Whether retail or commercial, bank customers have their expectations shaped by a world of always-available, instantly-actioned tech. Payment apps and social media, communications and productivity, are all now non-local, device-agnostic and semi-automated.
When users bring those expectations to the banking world, they’re in for a shock. Banking has more in common with the old pre-breakup AT&T than with the internet age. Moving money costs money and takes a significant time. Many of banking’s most valuable services are rendered less valuable in the eyes of customers because of the time taken and the fees charged.
At the same time, banks face pressure as state governments alter the value of currency through quantitative easing; the capacity of banks to spend money into existence through fractional reserve banking is an issue too.
Meanwhile, banks face significant financial pressures from both competitors and regulators. Competitors are sometimes able to offer high-value banking products and services for far less because they don’t have to support the infrastructure, regulatory burden or legacy costs of a traditional bank. Single-function services like payments services can come along and “snipe” banks’ most lucrative business away from them.
Regulatory burdens on banks are actually increasing. Worldwide, the percentage of regulatory costs vs fees earned has risen every year since 2008.
Major banking regulations include:
- Basel III — 2009: Set by the Basel Committee on Banking Supervision, Basel II established a risk-weighted minimum capital adequacy ratio of 8%.
- Dodd-Frank Act — 2010: Dodd-Frank regulates the financial services industry and is particularly aimed at curbing predatory lending.
- CECL (Current Expected Credit Losses): An accounting standard from the Financial Accounting Standards Board, CECL requires all institutions that issue credit to estimate expected losses over the remaining life of a loan, rather than incurred losses.
- ALLL (Allowance for Loan and Lease Losses): An estimate of the bank’s expected credit losses, based on estimated credit risk across all assets.
Obviously these regulations create accounting, recording and auditing requirements, including the acquisition of new technological solutions.
At first glance, digital assets appear to mitigate many of these problems.
Immutability and auditability: the case for digital assets
Digital assets are decentralized and intrinsically capped, meaning they can’t be quantitatively eased or banked by fractional reserve in the conventional sense. No-one can divide BTC and lend out 90% of the value (not directly; there are methods for tokenizing these coins, increasingly used for DeFi investment purposes); and no-one can add to the supply of BTC by any other method than mining.
Some digital assets contain systems for money supply management — BTS, for instance — while Bitcoin periodically undergoes “halving”, a roughly four-yearly event that halves the number of BTC each miner receives for adding a new block to the Bitcoin blockchain. Many tokens are periodically “burned” to reduce supply. But in the case of coins, supply records are inherent to each instance of the coin, and can’t be centrally managed by any entity.
Digital assets inherently create tamper-proof, immutable audit trails. Each coin contains within it a record of all transactions on the blockchain that supports it, and these records can be examined at will, which in theory sharply reduces the burden of complying with regulations. Transnational, trustless, secure and immune to fluctuation and management alike, digital assets appear to have some of the answers to banking’s biggest problems.
A hybrid solution
So can they fix the issues the industry faces?
Maybe, kind of. There’s a risk that very large investors buy a majority of high-value digital assets and then use them as a reserve in just the way banks historically used other assets including gold. This process has already begun: billions in BTC are already being tokenized and used for DeFi, decentralized finance, while billions more are simply accumulated as assets. Gresham’s law holds true when the money is digital, too.
What these digital currencies can do is ease the friction of transnational trade, offer an alternative, transnational reserve and eventually integrate the emerging digital asset ecosystem with the main banking system in a way that allows for greater flexibility and capital access.
This process has already made significant progress. The US OCC’s announcement that banks can custody digital assets represents a major step along this path, while explicitly recognising that right now, digital assets are to be regarded as assets, not treated as currency.
Banks do get the offer of new revenue streams and access to the fastest-growing asset class by investor numbers and dollar amount. But they don’t get something that can fix many of their existing problems with handling changeable fiat currencies and meeting increasingly-complex regulatory burdens.
True digital currencies
That might change in the near future, however. Many central governments are exploring the possibilities offered by Central Bank Digital Currencies (CBDCs), digital assets issued on a blockchain but controlled by central banks. Russia, China, Turkey, Norway and Pakistan are researching CBDCs, while Sweden has begun trials and Brazil, Canada and France have CBDCs under development.
The appeal is clear: security, auditability, and sharp reduction in the costs associated with handling cash (it’s no coincidence that the countries furthest along the road to a CBDC are effectively cashless already). Such initiatives would also provide financial inclusion for the unbanked and better control of monetary policy for governments.
The IMF has voiced support for some form of CBDC, with Dong He, deputy director of the IMF’s Monetary and Capital Markets Department, observing that “unlike bank transfers, crypto asset transactions can be cleared and settled quickly without an intermediary”.
There are potential downsides, including the risks of operating two currencies side-by-side (Gresham’s law could strike again here, creating an informal exchange rate between the country’s CBDC and its legacy fiat currency) and potential bank runs.
Convincing nations, banks, customers and partners
Many states oppose the use of contemporary digital assets for similar reasons to opposition to foreign currency transactions; Argentina’s 30% tax and $200 limit on transactions in foreign currencies, and its ban on digital asset purchases with credit cards, illustrate the point and indicate likely consequences: faced with such regulatory risks, Argentinian banks decline to handle transactions in fiat currency that relate to the purchase of digital assets.
For banks, CBDCs would provide the benefits of digital assets without many of the downsides, since the whole system would be backed by the state the way fiat currencies are now. Banks operate on the basis that should there be a run on any particular bank, the national state will step in through its central bank and supply sufficient cash to plug the breach and prevent a bank crash. With a CBDC, this assurance would be offered to banks using the new digital currency.
(However, there is no mechanism for doing this for conventional digital assets. This means that in practice, high-value digital assets are bought for investment purposes.)
One possible outcome of the creation of digital currencies by nation states would be a basket-managed “synthetic hegemonic currency” to act as a global reserve (Bank of England Governor Mark Carney floated this idea at last August’s Economic Policy Symposium). While this isn’t the most likely immediate result, it does raise an interesting opposition to the Austrian School’s perspective that central bank control is unnecessary or counterproductive.
Integration and consolidation
In the short term, digital assets will neither kill banking nor save it. Instead they will be integrated into it. In the process, though, banks will become integrated into the digital asset ecosystem; obliged to acquire new skills and technology to offer fiduciary custody of multiple digital assets in fast-moving global markets, many banks will choose to partner with or acquire more experienced businesses.
Regulation, already a major issue for the sector, will divide banks across national lines, with banking sectors of digital asset-friendly countries incentivized to enter the space while other nations restrict banks’ access to the space. In addition, sensible regulation will help to create a situation where some banks seek to expand into digital assets seeking competitive advantages as a partner in both investment and payments.
For example, JP Morgan Chase — historically an early entrant to the digital assets banking space — has created its own digital asset, JPM Coin, which it says is already being used by a “large technology client”. The bank has also created a specific business unit, Onyx, with over 100 staff, to facilitate its embrace of digital assets. In the process, JP Morgan Chase has recovered one of its most lucrative business areas — payment processing — by de-commodifying it and offering itself instead as a platform partner.
The JP Morgan Chase/Onyx model, of banks entering the digital asset space to offer lower-friction payments to their transnational business partners through spin-offs, will become one established approach. In the US, banks are moving to custody digital assets and will largely be doing so for institutional investors and HNWIs, creating a new specialist industry. Across the Asia-Pacific region, dedicated digital asset custody and management providers already operate successfully out of Hong Kong, Singapore and other regional centres and will likely partner with regional and global banks.