Thriving in a digital age: Digital currencies pose the biggest threat to banks – Part III

  This is the final part of a revised and improved version of a paper published in the Association for Professional Bankers 2016 Annual Convention Publication titled ‘Thriving in a Digital World’. 

Part I of this paper (available at: http://www.ft.lk/article/581122/Thriving-in-a-Digital-Age--Digital-currencies-pose-the-biggest-challenge-for-banks-%E2%80%93-Part-I) examined how paper currencies came to existence and how they were abused by those who had the authority to issue them. The abuse was manifested by an oversupply of paper currencies by central banks and governments leading to a continuous erosion of their value. The victims were people who had accepted them as an important component of their wealth. As a result, there was a growing demand for the introduction of alternative currencies. 

The main qualifying candidate was digital currencies, also known as ‘cryptocurrencies’. A cryptocurrency is simply a currency that exists in cyberspace and is operated by using computer and internet technology. The smart mobile phone has been the leading instrument of accessing the internet for using cryptocurrencies for doing transactions and making payments. 

Part II (available at: http://www.ft.lk/article/582549/Thriving-in-a-Digital-Age--Digital-currencies-pose-the-biggest-challenge-to-banks-%E2%80%93-Part-II) of the paper examined in detail the operation of one of such cryptocurrencies, known as Bitcoins or BTC, that has become popular among many throughout the globe since its introduction in 2009. BTC was introduced following a seminal paper published by an anonymous developer who had taken the penname Sotoshi Nakamoto. 

BTCs are governed by a computer program that uses complex algorithm to produce them. Those who use the computer program to produce BTCs are called ‘miners’ and since the supply is restricted by the program itself, it is not an easy enterprise for miners to mine them. Because of the higher demand for BTCs over their limited supply, the value of BTCs has increased in the open market over the last seven-year period. The article examined the risks faced by central banks in particular and banking institutions in general due to the proliferation of BTCs in the global financial system. 

Part III of the paper will look at how banks and central banks could overcome the threat of the proliferation of cryptocurrencies in the global financial systems.

The demand for digital currencies

Many believe that Bitcoins do not have a future as an alternative currency because they are not backed by any national economy. Hence, the value of Bitcoins and the attraction to them are derived from their limited supply. 

Despite the shortcomings of digital currencies like Bitcoins, there is still a growing demand for digital currencies in society. That is because societies desire to have low cost swift transactions when they make payments by cutting out banks which have increasingly become more expensive specifically for low value money payments. This is specifically important in developing countries where there is limited access to banking by majority of people. The advantage of a digital currency is that anyone with a smart mobile phone or internet connection can make payments as small as Rs. 10 without going through the banking system. 

Another benefit is their low transaction costs compared to credit cards. Thus, retailers with narrow margins stand to gain through the use of digital currencies. Therefore, authorities on the subject like Campbell R. Harvey believe that there is a growing demand for cryptocurrencies and technology would advance suitably for the proliferation of their use. Harvey presented this idea in an article he wrote to Wall Street Journal under the title ‘Do cryptocurrencies such as Bitcoins have a future?’ (available at: http://www.wsj.com/articles/do-cryptocurrencies-such-as-bitcoin-have-a-future-1425269375). 

The perceived merits of Bitcoins

Writing on the merits of Bitcoins which are equally relevant to any form of digital currency, Harvey has highlighted a number of advantages which society would get by using them. The ability to conduct online transactions without compromising personal data, easy use through smart phones, low transaction costs and the absence of the inflation risks are some of those merits which digital currencies possess. 

Nick Marinoff, another financial expert writing in the Wall Street Journal (available at; http://www.newsbtc.com/2015/03/02/wall-street-journal-asks-bitcoin-future) has argued that digital currencies like Bitcoins have only a temporary future. That temporary future comes from the acceptance of the people that Bitcoins exist and they can be used for transactions, despite the fact that they are simply produced through computer programs. 

Argues Marinoff: “People see value in Bitcoin. They see its abilities to give financial capabilities to those who did not have them before. They see that Bitcoin has the ability to remove power from banks and place it in the hands of customers, and for that, Bitcoin has a strength that cannot be replaced or taken away. Bitcoin has earned its place in the financial sector. Once that place is secure and tightened, bitcoin’s future will travel beyond what we have foreseen.” 

