First of two parts
Virtual currencies present both a threat and an opportunity to financial institutions. Regardless of your position on this new market development, you would be well advised to watch this space closely.
The announcement of the closure of bitcoin exchange Mount Gox in early 2014 sent shivers across the virtual-payments sector. Eight hundred and fifty thousand bitcoins worth over $470 million were declared lost or stolen by hackers, with bitcoin’s price duly plummeting, calling into question the viability of this and other virtual currencies.
Bitcoin weathered the storm and, along with the likes of Ripple, continues to grow at a rapid rate, with over 8 million accounts anticipated by the end of 2014, up from just 750,000 in mid-2013. Although the daily transactions figure of around $85 million is a mere drop in the vast global retail ocean, it is enough to make banks sit up and take notice and further consider their roles in the new digital currency marketplace.
A virtual currency is essentially a medium of exchange not attached to a fiat currency such as the dollar, yen, euro or sterling. Such currencies are also unregulated by authorities or governments, although this may be about to change. The state of New York has proposed regulations for bitcoin operators, including many of the same requirements that apply to banks and money transfer providers, such as anti-money laundering, cyber security, privacy and information security, as well as capital levels. Governments are also getting in on the act, with the US and China both considering how to tax bitcoin revenue.
Transactions are peer-to-peer and fast, bypassing traditional payment systems. Bitcoins are initially created through a process known as “mining,” where information-technology (IT) specialists are awarded a bitcoin each time they confirm a hash through the blockchain process. Other users can then purchase units of currency through a bank transfer at the current market rate, which can then be exchanged for goods or services, either direct from other “members” or from a growing number of online or physical retailers.
Bitcoins are stored in a wallet with a unique ID number, and companies like Coinbase and Blockchain can hold the currency for the user. When buying from a merchant’s web site, customers simply click the bitcoin option in the same way as they would select credit card or PayPal and type their wallet ID.
Seventy or so exchange forums have evolved to allow the transfer of fiat currencies into virtual money or vice-versa, with Coinbase, Bitpay and Kraken, among the better known. Despite this abundance of exchanges, price differentials have created significant arbitrage opportunities for traders, with some individuals and organizations adopting a hedging strategy, holding units in hope of a rise in value.
With multiple currencies and exchanges and a lack of an overview across exchanges, supply and demand can differ, leading to differences in price. Hedge funds and other capital markets players are looking closely into the risks and benefits of holding such currencies and are likely to favor exchanges with the highest volume, on the basis that these are likely to be more stable and predictable. Compared to more conventional investments such as stocks or bonds, the market for bitcoins is still in its infancy and remains highly volatile.
In response to demand for an efficient means of hedging, in September 2014, TeraExchange announced the launch of the first regulated bitcoin swap-trading exchange and price index. This forum is based around bitcoin derivatives, with traders buying and selling long and short against anticipated bitcoin future prices. Some form of insurance product is likely to follow to protect against prices falling. The facility is registered with the US Commodity Futures Trading Commission and will be regulated under the commission’s rules.
Ripple differs slightly from bitcoin; while it has its own currency, XRP, it is primarily an exchange medium or protocol using a set of rules for transaction-clearing and settlement based on a consensus model for real-time settlement. Most widely known for its “virtual trading floor” used for swapping any commodity for another, most notably gold, as well as reward program points such as frequent flyer miles.
Investment banks that trade in commodities may consider using this facility, with the added advantage of zero storage fees, but also the potential for greater risk. Ripple’s technology can enable banks to optimize internal payments operations (for example, back-office) and provide new and enhanced external payments services to customers (for example, retail, commercial and institutional clients).
Then there is block chain technology—the technology behind bitcoin that allows computers to store and exchange value across a distributed network. This technology has the potential to disrupt the current payments system. It can be adapted to verify and record a wide range of real-world financial transactions, such as transmitting international payments and other assets or clearing securities, all using a database that is distributed across the Internet yet still held secure. To be continued