Could Virtual Currencies be the Future of Payment Systems?

Transferring money to someone in another country can be a long, expensive and risky process.  The funds exchange hands multiple times before arriving at their destination, and with each exchange comes delays, more fees, and a higher risk that the funds will be misrouted or end up in the hands of the wrong person.  The U.S. government is aware of the flaws in the  current system and is exploring solutions to address it, which may include replacing or supplementing this outdated system with technologies utilized by virtual currencies.

On January 26, 2015, the U.S. Federal Reserve issued a much anticipated report on “Strategies for Improving the U.S. Payment System.”  The report focuses on modernizing the current payments system and identifies nine potential design options to increase the speed of payment system infrastructure.  One such design option noted in the paper is “Digital Value Transfer Vehicles,” defined as “decentralized digital stores of value that can be exchanged.”  The report states that this technology “was not considered [ ] sufficiently mature…at this time, but was identified for further exploration and monitoring given significant interest in the marketplace.”  Notwithstanding this concern, it goes on to acknowledge that one option the Fed is considering is a centralized, distributed, point-to-point (rather than “peer-to-peer”) architecture through the internet, which it concedes is very similar to “digital value transfer vehicles.”  The main difference between this proposed option and existing virtual currencies is that this system would have a central ledger and central authority overseeing it.

Based on comments made by the Fed during its January 29, 2015 webcast, it seems clear that, despite some lingering skepticism, the Federal Reserve is at least considering how it can leverage upon virtual currencies and their infrastructure to resolve many of its current concerns with current U.S. banking and payments system as we know it.  During that webcast, the Fed was asked about the future of payments systems involving virtual currency.  Federal Reserve Board Governor Jerome H. Powell acknowledged that “virtual currencies can offer speed and they can offer lower fees,” but, consistent with the report, expressed concern that “virtual currencies are not at a mature enough stage” to be considered as part of the Feds faster payments initiative for the broader US economy, noting that “the industry is really nascent and while it may play a bigger role in the longer term, it’s not really ready to play a role at this point.”

Esther George, President of the Federal Reserve Bank of Kansas City and a member of the Federal Reserve’s Financial Services Policy Committee, however, expressed a more optimistic approach to virtual currencies, noting that they are important to understand “how technology brings about innovation,” noting that virtual currencies “will inform us on what capabilities exist and how we need to think about some of these issues on the systems we settle on.”  Powell ultimately agreed, noting, “there may be technological innovations within particular virtual currencies which themselves become important for the broader payments system as opposed to the actual currency becoming important, so we are very mindful of that and keeping a close eye.”

In addition to gaining momentum with the U.S. Federal Reserve, virtual currencies have made dramatic  strides over the past few months towards gaining acceptance by central banking authorities in other countries and within the private sector.  In January, the Central Bank of Italy issued a Notice announcing that virtual currency exchanges are not subject to any AML requirements.  The Notice allows financial institutions regulated by the Bank of Italy to do business with virtual currency companies, provided that they respect existing AML/KYC requirements for account holders and warn them about the risks involved.

And just last month, the Bank of England published a report entitled “One Bank Research Agenda” which embraces the potential use of virtual currencies in its central banking system.  This report is a stark contrast the BoEs September 2014 policy report, which was highly critical of virtual currencies.  The new report notes that “[d]igital currencies, potentially combined with mobile technology, may reshape the mechanisms for making secure payments, allowing transactions to be made directly between participants.”  It further acknowledges that, “[w]hile existing private digital currencies have economic flaws which make them volatile, the distributed ledger technology that their payment systems rely on may have considerable promise” which “raises the question of whether central banks should themselves make use of such technology to issue digital currencies.”  Thus, it appears that, in just a matter of a few months, the BoE has done a complete 180 and may begin using virtual currencies sooner than anyone expected, or perhaps even minting its  own.

In the private banking sector, virtual currencies are becoming more mainstream.  Recently, a Belize-based company entered into an agreement with Sofort Banking, which provides Bitcoin purchasing access to over 400 banks in ten countries.  Additionally, Fidor Bank, an internet-based direct bank licensed in Germany, and two U.S. banks, Cross River Bank in New Jersey and CBW Bank in Kansas, are now working collaboratively with  Ripple Labs and others  to permit account holders to transfer funds using virtual currency technology.

It may not be long before other central banking authorities and private banks realize the inherent value of virtual currencies and their technology and follow this trend.