Virtual Currencies: 'Wait and See' Approach Best for Banks

Spare a Ripple? Got change for a Bitcoin? Want to buy a PPCoin?

Like it or not, it seems that digital and virtual currencies are starting to gain traction. But not everyone is jumping in with two virtual feet; most banks have valid concerns and are waiting to see how the upstart currencies will fare and what opportunities they create for banks operating in the "real" banking sector.

First, it's important to note that there are major differences between most of the more popular digital – or virtual – currencies now in circulation. Bitcoins, for example, are generated (or "mined") by individuals who are rewarded with the currency in return for use of their spare computing capacity which is used to run the algorithms underpinning the system. Others – like the now-defunct Facebook Credit system – exchange traditional currencies into virtual ones that can be traded for games, services or online products.

But in many ways, it is digital currencies' differentiating factors that will create the greatest challenges to the fledgling system, in particular the current lack of regulatory oversight. In fact, many regulators have been watching the evolution of the sector with concern, citing not only lack of control should the system fail, but also that the systems may be vulnerable to money laundering, terrorism financing and fraud.

Not surprisingly, the U.S. regulators were the first to move. The Financial Crimes Enforcement Network published guidance that attempted to clarify how digital currencies would be governed. Since the U.S. regulator often sets the precedent for other regulators around the world, it seems likely that many virtual currencies will soon be forced to align to the same rules that apply to their traditional competitors. 

The virtual nature of the currencies also creates unique opportunities and challenges. A virtual exchange system – if properly managed – could greatly speed up transactions, particularly in markets where payment processing is a complex process. But virtual exchanges are also more likely to experience catastrophic failures should the system go down or – worse – be hacked.

Users are also concerned about the safety and security of their personal and private data since many of these currencies operate on a peer-to-peer level and are therefore perceived (rightly or wrongly) as being less secure. Bitcoin exchange servers have already been subject to the dreaded distributed denial of service attacks as have many of their financial services peers across the sector. Likely the biggest hurdle for banks, however, is the anonymous or pseudonymous nature of most of these new currencies, which makes standard antifraud processes – such as know-your-customer and anti-money-laundering measures – impossible to carry out. Few (if any) traditional banks would be willing to take on the risk that would come from issuing, trading or transacting in these new currencies, particularly in today's risk-averse climate.

Those virtual currencies that essentially operate as "floating currencies" have also come under pressure recently with many pundits claiming that, without the backing of government debt or equity, these currencies are prone to market bubbles and volatility.

Some of these concerns are well founded. In April, the value of a bitcoin plunged from $260 to just $130 before regaining some of its strength. At one point, a (now infamous) Bitcoin user paid 10,000 bitcoins for two pizzas which – at $260 per coin – must go down as the world's most expensive fast food purchase (of course, the value of a bitcoin was a mere one-quarter of one cent at the time of purchase).

However, I also believe that the strength and popularity of virtual currencies are directly correlated to the strength and perceived value of the U.S. dollar. What this means is that if inflation remains low and the dollar stays strong, virtual currencies will likely fade away into the annals of failed experiments. If, however, inflation starts to rise, we will likely see much more interest in alternative currencies.

So how should the traditional financial services sector respond to these new kids on the block? So far, banks have broken into three camps. The first camp is reactive: accounts belonging to exchange operators have allegedly been unceremoniously closed due – I assume – to the risk of fraud and regulatory scrutiny. Another camp is looking at virtual currencies to see how they can win from partnering with the new sector to facilitate financial flows for exchange operators.

The third – and vastly largest – camp is firmly in wait-and-see mode. In my opinion, this is likely the most prudent camp for the traditional banking sector; much must still be clarified with respect to the new currencies and few have developed viable or secure business models that warrant defensive movement from the traditional banking sector just yet.

In particular, banks taking a wait and see approach will want to pay close attention to how the currencies are treated by U.S. regulators over the coming year, study any new business models that may emerge from the more innovative banks and monitor the extent to which the currencies are buffeted by volatility.

That is not to say that the sector can be blithely ignored for the next few years. Virtual currencies have come a long way in a very short time and should therefore be kept on the horizon for those banks considering how their business model might change in the not-so-distant future. 

Mitch Siegel is an advisory principal in KPMG's financial services practice.