Cryptocurrencies are holding the media spotlight. So, what’s all the fuss about … and how should banks prepare? Marc Kenigsberg, founder of Bitcoin Chaser gives us a clue: “Blockchain is the tech. Bitcoin is merely the first mainstream manifestation of its potential.” This blog considers the origins of crypto, why banks need to take it seriously, and how to prepare for the next phase of digital currencies that are to come. 

Bitcoin was the original cryptocurrency. Launched in the wake of the global financial crisis, its origin story is often portrayed as a reaction to the ensuing global upheaval, a general distrust of banks and a desire (by some) to avoid them. While this makes for a good story, it’s not the full picture. Although Bitcoin was introduced in 2009, writing of the seminal Blockchain tome “The White Paper” by Satoshi Nakamoto began in early 2007, a year before global banking went into freefall. To assume that Bitcoin was a reaction to the crisis both misses the point and diminishes the technical achievement.

The Challenge of Double Spending

So how did the whole cryptocurrency story begin?

Bitcoin arose as a solution to the “double spend” challenge that’s inherent in digital money. For decades, cryptographers looked for ways to avoid the duplication of money held in digital format. A secure, tamper-proof centralized ledger was required to show individual account holdings and to facilitate transactions over a private network.

The first practical solution was the Bitcoin blockchain, a cryptographically-secured public ledger that records transactions anonymously on every member’s computer. In this way, all participants have access to the same data and the ledger is simultaneously owned by everyone and no one. From a bank’s perspective, this distributed ledger technology (blockchain) is far more significant than any individual cryptocurrency.

From Theory to Practice

One of my previous blogs explored the disruptive potential of distributed ledger technology (DLT) in banking.[1] But the discussion is moving quickly from the backroom to the boardroom. Many banks have already invested in DLT as a platform for new services in payments processing, facilitating international cash transactions, and providing customer loans and investment in cryptocurrencies.

Some banks have gone further, for example JPMorgan Chase introduced JPM Coin, its own cryptocurrency, which it uses primarily for funds transfers and faster transaction settlements among clients. Specialized exchanges, such as Coinbase and Diginex have made investing in crypto more straightforward.  With growing interest in crypto as an investment, banks must – at a minimum – make it easy for customers to buy, sell or hold cryptocurrencies.

Recently, two European central banks (Banca d’Italia and Deutsche Bundesbank) have joined forces to work on settlements in central bank money of DLT-based asset exchanges. Although the proposed solution would operate in tandem with conventional systems, the project’s scope is significant: “DLT has the potential to usher in new products and services, generate additional revenue streams, reduce the cost of operations and make organizational structures more efficient, said Italian central bank governor Ignazio Visco.”[2]

With major banks investing heavily in DLT, banks without plans must take notice: Start soon, or risk being left behind.

Central Bank Digital Currencies are on the Horizon

Bitcoin is only one example of a cryptocurrency, but the underlying technology is similar for all digital currencies. In the coming years we can expect that all major economies will have a central bank digital currency (CBDC) – a virtual form of the country’s fiat currency – which will run in parallel with physical money. Countries around the globe are in various stages of researching, piloting and launching their CBDC. For example:

• Europe already has a framework to regulate digital cash
• The U.S. and U.K. are in the research phase
• Canada is piloting its digital currency
• The Bahamas have launched the Bahamas Sand Dollar digital currency

CBDCs have the capability to revolutionize the speed, cost, and efficiency of payments and transfers. With such strong incentives to succeed, investment in DLT should be a strategic priority for all banks.

An Architecture for Digital Cash

Every bank needs an architecture for digital cash. Although standards are evolving, a new blockchain protocol is available that builds on the inherent attributes of blockchain: decentralized, encrypted immutable and tokenized. However, the new protocol includes additional logic to facilitate regulatory compliance, including Know Your Customer (KYC), Anti Money Laundering (AML), and various privacy and data protection rules.

Banks should welcome the arrival of digital cash, which heralds a new era of processing efficiency. Regulated digital cash is a breakthrough architecture that’s expected to be at least 40% cheaper than cryptocurrency. But the main beneficiaries are bank customers who can transact money and data directly in near real time without friction, while business users can streamline processes and reimagine the customer experience.

In this new paradigm, banks may be called upon to issue and redeem digital cash, control governance and regulatory compliance, and safeguard funds. The important point is that regulated digital cash is far simpler and more cost effective than cryptocurrency and is moving quickly from theory to practice.   

The Next Phase of Digitalization

At a time when many banks are undertaking core transformations, it’s crucial that new platforms can accommodate the continued maturity and stored value of cryptocurrencies and CBDCs.  This doesn’t require a large speculative investment now in the hope of return later. What’s required is choosing the right componentized architecture that can incorporate additional cryptocurrency functionality and integration with specialist exchanges.

[1] https://www.finextra.com/blogposting/20469/distributed-ledger-technology-in-banking-friend-or-foe

[2] https://cointelegraph.com/news/eu-central-banks-work-on-dlt-based-asset-settlement