For Banks, Digital Currency Poses Threat — and Opportunity

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The digital currency called Bitcoin was conceived as a rebellion against the banking system. But it may also present business opportunities for banks that can get comfortable with the risks.

A Bitcoin is a computer file that is highly encrypted, based on open-source code and distributed through peer-to-peer networks, similar to the way digitized music is shared. The Bitcoin's defining characteristic is its lack of a centralized issuing authority — anyone with the technological know-how and the proper hardware can "mine" the currency as it's created by an algorithm.

A programmer calling himself "Satoshi Nakamoto" (widely believed to be a pseudonym) launched Bitcoin in 2009, declaring it would be a more user-friendly and predictable alternative to the fiat currencies printed at whim by the world's central banks and irresponsibly guarded by financial institutions. Since the software was programmed to create only 21 million units over the next 140 (no, that's not a typo) years, finite supply would preserve the currency's long-term value, Satoshi claimed. And the use of cryptography would remove the need for trusted third parties to store and transfer money.

Bitcoin is also said to be as anonymous as cash, a quality that has endeared it to privacy advocates but also made it a potential tool for illegal activities such as dealing drugs. Some merchants are intrigued by Bitcoin because, like cash, it does not require them to pay interchange fees.

And it's just plain cool.

"The Internet spawns disruptive technology and Bitcoin has the potential to be disruptive," says Jay Braver, owner of Jay Braver Web Development in Athens, Ga. Braver began offering to accept Bitcoins for payment more than a year ago, but so far none of his customers has offered to pay in Bitcoin.

Bitcoin still has significant legal hurdles and negative perceptions to overcome. Banks have had minimal involvement, at best.

That could change, particularly as numerous forward-thinking startups rush in to create services around managing Bitcoin transactions.

"There is a big role potentially for banks, just as banks deal in all sorts of other currencies like Euros and yen and dollars," says Gavin Andreson, the lead core developer for Bitcoin (an informal role in a diffuse community, somewhat like the one Linus Torvalds played in developing the Linux operating system).

The roles banks could play include processing payments, providing escrow services, facilitating international cash transactions, helping customers exchange their money for Bitcoins, and even making loans in the currency, some of its acolytes say.

"Banks should be paying attention to Bitcoin," says Jon Matonis, a payments industry veteran who now evangelizes for the currency on his blog, The Monetary Future.

Alternative currencies have come and gone before. During the dotcom boom, Beenz and Flooz attempted to grease the wheels of e-commerce by creating currencies that could be used to pay for goods and services online. Both companies folded, whereas PayPal Inc., which allowed consumers to pay in standard currencies, grew to become the dominant online payment company.

More recent examples of online currencies include Linden Labs' Linden dollars, which were used in its online game world Second Life. The reward points customers earn for spending with their credit cards are also becoming an online currency, as e-commerce sites like Amazon.com Inc. have begun to accept points as payments.

"With any of these [alternative currencies] they need to get a greater degree of legitimacy," says David Furlonger, vice president and fellow at the research firm Gartner Inc. of Stamford, Conn.

Legitimacy is earned by widespread use, but also comes from the support of traditional institutions, such as banks, Furlonger says.

Bitcoin has been most widely used by tech-savvy hobbyists, in part because the process of "mining" them, or acquiring them as they are created, requires fast and powerful computers. People without supercomputers or advanced programming skills can acquire Bitcoins and participate in the Bitcoin economy through one of dozens of exchanges that have cropped up to let people swap traditional currency for the digital coins.

The exchange rate for Bitcoin has been volatile. Bitcoins were first traded for fractions of pennies each. Last year, the price per Bitcoin reached $30, though today it trades for about $7. Over the past summer, the price dropped to 30 cents after a hacking incident at a prominent Bitcoin exchange.

As Bitcoin acceptance grows, it could run afoul of federal laws prohibiting the creation of currency that competes with the U.S. dollar. Bitcoin users may also run into trouble with the Internal Revenue Service.

"As long as Bitcoin is a couple thousand mathematicians playing with each other no one cares, but when real transactions start to go on, that raises the question of how we tax this," says Bruce Abramson, the intellectual-property advisory partner for Rimon Law Group Inc. of San Francisco.

Since one of Bitcoin's chief selling points is its purported anonymity, there is also concern that it could be used for illicit purposes.

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Comments (1)
Thanks for an interesting read. Just wanted to mention that Beans and Flooz were created by centralized corporations which made them vulnerable to failure.
Posted by Bitcoin F | Thursday, January 19 2012 at 11:33PM ET
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