What is cryptocurrency?
Cryptocurrencies like Bitcoin, Dash, Litecoin and several others are encrypted digital currencies. A feature of these currencies is that they are decentralized – whereas most traditional currencies are controlled by a centralized government, therefore able to be regulated by a third party.
Digital currencies are created and transacted in open source environments, where they are controlled by code and rely on peer-to-peer networks. No single entity can affect the currency.
How does cryptocurrency work?
This can be a somewhat tricky thing to get your head around, particularly as we’re all so used to the traditional banking system. Currencies like Bitcoin work by storing all transactions from the inception of the currency on a public ledger. The ledger uses cryptographic techniques to ensure that records are accurate and all owner’s identities are encrypted.
Cryptocurrency owners each have a “digital wallet” and it is the job of the ledger to ensure that those wallets show an accurate spendable balance. It also checks transactions to ensure that the owner is only spending their own wallet balance.
The next logical question is, where exactly do these currencies come from? What gives them their value? Cryptocurrencies are created when a “miner” solves a complex computational problem to confirm a transaction and add it to the ledger. Currencies have a limit (such as Bitcoin, which is 21 million Bitcoins), but you can think of them as all having been created when the currency was created initially, meaning that miners are being rewarded with a new piece of that 21 million when they confirm a transaction.
What? You may be saying — How does this make sense? Where does the value come from? The short answer to this is from the wider community of the particular cryptocurrency. By backing the value of the currency and agreeing to use it as money, they give it value. (Hey, there’s been nothing concrete backing many traditional currencies since being taken off the gold standard!).
Thus far, the value of many of these cryptocurrencies has skyrocketed. According to NPR, if you had bought $1000 worth of Bitcoin in 2010, that investment would be worth $20 million today. There are even ATMs around for Bitcoin – put your regular currency in along with your phone number, then get a receipt back for the purchase of Bitcoin. A check of the digital wallet on your phone should reveal your purchase there in the balance.
What are the implications for banks?
A major shift has happened in how people can do business and make transactions. Suddenly, value is able to be exchanged outside of the traditional banks in the flash of a mobile phone.
As Chris Skinner, author of Digital Bank, puts it:
“People who could not access trade and finance ten years ago can do so today. This will lift many out of poverty.”
This is a key point — people no longer have to go, cap in hand, to a traditional bank if they need financing. Peer-to-peer networks, including those based in cryptocurrencies are becoming more common and those who might be turned away by traditional banks now have another way around financing.
Are traditional banks feeling threatened by these new cryptocurrencies?
In short, yes. Those who are paying attention have already identified cryptocurrencies as an industry threat. French banking giant, BNP Paribas released a report where they discussed the technology behind cryptocurrency and how it could lead to making the traditional banks redundant.
An analyst for the bank wrote about the software behind cryptocurrencies stating that it “should be considered as an invention like the steam or combustion engine, that has the potential to transform the world of finance and beyond.”
A UK Banking Report concludes that cryptocurrencies definitely represent a threat to traditional banks, most especially if they ignore new consumer behaviors and preferences when it comes to how they transact and transfer money.
The report states:
“Bitcoin users can handle many of their daily payments needs themselves, without the need for interaction with banks, and avoiding the need to incur bank fees. In the same way, value stored in PayPal accounts moves outside of the bank’s payment systems, depriving banks of valuable payments revenue.”
There are a few issues cited with these cryptocurrencies, such as their perceived “haven” status for possible perpetrators of illegal activities, a relatively low market cap (Bitcoin’s is somewhere around $3.4 billion) and a sense of volatility with the value of the currency. The suggestion on NPR with regard to investing in Bitcoin was:
“Never, never, never invest more than you’re willing to lose because it could go to nothing.”
Still, traditional banks are becoming very much aware that they’re ceding some ground to the new wave of cryptocurrencies. There are many people out there who absolutely couldn’t wait to find a way around being beholden in some way to a big bank and these people are taking up new options with enthusiasm.
What do traditional banks need to do?
It comes back to what Chris Skinner talks about in Digital Bank; in order to remain relevant, big banks need to become digitized and offer similar real-time services to what people are demanding with cryptocurrencies.
He points out that traditional banks have often been guilty of customer-unfriendly account manipulations, such as applying debits before credits then charging fees for insufficient funds. In a digital age, customers can actually see this happening by glancing at their mobile phones – the big banks won’t be able to get away with such practices for much longer.
Traditional banks need to up their game in areas such as customer service, digital offerings and fees charged. If they’re not thinking of digital solutions beyond the standard mobile banking app, they run the risk of being left behind.
American Banker acknowledges that these cryptocurrencies can present a threat, but also some valid opportunities:
“The roles banks could play include processing payments, providing escrow services, facilitating international cash transactions, helping customers exchange their money for Bitcoins, and even making loans in the currency.”
While there are questions about the volatility of digital currencies and their potential to run afoul of financial regulations, their increasing popularity signifies a shift happening in consumer preferences. Traditional banks need to be onboard with digital and offering the instant, mobile services that many are demanding.
Final Thoughts
Is traditional banking under threat from cryptocurrency? Yes and no. Most big banks are now acknowledging that the technology behind cryptocurrencies should be treated as the next big thing, perhaps like the invention of the motorcar to the railroad.
At the same time, digital currencies have downsides like a perceived volatility and some uncertainty around whether regulators will need to step in.
However, banks who don’t want to go the way of the early Twentieth Century railroads, those who made the mistake of failing to see the motorcar as a threat, would be wise to pay attention to consumer preferences. Getting onboard with digital trends may help to mitigate the cryptocurrency threat.