Doing Business With Bitcoin?

E-cash experiments are the lawless Wild West on today's payments continent. The risks for CUs may be great, but so may be the eventual promise.

Want to put your credit union in a payments network of obscure origin, favored by Internet black markets like Silk Road (at one time the amazon.com for illegal drugs), one whose largest storehouse collapsed due to faulty security and wiped out hundreds of millions of dollars? Didn't think so. But if you're like a growing number of CU executives, you're keeping a cautious eye on the evolution of bitcoin, knowing that one day you could be doing business together or competing.

Bitcoin is the best-known brand name for a group of e-currencies that includes Litecoin (https://litecoin.org). This is digital or virtual currency that uses peer-to-peer technology to facilitate instant payments. For efficiency, this article will refer to the group of e-currencies as "bitcoin."

Don't dismiss the prospects of virtual currencies like bitcoin, cautions Sam Maule, managing consultant at Carlisle and Gallagher (www.cgcginc.com), a Charlotte, N.C., consulting group that works primarily with large banks.

"People who really know what they're doing-names with prestige and track records like venture capitalists Marc Andreessen of Andreessen Horowitz (http:// al6z.com/) and Fred Wilson of Union Square Ventures (www.usv.com)-are investing in the virtual currency ecosystem. These people absolutely understand data security," he insists.

The top banks are not rushing to open bitcoin accounts or accept bitcoin loan payments, but they are seriously studying it and producing white papers, Maule reports.

"There's an emerging consensus that the underlying protocols, algorithms and block-chain technology (a transaction database shared by all nodes participating in a system based on the Bitcoin protocol) point to a viable foundation for blue-sky banking with clear potential for person-to-person and cross-border payments," he says. "New York state political leaders are having discussions with the bitcoin community. The Fed and the 1RS have taken positions."

$460 Million Gone

But they haven't fully opened the door for regulated financial institutions to do business with bitcoin companies nor transactions in "bitcoin." The obstacles are the lack of any effective regulation or transparency and the risks that clearly exist.

"We saw $460 million fly out the window last winter when Mt. Gox [a leading bitcoin exchange] imploded," Maule reports. "No financial institution can expose itself to anything like that level of risk. And no financial regulator is likely to permit much exposure to virtual currency until regulatory control can be implemented."

At this point, the infrastructure for moving the currency is more promising than the currency itself, he says. Eventually virtual currency will not disintermediate financial institutions or displace established currencies, but it will "provide valuable tools for the digital movement of cash and data." The right strategy now for any bank or CU is to watch closely from the sidelines.

That didn't stop one financial institution-a credit union, actually-from trying. Internet Archive Federal Credit Union (h ttps://i nterne tcred i tu mon. or g), New Brunswick, N.J., sponsored by Internet Archive (https://archive.org/index. php) in 2012 as an experimental CU, briefly became the first regulated financial institution to accept bitcoin accounts.

The $3.8 million CU took the plunge last summer, and Tradehill Inc., a San Francisco bitcoin exchange, announced it was transitioning its exchange accounts to CU accounts at Internet Archive FCU, according to a August 2013 press report (http://tinyurl. com/bi tcoincu).

But the regulators quickly weighed in, and the CU's CEO announced in an Aug. 29 blog post (http://tinyurl.com/nomorebitcoin) that "certain operational and regulatory issues came up, including some that apply to new credit unions like ours. Until we have further clarity, we are unable to service some of our corporate members."

That doesn't mean CU members are waiting. To see where CUs and bitcoins actually intersect today, look no further than Matt Cropp, 27, an idealistic, technologically savvy bitcoin user and a CU member. In fact, he's a CU advocate. He keeps his dollars in a checking account at $395 millionVermont Federal Credit Union (www.vtfcu.org), Burlington, but also holds in an exchange bitcoins he received from selling T-shirts from a website in 2011.

He has one foot in tradition (he writes credit union histories) and one in the future. His April 11 blog post, "BitCoin: A Natural Experiment for Credit Union Development?" (http://tiny url.com/bitcoin4cus) is an examination of how CUs and bitcoins might someday come together.

"Bitcoin definitely has a future," Cropp insists. "It has succeeded where past e-cash experiments failed."

When Napster broke down proprietary walls in the recorded music business, the FBI moved in and put it out of business, he notes. E-cash ventures like Liberty Reserve and E-Gold met a similar fate. That can't happen with bitcoin. "Bitcoin is a protocol, not an institution. There's no place to raid," he explains.

Internet Archive FCU's mistake was not in betting on the viability of bitcoin, but getting too far in front of its regulators, Cropp says. "They discovered the regulatory drag of engaging in bitcoin before the regulators figured out what to do about it. As regulatory clarity emerges, such experiments are likely to move forward." If some countries impose tight restrictions on bitcoin, others will become bitcoin havens, somewhat like Delaware for corporate charters, he reasons.

Bitcoin still has a Wild West aura of lawlessness, Cropp says, but the regulators are starting to catch up. He predicts regulators won't ban bitcoin, but will build a regulatory framework around it so the traditional money system and the emerging virtual money system will work in parallel. The 1RS classification of bitcoin as property is a step to move it from the underground economy to the above-ground economy, he points out. Bitcoin users already are linking their checking accounts to bitcoin exchanges like Coinbase (https://coinbase.com), he adds.

