The Art of Transformation: Will Banks Keep Up?

Frank Doornink, Mike Rumping, Tom Smid

February 2017

Introduction

With a market capitalisation of over $19 billion the Bitcoin and other digital currencies cannot be neglected in today’s financial markets. Some business insiders even fantasize that the digital currency can take over the role of traditional currencies, with the traditional currencies slowly fading away into oblivion. For certain, this extreme case will not happen in the very near future; however, the innovation and revolution of digital currencies is very real and can dislodge the traditional banking sector. In order to keep up with the rise of digital currencies, banks have to transform their business models. Only in this manner they can avoid lagging behind and becoming possibly redundant in the future.

In this blog, we introduce some solutions for regular banks to remain profitable and not to get sidestepped by the digital currency, namely by facilitating the trading interface for the digital currency or by incorporating the digital currency, like traditional currencies, in their business model. Furthermore, we argue that central banks are solely able to keep up with the digital currency by developing their own digital currency. Mainly, because regulation and inflation control is close to impossible with the current system of digital currencies.

The rise of digital currencies

At a basic level, a digital currency is just an online ledger containing names, in the form of a personal code, and balances. If a transaction is completed, the values on the ledger change according to the amount that is transferred. Because everyone has the same type of ledger, verification is done by checking if the totality of the ledgers is still the same after the transaction. The biggest problem with this process is that there is no timestamp on a transaction. Therefore, it is possible to ‘spend money twice’. For example, when you have a balance of x, you can do two transactions of cost x. After the first transaction, your balance should be 0 and the second transaction should not hold. But without the timestamps, it can get unclear which transaction was done first. By manipulating this system correctly, you could get both parties to deliver your goods, while you only pay once. However, this problem was solved by Satoshi Nakamoto (2008), the founder of the Bitcoin. The Bitcoin became the first broadly used digital currency and its popularity is rising extremely fast. When introduced on the market on September the 19th of 2011, one Bitcoin was worth around $5 cents. Today, a single Bitcoin is worth over a thousand US dollars. Bitcoin’s main innovative characteristic is the Blockchain. The Blockchain is a same type of ledger system as discussed earlier, however, it has some valuable additions. The Blockchain contains all transactions ever made in the system because every block contains information on its current value, personal code, and transactions previously made. In other words, after a transaction a new block is made in the Blockchain, which also contains information on the previous block forming a chronological whole. Consequently, spending the same Bitcoin twice is practically impossible and in this manner, the Blockchain solves the problem that affected prior digital currencies, paving the way for the digital currency revolution.

How can banks keep up in a system with digital currencies?

In essence, a bank is a financial institution which accepts deposits and makes loans (Mishkin and Eakins, 2015). Furthermore, they are the largest financial intermediaries in the economy. When referring to banks, we refer to firms such as commercial banks, savings and loan associations, and mutual savings banks.

So, what makes digital currencies, like Bitcoin, so attractive to the public compared to traditional banking? Well, with the introduction of the Bitcoin, banks can be sidestepped because they have a number of disadvantages compared to digital currencies of which we will list the six most important here. First of all, Bitcoin opens up trading across the globe without limitations and challenges associated with using foreign currencies, derivatives, and interest rate swaps, because the Bitcoin can be used worldwide through the internet and is not linked to a specific country or union.[i] Secondly, there are close to no transaction fees when making use of digital currencies, while transaction fees in traditional banking can be substantial.[ii] Thirdly, the Blockchain assures that all transactions are stored in logs without revealing the names of the buyers and sellers, only their wallet IDs. Consequently, personal details are more private than in traditional banking and therefore it increases privacy. Another advantage is that a Bitcoin does not necessarily need to be compared to, or derive its value from, ‘normal’ money, since it is just a balance on a ledger and users can mutually agree on what it is worth, thus being different from commodities and equities which are based on money. Fifthly, the number of new Bitcoins created is predetermined by a mathematical formula, meaning that the number of Bitcoins is known at any moment in time. This de facto restricts the possibility of quantitative easing and the possibility of consequential devaluation or inflation of the currency. Lastly, and most importantly, digital currencies have shown that a decentralized record is feasible, allowing buyers and sellers to interact directly, instead of the involvement of a third party, such as a bank. In other words, the cash flows run directly from one party to another, saving users from costs which normally stick to the third party. This is completely different from the standpoint of the traditional banking sector, where banks are intermediaries that arrange most money transactions.[iii]

This last advantage of digital currencies over banks, the removal of a third party, can become a game-changing innovation, threatening to drive banks out of business. So, how can a bank turn this -at first sight- disadvantage to an advantage?

One way to remain profitable and not to get trapped by the age of digitalization is to facilitate the exchange of digital currencies and to try to seize on arbitrage opportunities in the digital currency market as well as gaining on the bid-ask spread by being a market maker in the same market. Of course, a bank can ask a fee from (private) investors in order to make money, but, more importantly, the bank is fast in detecting trades and is able to function as a market maker. Because of the speed, a bank can capture on arbitrage opportunities by performing trades where the market is not in equilibrium. Moreover, the bank can capture on the well-known bid-ask spread by quoting bid and ask prices.