His argument is that when people see the price of Bitcoins rising, their popularity and usage can be expected to grow. 

Bitcoins are not that superior too

However, due to several reasons, Bitcoins cannot be expected to have a permanent future as a substitute for national currencies. In the first place, they are not supported by any national economy and therefore, in the event of any economic calamity, those who hold onto Bitcoins cannot have their value exchanged for any valuable asset. 

Bitcoins are demanded by people for speculative purposes and not for holding their wealth. The very same fact would cause their destruction as well. When the holders rush to exit Bitcoins, the value will fall and eventually they would disappear from financial markets. 

Another reason that would cause them to have only a temporary future is the absence of a godfather to protect their value. In the case of national currencies, there is a national government that would consider it as its responsibility to protect its value.

 These sovereign governments can borrow from international markets and hold onto the value of their national currencies. Bitcoins do not have such a godfather and in the absence of a godfather, there is no one to protect its value when it starts its downward march for whatever the reason. 

Hence, there is now an increase in the demand for other alternative currencies in place of Bitcoins.

Digital currencies are a galore

The rise of the demand for alternative digital currencies, in place of Bitcoins, is a challenge which financial institutions cannot overlook. The market place has identified 12 such ‘altcoins’. They are ‘Litecoins’, ‘Peercoins’, ‘Primecoins’, ‘Namecoins’, ‘Ripples’, ‘Sexcoins’, ‘Quarks’, ‘Freicoins’, ‘Mastercoins’, ‘Nxts’, ‘Auroracoins’ and ‘Dogecoins’. But there are more such digital currencies and Wikipedia has listed 24 such currencies. These altcoins are directly in competition with banks and their payment instruments. Hence, unless banks get into the business of producing their own digital coins, they could be competed out by market developed alternative digital currencies. 

Though Kenneth Rogoff says that they are not competing with physical currencies produced by central banks, they do compete with them in the way they compete with financial instruments issued by banks. 

If societies go for such alternative digital currencies instead of using physical currencies, central banks would lose seigniorage, inability to cover their costs, fail to conduct monetary policy and maintain price stability, find financial system stability more complex and finally become irrelevant in society. 

Hence, central banks and commercial banks should get into the business of producing digital currencies before private party produced altcoins become a common place. 

Citibank’s Citicoin

To face the challenge, several leading banks have ventured into developing their own cryptocurrencies. One such move is by Citibank which is reported to have begun work on its altcoin called Citicoin (available at http://truthinmedia.com/citibank-is-developing-citicoin-a-bitcoin-inspired-cryptocurrency). The Citicoin is being developed by the bank’s technological innovation subsidiary, Citi Innovation Labs and is being mined in the lab as an alternative to Bitcoins. It is the view of the Citibank that such digital currencies can cross the borders without time consuming regulatory hurdles. Citibank has developed three ‘blockchains’ – a digital distributed ledger that records all transactions relating to its new digital coin – and has started to test the currency’s cross border payments. The advantage for the Citibank in this connection is that it has a global network and it can use the new technology to move money from country to country. 

According to Citibank, it is also considering the ways available to it to eliminate counterparty risks when it does transactions with small banks which cannot keep required collateral for same. The bank is now looking for possibilities of issuing state-backed digital currencies in different countries by using its blockchain technology. If this happens, the central banks also can move from paper currencies to digital currencies, a move that will bring substantial savings in their operations. 

Citicoin is still in its testing stage. The advantage of Citicoin over Bitcoin is that Citibank exists in the real world, it has a global network and it can provide liquidity to the system in case of settlement problems and it is governed by a governance structure acceptable to participants. The Bitcoin, on the other hand, lacks any of these attributes. Hence, once Citicoin hits the market, there is reasonable expectation that it would replace the currently popular Bitcoin which is only a payment and speculative mode.

Following the Citi’s example, four other major banks also have entered the race to develop a digital currency of their own. They are UBS, Deutsche Bank, Santander and Bank of New York Mellon. They have been prompted by the desire to cut costs and improve operations. 

