Virtual Currencies part 1: Are banks losing their dominance in payments?

Thursday, 14 August 2014 10:38

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.

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