The Impact of Bitcoins on The Banking System

Introduction

A brief definition of Bitcoin is that it is a type of virtual currency. However, there is much more to bitcoins and the reasons why they have become more popular. Some people prefer bitcoin because it allows them to remain anonymous while making monetary transactions. Other people simply support bitcoins because they do not trust banks. Whatever the reason, an increasing number of individuals seem to believe that bitcoin is a superior choice when compared to banks. However, evidence shows that the market of Bitcoin is too volatile and unsecured to be considered as an alternative to banking, which may explain why bitcoins are not accepted as a form of payment everywhere. What follows is a discussion based on the nature of the Bitcoin and its potential to dethrone central banks in America.

Definition

According to Segendorf (2014), bitcoin is a “so-called virtual currency that has been devised for anonymous payments made entirely independently of governments and banks” (p. 71). The idea of bitcoins as a digital currency was introduced years ago, but it materialized in 2009. Nobody has been able to confirm who the creator was, which illustrates the anonymous nature of the system, but many believe that it was developed by a Japanese man called Satoshi Nakamoto. Now, the term virtual or digital currency refers to a means of payment; in that sense, bitcoins are similar to cash. Each one has a determined value, and it is used by people to make purchases or payments. Bitcoins are not physical currency, and they are not issued by any official entity. Some argue that Bitcoin cannot be defined as legal tender yet.

Claims

As stated by Stanford University (2017), there are some alleged advantages of using bitcoin versus other payment systems. First, there is no third-party seizure; there is no way for someone to seize bitcoins, so governments cannot freeze someone’s wealth. What this means, according to supporters, is that Bitcoin users always have freedom to do anything that they want with their money. Second, there are no taxes involved. Because nobody can intercept transactions of bitcoins, nobody can attempt to create a bitcoin taxation system. As will be discussed next, that is not entirely true because bitcoins are still considered assets. Third, transactions are made anonymously.

There is increased privacy and no way to trace transactions back to a user. Further, “by using bitcoins users will be contributing to the network, which greatly reduces transaction costs” (Stanford University, 2017, para. 5). Finally, bitcoins cannot be stolen unless a criminal has physical access to a user’s computer and can send bitcoins to his or her own account. Again, the discussion that follows will provide evidence that bitcoins can still be stolen or lost.

Mechanism

The Bitcoin system was one of the first to use peer-to-peer technology to aid with instant payments. As described by Lo and Wang (2014), Bitcoin “enables the proof and transfer of ownership without the need for a designated third party” (p. 2), which adds to its convenience; people are able to perform transactions instantly and easily. To use a bitcoin, the user submits his or her account credentials to the block chain.

The block chain is the public transaction ledger; it is the system that allows individuals to purchase, sell, mine, and use bitcoins. Once the individual logs into the system, he or she chooses what action to perform next. If the person initiates a transfer, it is only completed after it has been verified by so-called “miners.” Miners are people “who use their computing power to verify that the transaction is real by solving a computationally intensive problem” (p. 2). As one can imagine, not everyone can work as a miner, and it is not an easy job, yet the system allows for thousands of individuals to verify the transaction. The person who solves the problem or “hash,” is rewarded with a given number of bitcoins for helping.

For some, the work of miners is nothing other than money creation. The work of miners is key to the continued existence of bitcoins. Every time that they use their skills, bitcoins are created to reward them for their work, and those bitcoins add to the already existing stock of bitcoins. Lo and Wang (2014) mentioned that it is important to note that each transaction and problem-solving that goes with it lasts less than 10 minutes, so the user trying to spend his or her bitcoins is able to do so in a short period of time.

Moreover, if miners obtain bitcoins every time that they verify a transaction, they could be generating millions of bitcoins per day. In an attempt to control the number of bitcoins “mined,” the algorithm used to create them also fixes the future supply of bitcoins. Its limit is 21 million units, which is still an incredibly high number for a form of currency that is not regulated by anyone.

Popularity

In spite of the many claims that bitcoins are becoming as popular as other payment forms, the reality is that this digital currency is still far from surpassing the popularity of traditional methods such as credit cards. According to Segendorf (2014), Bitcoin usage is low globally. In 2013, about “60,000 bitcoin transactions per day were made” (p. 77). Although that number reflected about USD 64 million per day, the success did not last.

In 2014, less than 28,000 bitcoins were created per day. Such a drastic decline suggests that global demand for bitcoins decreased significantly. On the other hand, Bitcoin popularity has recently increased in the United States. Heller (2017) stated that in the U.S., bitcoin has “more than 13 million registered users... and every second up to 10 payments are made in bitcoin” (p. 1750). It is because of its increasing approval in the U.S. that many people argue that bitcoins could eventually replace the traditional banking system.

Banking System

In order to perform an accurate comparison between bitcoin and the banking system, one must understand the state of banking in America. According to Sylla (2017), “banks are among the oldest businesses in American history” (para. 1). For example, the Bank of New York was founded back in 1784. Others, such as JPMorgan, Chase, Bank of America, and Goldman Sachs, may not be as old but are the most powerful banks in the country today. These banks share two common purposes.

