Bitcoin & The Banking System: Not Just Different, But Entirely Incompatible

Commercial banking is a money making endeavour; literally.  Sure there’s a complex set of rules, but the short story is commercial banks create money. A button is pressed and congratulations, your loan has been approved and $50k of brand new digital Dollars are now sitting in your bank account.

As you might imagine, creating new money is a very handy little trick for banks. In fact, the commercial banking business model is dependent on the variable nature of national fiat currencies which makes this possible.  But this trick only works on fiat currencies, replace the US Dollar with Bitcoins, and the banking system as we know it today ceases to exist.

Comparing national fiat currencies and Bitcoin isn’t a case of apples vs. oranges; it’s more like fashion vs. math. The rules that determine the creation, transfer and value of national fiat currencies are constantly changing and are subject to the prevailing wisdom of the financial regulators of the time.  While proponents of national fiat currencies believe it’s variability to be an advantage, Bitcoin is based on an entirely different premise. The rules that determine Bitcoin’s creation and supply do not change. Only 21 million Bitcoins will ever be created and this creation happens on a precise schedule.  Bitcoin is ruled by math. As such, these two systems are not only fundamentally different, but incompatible.

To understand this incompatibility, it is necessary to understand the variable nature of fiat currencies and the primary method of money creation, fractional reserve banking. This isn’t known for being a particularly exciting topic and one could devote an entire career to understanding its nuances. However, the key fact is this: not only does the Federal Reserve create money, but commercial banks do as well.  There are rules of course; the Fed creates money for purchases & commercial banks create money for lending.

Fiat currencies, in their digital form, exist as digits in a database on a bank’s computer server.  Think of an Excel spreadsheet where cell L254 represents your account’s balance.  When your loan is approved, the bank’s computer system simply increases the value of the digits in cell L254. The cell representing the bank’s account is not reduced by an equal amount; this extra money was brought into being with the push of a button.

“Where did the money come from? It came – and this is the most important single thing to know about modern banking – it came out of thin air.” –Murray Rothbard

As a consequence of this ability, Fed policy and demand for loans has a dramatic impact on a national money supply. The supply of Bitcoin has none of this variability. As mentioned, only 21 million Bitcoins will ever be created and this creation happens on a precise mathematical schedule.  Bitcoin is not an account based system. There is no spreadsheet with cell’s representing account balances, Bitcoin is a cryptographic p2p network, no one entity owns or controls it. When you hold USD, you have a cell in a spreadsheet linked to your name. When you hold Bitcoins, you have a private cryptographic key.  No one can transfer your Bitcoins or alter your balance without that private key.  In this way Bitcoin is similar to gold. You either have it or you don’t and there is only so much of it.

The difference between Bitcoin and commercial banking (fractional reserve banking) can be understood by imagining the difference between gold and commercial banking.  Gold does not fit into cell L254 on the bank’s spreadsheet.  Gold cannot be deposited in a bank account. What is possible is to deposit an otherwise incompatible asset, such as Bitcoin or gold, with a commercial bank and have an account credited accordingly.

Of course the inability to manipulate the Bitcoin supply does not mean Bitcoin fractional reserve banking is not possible. You could have a Bitcoin accepting bank that issued vouchers or receipts in excess of their Bitcoin deposits or reserves. After all, gold storage facilities did exactly that hundreds of years ago which is what lead to modern fractional reserve banking.

However, having Bitcoin backed bank accounts would put limits on the amount of credit creation possible. The effect that this would have on the banking system would be similar to the effect of returning to a gold standard.  This would restrict expansion of the money supply and fundamentally alter the current functioning of the banking system and monetary policy.

A serious limit on money creation would cripple the current financial system; as such Bitcoin (and gold), are not compatible with fiat national currencies and commercial banking.

Reports of Bitcoin’s integration with the banking system should more accurately be reported as co-operation for easy conversion.  An example of this situation is the recent story of Bitcoin-Central, a French Bitcoin exchange, and their ‘integration’ with the banking system.

