The following is taken from a Deloitte report on Bitcoin entitled Bitcoin, the new gold rush? The full report can be viewed here.
Bitcoin is a cryptocurrency, a digital alternative to traditional money relying on cryptography for its operation. The Bitcoin protocol, a system of open source processes, governs the currency and is primarily supported by a peer-to-peer network. This design also makes Bitcoin a payment network, one that exists outside the traditional payments system. Unlike more traditional currencies, there is no principal authority backing Bitcoin. The Bitcoin Foundation, an advocacy group, does help support the use of the currency.
Can Bitcoin enter the mainstream?
Bitcoin’s potential impact is significant though widespread acceptance may seem an unlikely scenario. For Bitcoin to enter the mainstream, at least three conditions would have to be met.
• Stability: First and foremost, bitcoin volatility would have to moderate. Prices have gone through multiple cycles of attention-driven boom and bust. A bitcoin’s dollar value grew 100 percent from December 2012 to June 2013, fell nearly 50 percent from June to July, and shot up another 100 percent in November before crashing in December, and recovering somewhat in 2014.
A currency’s adoption for day-to-day use likely depends on price stability, which consumers and businesses need when planning consumption and savings decisions. In this way, Bitcoin is like an unstable conventional currency — nobody expects it to become the standard for international transactions anytime soon. As long as the currency is subject to speculation and wild swings in value, its utility as a medium of exchange, unit of account, and store of value will be limited.
• Acceptance: A second necessary condition is widespread acceptance. An increasing number of businesses accept bitcoins, but the currency still remains a niche phenomenon. If more major retailers begin accepting bitcoins, the currency’s credibility and popularity might increase significantly. But without more price stability, widespread adoption appears unlikely. Similarly, the current lack of acceptance by traditional financial institutions limits Bitcoin’s use.
Overall near-term acceptance may also be limited given the current size of the Bitcoin market. As of late February 2014, there are approximately $7 billion worth of bitcoins in circulation, a drop in the bucket if one considers the more established currencies. Payment transaction volumes, in February approximately $100 million each day, are also still low relative to volumes through traditional providers.
• Trust: The final, and vital, condition for Bitcoin’s adoption is trust. Gaining businesses’, governments’, and individuals’ trust is no easy hurdle, given the cryptocurrency’s complexity, decentralised system, recent operational issues, volatility, and association with illicit uses. Bitcoin's lack of protection, which consumers have grown accustomed to from traditional financial providers (including fraud protection, deposit insurance, dispute resolution, and safeguards from theft) may further inhibit the development of trust.
One of the major uncertainties facing Bitcoin and other alternative digital currencies is the regulatory environment. Clear regulations, especially in areas such as tax, accounting, and anti-money laundering, may increase Bitcoin’s acceptance and provide a measure of stability and trust.
Until now, regulators’ main focus has been on illegal transactions. For instance, U.S. officials have investigated anti-money laundering compliance and the purchase of illicit substances; one online marketplace, Silk Road, was shut down in October 2013 for allegedly enabling such activity.
Instituting a comprehensive regulatory architecture for alternative currencies such as Bitcoin might not be as straightforward as cracking down on illicit use. The complex interactions between U.S. state and federal guidelines may stymie these efforts, possibly pushing business outside the country.
But there are signs that regulators at the federal and state level are keen to offer regulatory guidance. In fact, the New York Department of Financial Services has stated that it will “begin considering proposals and applications” for virtual currency exchanges in the state. Furthermore, it has also indicated that there would be regulatory guidance before the end of the second quarter of 2014. Meanwhile, the Conference of State Bank Supervisors has formed an emerging payments task force to “coordinate oversight and protect consumers.”
On the international front, the responses of various countries’ regulators has been inconsistent. U.S. authorities have taken a more restrained approach to the broader use of Bitcoin. On the other hand, Chinese regulators have severely restricted the use of Bitcoin, which is very popular in China: a third of Bitcoin trading happens on a China-only Bitcoin exchange.
Implications for financial services
Regardless of whether these conditions are met, Bitcoin could potentially inform innovation for a wide range of institutions, including those in the traditional banking sector.
• Payments: Transfers between individuals via Bitcoin, especially internationally, are faster, simpler, and less expensive than those offered by many financial services companies. Further, processing Bitcoin transactions is far cheaper for businesses than the cost of processing card transactions. As competitors emerge within the Bitcoin ecosystem, traditional banks and payments processors may see an increased threat, forcing them to innovate to retain their traditional dominance.
