Thriving in a digital age: Digital

currencies pose the biggest threat to

banks Part III
Monday, 5 December 2016
This is the final part of a revised and improved version of a paper
published in the Association for Professional Bankers 2016 Annual
Convention Publication titled Thriving in a Digital World.

Part I of this paper

(available at: http://www.ft.lk/article/581122/Thriving-in-a-DigitalAge--Digital-currencies-pose-the-biggest-challenge-for-banks%E2%80%93-Part-I) examined how paper currencies came to
existence and how they were abused by those who had the
authority to issue them. The abuse was manifested by an
oversupply of paper currencies by central banks and governments
leading to a continuous erosion of their value. The victims were
people who had accepted them as an important component of
their wealth. As a result, there was a growing demand for the
introduction of alternative currencies.
The main qualifying candidate was digital currencies, also known
as cryptocurrencies. A cryptocurrency is simply a currency that
exists in cyberspace and is operated by using computer and

internet technology. The smart mobile phone has been the

leading instrument of accessing the internet for using
cryptocurrencies for doing transactions and making payments.
Part II (available at: http://www.ft.lk/article/582549/Thriving-in-aDigital-Age--Digital-currencies-pose-the-biggest-challenge-tobanks-%E2%80%93-Part-II) of the paper examined in detail the
operation of one of such cryptocurrencies, known as Bitcoins or
BTC, that has become popular among many throughout the globe
since its introduction in 2009. BTC was introduced following a
seminal paper published by an anonymous developer who had
taken the penname Sotoshi Nakamoto.
BTCs are governed by a computer program that uses complex
algorithm to produce them. Those who use the computer program
to produce BTCs are called miners and since the supply is
restricted by the program itself, it is not an easy enterprise for
miners to mine them. Because of the higher demand for BTCs
over their limited supply, the value of BTCs has increased in the
open market over the last seven-year period. The article
examined the risks faced by central banks in particular and
banking institutions in general due to the proliferation of BTCs in
the global financial system.
Part III of the paper will look at how banks and central banks could
overcome the threat of the proliferation of cryptocurrencies in the
global financial systems.
The demand for digital currencies
Many believe that Bitcoins do not have a future as an alternative
currency because they are not backed by any national economy.
Hence, the value of Bitcoins and the attraction to them are
derived from their limited supply.
Despite the shortcomings of digital currencies like Bitcoins, there

is still a growing demand for digital currencies in society. That is

because societies desire to have low cost swift transactions when
they make payments by cutting out banks which have
increasingly become more expensive specifically for low value
money payments. This is specifically important in developing
countries where there is limited access to banking by majority of
people. The advantage of a digital currency is that anyone with a
smart mobile phone or internet connection can make payments
as small as Rs. 10 without going through the banking system.
Another benefit is their low transaction costs compared to credit
cards. Thus, retailers with narrow margins stand to gain through
the use of digital currencies. Therefore, authorities on the subject
like Campbell R. Harvey believe that there is a growing demand
for cryptocurrencies and technology would advance suitably for
the proliferation of their use. Harvey presented this idea in an
article he wrote to Wall Street Journal under the title Do
cryptocurrencies such as Bitcoins have a future? (available at:
http://www.wsj.com/articles/do-cryptocurrencies-such-as-bitcoinhave-a-future-1425269375).
The perceived merits of Bitcoins
Writing on the merits of Bitcoins which are equally relevant to any
form of digital currency, Harvey has highlighted a number of
advantages which society would get by using them. The ability to
conduct online transactions without compromising personal data,
easy use through smart phones, low transaction costs and the
absence of the inflation risks are some of those merits which
digital currencies possess.
Nick Marinoff, another financial expert writing in the Wall Street
Journal (available at; http://www.newsbtc.com/2015/03/02/wallstreet-journal-asks-bitcoin-future) has argued that digital
currencies like Bitcoins have only a temporary future. That
temporary future comes from the acceptance of the people that

Bitcoins exist and they can be used for transactions, despite the
fact that they are simply produced through computer programs.