Central banks too have joined the fray to issue digital currencies

Central banks are also considering the issue digital currencies today. The Deputy Governor of the Bank of England, Ben Broadbent, in a speech delivered at the London School of Economics in March 2016    (available    at: http://www.bankofengland.co.uk/publications/Documents/speeches/2016/speech886.pdf) has argued that a central bank variety of a digital currency is possible side by side with its physical currencies. The advantage for a central bank to have a digital currency, unlike a private party developed digital currency like the Bitcoins, is that it can function as both the clearer of currency payments and liquidity provider in case of liquidity shortages. 

However, such a digital currency – called central bank digital currency or CBDC – will compete with commercial bank deposits as money and unless commercial banks are able to cut their costs, they will eventually be replaced by CBDCs. In July 2016, the Bank of England issued a detailed staff working paper under the title ‘The macroeconomics of central bank issued digital currencies’ (available at: http://www.bankofengland.co.uk/research/Documents/workingpapers/2016/swp605.pdf).

The paper has argued that CBDCs are interest bearing central bank liabilities accessible to all citizens and therefore would compete with commercial bank deposits. Unlike the private sector developed digital currencies, these CBDCs have a permanent existence since they are backed by the strength of a national economy. 

If commercial bank deposits move into central bank issued digital currencies, commercial banks face a serious threat in the form of losing their deposit base and consequently the lending operations.

The planned experiment 

by Sweden  

In the meantime, Sweden where cash transactions have declined to a minimum is now considering the introduction of a digital currency to take its place (available at: http://www.wsj.com/articles/swedens-central-bank-considers-digital-currency-1479296711). The Riksbank - Sweden’s Central Bank – is now looking at the technological, legal and policy implications of introducing a digital currency to replace its paper currency. But it is a risk to commercial banks because at a time of financial crisis, people might move their bank deposits to central bank’s digital currency thereby aggravating the liquidity crisis in banks.

The challenge for commercial banks is real 

This emerging development is a real challenge for banks in the digital age. When societies demand for better services, banks should be ready to provide them. In the current payment system which is done through banks, the prohibitive commissions charged by them have been the main criticism against them. 

Hence, it is quite natural for technology to support individual customers who are desirous of transferring money from person to person swiftly, efficiently and cheaply. Such technology is a disruptive technology for banks; but they cannot avoid it since they have not gained capacity to serve their customers in a digital world. If they do not come up with alternative arrangements, banks as payment providers will become irrelevant pretty soon. 

Need for fresh approach by commercial banks

Banks have been the first to embrace the advancements in ICT to cut costs, have a wider outreach and make banking services inclusive. The move was prompted by the need for sustaining their business in a world of thinning margins and fierce competition. 

However, though banks have moved along with the developments, they have been a little sluggish in capturing all the advancements compared to other industries that have been late adopters of advancing technology. Therefore, banks now have to compete with non-bank money transfer institutions which have been able to supply a better service to clients at a cheaper cost. It is therefore a matter of time that banks would completely be displaced as managers of making money transfers and payments in modern economies. Banks, therefore, have to modernise themselves to meet the challenging service requirements of the day. 

The problem has been complicated by the emergence of a new class of customers who are tech savvy – called Generation-Y or e-Generation – and therefore, in the habit of demanding prompt banking services through advanced ICT. This has required banks to invest heavily in the digital infrastructure and digitally competent personnel. 

Threat for displacement of commercial banks?

The biggest challenge for banks today is the threat to displace them as the monopoly providers of national and across the border payments. This has been prompted by the loss of trust in national currencies issued by governments. 

Since the power to issue currency has been abused by governments by overproducing money and causing an erosion of the wealth of the people, there has been a growing demand for alternative currencies. The market is, therefore, in the business of producing digital currencies which are competing with both banks and national governments. Thus, central banks too are now considering the entry into digital currency world through their own digital currencies. 

Since the pressure is mounting and enabling technology is being developed, it will be a matter of time that banks would be fully displaced in their present role as deposit mobilisers and payment system providers. The way out for banks is to produce their own digital currencies, as has been experimented by Citibank and others recently. 

(W.A. Wijewardena, a former Deputy Governor of the Central Bank of Sri Lanka, can be reached at [email protected]).