Virtual Currencies

PART 1: Are banks losing their dominance in payments?

August 2014

Just several years ago, any mention of "virtual", "crypto" or "digital" currencies was typically met with bewilderment and lack of awareness. A few years later, virtual currencies (VCs) are prevalent in the media and opinions abound. Bitcoin is just one "brand" - although the most prominent - of a multitude of VCs which have sprung up over the last years.

For banks, VCs pose many challenging questions: will VCs take away their traditional payments business and make them obsolete? Will regulators protect banks in their traditional payments domain? Should banks defend themselves against the VC's or should they embrace the benefits?

This article is the first of 3 Payments Advisory Group articles on the subject of Virtual Currencies:

  1. Introduction to Virtual Currencies: the advantages & disadvantages
  2. Virtual Currencies and the impact on banks' role in payments
  3. Virtual Currencies & regulation; what will the future hold for VC's?


Bitcoin – shrouded in mystery

Due to its amazing history of price gains – and subsequent deep falls - Bitcoin has attracted more attention than any other VCs. Bitcoin´s origin is somewhat shrouded in mystery: its presumed creator is an individual or a group of people named Satoshi Nakamoto.  In 2009, the first units of the Bitcoin currency appeared.Bitcoins exist as computer code based on cryptography and are stored on electronic wallets. Bitcoin does not require a central clearing house or financial institution clearing transactions. Users must have an internet connection and Bitcoin software to make payments to another public account/address. They can send payments within a decentralized, peer-to-peer network; they can purchase and sellBitcoins through online exchanges and trade Bitcoins for traditional currencies. A total of about 12 million Bitcoins are currently in circulation. The system is designed to produce no more than 21 million Bitcoins.

Use of Bitcoin has grown dramatically since 2009. An increasing number of retailers, hotels, travel agencies, coffee shops and others accept Bitcoins. Merchants have an incentive to accept VCs because fees are lower than those typically imposed by credit card processors or transaction fees charged by banks for credit transfers.

Perceived advantages and disadvantages of Bitcoins

At first glance, Bitcoin is attractive:  it allows instant peer-to-peer transactions, enables payments worldwide and has zero or low processing fees. It can thus function as an alternative to credit or debit card payments or electronic credit transfers. As a digital currency, Bitcoins are more "secure" than cash as they are easier to "carry". Bitcoin is relatively anonymous and therefore attractive to individuals and countries where there is an intent to avoid taxes, capital controls and potential confiscation of currency accounts and cash.

But there are multiple disadvantages to Bitcoin: it does not require a central clearing house or even a financial institution clearing transactions. It operates with no central authority or central bank. Issuing VCs and managing transactions is carried out collectively by the network. It is an open-source; its design is public; no one owns or controls Bitcoin, and "everyone can take part".  This anonymity is seen as appealing to money launderers, fraudsters and terrorists.

The individual VC user takes on multiple risks:

  1. First, there is system risk: the user faces the risk that the VC system as a whole continues to work properly and is not corrupted by the collective, i.e. other users.
  2. Unlike bank accounts, VC accounts or "wallets" are not insured against loss. Errors cannot be corrected - there is no way to reverse VC transactions.
  3. As Bitcoin has amply demonstrated, VCs are highly volatile with the potential for complete loss of value.
  4. There is transfer risk: by transferring VCs from a personal account to a third party account, the user faces credit risk since third party accounts are not regulated, nor do they provide deposit insurance.
  5. The VC user faces risks connected with online exchanges: they are not regulated and will not offer any protection to investors should they be targeted by hackers. Several exchanges have already been closed down by regulators or gone bankrupt. The most well-known Bitcoin example is Mount Gox which had to file for bankruptcy earlier in 2014.
  6. VC usage might have tax implications. In the US, the IRS has recently announced that VCs are treated as property. General tax principles applicable to property transactions apply to transactions using VC.
  7. And finally, the user faces FX risk should he eventually want to exchange VCs into local currency.

Where does all this leave the banks? Do VC advantages outweigh the disadvantages? This will be explored in the second article in this series.


PART 2: Virtual Currencies and the Impact on Banks' role in Payments

This article is the second of 3 Payments Advisory Group articles on the subject of Virtual Currencies:

1. Introduction to Virtual Currencies: the advantages & disadvantages

2. Virtual currencies and the impact on Banks’ role in payments

3. Virtual Currencies & regulation; what will the future hold for VC’s?


Banks have traditionally enjoyed a dominant role in providing payments. Bank customers hold accounts at banks which transfer funds from the ordering bank to the beneficiary bank. This has been a model which has existed for decades. Recent developments have made payments more standardised, more secure, more transparent, as well as generally cheaper and faster (the Single Euro Payments Area is a case in point), but the model that a payment needed at least one bank in the middle to make it from point A to point B pretty much stayed the same. In other words, the payments industry is a network industry.

Given the listed advantages of VCs the question can be raised whether banks are needed for payments at all. Can one envisage a payments industry which does not need banks for payments any longer?

Critics of banks´ dominant position in payments would say yes. While SEPA has brought many benefits to payment users in the euro payments area, the situation for cross-border payments outside SEPA has not changed much. Banks charge hefty transaction, account maintenance, interchange, reporting and FX fees. Information is not always forthcoming or transparent, payment execution is slow and uncertain. Compare this with VCs instant processing, minimal transactions cost, absence of FX fees, and the ability to trade borderless around the world. It is easy to see why this may be more appealing than banks´ traditional payments models.

Does this mean that VCs could and should be used for international remittance flows? This is a tricky area for banks. As compliance requirements are increasing, particularly around anti-money laundering (AML), know-your-customer (KYC) and know-your-customer´s-customer (KYCC) rules, banks face not only enormous complexity but also increased cost in the payments business. To meet their compliance obligations, banks have been taking a closer look at their payment flows to emerging markets as well as their customer base and their customers´ customers. In many cases it is impossible for them to meet the KYCC regulatory requirements. As a result, many banks have cut back the number of customers they will service and have reduced or even closed down their international remittance business. No wonder these cut-backs have caused an outcry and a desire to find alternative ways to make payments into emerging markets.

Some VC enthusiasts perceive VCs as replacing banks in the international remittance area and hail VCs as a tool for financial inclusion: theoretically, VC payments could benefit countries which receive remittance inflows but which have a large “unbanked” population without access to bank accounts or mobile money platforms. To date, international remittances to these countries have been expensive, especially if traditional banks and payment systems are used. Yet the global remittance market is huge, growing and vast flows take place. So some VC promoters advocate VCs as stepping into this payments area, replacing traditional banks. However, the challenge remains how to transform theory into practice. VCs like Bitcoin require access to a computer or at least a smartphone. Exchanges would be needed to allow converting VCs into cash for buying food. All in all there is still a considerable number of prerequisites to be met before VCs can step into the payments space from which banks are currently retrenching.

Should banks therefore adopt a complacent danger over, return to normal position? Definitely not. Banks should take consumers´ dissatisfaction with slow, inefficient and costly (cross-border) payments to heart. They need to work on improvements in payments, in order to adopt rather than counter the benefits of VCs such as speed, low cost, absence of FX and increased use of the internet, in order to reinvent their position in Payments.

In any case, it is clear that there is a ‘virtual’ movement ongoing, yet the big question is: where will it take us? This will be explored in the 3d article in this series: Virtual Currencies & regulation: what will the future hold for VC’s?


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