But by classifying bitcoin as an asset, the 1RS may have killed its future as a currency, other commentators have speculated. Calculating taxable capital gains or losses by keeping track of the value of each bitcoin holding when it is acquired and again when it is spent could be a real hassle. Bitcoins could be relegated to a speculative investment instead of a functioning currency.

Where It Works

Notably, Internet merchants, such as overstock.com are starting to accept bitcoin payments, Maule notes.

"It looks like quite a bit of money, but it's a tiny sliver of their transaction value."

Now intermediaries like Zinc Save (www. zincsave.com) accept bitcoin for purchases from major retailers like Amazon, Target and Macy's, adds CU consultant John Best, CEO of Best Innovation Group (www.big-cu. com), Denver. Zinc Save essentially pays the retailers in dollars and resells to the consumer in bitcoin.

Merchants are drawn to accepting bitcoin payments, Cropp points out, as long as they can convert them quickly to dollars, because they can avoid paying the credit card and debit card fees. "Services like BitPay (https:// bitpay.com) are available that let merchants get paid in bitcoin and convert it seamlessly" to their preferred currency, he explains.

How the e-cash system works is pretty technical, but essentially bitcoins are created through a digital "mining" process, and the value is determined by the market, explains Mickey Goldwasser, VP/marketing for Payveris (www.payveris.com), a digital payments solution provider for CUs based in Wethersfield, Conn. They're held by bitcoin exchanges, which enable people to buy or sell regardless of their base currency. A consumer can come to an exchange and use a checking account debit to exchange dollars for bitcoin at the current exchange rate, he says. The dollars are converted (or euros or yen because bitcoin is a global phenomenon, more widely used outside the United States), and the bitcoin is digitally banked by the bitcoin holder.

Similar to sending cash digitally, individuals can send bitcoins to each other using mobile apps or their computers. Additionally, as the consumer does business with Internet merchants, he or she has the option to settle in bitcoin if the merchant accepts it. The bitcoin is debited from the consumer's virtual account and credited to the merchant's, or it flows through an intermediary for conversion, Goldwasser explains. Because the purchases are completely anonymous, bitcoin has been favored for illegal commerce, which has contributed to its tainted reputation, he observes.

Bitcoins are essentially ghost cash, Goldwasser says. They exist only as data. If they are lost through hacking or accidental deletion, they can't be recovered. They just vanish. Transactions are also bankless. "To move money through bitcoins," he points out, "you don't need banks or CUs."

CUs and banks will necessarily be slower to board the bandwagon. CU executives have "tons of interest in digital currencies," Best reports. "They want to understand it, but they don't want to touch it yet. I don't know of a CU that offers a bitcoin savings account," he reports. "That whole market needs to mature."

But CUs must be ready to deal with a member who holds a lot of bitcoin or earns a living primarily by selling in bitcoin when that member applies for a loan. How to calculate that member's bitcoin creditworthiness could be difficult-but still manageable, Best suggests.

"It would be a risk-based asset, much like any other risk-based asset, such as gold or stocks," he says. The loan committee would have to consider its historic volatility and its susceptibility to hacking, which would be different from other riskbased assets, but the principle would be the same, he explains.

If a member is an Internet entrepreneur with income largely composed of bitcoins, calculating a prudent loan-to-income ratio could be a challenge. And whether such a loan would be welcome on the secondary market is still unknown, Best concedes. CUs almost certainly would denominate the loan in dollars and require bitcoins to be converted to dollars for payments, he adds.

Bitcoin will create payment mechanisms that are faster, cheaper and more directly peer-to-peer than CUs can offer through their traditional payment mechanisms, Cropp notes. But he expects the bitcoin community to favor CUs over banks where it needs to connect to regulated, insured financial institutions.

The bitcoin world is a bit counterculture, which sees banks as bureaucratic, rigid and tied to an establishment that is corrupt and unfriendly to innovation. CUs seem more loveable, more cooperative and possibly more naïve if the bitcoin entrepreneurs are trying to pull a fast one. In all, the virtual cash future will be built on technological protocols rather than institutions, and protocols will prove more efficient and less corruptible, he envisions.

At some point, a consortium of credit unions, perhaps operating through a CUSO, could acquire the hardware and software to create its own bitcoin mining operation and run an exchange, Best speculates, but that would come after regulators have established rules and found a level of comfort with the technology.

The gulf between bitcoin and CUs is huge at this point. CUs are safe, slow, highly regulated, trusted and somewhat fee-based. Bitcoin and its ilk are risky, fast, unregulated, hardly trustworthy and free. But it would be a mistake to dismiss Bitcoin as a digital fad, Goldwasser says. The younger, tech-savvy members want to transact digitally in real time, and even the Federal Reserve is encouraging the industry to develop solutions that can move money faster, he reports. With this in mind, CUs need to plan for ways to expedite payments over the digital channel and should continue to monitor the impact of bitcoin as it develops.

"Bitcoin definitely has a future. It has succeeded where past e-cash experiments have failed."

Matt Cropp

Resources

Also read "What's in Your Wallet Strategy" at cues.org/0414waiiet.

Learn more about the <org>CUES School of Product and Channel Management, the CUES School of Growth and Profitability, the CUES School of Risk Management and the CUES School of Applied Strategic Management at cues.org/schools.

Internet payments guru Brett King will be a keynote speaker at Directors Conference in December. Learn more at cues.org/dc.

Richard H. Gamble is a freelance writer based in Colorado.