Argues Marinoff: People see value in Bitcoin. They see its abilities
to give financial capabilities to those who did not have them
before. They see that Bitcoin has the ability to remove power from
banks and place it in the hands of customers, and for that, Bitcoin
has a strength that cannot be replaced or taken away. Bitcoin has
earned its place in the financial sector. Once that place is secure
and tightened, bitcoins future will travel beyond what we have
foreseen.
His argument is that when people see the price of Bitcoins rising,
their popularity and usage can be expected to grow.
Bitcoins are not that superior too

However, due to several reasons, Bitcoins cannot be expected to

have a permanent future as a substitute for national currencies. In
the first place, they are not supported by any national economy
and therefore, in the event of any economic calamity, those who
hold onto Bitcoins cannot have their value exchanged for any
valuable asset.
Bitcoins are demanded by people for speculative purposes and
not for holding their wealth. The very same fact would cause their
destruction as well. When the holders rush to exit Bitcoins, the
value will fall and eventually they would disappear from financial
markets.
Another reason that would cause them to have only a temporary
future is the absence of a godfather to protect their value. In the
case of national currencies, there is a national government that
would consider it as its responsibility to protect its value.
These sovereign governments can borrow from international
markets and hold onto the value of their national currencies.
Bitcoins do not have such a godfather and in the absence of a
godfather, there is no one to protect its value when it starts its
downward march for whatever the reason.
Hence, there is now an increase in the demand for other
alternative currencies in place of Bitcoins.
Digital currencies are a galore
The rise of the demand for alternative digital currencies, in place
of Bitcoins, is a challenge which financial institutions cannot
overlook. The market place has identified 12 such altcoins. They
are Litecoins, Peercoins, Primecoins, Namecoins, Ripples,
Sexcoins, Quarks, Freicoins, Mastercoins, Nxts,
Auroracoins and Dogecoins. But there are more such digital

currencies and Wikipedia has listed 24 such currencies. These

altcoins are directly in competition with banks and their payment
instruments. Hence, unless banks get into the business of
producing their own digital coins, they could be competed out by
market developed alternative digital currencies.
Though Kenneth Rogoff says that they are not competing with
physical currencies produced by central banks, they do compete
with them in the way they compete with financial instruments
issued by banks.
If societies go for such alternative digital currencies instead of
using physical currencies, central banks would lose seigniorage,
inability to cover their costs, fail to conduct monetary policy and
maintain price stability, find financial system stability more
complex and finally become irrelevant in society.

Hence, central banks and commercial banks should

get into the business of producing digital currencies before private
party produced altcoins become a common place.

Citibanks Citicoin
To face the challenge, several leading banks have ventured into
developing their own cryptocurrencies. One such move is by
Citibank which is reported to have begun work on its altcoin called
Citicoin (available at http://truthinmedia.com/citibank-isdeveloping-citicoin-a-bitcoin-inspired-cryptocurrency). The Citicoin
is being developed by the banks technological innovation
subsidiary, Citi Innovation Labs and is being mined in the lab as
an alternative to Bitcoins. It is the view of the Citibank that such
digital currencies can cross the borders without time consuming
regulatory hurdles. Citibank has developed three blockchains a
digital distributed ledger that records all transactions relating to
its new digital coin and has started to test the currencys cross
border payments. The advantage for the Citibank in this
connection is that it has a global network and it can use the new
technology to move money from country to country.
According to Citibank, it is also considering the ways available to
it to eliminate counterparty risks when it does transactions with
small banks which cannot keep required collateral for same. The
bank is now looking for possibilities of issuing state-backed digital
currencies in different countries by using its blockchain
technology. If this happens, the central banks also can move from
paper currencies to digital currencies, a move that will bring
substantial savings in their operations.
Citicoin is still in its testing stage. The advantage of Citicoin over
Bitcoin is that Citibank exists in the real world, it has a global
network and it can provide liquidity to the system in case of
settlement problems and it is governed by a governance structure
acceptable to participants. The Bitcoin, on the other hand, lacks
any of these attributes. Hence, once Citicoin hits the market,
there is reasonable expectation that it would replace the currently
popular Bitcoin which is only a payment and speculative mode.

