Bitcoin: boon for investors or threat to financial institutions?

Bitcoin's capitalization recently surpassed $1 billion. It is no longer the crypto-currency we knew at its beginnings a little over a decade ago. Bitcoin is starting to be used as a real currency for buying and selling transactions: recently even Tesla announced that it accepts the famous token for the purchase of its electric cars.

What makes bitcoin unique is that it relies entirely on digital technology for its creation, use and value. It is not associated with any government, central bank or financial institution. It exists only as data on a decentralized global network of computers.

It is this feature in particular that gives it some advantages that can be useful in many areas. Indeed, as an example, to carry out money transfer transactions, instead of relying on the traditional banking infrastructure, with cryptocurrency the trust is instead placed in the blockchain code and its distributed nature, which represents a very strong alternative.

However, while the world of cryptocurrency continues to expand and gain popularity, traditional banks are hesitant to embrace the use of these digital assets, believing that their inherent risks outweigh their potential benefits.

Risks around bitcoin

According to a study conducted in the UK, nearly 63% of people surveyed working in the banking industry perceive cryptocurrency as a risk rather than an opportunity.  This is mainly due to several types of risks.

Decentralized nature

Because of its decentralized nature, bitcoin, like other crypto-currencies, is neither managed by a central bank nor backed by an asset, and its value is therefore not guaranteed by any authority, which diminishes its appeal as an asset. In addition, many consider that the decentralized nature of the currency undermines the authority of central banks and thus exposes crypto-currencies to the risk of very strong measures from the authorities, a potential ban for example.

AML / KYC concerns

Cryptocurrencies allow for transactions without a regulated intermediary, allowing the user to easily transfer funds without paying transaction fees. Instead of identifying the transaction through an individual bank account via a financial institution, transactions are simply linked to the transaction ID on the blockchain.

This type of anonymity is a concern for banks and authorities who fear that cryptocurrency can be used for illegal activities such as money laundering. Also, due to its decentralized and all-digital nature, cryptocurrency can be vulnerable to sophisticated hackers and other types of online criminals. South Korean cryptocurrency exchange Youbit paid the price: a cyberattack, the second of the year, forced it to shut down in 2017.

Volatility

The price of crypto-currencies is very volatile due to the size of the market, the liquidity and the number of people involved. Banks see this as a risk because historically the price has not been stable, so they believe that these virtual currencies may not remain a reliable investment vehicle over time.

Regulation problems

But perhaps the biggest risk is related to regulation. Indeed, there is currently no global regulation of cryptocurrency transactions or exchanges. Most governments and central banks of the world's largest economies have begun to study the issue, yet existing regulations at the national level are very different from each other. This regulatory inconsistency is one of the biggest barriers to the development of the cryptocurrency market.

Investors are well aware that the current scarcity of regulation makes cryptocurrency markets prone to manipulation and that their investments could lose value if regulations change. There also remains a lack of clarity around their tax treatment even though there are steps forward in North America on the issue.

Bitcoin ETFs: a reality

An exchange-traded fund (ETF) is a type of security that tracks an index, industry, commodity or other asset and can hold many types of investments, including stocks, commodities, bonds or a mix of investment types. The ETF market is huge, exceeding $5 trillion.

However, despite the very large market for bitcoin and other crypto-currencies, until recently crypto-currency ETFs did not exist.  Indeed, several attempts to launch ETFs in the United States failed because of the regulator's refusal to allow such a product, justified by the fact that crypto-currencies are too volatile.

An ETF of bitcoin is one that mimics its price. Such a financial tool allows investors to buy the performance (as well as the risk) of bitcoin without going through the complicated process of buying bitcoin itself. In addition, because the ETF owners are not directly invested in bitcoin itself, they do not have to worry about the complex storage and security procedures required by cryptocurrency investors.

While no such ETF has yet been launched in the U.S., the world's first two ETFs were recently launched in Canada in February following the approval of the Ontario regulator. These are the Purpose Bitcoin ETF (BTCC) and the Evolve Bitcoin ETF (EBIT), which are both listed on the Toronto Stock Exchange. It should be noted that investors expect the United States to follow Canada's lead in the near future.

An opportunity for financial institutions?

As highlighted, real risks exist around cryptocurrencies for banks. However, there are also real opportunities for financial institutions as these digital assets could rationalize, improve and upgrade financial services with their many benefits.

This would allow financial institutions to provide cryptocurrency custody services to customers, including holding unique cryptographic keys associated with access to private wallets. This means that banks could securely and efficiently hold either the cryptocurrency itself or the key to access it on a personal digital wallet for its clients. This would help secure digital currencies from theft or hacking.

It is also possible that blockchain technology could be used to automate AML and KYC verifications. This technology could potentially allow all customer data to be stored on the blockchain. This data could then be used by all financial institutions.

Banks can also use public blockchains to process payments and money transfers much faster and without the need for a third-party agency. This would potentially put blockchain networks in the same category as SWIFT, for example, paving the way for these networks to become part of the broader banking ecosystem. They could also use smart contracts for mortgages, commercial loans, letters of credit or other transactions.

Currently, many financial institutions are cautious about adopting cryptocurrency. Concerns about mainly security and stability are holding them back. However, there are still exceptions like JP Morgan or Morgan Stanley that have started to invest in this sector, as they are aware of its potential benefits.

Without underestimating the risks, banks could play an important role in this industry, adding much-needed insurance and security to the largely unregulated environment. The adoption of cryptocurrencies and blockchain technology as a whole can rationalize processes and bring banks into the next generation of efficiency and innovation.