Bitcoin boom prompts banking dilemma

Bitcoin has become a global phenomenon. But will it stick?

Bitcoin is more traceable but less regulated, less expensive but more volatile, and more decentralised but less accountable than a regular currency. Feeling confused? That’s not the half of it, according to Ernst & Young.

Founded in 2009 by developer Satoshi Nakamoto (a pseudonym), Bitcoin is a peer to peer digital currency. Despite the fact that it is not currently used by any major bank anywhere, the currency has become a talking point for financial services firms, and has spawned numerous imitators and competitors, including Amazon Coin, Litecoin and Peercoin.

The currency has also seen a meteoric rise in value. At the start of this year, a single Bitcoin was worth less than $20. By the end of November, one Bitcoin was worth $1,000. Yet not everyone is convinced. Earlier this month, Chinese regulator the People’s Bank of China warned  the country’s banks that Bitcoins had no legal status and should not be used as a currency. However, even in China individuals are still able to trade in Bitcoins. So what’s the deal?

“Bitcoin is really an experiment,” said Colin Pickard, director of financial services, Ernst & Young. “Virtually all mainstream currencies are inflationary. What that really means is that governments borrow from tomorrow’s children, which isn’t necessarily a good thing. Bitcoin is the opposite – it’s deflationary.”

One of the founding principles of Bitcoin is that there will only ever be a set amount of Bitcoins in existence – more will not be created. Although Bitcoins have to be ‘mined’ by computer processors before they can be extracted and used to make a payment, and there are plenty of Bitcoins left untapped at present, eventually they will all have been mined. In addition, as more and more Bitcoins are ‘unearthed’, the processing power required to acquire the remaining unclaimed Bitcoins gradually rises.

In theory, this means that the value of the existing Bitcoins will gradually increase over time, as existing Bitcoins that are ‘lost’ cannot be replaced. Bitcoins cannot be destroyed, but they can be irrecoverable if the owner forgets their password or dies without telling anyone, for example. Ostensibly, that could mean that Bitcoin owners are incentivised to hold onto their Bitcoins to take advantage of the rising value – but eventually, if hoarding becomes too widespread, scarcity will cause liquidity to dry up, potentially causing a catastrophic crash in value as users realise that their Bitcoins are not actually worth anything.

Just such a scenario caused economic chaos in Medieval China, for instance, where stockpiles of the coins of one ruler would suddenly be outlawed, making them worthless overnight. Hoarding took place because new coins were sometimes not issued but instead replaced with old ones of limited circulation, which then sharply appreciated in value but might become worthless at any moment. However, Ernst & Young have concluded that Bitcoin is likely safe from this boom and bust scenario, since unlike ancient units of currency each Bitcoin can be infinitely subdivided into smaller increments of value. Instead, the main risk is the lack of regulatory framework and associations with fraud.

“Most tier one banks don’t want to be the first to risk using Bitcoin, because the regulatory framework hasn’t evolved to handle it,” said Pickard. “That’s a shame, because the cost of a transaction on Bitcoin is less. There’s benefit in that for the economy. But it needs to satisfy governance and regulation otherwise it’s not going to work.”

Public perceptions of Bitcoin may be slightly out of sync with the reality, according to Ernst & Young. Notoriously, Bitcoin was used by customers accessing Silk Road, the shadow internet site that sold illegal drugs. Yet the reality is that Bitcoin is more traceable than cash, and potentially even than conventional banking transactions through multiple accounts.

“Perceived as an anonymous form of payment, Bitcoin is in fact traceable,” said Roger Willis, senior executive, fraud investigation and dispute services at EY. “The location of every Bitcoin as well as the list of all Bitcoin transactions are all recorded electronically and held by the Bitcoin ‘blockchain’, a list that is constantly updated. There are also computing groups that have been able to figure out which postal addresses are accessing the Silk Road, leading to criminal prosecutions of individuals.”

However, Willis was keen to emphasise that significant challenges remain, especially if merchants, banks and regulators are to be convinced that Bitcoin is a legitimate form of exchange. “If Bitcoin can’t compromise with the regulators, it’s not going to take off,” he said. “Complexity and volatility are a problem. If you can’t understand it, how can you be sure it’s safe? And if it’s so volatile, how can you be sure of its value? Merchants won’t use it if banks won’t use it, and banks won’t use it till they understand it. We need a Bitcoin exchange that incorporates all the FCA rules, including the EU Payment Services Directive. The other stability concern is that Bitcoin has four gateways, and if they get shut down all is lost. That’s a hurdle, so there’s a need for more investment and more expertise.”

In the US, the financial regulator FINMA has stated that Bitcoin transactions will be treated as an exchange of currency, despite its official stance that Bitcoin is not actually a legitimate currency. In the UK, payments in Bitcoin are liable for capital gains tax, but no VAT is collected. As a global currency, it also remains unclear where exactly the boundaries of regulatory supervision lie – which country should take the tax, for example, at what point of the transaction, and in what currency.

There are also issues of accountability to wrestle with. According to Pickard, the digital currency poses a question of public interest, because currencies have until now been controlled by governments at least nominally acting in the interests of the people. Bitcoin was designed with a decentralised structure, in which no single individual or organisation can easily exert control.

“It’s revolutionary, because any other kind of payment will clear on a regulated exchange,” he said. “Bitcoin moves us outside that protection. A regular currency is in the hands of our elected representatives, at least nominally, because it is managed by a central bank which is run by the government which consist of our elected representatives. You can have a say in that system, but the Bitcoin Foundation isn’t accountable in the same way. What are the motives of the Bitcoin Foundation? Are they acting because they want to increase liquidity, or do they collectively own a large proportion of Bitcoins and they simply want the price to appreciate?”

There is also no guarantee of value when investing in Bitcoin, because the currency is not backed by a similar guarantee to the central bank that features on most conventional bank notes. Bitcoins could potentially be used to aid Ponzi schemes, such as the $18 million oil and gas Texas ponzi scheme handled by US regulator the SEC in July, which was denominated in Bitcoins.

Bitcoin currently trades more like a commodity than a currency, which is a problem because commodities are vulnerable to price bubbles. In the end, according to Willis at Ernst & Young, Bitcoin’s ‘outsider’ status is the source of both its greatest strength – the direct peer to peer connection – as well as its greatest weaknesses, the volatility and lack of regulatory certainty.

“Satoshi didn’t want a centralised system,” said Willis. “He wanted it decentralised so that no one can control it. Its structure reflects that. The value of Bitcoin is transferring money peer to peer: Bitcoin was made for e-commerce micro transactions between peers, and that was never possible before.”