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07 March 2014

Bitcoin and Banks, Part I: Will Bitcoin gain currency with Banks?

Welcome to the first of this two-part blog on Bitcoins. The first part will discuss the foundations and principles of the digital currency and summarise the responses so far by financial institutions. The second part will discuss the likely future of Bitcoin and the actions that we can expect financial institutions to take as a result.

Introduction

In 2013, 'What is Bitcoin?' was in the top 10 Google searches in the US alongside 'what is Twerking?' and 'Nelson Mandela'. Bitcoin also represents the lion's share of the total digital currency market value.  As a result it is the prime case study in assessing the implications of virtual currencies' surge in popularity for the global banking industry. Before we review the reaction of the Banking Industry, however, it is useful to understand how digital currencies differ from traditional currencies.

How is Bitcoin different?

Fiat money, the currencies used commonplace today (eg GBP) have no intrinsic value, but are typically at least partially commodity-backed due to fractional reserve banking.  Crucially, however, most fiat currencies are, in fact, backed by real output and wealth of the systems (economies) in which they operate.

Digital currencies are electronically-created mediums of exchange. They have been around for over a decade, but serve specific purposes. Prime examples include computing game 'credits'  - for use in niche markets only - and Digital Gold Currencies – 100% backed by precious metals.

Bitcoins, however, are not commodity or output-backed and are designed for use across markets and borders rather than discrete communities. The differentiators that it offers, due to the strict cryptographic code it is based upon, are:

  • decentralisation – validation of Bitcoin transactions is assured by the Bitcoin 'miners' so they cannot be duplicated or double-spent
  • finite supply – Bitcoins are limited in number and the money supply cannot be manipulated by a single party (i.e. central bank), devaluing it.

This was the intention of Satoshi Nakamoto, reported creator of the Bitcoin code, who believed that “the root problem with conventional currency, is all the trust that's required to make it work. The central bank must be trusted not to debase the currency. Historically, he argues, it cannot be.

Bitcoin: welcomed or feared?

These characteristics of Bitcoin, should it reach a critical mass, pose real risks to both governments, via the undermining of monetary policy, and financial institutions as the Bitcoin network processes transactions at near-zero cost, threatening traditional transaction banking revenue streams. The global response, however, has been mixed.

In recent months, China has forbidden all third party payment providers from offering clearing services for digital currency exchanges. Taiwan's Financial Supervisory Commission (FSC) has prevented the installation of Bitcoin ATMs and India's largest Bitcoin exchange, BuySellBitCo.in, has closed after the country's central bank issued a statement warning about the risks of using virtual currencies. Germany, optimistically, will recognise Bitcoin as a “currency unit" meaning that it can be used for tax and trading purposes, whilst Ben Bernanke, chairman of the Federal Reserve, declared that the idea “may hold long-term promise".

Similarly divided, the global banking industry is also polarised. Some are hedging their bets - JPMorgan has filed a US patent application for a computerised payment system for “a computer-implemented method of providing an anonymous payment from a mobile device to a payee device. Wells Fargo is embracing change by setting up a team to examine how it might safely offer Bitcoin-related services or banking arrangements to virtual currency entrepreneurs whilst adhering to Anti Money Laundering regulation. Conversely, there are an ever-growing number of reports of banks shutting down the accounts of Bitcoin-related start-ups – a pre-emptive strike, perhaps? These reports include Bank of America who, in a recent report on Bitcoin stated that they believe that the currency will "emerge as a serious competitor" to cash in e-commerce and digital money transfers.

What the future holds

Whether digital currencies become an established threat to core banking services, whether they retreat back into niche markets or whether they die out completely remains to be determined. We will discuss the likelihood of the possible outcomes in the next instalment in the series and what the incumbent parties can do to respond.

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