• Retail and investment banking: The emergence of Bitcoin raises many questions for both retail and investment banks, including the acceptance of bitcoins as deposits, the use of bitcoins as collateral, and the pursuit of business with Bitcoin-related companies. Firms may also have to decide whether or not they should actively participate in Bitcoin trading for themselves or their clients, provided this is within the bounds of current financial regulations. A crucial question will be the optimal investment: a heavy bet will be inappropriate for many institutions, but there could also be risks to avoiding the Bitcoin and cryptocurrency sector entirely.
• Hedging and investment services: Bitcoin, like other assets such as gold, can create demand for peripheral products. Institutions are already starting to offer financial instruments, including insurance and derivatives, to help hedge clients’ risks. They may also create new investment offerings focused on Bitcoin, such as index funds and exchange-traded funds. Building competence and expertise will be a key part of this development. Investment in new talent and training may be required.
• Tax and accounting: The adoption of Bitcoin may carry numerous tax and accounting implications, among them revenue recognition, mark-to-market valuation, the characterization of profits and losses for tax purposes, the applicability of barter transaction rules, basis tracking, and hedging considerations. Financial providers should consider necessary reporting and withholding for cross-border transactions. Further, firms must ensure they can properly reconcile the transactions within their institutional Bitcoin e-wallets to the entries reflected in their general ledger. These implications have provoked intense debate, making it vital to remain keenly aware of future developments.
• Risk and compliance: Bitcoin raises many concerns from a compliance and risk perspective, especially fulfilling anti-money laundering requirements, adequately safeguarding against cyber threats, and properly assessing counterparty risk when a new or existing customer begins using cryptocurrencies. Risk governance and internal controls may need to be developed or updated to account for Bitcoin and other cryptocurrencies. For instance, new risk tools might be necessary to assess and manage market, credit, and operational risks associated with cryptocurrencies. As these issues emerge, proactive and transparent collaboration with regulators will be essential.
• Operations and technology: Depending on the decisions firms make and the state of their systems, software and other IT investments may be needed to integrate alternative digital currency platforms into infrastructure and product offerings. Given the fast pace of change, adopters must continually assess the need for new investments to safely integrate alternative currencies.
Establishing a strong brand in the early stages of the alternative digital currency trend may bring substantial competitive advantage in years ahead, but firms may need to carefully consider the range of outcomes. Moving too fast may result in over-exposure — and embarrassment — if Bitcoin does not enter the mainstream.
Financial consumer implications
Bitcoin and other alternative digital currencies’ popularity also carry important implications for financial services consumers. In addition to the natural education involved in adopting a new currency, customers will have to become comfortable with the use of their digital wallets, learn best practices for maintaining the security of their holdings, and adjust to the inability to challenge transactions. Tax treatment will also be an issue for individuals.
Differing treatments of Bitcoin by jurisdiction may expose users to additional complexity, legal issues, and double taxation. As consumers wrestle with these issues, they may turn to traditional financial institutions for help.
Setting an example
Immediate responses aside, the real impact of Bitcoin may be in its example. While it is not clear what aspects of Bitcoin will endure — the protocol, the public ledger and transparency of transactions, the distributed peer-to-peer network, or others — Bitcoin has demonstrated that payment systems based on open cryptographic networks and decentralised trust can work in practice. It has also increased awareness of cryptocurrencies and alternative digital currencies in general, opening the door to numerous Bitcoin imitators purporting to improve on the original.
As is typical of most new technologies, such as the Internet in the 1990s or mobile technology over the last decade, new and advanced features are being developed on top of the Bitcoin protocol and infrastructure. Emerging open-source projects might represent what HTML became for the Internet: the trigger for massive adoption.
While the protocol and public blockchain have been used to facilitate Bitcoin transactions in this instance, the features enabling digital transfer of assets could have a wide range of other applications, such as exchanging land deeds, automobile titles, or securities holdings. Despite its recent momentum, it is possible Bitcoin might give way to other followers more adept at dealing with the challenges facing cryptocurrencies and other alternative digital currencies.
Conversely, like other pioneers, it may have greater impact than many sceptics imagine. Making concrete predictions about such a fledgling phenomenon is difficult, but regardless of Bitcoin’s trajectory we can expect to see its influence live on in challenges and opportunities posed by other cryptocurrencies to traditional financial services.