Another way to add value is to act as a facilitator of digital currency deposits much like banks facilitate deposits of traditional currencies. Currently, banks make profits by selling liabilities, and by investing in assets with a different set of characteristics than the liabilities; thus, basically through asset transformation. Deposits are an essential part of the banking process as well by balancing the books in order to allow for the selling of liabilities and by assuring liquidity to the banks. By facilitating digital currency, deposits banks can maintain their core business model, namely by using digital currency to balance the books and assure liquidity of the business. The bank can add value for the consumer by paying out interest in a similar fashion as it currently does. This addition of value can possibly alleviate the fact that the bank is in essence an intermediary. However, facilitating deposits of digital currency can only be profitable when the currency risk of digital currency is fairly low. Currently, digital currencies are very volatile and are not widely accepted by more traditional industries and investors. Only when the use of digital currency becomes more widespread and common will this business strategy be an option.

Digital currencies and central banks

Central banks have a few important functions in an economy. The most important task is to create price stability and control inflation of its respective currency. They also have an important supervisory role, devising regulations, and checking if banks satisfy these. Lastly, they buy and sell government bonds and supply its economy with funds when necessary.

The inventor of the Bitcoin, Satoshi Nakatomo, said that the purpose of the Bitcoin is to knock the central banks off its current core position[iv]. Thereby potentially shifting the monetary unit to digital currencies which are supported by a market-based legitimacy rather than a regulatory-based legitimacy. Thus, giving businesses and investors an opportunity to enter the market without being subject to the confines of legacy systems.[v]

While great for the public, the use of digital currency can be a nightmare for central banks and even for governments, due to the lack of centralized surveillance. Any transaction made with Bitcoin is virtually untraceable, making it attractive for criminal activities as mentioned in the year report of 2013 of the Dutch Central Bank (DNB, 2014). Central banks acknowledge these threats and are working on solutions. One solution is the introduction of their own currency. Here, we will focus on the introduction of the RSCoin (Danezis and Meiklejohn, 2015), inspired by the research agenda of the Bank of England.

The advantage of the RSCoin is that it has a relatively large degree of centralization compared to other digital currencies, mainly because the monetary supply as well as the composition of a ledger are controlled by the central bank itself. This solves two major problems of Bitcoin for central banks. Firstly, the personal codes on the ledger are now traceable to specific persons or organizations. This makes surveillance for criminal activities possible again. Secondly, the pace of the growth of the monetary supply of Bitcoin is fixed and the establishment of new Bitcoins is solely effected by the so-called miners that determine who will get the new Bitcoins. These miners have to solve mathematical puzzles in order to create new Bitcoins. The value of these Bitcoins is in line with the cost of computational power and energy needed to solve these puzzles. This makes miners in control and they can potentially abuse this power when they get hold of a large part of the mining capacity. With the RSCoin, this process is centralized, making it more auditable as well. And because the bank can create more coins whenever they desire, they can control the money supply of the economy better, keeping the core function they have today.

With digital currencies emerging and getting more widely used, introducing an own currency seems the only way for central banks to keep up. Otherwise, they lose their way to stabilize prices and inflation and they have no way to regulate and supervise financial institutions.

Conclusion

With the continuation of the age of digitalization, banks as well as central banks need to make a dramatic change in their business model in order not to get sidestepped by the digital currencies. Banks can keep up if they facilitate the exchange of digital currencies while trying to seize on arbitrage opportunities in the digital currency market as well as gaining on the bid-ask spread by being a market maker in the same market. Moreover, banks can keep up if they start facilitating digital currency deposits, essentially integrating digital currency into their current business model. Central banks need to introduce their own digital currency in order to stabilize prices and to regulate and supervise financial institutions.


Footnotes

[i] http://www.coindesk.com/banking-innovation-depends-bitcoin/
[ii] http://money.cnn.com/infographic/technology/what-is-bitcoin/
[iii] http://www.indiabitcoin.com/with-the-rise-of-virtual-money-core-functions-of-a-bank-comes-under-pressure-economic-times/
[iv] http://parisinnovationreview.com/2016/11/25/bitcoin-central-banks/
[v] http://www.coindesk.com/banking-innovation-depends-bitcoin/

References

  • De Nederlandsche Bank. (2014). Annual Report 2013.
  • Danezis, G., & Meiklejohn, S. (2016). Centrally Banked Cryptocurrencies.
  • Mishkin, F. S., & Eakins, S. G. (2015). Financial markets and institutions, 8th global edition.
  • Nakamoto, S. (2008). Bitcoin: A peer-to-peer electronic cash system.

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Frank Doornink

MSc Finance at VU Amsterdam
Main interests: trading and financial markets

Mike Rumping

MSc Economics at VU Amsterdam
MA Philosophy of Management and Organizations at VU Amsterdam
Main interests: financial policy and professional ethics

Tom Smid

MSc Finance at VU Amsterdam
Main interests: behavioral finance and trading