Bitcoin Compared to Banking

The emergence of bitcoin has challenged the status quo of the traditional banking system. It manages to address some of the biggest drawbacks of the banking system and offers some unique advantages as a global currency.

However, it seems to be having many drawbacks of its own, making it important for the individuals connected with both the worlds to know everything there is to know about both these “systems” and their differences.

So with that said, let’s get down to business.

The Traditional Banking System

The traditional banking system is driven by something known as fiat money, a term that refers to inconvertible paper money that has been legalized by the government. It relies heavily on the reserve currency, which is basically a currency that’s held in large quantities by governments across the world.

In recent times, the US dollar has emerged as the most dominant reserve currency. However, its supply is completely in the hands of the US government, and it can print as much or as little currency as it wants.

The system works by the banks working in sync with one another to keep a track of the balance after each transaction is completed with respect to the accounts involved.

One of the major disadvantages of traditional banking that the world has had to face from time to time is manipulation of the exchange rate by high profile banking authorities and governments. Similarly, due to the ease at which paper currency can be produced as well as factors like inflation, its real value may gradually erode over time.

Then there’s also the fact that many banks follow a process known as fractional reserve banking. It means at any particular point in time, they only have just enough money to pay a certain percentage of their customers, and not all. In other words, if all or even a large percentage of customers of one of these banks were to ask for all their money to be paid immediately, the bank wouldn’t be able to honor their request and would likely have to declare bankruptcy.

As far as the positives are concerned, a crucial advantage of the traditional banking system is its ability to prevent fraudulent transactions. All banks have the authority to reverse payments in a case of fraud, which is the reason the banking system enjoys an incredibly high level of trust.

Another important benefit the banking system offers to its customers is reliability. This system has been around in some form or the other as far back as around 2000 BC and is hence believed to be extremely reliable and well-established.

However, the reliability does come at a cost, and it’s often a considerably longer period of time for completing a transaction.

Let’s take a quick look at some of the most important advantages and drawbacks of the traditional banking system.

Advantages:

• The traditional banking system is already very well-established, reliable and trusted across the world
• The cards issued by banks are accepted almost everywhere, making them a smooth, easy way of making payments
• Banks are allowed to have enough flexibility by the governments to help their customers against any kind of fraud, although it can sometimes also be used to commit frauds
• The use of cash doesn’t require the use of any form of electronic media or the internet, making it the preferred mode of payment for a large part of the world population, and the underdeveloped countries in particular

Drawbacks:

• As discussed above, the system is open to manipulation of exchange rates and the authorities with a higher financial power have more control over how it works
• Fractional reserve banking can turn out to be a risky way of banking, especially in times of financial crisis
• Factors like inflation can eat into the value of paper or traditional money over time; not to mention it can be a much bigger trouble in the event of hyperinflation
• There’s not much transparency about how the banking system exactly works and the transactions being processed, leaving customers with no option but to rely heavily on their banks
• Banks charge a fee for pretty much all types of services they offer, which can often add up really quickly if you’re doing many transactions or deal with large volumes of money

Bitcoin (and Other Crypto Currencies)

As anyone reading this probably already knows, bitcoin is a digital currency first introduced to the world in 2009. Its creator is known as Satoshi Nakamoto, although there isn’t much information about them at all.

Some of the highlighting features of bitcoin include:

• Fixed amount of “coins,” meaning the supply is fixed and limited
• It has its own set of operating rules
• It is believed to be resistant to the kind of manipulation that the paper currency markets witness
• It offers a much higher level of privacy than bank transactions, despite the transactions actually being recorded on an “open” ledger

The Bitcoin Network Explained

Bitcoin works very different to a system that's based on fiat money. The bitcoin network basically runs on something known as nodes.

These nodes are run on systems across the world, with the systems being operated by many different parties such as small-time bitcoin miners and large mining pools.

Simply put, what these nodes do is solve complex mathematical problems that allow a bitcoin transaction to be completed. At the same time, they also “memorize” all the transactions that happen after the last set of mathematical problems they solve and the last transaction they record on the bitcoin ledger.

Each transaction is written into ‘blocks,’ which is how the bitcoin ledger gets its name, ‘blockchain.’

Now, if you have been familiar with bitcoin or the blockchain technology, you may be aware that it’s believed to be very secure. This is because for a transaction to be completed, the majority of the nodes (which turns out to be 51%) must agree with it.

This is based on the idea that even if 51% of the network’s computing power is working how it should be and has not been manipulated in any way, the system cannot be influenced in a way that favors any particular party involved. This includes even the ones with a lot of bitcoins or other wealthy institutions, which are often the ones that are linked to any kind of manipulation that happens in the traditional money markets.

The fact that the blockchain is a very powerful technology is clearly evident in the fact that now banks too are trying to come up with their own ‘blockchains.’ However, it's believed that their blockchain wouldn't be comparable to the kind of blockchain technology cryptocurrencies like bitcoin boast of, which is because they will be using their own computing power to run the system.

This might as well be a case of being back to square one, as this kind of arrangement may end up putting a lot of control in the hands of the banks, which isn’t the case with bitcoin where the computing power is provided by different individuals and corporations across the world.

Coming back to the features of the bitcoin network, here’s a recap of its three most unique, important features.