Following the Citis example, four other major banks also have
entered the race to develop a digital currency of their own. They
are UBS, Deutsche Bank, Santander and Bank of New York Mellon.
They have been prompted by the desire to cut costs and improve
operations.
Central banks too have joined the fray to issue digital
currencies
Central banks are also considering the issue digital currencies
today. The Deputy Governor of the Bank of England, Ben
Broadbent, in a speech delivered at the London School of
Economics in March 2016 (available at:
http://www.bankofengland.co.uk/publications/Documents/speeche
s/2016/speech886.pdf) has argued that a central bank variety of a
digital currency is possible side by side with its physical
currencies. The advantage for a central bank to have a digital
currency, unlike a private party developed digital currency like the
Bitcoins, is that it can function as both the clearer of currency
payments and liquidity provider in case of liquidity shortages.
However, such a digital currency called central bank digital
currency or CBDC will compete with commercial bank deposits
as money and unless commercial banks are able to cut their
costs, they will eventually be replaced by CBDCs. In July 2016, the
Bank of England issued a detailed staff working paper under the
title The macroeconomics of central bank issued digital
currencies (available at:
http://www.bankofengland.co.uk/research/Documents/workingpap
ers/2016/swp605.pdf).
The paper has argued that CBDCs are interest bearing central
bank liabilities accessible to all citizens and therefore would
compete with commercial bank deposits. Unlike the private sector
developed digital currencies, these CBDCs have a permanent
existence since they are backed by the strength of a national

economy.
If commercial bank deposits move into central bank issued digital
currencies, commercial banks face a serious threat in the form of
losing their deposit base and consequently the lending
operations.
The planned experiment
by Sweden
In the meantime, Sweden where cash transactions have declined
to a minimum is now considering the introduction of a digital
currency to take its place (available at:
http://www.wsj.com/articles/swedens-central-bank-considersdigital-currency-1479296711). The Riksbank - Swedens Central
Bank is now looking at the technological, legal and policy
implications of introducing a digital currency to replace its paper
currency. But it is a risk to commercial banks because at a time of
financial crisis, people might move their bank deposits to central
banks digital currency thereby aggravating the liquidity crisis in
banks.
The challenge for commercial banks is real
This emerging development is a real challenge for banks in the
digital age. When societies demand for better services, banks
should be ready to provide them. In the current payment system
which is done through banks, the prohibitive commissions
charged by them have been the main criticism against them.
Hence, it is quite natural for technology to support individual
customers who are desirous of transferring money from person to
person swiftly, efficiently and cheaply. Such technology is a
disruptive technology for banks; but they cannot avoid it since
they have not gained capacity to serve their customers in a digital

world. If they do not come up with alternative arrangements,

banks as payment providers will become irrelevant pretty soon.
Need for fresh approach by commercial banks
Banks have been the first to embrace the advancements in ICT to
cut costs, have a wider outreach and make banking services
inclusive. The move was prompted by the need for sustaining
their business in a world of thinning margins and fierce
competition.
However, though banks have moved along with the
developments, they have been a little sluggish in capturing all the
advancements compared to other industries that have been late
adopters of advancing technology. Therefore, banks now have to
compete with non-bank money transfer institutions which have
been able to supply a better service to clients at a cheaper cost. It
is therefore a matter of time that banks would completely be
displaced as managers of making money transfers and payments
in modern economies. Banks, therefore, have to modernise
themselves to meet the challenging service requirements of the
day.
The problem has been complicated by the emergence of a new
class of customers who are tech savvy called Generation-Y or eGeneration and therefore, in the habit of demanding prompt
banking services through advanced ICT. This has required banks
to invest heavily in the digital infrastructure and digitally
competent personnel.
Threat for displacement of commercial banks?
The biggest challenge for banks today is the threat to displace
them as the monopoly providers of national and across the border
payments. This has been prompted by the loss of trust in national
currencies issued by governments.

Since the power to issue currency has been abused by

governments by overproducing money and causing an erosion of
the wealth of the people, there has been a growing demand for
alternative currencies. The market is, therefore, in the business of
producing digital currencies which are competing with both banks
and national governments. Thus, central banks too are now
considering the entry into digital currency world through their own
digital currencies.
Since the pressure is mounting and enabling technology is being
developed, it will be a matter of time that banks would be fully
displaced in their present role as deposit mobilisers and payment
system providers. The way out for banks is to produce their own
digital currencies, as has been experimented by Citibank and
others recently.
(W.A. Wijewardena, a former Deputy Governor of the
Central Bank of Sri Lanka, can be reached at
waw1949@gmail.com)
Posted by Thavam