The capitalisation of bitcoin recently exceeded one billion dollars. It is no longer the crypto-currency we knew at its inception just over ten years ago. Bitcoin is starting to be used as a real currency for buying and selling transactions: just recently, 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 solely in the form of data on a decentralised global network of computers.
It is this characteristic in particular that gives it 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 cryptocurrency world continues to expand and grow in popularity, traditional banks are reluctant to embrace the use of these digital assets, believing that their inherent risks outweigh their potential benefits.
The risks surrounding bitcoin
According to a study conducted in the UK, almost 63% of respondents working in the banking sector perceive cryptocurrency as a risk rather than an opportunity. This is mainly due to several types of risk.
Decentralised nature
Due to its decentralised nature, bitcoin, like other cryptocurrencies, is neither managed by a central bank nor backed by an asset, so its value is not guaranteed by any authority, which diminishes its appeal as an asset. In addition, many consider that the decentralised nature of the currency undermines the authority of central banks and therefore exposes cryptocurrencies to the risk of very strong measures from the authorities, a potential ban for example.
AML / KYC concerns
Cryptocurrencies enable transactions without a regulated intermediary, allowing the user to easily transfer funds without having to pay 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 pseudonymity is of concern to banks and the authorities, who fear that cryptocurrency could be used for illegal activities such as money laundering. Also, due to its decentralised and entirely digital nature, cryptocurrency can prove 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
Cryptocurrency prices are highly volatile, mainly due to the size of the market, liquidity and the number of participants. 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.
Regulatory problem
But perhaps the biggest risk is linked to regulation. Indeed, there is currently no global regulation of cryptocurrency transactions or exchanges. Most of the governments and central banks of the world’s largest economies have begun to study the issue, but the regulations that exist at national level are very different from one another. This regulatory inconsistency is one of the biggest obstacles 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 regulation changes. There also remains a lack of clarity around their tax treatment, although there has been some progress in North America on this issue.
Bitcoin ETFs: a reality
Source: Glassnode.
An exchange-traded fund (ETF) is a type of security that tracks an index, sector, commodity or other asset and can hold many types of investment, including equities, 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 cryptocurrencies, until recently cryptocurrency ETFs did not exist. Indeed, several attempts to launch ETFs in the United States failed because the regulator refused to authorise such a product, citing the excessive volatility of cryptocurrencies.
An ETF of bitcoin is one that mimics its price. Such a financial instrument 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 ETF holders are not directly invested in bitcoin itself, they do not have to worry about the complex storage and security procedures required of cryptocurrency investors.
Although no such ETF has yet been launched in the United States, the world’s first two ETFs were recently launched in Canada, in February this year, following approval by the Ontario regulator. These are the Purpose Bitcoin ETF (BTCC) and the Evolve Bitcoin ETF (EBIT), both of which are listed on the Toronto Stock Exchange. Investors expect the US to follow Canada’s lead in the near future.
An opportunity for financial institutions?
As noted, there are real risks surrounding cryptocurrencies for banks. However, there are also real opportunities for financial institutions, as these digital assets could streamline, improve and upgrade financial services thanks to their many advantages.
For example, financial institutions could 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 customers. This would help secure digital currencies against theft or piracy.
It is also possible that blockchain technology could be used to automate AML and KYC checks. 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 wider banking ecosystem. They could also use smart contracts for mortgages, commercial loans, letters of credit or other transactions.
Currently, many financial institutions are wary of cryptocurrency adoption. Concerns mainly about security and stability are holding them back. There are still exceptions, however, such as JP Morgan or Morgan Stanley, which have begun to invest in this sector because 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 streamline processes and take banks into the next generation of efficiency and innovation.