First, they operate a payments system; very few, if any, modern economies are able to function well without an effective payments system. People trust banks with their money and make most of their payments with the use of cash, checks, credit cards, or debit cards. Most individuals who receive forms of payments tied to a recognized national bank have no doubts that the payment is legitimate. In other words, banks have such a high name value that they do not need to enlist the help of customers (or miners) to determine whether transactions are real and legal. Sylla (2017) added that the main evidence of the popularity of banks in the U.S. is the fact that most of the money stock of the country is bank money.

In addition to offering efficient and legal payment systems, banks serve as financial intermediation. They use their money to invest or lend. For instance, they offer credits for individuals and the government itself. The intermediation function of banks is actually one of the reasons why the American economy has grown. According to Sylla (2017), banks helped finance different generations of entrepreneurs who ended up contributing to the American economy. They also provided support for those individuals who went on to create ordinary businesses that continue to support the economy today. Now, banking can definitely be a risky business.

For example, what would have happened if those entrepreneurs did not eventually repay the loan? On the other hand, what would happen if banks only cared about their profit and did not maintain money reserves? In order to prevent these situations from ever occurring, banks are regulated, and they closely monitor people to whom they lend money. It is thanks to those regulations that the banking system has continued to succeed despite financial crises and challenges. While some claim that bitcoins are better because they are not regulated, the truth is that lack of regulation is not always the best.

Classification of Money

Many forms of money exist today, and that includes digital currencies such as bitcoins. According to Heller (2017), the two main forms of money today are physical and electronic money. The physical money includes “beads as well as banknotes and metal coins (cash) issued by a central bank” (p. 1750). Electronic money refers to e-money, and e-money includes all monetary value stored on a card. When people use their credit card, they are using electronic money. Note that electronic money is different from digital currency. Electronic money comes from a bank and is regulated; digital currency is not.

Heller (2017) explained that digital currencies could technically be issued by a central bank, but they are often decentralized and generated by a computer system. Bitcoins are classified as digital currency because they are produced by a computer algorithm, and there are no institutions that regulate them. Further, digital currency is not denominated in a sovereign currency; instead, digital currency is a type of currency on its own. The U.S. has dollars; the internet has bitcoins.

Banking vs. Bitcoin

Segendorf (2017) stated that the main benefit of Bitcoin is that it protects user identity. The system is designed in a way that allows for payments to be made or received without leaving record of the people involved. While people have to waste minutes entering all of their personal information to purchase a product online, bitcoin users only enter a number, and they are ready to check out. It makes payments easier and less risky, according to some people. With Bitcoin, “the risk of fraud can be perceived as lower unless card numbers or account numbers need to be disclosed to the recipient” (p. 81).

Issues such as fraud or identity theft would basically disappear if all transactions were anonymous. If that is the case, why have not banks considered this system? As with most things, being anonymous tends to encourage people to engage in illegal or unethical behaviors. People could take advantage of the fact that they cannot be recognized to make payments to illegal organizations or request illegal services. For example, individuals who support terrorist organizations could easily use Bitcoin to make donations to them, which is something that they would never be able to do in the banking system.

In fact, Heller (2017) said that currencies like bitcoin are very vulnerable to money laundering and terrorist financing. In addition, tax authorities in the U.S. have begun to seek information about taxpayers who conducted transactions in Bitcoin but did not declare them.

Although it is not discussed in much of the literature available, banks offer consumers something that Bitcoin cannot provide, which is the ability to make purchases and payments almost anywhere in the world. As of now, only a few companies accept Bitcoin as a form of payment, and Bitcoin can only be used to make transactions online.

On the other hand, most organizations accept checks, credit cards, and debit cards as a form of payment, and they can be used both online and in physical stores. According to Stanford University (2017), banks are already an established system, and bank cards are accepted nearly everywhere, which is certainly a significant advantage over digital currency. Some individuals still prefer to make purchases in physical stores or want to carry cash, and only banks can meet those needs. Some have suggested the development of Bitcoin debit cards, but even if that were to become a reality, it would still be a long time before most merchants accept it as a payment option.

Another alleged benefit of Bitcoin is that it is not regulated by any national legislation. There is no single Bitcoin issuer because the units are automatically created in the network. Because of that, it is impossible to regulate bitcoins. Again, the only instance in which this would be ideal would be if an individual wanted to conduct illegal business. Other than that, dealing with a payment system that is not regulated can do more harm than good.

For example, people could request a transfer in exchange for a product, and once the transfer is received, they could turn off their computer and never contact the other individual again. The person who made the payment would be left with nothing because the system is not regulated and there is nobody to assist him or her with issues. Situations like this would never arise if people were dealing with traditional payment services.

