A year ago, financial institutions were left in the dark as the world of crypto-currencies gathered momentum. As Bitcoin garnered more media attention, transaction-banking and FX analysts initially shrugged off the competitive threat posed by the digital currency in disrupting the norms of global banking. That is no longer the case.
After all, the stock of Bitcoins has grown from roughly $150 million to $1 billion in the space of a year, while transaction volumes of rival digital currencies have similarly jumped.
The stakes for banks have increased. The peer-to-peer nature of the market means banks are disintermediated in the payment process, and are unlikely, at this stage, to earn commissions by providing a gateway to exchanges. An IIF report released last week on the Bitcoin mania sheds light on how financial institutions reckon the jury is still out on whether the digital case amounts to a game-changing threat.
Tempering the charm offensive launched by digital-currency aficionados at a recent US Senate hearing, the IIF report casts doubt on Bitcoin’s ability to function as a medium of exchange given the volatility of the currency and the lack of an institutional backstop.
“A key concern for Bitcoin has been volatility. It is estimated that 50% to upwards of 90% of Bitcoin owners are speculators – thereby contributing to the recent substantial price fluctuations. In December, just three days after reaching its high of $1,240, the digital currency plunged to $576 intraday after China – citing concerns about money laundering and risks to financial stability – banned its financial institutions from conducting Bitcoin transactions. The ban prompted Baidu, China’s largest search engine, to stop accepting Bitcoins, dealing a big setback to the cyber currency’s struggle for legitimacy. Bitcoin has since rebounded and as of January 6 was trading at $1,027 on Mt.Gox, one of the more active online exchanges. If this remarkably high volatility persists, it will compromise Bitcoin’s capacity to function as a medium of exchange, as it deters most large companies from accepting the digital currency as a form of payment.”
Prospect that Bitcoin is effectively a fiduciary currency
“Bitcoin proponents claim that the digital currency is a sound alternative to traditional physical currencies (notably those issued by profligate governments). In line with many libertarian thinkers, they suggest that monetary management is healthier if it reflects the decisions of a large community of users as opposed to a central bank board or governor. Conversely, Bitcoin detractors argue that the functionality (and ultimate success) of the digital currency is determined by programmers – and their goodwill is taken for granted. There is the possibility that over time such actors might become driven by individual self-interest, potentially leading to widespread panic and chaos within the network. Thus it is far from certain that such a system would be healthier than one where central banks are mandated to stabilize the economic and financial markets, even if their performance is imperfect. Furthermore, Bitcoin detractors argue that the built-in scarcity incentivizes hoarding, decreases liquidity, fuels price volatility and thus impedes the digital currency’s acceptance for payment. Lastly, unlike fiat money, nobody is obliged to accept Bitcoins for payment.
Consequently, the currency's worth is determined by the users’ perception of its value. Without a backstop buyer, Bitcoin could rapidly vanish should perceptions of its value deteriorate. A recent study conducted by the Chicago Federal Reserve concludes that Bitcoin provides an elegant solution to the problem of creating a digital currency, ie, “...how to regulate its issue, defeat counterfeiting and double-spending, and ensure that it can be conveyed safely – without relying on a single authority. However, the author also underscores that Bitcoin is effectively a “fiduciary currency” with no intrinsic value – hence inherently fragile. Thus despite Bitcoin’s “ingenious features” it cannot provide a currency of stable value and its use as a broadly accepted medium of exchange appears limited – although it is a “remarkable conceptual and technical achievement”.”
Although JPMorgan’s patent for a Bitcoin-like platform has been rejected, analysts, as Euromoney has reported, say banks could generate fees by facilitating access for small banks and credit agencies to a free digital payments system; seek to create their own proprietary payment system; acquire companies that harness the power of Bitcoin; and eventually enter the world of Bitcoin loan and deposit-taking.
Here’s a handy round-up of regulatory developments, courtesy of the IIF:
"Governments worldwide are examining how Bitcoin will operate within the broader payment network and how they can and should be regulated given the decentralized and virtual components of the system. Government regulation and/or guidelines are continually evolving and amendments occur regularly; a few examples are set out below:
- In the US, while the Federal Reserve has provided a degree of tacit approval, stating “virtual currencies like Bitcoin have legitimate uses and should not be banned”, the IRS has not yet issued tax guidance. Washington policymakers are actively studying digital currencies, and taking steps towards solidifying their position and developing formal rules and regulation.
- Although the German finance ministry has formally acknowledged Bitcoin as a “unit of account” (meaning it can be used for tax and private trading purposes in the country), the German Bundesbank has become the latest big central bank to warn about the risks of Bitcoin, amid rising concerns from regulatory authorities around the world as the virtual currency grows in popularity.
- China has banned the country’s Bitcoin exchanges from accepting new inflows of cash, putting the virtual currency in danger in its biggest market. Regulators were concerned that people might use Bitcoins to skirt the country’s capital controls, and about the widespread speculative demand for Bitcoins and potential for a price bubble. However, transaction activity is reportedly continuing, with some exchanges finding ways to work around the controls.
- Bitcoin exchanges in India shut down in late December 2013, days after the Reserve Bank of India (RBI) warned users of virtual currencies against security and financial risks associated with them. The RBI stated that it feared users might unintentionally breach anti-money-laundering and financing-of-terrorism laws; it continues to study the status of Bitcoin under current law.
- In July 2013, Thailand banned the buying and selling of Bitcoins, as well as sending the currency to other jurisdictions or receiving it from them.
- Bitcoin-friendly sovereigns such as Denmark, Poland, and Singapore are currently taking a laissez-faire approach, claiming that no regulation is needed, although the issue will be revisited in the future.
- Norway classifies Bitcoin not as money but as an asset subject to capital gains tax."