One could be forgiven for doing a double-take at the idea of ‘Blockchain Banking.’ Effectively take your money, put it into some combo of Bitcoin, stable coins (pegged to fiat) and other ‘digital assets’ and live your lifestyle using that.
It sounds like a bad idea, except for the fact that many countries themselves are seemingly infatuated with the idea of the CBDC (Central Bank Digital Currency); meaning if it is such a bad idea, why would they do it. The main question here is, is there a future for the Blockchain Bank?
The timing for this post is particularly apt. Not only are we less than 2 months removed from the major meltdown in the crypto markets (along with global equity markets), but this week a major ‘crypto bank’ in Germany – Nuri formerly Bitwala – with over 500K users filed for insolvency.
While fully regulated (and therefore insured) and offering a chequing account in the local fiat currency (€uros), the idea was to shift behaviors towards saving in Bitcoin/Ether, earning interest in Bitcoin/Ether, and investing in other cryptocurrencies.
The cause of the bankruptcy is, apparently, predominantly related to the macro factors and liquidity concerns on the entity, but according to the company, none of the following are affected or impacted while the business restructures:
- €uro deposits with local banking partner SolarisAG
- Cryptocurrency investments, whereby Nuri acts as the custodian
- Nuri Pots investments where users invest in ‘tokens’ that are allocated into stock market ETFs
- Bitcoin and Ether in either Wallets or Vaults (interest)
Through this list, we see the general model of a Blockchain Bank – a mix of on-chain assets (Bitcoin, Ether, etc.) and off-chain assets (Euros, equities, etc.) blended into one account.
In this case, we can see that the entity is regulated by an authority in a rigorous financial-oversight jurisdiction (Germany). There is no apparent scam here. A new model is developed, launched, tested, and in this case fails.
The question, is there something here worth studying or is this a flash in the pan?
The Blockchain + Banking
A lot of the core Bitcoin innovation was built on Proof-of-Work that uses essentially supercomputers to hash blocks and secure the network. This has enabled Bitcoin to scale, securely; yet their are tradeoffs to this model, which can be (theoretically) mitigated and improved using Proof-of-Stake.
#2 Digital Asset Ethereum (by market cap) is about to merge its mainnet to Proof-of-Stake in mid September, so the theory will be put into runtime in the very near future.
Taking the debate between Proof of Work (ie. Bitcoin Mining) and Proof of Stake (Ethereum concept) aside, the main security mechanism of these blockchains over the last decade has come from essentially supercomputers that work 24/7 to verify the validity of each transaction and publish it to the network.
New Tech – Blockchain
The major difference between Proof-of-Stake and Proof-of-Work is that a Bitcoin miner doesn’t necessarily hold Bitcoin. They dedicate their computing power to mining it, which in turn secures the network. They are rewarded in Bitcoin, but since they have to pay operating expenses, they naturally will sell Bitcoin to local fiat currency frequently.
The correlation between number of miners and network security is thus measurable. Proof-of-Stake, on the other hand, requires those who effectively secure the network to hold the token. That means that in the case of Ethereum, those who hold the most Ether hold the most power. This could be exchanges, entities, investors, etc. They ‘stake’ their Ether and are paid in return.
The security and potential censorship dynamics are much different between Bitcoin and Ethereum. In many ways, the two communities oppose each because of this. Bitcoin consumes large amounts of energy and is effectively unaffordable to the average person. Yet, there is no doubting Bitcoin’s security over the last 13+ years it has been in existence. Ethereum has created a large ecosystem, which has led to many new experiments in the form of Dapps (decentralized apps), DEXs, (decentralized exchanges) and a host of other ‘web3’ tools.
But the principal use case of both Bitcoin and Ethereum remains value transfer. The ‘blockchain revolution’ in payments has really only just begun. Bitcoin has a Lightning Network that is being rolled out progressively to enable ‘lightning-fast payments.’ Ethereum has a completely different code architecture than Bitcoin as is generally considered to be faster and have lower tx (transaction) fees. Some countries have huge cryptocurrency penetration rates, especially in Africa and Eastern Europe.
Narratives around ‘cryptocurrencies’ emerged around a rebel paradigm that it is the future and ‘government fiat will die.’ Unlikely. Furthermore, many retail investors around the world have lost their life savings on ‘investments’ branded as some form of ‘token.’ The space is hardly a nirvana but the core “blockchain innovation” is revolutionary long-term for banking, payments, and inevitably currency.