As stated by Segendorf (2017), Bitcoin makes it impossible for anyone to know whether a payment was made or received by a certain person; the only exception is when both parties know each other’s identities, but those cases are rare. Because of the anonymity, individual users “thus only have a narrow possibility of asserting their rights in the event of a payment going wrong” (p. 81). There is no consumer protection, no mediation, and no regulation to protect users who choose to make payments in bitcoins, which can attract criminals to the system.

Lastly, while people claim that the value of Bitcoin has been increasing steadily, there are still sharp fluctuations in the bitcoin exchange rate. The value of a bitcoin is very sensitive to changes in the market; “depending on the point in time at which somebody buys or receives Bitcoin, major exchange rate gains or losses can be made” (Segendorf, 2017, p. 82).

Now, relatively constant changes can be good or bad depending on the purpose of holding bitcoins. Those who use bitcoin for transactions could be inconvenienced by having to determine an exchange rate knowing that the rate tends to change quickly. On the other hand, people who want to hold bitcoins for future use could benefit from changes in the market. For example, a significant increase in exchange rates could mean that the individual could make much more money than initially invested. Still, bitcoin holders are at risk of losing their money.

Segendorf (2017) said that in some instances, people have lost everything. That is because the wallet and account information is stored in hard drives; therefore, if the hard drives are destroyed for some reason, all information –including the bitcoins—are lost. These potential issues are something else that separates banks from bitcoins. Funds in bank accounts are more protected and stable, and even if something were to happen, banks are liable to pay compensation.

Predicted Future of Banking

Despite all the concerns regarding bitcoin use, people still support it. American banks, on the other hand, do not feel as threatened as some may believe. In fact, some of them are learning from the virtual currency system and improving their own services. Popper (2016) described how Bitcoin is used by people who distrust central banks, yet central banks “are doing some of the most ambitious work in trying to harness the technology introduced by Bitcoin” (para. 2).

That is, while central banks have made it clear that they do not support and will never try to own currencies such as bitcoin, they want to add some of its features to their own systems. For example, banks are considering the use of a decentralized method of record keeping similar to the one used by bitcoin.

The method, called blockchain or distributed ledger, would not keep transactions anonymous but it would make them more secure. It would also allow central banks to monitor the financial system in real time. If central banks succeed, “it would be one of the greatest unexpected twists in new technology” (para. 6) because it would mean that an invention with the goal of destroying banks ended up empowering them.

The impact of bitcoins on the banking system is difficult to measure. However, experts agree that banks should learn from emerging virtual currency options. The fact that they have become popular among people may reflect a deeper issue with banking in America, and unless banks keep up with changes in people’s preferences, they will be left behind. According to Stalter (2015), one of the reasons for the popularity of bitcoin may be that it is entirely digital. Americans are no longer “setting foot in bank branches these days, opting to conduct transactions with mobile apps or ATMs” (para. 3). Today, most banks offer mobile banking and allow customers to make payments with their smartphones instead of credit cards. These changes suggest that the banking system has begun to adapt to technological changes, which is a good sign.

When discussing the future of banks, Stalter (2015) claimed that there will be fewer branches. Banks will continue to close branches, and those that remain will look very different. Instead of big buildings, “we will see more use of kiosks and other technologies” (para. 9). While the solution to changes is to adapt, smaller banks will not be able to afford to implement new technologies; as a result, many will eventually close, and there will be fewer banks.

On the positive side, those banks that survive the changes will begin to offer more online and mobile options. Research shows that millennials prefer mobile banking, and it also suggests that even baby boomers are moving away from traditional banking. The fact that customers are gravitating toward mobile banking suggests that banks are not going anywhere, they will just change their tactics. If the issue was with the banking system, people would not be choosing online banking; they would be closing their accounts. However, that is not the case.

Conclusion

The traditional banking system has been around for ages, and it remains the popular choice among Americans. One of the main reasons why people choose banks is that these institutions have established trust during their many years in the business. In addition, the fact that they are regulated means that they are less likely to commit fraud or fail to fulfill their commitment to customers. Bitcoins, on the other hand, are not regulated, so they are open to criminal activity. Ever since it appeared in 2009, Bitcoin began to attract people because it allowed them to spend their money however they see fit without any repercussions.

Also, transactions are anonymous, which many consider a good thing. What people fail to realize is that a lack of regulation and the fact that transactions cannot be traced can lead to negative experiences. For example, there have been many instances of fraud. In these cases, there is not much to be done because there is no one entity that can assist victims. People simply lose their money, and there is no one out there to help them.

Finally, the value of bitcoins tends to change rapidly. Drastic changes in its value can result in people losing large sums of money, and can make transactions much more challenging because there is no way to know when the value of the coin will change. Because of these disadvantages, it is believed that bitcoins will never be able to become a preferred system over traditional banking. While it has been predicted that the future of banking is uncertain, banks have already learned a lot from digital currencies and realized that users prefer to do most of their banking online. As such, banks have begun to adapt to changes in user preferences, and it is highly unlikely that they will be replaced.