Bitcoin Central announced in December via the Bitcoin forum that they were “the first exchange licensed to operate as a bank”, a statement which was factually incorrect and has since been changed to “the first exchange licensed to operate with a bank.”

What this deal actually represents is close cooperation with the banking system. Customers’ Bitcoins and fiat currency will necessarily be held separately and treated differently. Bitcoin Central, the Bitcoin exchange, holds all of their customers’ Bitcoins on their servers. For the handling of national currencies, in this case Euros, the exchange has partnered with Aqoba, a French licensed “payment services provider”.

Aquoba is licensed to handle “payment accounts” which will have IBAN numbers and be able to receive money wires and be associated with debit cards. Bitcoin Central customers can have fiat funds deposited to their payment account at Aqoba and then converted to Bitcoins at Bitcoin Central. They can also have a debit card linked to their payment account, and when they use that card, their Bitcoins will be converted to fiat to be spent via the traditional banking system.

This situation is not integration, but co-operation and easy conversion.

An important illustration of this is that only the fiat/Euro denominated portion of customer funds will be insured via the French equivalent to FDIC insurance.  The Bitcoin denominated accounts at Bitcoin Central are not covered, as these are outside the French banking system.

These two systems can co-operate to some extent, but it is unlikely that they will co-exist for any extended period of time. To financial regulators, fiat currency is not just a medium of exchange but a method of economic regulation, and central banker’s monetary tools are ineffective without the ability to create money and expand the money supply.

This tool, the creation of money, is not possible (or at the very least is seriously limited) in a Bitcoin world. The digits in spreadsheets called Dollars are what financial regulators can influence.  If Dollars lose their dominance, financial regulators’ current methods will suffer the same fate.

Gold cannot be created with a new piece of legislation and likewise, Bitcoin’s cryptographic private keys cannot be altered with the change of a regulation. This effectively makes Bitcoin  immune to Federal Reserve monetary policy.

A nation’s monetary policy cannot function without a monopoly on the unit of account; Dollars, Euros, Yens etc.  The unit of account provides a common measure of the value of goods and services.  Monetary policy alters the value of the monetary units that’s its regulating.  When the Fed expands the supply of Dollars this dilutes the value of all pre-existing Dollars.  If people begin to transact using an alternative “unit of account”, they are opting out of this dilution.

In a recent paper from the European Central Bank is it clear that this fact is not lost on financial regulators.  The October 2012 paper titled “Virtual Currency Schemes” covered the possible impact that “virtual currency” could have on monetary policy.

“The ways in which innovations to payment systems might have an impact on price stability and monetary policy has been extensively discussed in the context of electronic money.2 The most important challenges identified were (i) the preservation of the unit of account, (ii) the risks to the effectiveness of monetary policy and its implementation, and (iii) the possible distortions to the information content of monetary aggregates.”

As central bankers believe their policies promote financial stability, they fear that a weakening of their monetary tools would lead to declining stability. The ECB report expressed a concern for “financial stability” should alternatives such as Bitcoin gain market share as they are aware that this would erode the effectiveness of their tools.

Any significant gain in market share for Bitcoin would mean a corresponding decrease in the influence of monetary policy. The issuing of new money, inflation, is effectively a wealth transfer from those holding the pre-existing money to those who are first to receive the new money.  Fiat inflation does not affect people who do not hold their wealth in the fiat currency.  The Fed cannot dilute the value of your Bitcoins. It cannot lower Bitcoin interest rates. It has no direct influence over the Bitcoin economy and the bigger this market becomes the more ineffective monetary policy will be.

Commercial banks are major players in the regulation of the money supply.  In addition to creating money themselves, large banks engage in many transactions with the Fed via open market operations, assets purchases involved in quantitative easing, etc. Commercial banking’s business model is deeply entangled in the flexible nature of the national currencies that they use.  Removing this flexibility would fundamentally alter the functioning of these banks.

The growth of alternative currencies, such as Bitcoin, has dramatic implications for banking.  Bitcoin can exist alongside competitors, but the commercial banking system and its national fiat currencies cannot.  These systems are incompatible to the point where the rise of one may destroy the other.


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