• The system seems to be fully resistant to any kind of tampering or manipulation by financially powerful institutions of the world, including even the governments
• The nodes are believed to be extremely accurate at determining the genuineness of a transaction, and then securely recording them on the blockchain ledger
• The bitcoin is a decentralized digital currency that’s globally accepted and cannot be controlled or regulated by a particular country’s government

Now, if you couldn’t already tell, the level of security the bitcoin network offers depends on the computing power fueling the network. The more the computing power, the more secure the network gets.

Similarly, if there are any changes to the way the network works, then those too must be agreed by at least 51% of the nodes. In a practical scenario, however, this figure would usually be much higher due to there being many variations in the timing of solving the mathematical problems.

That said, the other 49% that may not agree with the changes, is still a large part of the network, and hence it’s free to operate on its own, which it may be able to do so without encountering any major issues.

Understanding Bitcoin’s “Fixed” Supply

As told before, unlike the fiat money system, there’s a fixed supply when it comes to bitcoin. There are 21 million bitcoins, which is a figure confirmed by 100% of the nodes.

A bitcoin, however, can be split into many small units, with the smallest unit being called a ‘satoshi.’ The fixed amount of 21 million bitcoins can be broken down 100 million times.

The bitcoin network also rewards its miners, the people who help run the system. The initial reward was 50 bitcoins for solving the mathematical problem, but it’s reduced by half every 4 years.

This means that in 2012, it was reduced to 25; and a bitcoin miner would be rewarded 12.5 bitcoins for solving the same set of mathematical problems now.

Once all the bitcoins are mined, the miners would be rewarded using the fees that are charged on every bitcoin transaction.

Transaction Fees

Unlike the traditional banking system, the fees for using bitcoin have been historically low. To be precise, you may just have to pay 0.0001 bitcoin for every bitcoin you send. However, fees have recently gone up tremendously thanks to Bitcoin's rising prices.

The reason the fees are even charged is to have some form of incentive for the miners once all bitcoins are mined. There’s also a possibility that the miners may be willing to complete a transaction and record it to the blockchain without any incentive, or you having to pay a fee. This is especially true when there’s very low network demand.

However, these fees do add up for the miners when thousands of transactions are made using the computing power provided by them. Also, just like the supply, no person can manipulate the fees being charged to benefit themselves in any way.

Buying and Using Bitcoins

You need a bitcoin wallet to send and receive bitcoins. Once you register for one, you will be provided with a wallet address and a private key.

The private key must be kept very secure, and it’s the only way you would be able to send the bitcoins you own to others as well as through which the system could confirm your ownership of those bitcoins. Most wallets do allow you to have a backup of the private key, though, which may certainly come in handy at times.

Bitcoin transactions can be made using multiple devices, including even a USB stick (if your wallet allows it).

Although you can buy bitcoins through exchanges and perhaps even directly from individuals, the bitcoin network currently has to rely on the traditional money market. This is because bitcoins are primarily bought using the US dollar.

As for the time it takes for a transaction to go through, it can be as quick as just a few seconds. However, in order for it to be confirmed and recorded to the bitcoin ledger, it may take about 10 minutes on an average.

Something important to note here is that a transaction once confirmed cannot be reversed. If you have sent bitcoins to a merchant you would have to rely on them if you want the transaction reversed.

Block Size Issue

A major problem that has surfaced with respect to the use of Bitcoin due to its growing popularity is the small ‘block size.' Currently, a block cannot be larger than 1MB.

The reason it affects the use of bitcoins is that the small size of the block limits the number of transactions that can be recorded on the blockchain ledger. Similarly, you’re also required to pay a higher fee during peak times of the network’s demand.

With that said, let us now take a quick look at the advantages and drawbacks of the bitcoin network.

Advantages:

• The bitcoin network doesn’t require to be backed by any entity or an organization as there doesn’t need to be any trust factor involved
• It's believed that the bitcoin network cannot be manipulated in any way even by individuals or organizations with a lot of financial power; in fact, the creator of bitcoin himself cannot manipulate it even if he wanted to
• A global currency with extremely fast transactions and low fees
• Bitcoin debit cards allow users to get around the issues that may emerge due to the differences between the bitcoin network and the traditional money system; they can be used to pay even those merchants that don’t accept bitcoins directly
• Bitcoin cannot be manipulated in the way the traditional banking system can be
• One currency that can be used throughout the world instead of many different currencies
• With more popularity, its acceptance and the potential ways in which it can be used is increasing as well

Drawbacks:

• A huge majority of merchants still don’t accept bitcoin
• The blockchain is expensive to maintain and the network demands a huge amount of power resources, enough to meet the power consumption of a small country
• With more and more countries banning bitcoin and putting legal restrictions on its use, there are some obvious legal issues
• The use of bitcoin has greatly boosted fraudulent activities due to the privacy it offers
• The transactions cannot be reversed, which increases the chances of huge losses due to a minor error or mistake, or even during a fraud
• The threat of one particular organization controlling 51% of the network's computing power is very real, with there being a case of a large bitcoin mining pool coming as close as 50%; however, some say it's been addressed to some extent by introducing more mining pools

Bitcoin vs Banking - Final Word

All said and done, it looks like both the traditional banking system and the bitcoin network aren’t going anywhere anytime soon. The latter obviously being in an early phase of its development is still far from mainstream or having a major impact on the banking system, but it wouldn’t be wrong to say that it has already got the bankers worried about its increasingly growing popularity.

For the time being, though, it's safe to say that they both would have to co-exist together and, if they manage to take a leaf out of each other's book, they may manage to drastically improve as a financial system.