Proof-of-Stake currencies like Ethereum will make up the next wave of innovation, but will they succeed? The fact that this question remains open and hotly contested is why the whole future of ‘Blockchain Banking’ is so enticing to explore in more depth.
Bitcoin + Stable Coins
Since the Genesis block launched in early 2009, Bitcoin has been an enigma.
Part of what has plagued its existence is the corresponding narratives linking it to the dark web, criminal activity, and fraud. Those topics are not what this post is about, as like most arguments related to controversial topics, there are points on both sides.
But among economists, macro strategists, and bankers, one thing they have oft criticized is its relation to a ‘currency.’ One thing few would argue is that Bitcoin is very volatile.
Let’s say you had $100,000 in Bitcoin at our near a peak in 2021, 2017, or any other year and you wanted to hedge without selling all of it and moving it back into fiat (USD, €uro, etc.) Moving it from say Bitcoin into Ethereum or Dogecoin would not really solve any problems as they also move downwards with Bitcoin, generally.
Stable coins were invented to solve this problem. Many exchanges started offering USD-T which was issued by a very often-mentioned (and criticized) entity called Tether. Tether effectively operated like a Central Bank and was able to print Tethers, which were pegged to the US Dollar; therefore, an exchange offering USD-T could offer ‘dollars’ to their customers without them being dollars.
Many other types of stable coins emerged. Keeping them ‘stable’ during liquidity crises – as we saw in June 2022 for example – is no simple feat. Just like other fiat currencies pegged to the USD during a bank run, for example, a stable coin can lose its peg and collapse. But while it is ‘stable’ it does create a lot of value in the space. In the example above, one could move their Bitcoin to a trusted exchange, cash out say 50% into a stable coin, and hold that money there until they wanted to rebuy. Stable coins have a huge utility.
Not to be outdone, naturally no Central Bank wants to lose their own power in a local economy to stable coins. The CBDC (Central Bank Digital Currency) is a stable coin, pegged to the local currency, and backed by the state. There are dozens of dystopian realities unleashed by the CBDC concept – none of which will be dived into here – but once again the practicality and utility of these ‘coins’ is the same as a stable coin.
If on one side, you hold only Bitcoin and would never touch a stable coin/CBDC, you take all of the risk related to the underlying asset – up or down:
- if you had bought in 2015 at $200 and were holding now at $24,000 US, the risk of loss is virtually nil
- but if you bought at $20,000 and are holding here at ~$24,000 US, the question is what is the best move?
Selling Bitcoin carries tax consequences, as it is taxed as a capital gain in most jurisdictions. But similarly, holding through a 50% drawdown carries large financial and emotional consequences. The average person is not a trader. This interplay between the top digital assets and fiat currencies lies at the heart of the future – in whatever shape it may take – of Blockchain Banking.
Blockchain Entering the Banking Sector
(Multi-trillion dollar asset manager) Blackrock recently announced a partnership with Coinbase to enable its clients to purchase Bitcoin in the form of a private trust. Some European banks have also recently announced they would offer custodian services to clients, meaning those digital assets held there are ‘guaranteed.’ They won’t disappear like they could on an exchange that disappears overnight, as we have seen happen many times in many different countries through the lifespan of ‘crypto.’
Many Bitcoiners would admonish the term blockchain in relation to Bitcoin due to the fact it has been used maliciously by many scammers and amateurs in the form of token sales, unregistered securities, and other unscrupulous use cases. But the key point here is the trend. As it is still unclear that Bitcoin will be the long-term winner in the space. Right now, it is the crown jewel of the digital asset space with a market cap of ~$500 Billion.
When you put your money into Bitcoin it is secured by the network of miners on the Bitcoin blockchain; if you hold your Bitcoin on a wallet, your password, private key and 12-word (or 24) seed phrase are your security mechanisms to ensure your Bitcoin are yours. Lose those and there is nobody on the planet that can retrieve them for you. They are stored purely on the blockchain.
As we imagine bankers and banks themselves looking at not only the value stored in Bitcoin and the cryptocurrency space as a whole (currently ~$1 Trillion USD in aggregate), it is clear that this mechanism will not hold-up long-term. Not to mention KYC (Know Your Customer) and AML (Anti Money Laundering) regulations.
