Why Risks to Lending to Bitcoin Companies Shouldn’t Be Dismissed Outright

Last week, American Banker published an article “What Banks Should Know Before Lending To Bitcoiners”, in which the author David Lawson highlighted five areas of risk of which lenders should be aware, four of which are equally applicable to consumers. The article was fairly simplistic in a number of ways and may be quickly dismissed by digital currency industry insiders, but it should not be. In many ways the article not only provides insight into how the traditional financial services sector views the digital currency industry, but highlights risks which still remain not just for lenders, but for consumers, and consequently may slow or limit adoption.

Risk 1: Bitcoin prices are volatile

This is news to no one who has heard of bitcoin. Bitcoin prices rapidly fluctuate on a daily basis. This is a side effect of a new technology with low liquidity, few supporting services, and little market penetration. As the digital currency industry evolves, volume and use will continue to increase, and as new services are laid over or incorporated into the technology, such market fluctuations will even out.

Nonetheless, we are not there yet. While the typical Bitcoin enthusiast has little problem with their bitcoin holdings wildly fluctuating in value, as they have a longer term view that the commodity will increase in value, the average person on the street has no such conviction. The majority of wallets hold bitcoin, which may be worth $100 one day and $80 the next. Until the average consumer knows that they can have the same purchasing power in a month as they do today – as they can with a bank – this is a real limiting factor. Services such as Bitreserve, which lock in a price at which Bitcoin is purchased, may assist with this.

Risk 2: More Bitcoin exchanges and bitcoin banks are likely to go under

Lawson states that “many observers believe that the bitcoin industry is in crisis”, referencing the closure of Silk Road in October 2013 and Mt. Gox in February. He highlights as a risk that “More bitcoin exchanges… are likely to go under. If that happens, the bitcoins at those institutions will likely be irretrievably lost forever.”

Highlighting events that happened over six months ago as representative of the direction of the industry is a stretch, to say the least. Additionally, stating that “the bitcoins” will likely be lost forever is also possibly no longer accurate, considering the reputations of investors behind many of the largest exchanges now operating. An exchange collapsing due to bad management will not immediately lose all private keys. Nonetheless, from a consumer’s perspective, what assurances do they have that their funds are protected? Bitcoin holdings are not FDIC insured. Wallets and exchanges do not require independent audits. A number are still run in the manner of a software start-up, without the governance structures and controls in place that would be expected of any financial institution. Holding people’s savings is a very different matter than providing a technology service.

Risk 3: Potential government intervention

Intervention can come in a number of forms. The two Lawson speaks to are outright banning and regulation, in particular by the CFPB. The prospect of future regulation, however, is more likely to be a benefit than a risk from the average consumer’s point of view. Increased regulation, by its definition, is intended to reduce risk, and while there have been arguments for decades over whether regulation does in fact achieve this or not, it is how the current financial paradigm operates. Consequently, the average consumer is more likely to look for increased regulation that will provide them comfort that this new technology can be trusted, and that there are legal ramifications for breaching that trust.

Risk 4: Bitcoins can be easily stolen

“The public address and private key associated with a bitcoin are all that is necessary to sell or transfer it,” states Lawson. This is true. How this is drastically different from requiring a username and a password to someone’s online banking account, however, is unclear. Nonetheless, there are forms of protection that in many other financial products allow the recovery of losses from fraud. If someone’s credit card details are stolen, they can seek reimbursement from the card issuer.

What Bitcoin does allow is total management of one’s finances. One can hold a hardware wallet and have 100% control and possession of that wallet’s value without the need for a financial institution or third party, and many consumers may prefer that. There are, however, many consumers that will not want that responsibility. With 100% control comes 100% liability in the case of loss. Such loss protection mechanisms do not currently exist or are very limited in the Bitcoin ecosystem. This may well limit adoption. Consequently, for this risk to be addressed, products may be developed that will take on this risk and provide the protection consumers expect.

The Bitcoin industry is still very young, and the ecosystem still immature. It is not a fundamentally risky or dangerous technology, however there are still a number of areas of improvement required before it starts to resemble a reliable, robust financial system with all the expected consumer protections – be they formal government-imposed regulations, or controls applied with the guidance of self-regulatory entities.

As these controls are established, the question will be how different the industry will be from the current financial industry. To reach this state, “middlemen” will most likely be required to provide consumer protection and other such services, likely commanding fees for their efforts. New regulations will have cost implications, which will be more easily met by larger, better funded institutions. While some regulators and jurisdictions such as Japan are promoting themselves as Bitcoin-friendly, regulators are unlikely to give one type of money transmission (such as Bitcoin) a free pass on performing similar activities to other money transmission activities simply because it is a new technology. Consequently, while Bitcoin is touted as enabling free transmission of value, it is most likely the laws, regulations, and services laid over the top of the technology that will, much like traditional financial institutions, add up in costs.

Technology such as Bitcoin has huge potential to benefit consumers in the future in many applications, both in its currency use case and beyond. Considering what may be needed to mirror current consumer financial products however, these next generation applications may be more likely to realize the potential of the technology for the general consumer.

Article reposted with author’s permission from: http://bankingbytes.com

You can follow the author on Twitter @anguschampion 

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A software engineer and white hat hacker by background, Angus now serves as a Senior Manager in Ernst & Young’s Regulatory Compliance Technology practice in New York. While in this role he has worked across a number of aspects of regulatory compliance, over the last four years he has specialized in anti-money laundering remediations at top tier banks following regulatory consent orders and other action letters. Angus has worked on and led teams that have established industry leading AML practices in these banks, often requiring the development of customized technology and applications to address tactical and strategic compliance needs. In recent months, Angus has established EY’s cross-competency Digital Finance task force, which is researching how blockchain and consensus technologies may assist our financial services clients. Angus also serves on the Advisory Panel for LibraTax, the first comprehensive tax and accounting software solution for digital currencies.


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