How Digital Currencies Like Bitcoin Are Impacting the Banking Industry

Estimated read time: 4 minutes

Just over 10 years ago the financial industry experienced one of the worst recessions since the Great Depression. The housing market collapsed, the stock market tanked, and two of the world's largest banks went under.

The culprit was the subprime mortgage market. Now there's another potential disruptor to financial institutions that do business in the space. It's digital currencies, which are largely known as cryptocurrencies like Bitcoin.

Banking enthusiasts have dismissed the impact of cryptocurrencies on financial institutions. However, there have been several moves by investment banks that show they understand the crypto space should not be ignored.

The endless crypto debate

Bitcoin was the first cryptocurrency to gain worldwide attention. The legend is that a person, or group, named Satoshi Nakamoto created Bitcoin after becoming fed up with the traditional banking system.

A driver behind the need for Bitcoin relates to electronic payment processing. Nakamoto's white paper about Bitcoin details the need for digital currency:

Commerce on the Internet has come to rely almost exclusively on financial institutions serving as trusted third parties to process electronic payments. While the system works well enough for most transactions, it still suffers from the inherent weaknesses of the trust based model. Completely non-reversible transactions are not really possible since financial institutions cannot avoid mediating disputes."

In the white paper, it is stated that payment uncertainties can be alleviated when they are made in person with cash, however, there is no mechanism, "to make payments over a communications channel without a trusted party."

Here's another excerpt.

What is needed is an electronic payment system based on cryptographic proof instead of trust, allowing any two willing parties to transact directly with each other without the need for a trusted third party.

The third parties being referred to in the white paper include traditional financial institutions. The white paper goes on to state that a "purely peer-to-peer version of electronic cash would allow online payments to be sent directly from one party to another without going through a financial institution."

No cheers for Bitcoin, Blockchain seems formidable

Traditional banks have put in place rules that relate to their customers and Bitcoin. For example, a number of them don't allow their credit cardholders to use their cards to buy cryptocurrencies.

While they may not be enamored with the digital currencies, bank execs' curiosities have been piqued by the technology that underpins cryptos. Called Blockchain, the immutable digital ledger has the potential to significantly benefit the finance industry, as well as many other sectors.

CB Insights weighed in on the matter by asking whether the traditional banking industry will embrace the technology or be replaced by it. In a report, CB Insights states, "blockchain and ‘distributed ledger technology (DLT),' could help corporates establish better governance and standards around data sharing and collaboration."

With global banking currently a $134T industry, Blockchain technology and DLT could disintermediate key services that banks provide. Blockchain technology provides a way for untrusted parties to come to agreement on the state of a database, without using a middleman. By providing a ledger that nobody administers, a Blockchain could provide specific financial services — like payments, or securitization — without using a middleman, like a bank.

Take a look at how Blockchain poses problems for traditional banking institutions, according to CB Insights:

  • By establishing a decentralized ledger for payments (e.g. Bitcoin), Blockchain technology could facilitate faster payments at lower fees than banks.
  • Distributed ledgers can reduce operational costs and bring us closer to real-time transactions between financial institutions.
  • Blockchain technology can make borrowing more secure and cheaper because the technology removes the need for the third-party gatekeepers and their high-interest rates for loans.

By replacing the cumbersome, paper-heavy bills of lading process in the trade finance industry, Blockchain technology can create more transparency, security, and trust among trade parties globally."

Is there a place for Bitcoin and other cryptos?

Traditional banks may not be excited about the future of cryptocurrencies. However, others in the finance space are making moves that indicate they are realizing the significance of the space.

For example, in 2017 the Commodity Futures Trading Commission announced it would allow CME Group and CBOE Global Markets to list bitcoin futures. Observers anticipated that the move could increase crypto investments.The exchanges became the first to offer investors the chance to trade Bitcoin-related financial products.

One of the draws and handicaps for cryptocurrencies relates to regulations, or the lack thereof. Many are calling for more of them to be put in place to protect consumers from becoming victims of fraud that persists in the crypto world.

Standard & Poor's Global Markets discussed the matter in a report. Here's an excerpt:

We believe that cryptocurrencies, in their current version, have many characteristics of a speculative instrument. We think that retail investors would be the first to bear the brunt in the event of a collapse in their market value."

There have been calls for the creation of a crypto that would be backed by a central bank, such as the Federal Reserve. The intent is to give people direct access to this central bank's ledger is potentially a game-changer to banks as we know them.

However, as noted by S&P Global, "this does not mean that banks will disappear, but it would mean significant changes in the way they do business."