I often hear from the libertarian leaning friends of mine when they talk about bitcoin they often herald it as signalling the end of banks. Bitcoin allows for peer-to-peer transactions, without a central clearing authority, so it is often thought that the mass adoption of Bitcoin will mean the end of the need for the banking industry. This is one of the biggest misconceptions about Bitcoin and by extension alternative digital currencies today. To say that the digitization and the liberation of money means the end of banks is akin to saying that the digitization and liberation of information means the end of universities and schools; it just doesn’t add up. But why? To explore this question, one first has to quantify exactly what the institution of a bank is and what are the functions that it performs. After which it should become obvious why the removal of an intermediary for cash transactions does not mean the end of the banking business.
Savings and loans
This is the bread and butter of a commercial bank. Commercial banking is simply the banking business that caters to persons and for-profit, non-financial corporations (company’s that make things or do things, and charge you money for it). This business is simply the collecting of excess funds from individuals, providing them safe keeping of the money and in turn loaning a portion of the money out to businesses in need of funds. In return for loaning out individuals money, the bank pays interest. On the other side, the bank needs only to charge a higher rate of interest on the loans, and the bank turns a profit (assuming they also properly manage the default risk of borrowers). This model relies on the fact that the money in deposit accounts not all be withdrawn at the same time, as the bank has already lent it out. In order to create a dis-incentive for people against withdrawing their funds, the bank charges usage fees, which it usually waives if you keep your balance over some requisite amount on a monthly basis.
In a hypothetical world which is completely converted over to a digital currency, the need for the pooling and lending of excess capital from people who have it to people who need it is a fundamental requirement in a capitalist system. Without it, the economy would sputter to a standstill as businesses in need to raise funds will find it extremely hard to do so if the funds are all distributed. Additionally, loaning out funds isn’t something that can be simply ‘open sourced’. Running a profitable S&L business requires a certain level of expertise in evaluating the credit worthiness of the borrowers. Something that takes experience and significant accounting rigor to do correctly. The instant somebody or a group of people start doing this, they essentially are doing banking.
This is the business of creating and dealing with financial instruments which allow for businesses to manage their business risks. They range from Kellog’s buying commodity futures contracts to hedge against drought which may affect corn prices, to businesses looking to restructure their debt. Although investment banks are not normally the ‘banks’ that people mean when they talk about the end of banking due to digital currencies, they have been loosely associated with a negative image of banks due to the financial crisis’ that occurred in the last decade due to over-leveraging and lack of proper fiscal controls. This business is largely unaffected by the advent of digital currencies. If anything Bitcoin and blockchain currencies promise to drive this business to become more transparent, as contracts which contain settlement risk can be better managed using a system that does not require 3rd parties to ensure trust. Imagine swap contracts where the notional is lockup up in a multi-signature wallet. No hiding these off balance sheet if everything is open for all to see.
This is the business of issuing and disseminating debt. Debt is what drives the current economy, as businesses often spend what they do not have, in a calculated bet that they can become profitable and pay off the debt before the interest burden drives them to bankruptcy. The analogy I often use is that a debt driven society is like a Formula One race, everyone is driving a very fragile, specialized car, which is optimized for speed and running on paved tracks. A debt-free society is more like a rally car, a much more durable car, which can operate on different road conditions, and can take a lot of damage before becoming inoperable. Problem is, if you bring a rally car to a Formula One race, you are going to lose. However, when an external, unforeseen event happens, (a black swan waddles across the race track) most of all the F1 cars will end up in a smoldering multi-car pile-up.
Though economists may argue the merits of an economy based on debt, the fact is that Bitcoin won’t really affect this market at all. In fact, having debt in a Bitcoin world may even be safer, as collateral can be put onto the blockchain and debt failure events would automatically release collateral as needed without third party trustees or escrow companies to facilitate the transfer. What this means is less fees, more efficiency.
Security and Availability of your Funds
Banks allow for you to deposit your money in one branch, and for you to withdraw it from another branch somewhere else geographically. This was actually the very first service that banks offered, dating back to the Knights Templar holding the gold of crusaders who deposited in Europe and issued them notes with which they could use to redeem for gold in the Holy Land. This is arguably the ONLY service which will completely disappear with Bitcoin. With the exception of some cases where security on a large scale may be required, the function of being able to move your money around freely does come essentially free with bitcoin and does not require a centralized authority to ensure its operation. Additionally Bitcoin allows for one to arguably make your savings as secure as Fort Knox, by way using paper or brain wallets.
So what does the future of banking look like?
Whether we know it or not, we still need the economic functions that a bank provides, though one can argue that there may be less of a compelling reason for these functions to be concentrated in a single social institution like a bank. That said, the only thing that I am convinced about regarding Bitcoin’s effect on the existing banking system is that it will force banking functions to dis-aggregate from the banks that fail to respond to this evolution, to one’s that decide to change their business model and adopt a more distributed view on banking services. If one were to use the example of the internet, one only needs to point to the fact that we still have information clusters, like YouTube, Wikipedia, Google, to see that even in a fully free and distributed environment, people tend to gravitate towards certain aggregated clusters of information, perhaps driven by the same forces that drive humans to live in cities instead of in rural communes.
So does this mean that like the Masons of the Middle Ages, people with banking skill will naturally form closed societies that protect and progress the art of banking? Or will it be more like the art of computer science, which has become the model of a free academic movement where participants are more than willing to assist new learners in the art, for nothing more than progressing the art itself and peer recognition?
Only time will tell, but if I had to put my bitcoin on it, I would put it on the Masons.