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March 7, 2016updated 05 Sep 2016 7:38am

Cashing in on Bitcoin: How banks can turn a profit on the cryptocurrency

List: Although Bitcoin is increasingly being looked at by financial services problems remain that need to be overcome.

By James Nunns

Bitcoin, the digital currency which is created and held electronically is part of the cryptocurrency category, and is increasingly being looked at by companies and banks as a potential future form of currency that could replace cash.

Bitcoin is already being used online as a source of currency for trade. In the UK for example eBay allows customers to sell Bitcoins (BTC) and other digital currencies, while online sites such as TabsWear and Reddit also accept the currency.

While it is growing in use in ecommerce and retail settings, the technology is definitely in its infancy when it comes to being used by banks.

CBR identifies why the technology might be used by banks, how it can be used and the problems it faces.

 

Why use BTC

People can’t steal payment information

This is one of the major perks of BTC. The problem with the existing reliance upon credit cards is that they were first conceived before the Internet, meaning that the cards were never supposed to be used online and have more insecurities than is ideal.

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Basically this is because it requires the user to enter all their information into a web form.

BTC however doesn’t require any secret information to be given up, it instead uses two keys, a public one and a private one. The user’s address is the public one and can be seen by anyone, however, the private key is kept secret.

To complete a transaction a mathematical equation combining the public and private keys must be done to prove it comes from the user.

It isn’t inflationary

In the fallout from the banking crash of 2007/08 some governments took the measure of printing money to help pay off national debts, this has also been done to help strengthen the economy through quantitative easing. The problem with this is that is causes the value of a currency to decrease.

This leads to inflation and a rising cost of goods and services. BTC was designed to have a maximum number of coins, 21 million, this can be considered both a positive and negative.

Because only 21 million will be created it means that the number won’t grow, the knock on from this is that inflation won’t be a problem, deflation however, is more likely.

 

How it can be used

Reduced fees

Most banking transactions result in fees for both the bank and the consumer, moving money across borders from buyer to seller, for example, usually uses correspondent banking. Basically, separate banks in each country agree to act on behalf of the buyer and the seller in accepting and transferring funds.

This results in transactions and exchange fees, which are typically passed on to the buyer. The peer-to-peer technology which underlies Bitcoin can make this cheaper and faster. This is because a decentralised ledger does not require an intermediary to keep track of payments and so the buyer and seller banks can deal directly.

Technology from the likes of Ripple Labs for example allows banks anywhere in the world to bypass traditional correspondent systems and transfer payments in real time.

Smart contracts

Last week forty of the world’s major banks completed a series of cloud-based tests on different blockchain technologies, the technology that underpins Bitcoin.

The purpose of the tests were to better understand the technology and how it can be used in regards to smart contracts.

Smart contracts are computer protocols that facilitate, verify, or enforce the negotiation or performance of a contract.

The capability that was used in the trial would allow for developers to encode any "rules" that the blockchain will enforce. Basically it means that it could allow anything from asset issuance to complex financial derivates to be implemented on the platform.

The benefit of this is that it can improve speed by again removing the middleman.

Resilience and decentralisation

Because BTC is decentralised there is no chance of a central point of failure that can disrupt trading. The widely dispersed network breeds greater resilience and security.

The decentralised nature of it also means that central governments can’t take it away. In March 2013 the Central Bank in Cyprus wanted to take back uninsured deposits larger than $100,000 in order to help the country to recapitalise itself.

This obviously caused huge unrest in the local population. This isn’t a possibility for BTC basically because no central authority has control over it.

Not having banks in control of the cryptocurrency may go some way to alleviating people’s fears in the strength of the banking system, which in times of hardship may be of particular value to users.

 

Problems

Block-size

One of the major problems that face BTC comes under the bracket of the block-size debate. Basically blocks are limited to 1mb in size, with any block larger than this invalid. Blocks are basically batches of transactions which are confirmed and then shared on BTC’s public ledger.

A low blocksize limit encourages higher transaction fees to incentivise miners, while an increased blocksize with leave space for extensions like Mastercoin and Counterparty.

Although BTC currently has no fees associated with it, the introduction of them may be good for the miners but could make it look unattractive to new users. These high feeds could stop adoption of the technology along with investment, development and support.

What this boils down to is essentially a constitutional crisis, it splits the BTC community and that isn’t a good sign for a technology that is hoping to be the backbone of financial transactions.

A proposal by Gavin Andresen, the current chief scientist of the Bitcoin Foundation, suggests raising the limit of blocks to 8mb, increasing 40% every two years until 2036 in order to accommodate future growth in CPU power, storage and bandwidth.

This is a problem that needs to be solved before organisations can get behind the technology and back it, as otherwise many won’t known exactly what is being backed.

Low adoption

Given issues surrounding things such as poor mobile support, bad actors, and the potential for centralisation and regulation challenges, the average person may not want to use the currency.

Although it may offer benefits and appeal to customers due to a feeling of it representing something new away from the tradition financial institutions, it isn’t easy to undo hundreds of years of reliance on basically one form of currency.

The problem is that if BTC doesn’t get widely adopted by banks and consumers alike then it will never be a viable replacement for existing systems.

Regulation

In a 2014 State of Bitcoin report by CoinDesk it was found that 12% of 73 countries that have taken some regulatory action on BTC could be considered hostile or contentious. In essence, a number of countries have taken a less than favourable stance against the technology.

In India for example a BTC exchange was raided three days after the Reserve Bank of India issues a public advisory warning against the trade of digital currencies.

The exchange, called buysellbitco, was investigated for violating the Foreign Exchange Management Act. Raids have also been carried out in China and Rissua is said to be considering banning virtual currencies.

What this may reveal is that some financial systems simply don’t want to compete with the technology and regulating its demise is a good way to get rid of it.

Currently there are no far reaching regulations in place that control its use, which means it is competing against a patchwork framework, much like the data regulations that have been in place in Europe.

 

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