both marijuana stocks and bitcoin likely remain too risky for your hard-earned money.

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