Bitcoin is the outlaw of the space and will always be that way while it is considered #1. But if a customer at a bank wants Bitcoin through their bank, the bank itself will be the custodian. There are practical reasons why a customer would want to do this. Imagine individuals with several million in assets who want exposure to digital assets and/or currencies; many don’t want the headache and/or exposure to self-custody.
‘Storing’ their digital assets like Bitcoin at the bank suits them just fine, as they will not see a need to use them for daily/monthly cashflow purposes. This is much different to say a 20 year old who’s “savings” are partially or fully allocated into digital assets of one form or another.
As discussed in the Future Banking Business Model post, banks make A LOT of money through lending out against assets they have on their balance sheet. It suits them just fine to offer ‘blockchain assets’ to which they can further lend against. The bank itself has to manage the private keys and practical elements related to order execution, custody, etc. just as they do with equities and/or forex.
The difference is that challenger banks can also get into this space (and some like Revolut already have in a big way) and will do so in a way that distances themselves from Big Banks. What if, for example, a member of Gen Z holds half of their liquid assets in digital currencies like Bitcoin and Ether?
This is what entities like Nuri (mentioned in the intro) and many others are tapping into. Blockchain is making its way into the Big Banks, but they will mostly focus more on the asset management side of it, as we envision that the distribution and management of state-backed CBDCs will be where they focus into the future.
Nevertheless, as with any new ‘rollout’ we don’t know how well CBDCs will be received. If they aren’t ‘cool’ then the growth of blockchain away from big banks will proliferate. The risks we have seen in 2022 with the likes of Luna, Voyager Digital, and Celcius show us that this type of ‘shadow banking’ carries the same risks we saw in 2008. Unregulated ‘banking’ can be a metaphor for effectively a ponzi casino type of value transfer system run by offshore entities, one that is not dissimilar to how online gambling started to emerge in the early 2000s.
There is a nuance to the future of blockchain banking that is exciting to explore.
Future of the Industry
There is an old adage that ‘banking should be boring.’
Look at the banking business model and you will realize that banks make the lion’s share of their money by loaning out money to customers and profiting on the spread (NIM – Net Interest Margin) between the rate they loan out the money at and the rate they pay depositors. Over the last decade, NIMs at US banks generally range around 3 – 3.5%.
Everyone is talking about interest rates in 2022 because by raising interest rates, a Central Bank is able to cool inflation. But this has to be done carefully, as raising too soon can tank equity markets and cause a recession. Not raising enough can cause persistent inflation, which erodes citizens’ purchasing power, which throughout history has led to civil unrest and/or wars.
The likely outcome is some kind of stagflation where growth is timid – maybe in the form of a mild recession – and inflation remains persistent but not Zimbabwe-like.
In this current environment, we see many people struggling financially. People are forced to burn through savings and take on debt just to survive. At the other end of the curve, wealthy individuals and retirees are forced to ‘chase yield’ because their savings in the bank don’t pay a high enough interest rates. This combo of factors is a major reason why so many retail investors chase cryptocurrency “returns.” Who can blame them?
But if interest rates continue to increase – which they likely will – the dynamics start to shift. If the risk-on attitude among younger people shifts away from high-risk cryptocurrencies towards more stable and liquid ones, then this will have a profound effect on how Blockchain Banking evolves. Historically, we know that younger generations drive future innovations. We only need to look at social media to see how it now impacts content consumption, news, and advertising. Banking is at the same phase social media was in 2010 – the model will shift.
But everything comes down to trust and relationships. We can’t really have a relationship with Bitcoin or Ethereum. They are decentralized assets by design. ‘No middlemen’ and ‘trust the code’ are their mantras. When it comes to money, we need middlemen of some form or another. Furthermore, beyond the Big Banks, there are Credit Unions, Challenger Banks, and other Fintechs that can legally hold money on behalf of clients.
The structure of Blockchain Bank in the future is likely to look nothing like a Big Bank. The Big Banks will likely hold digital assets on behalf of their wealthier clients and look for innovations in public blockchains that benefit their core NIM-centric business model. But other Banks of the Future will capitalize on new innovations that emerge in the market. Many will likely be open-source just like Bitcoin.
Overall, to make banking “boring” in the Blockchain Era seems to be the challenge of a lifetime. How it looks, feels, and executes is subject to a million interpretations and variables that today remain unknown. Younger generations will be willing to experiment in a way that millennials did with ‘illegal’ music-sharing services like Napster and Kazaa. These were eventually shut down, but paved the way for the Internet as we know it today. Buckle up!