In addition to acquiring some bitcoin of my own, I recently started to invest in bitcoin related startups. Since I’ve invested in a lot of tech startups over the years, and bitcoin startups are hot, this isn’t unusual.

But something unusual is happening with bitcoin startups that is different from what I’ve seen in other tech startups. Namely, existing financial institutions (i.e. banks) in the USA are showing a hostility toward bitcoin startups in a way that I certainly haven’t seen in the twenty years I’ve been involved with hi-tech startups.

I’ve already written about the difficulties I had in buying even one bitcoin a few months ago (have money, will buy bitcoin), since most of the exchanges to buy bitcoins were located outside the US (I eventually overcame this and did acquire some). I thought this difficulty was because of tough anti money-laundering and other financial regulations in the US, but now I’m starting to think it’s much more than that — that someone high up at these banks has realized that there’s something fundamental about how private banks work which could be threatened by cryptocurrencies like bitcoin.

Over the past few months, there have been ad-hoc reports of banks shutting down accounts of bitcoin related startups and individuals– ranging from Bank of America to smaller banks.

What’s even more troubling to me as a startup guy is that new startups in bitcoin are being denied the ability to open bank accounts if they are actively involve din buying or selling bitcoin! I recently got a confirmation that Silicon Valley Bank, which is about as friendly a bank to startups as you’ll see anywhere, is no longer letting bitcoin related startups open an account with them!

When you talk to anyone in a bank, this decision usually is coming from “higher up”, but they don’t say how high up.

This is a tremendously interesting and monumental development.

Drugs, Terrorists, and Speculators, Oh my!

The stated reason from the bank is usually that they want to wait for “regulatory clarity” before they proceed. The whispered reasons are that they are worried about fraud, chargebacks, money laundering and illegal activity done with bitcoin.

Despite earlier predictions to the contrary, a little investigation into bitcoin will reveal that illegal activity is not as big a part of the ecosystem as you would think. Many thought that once The Silk Road, the biggest site for buying illegal drugs on the internet, was shut down, bitcoin usage would wither and the price would dive. In fact, the opposite happened — the price rose significantly. Even with the recent correction, the price is well above where it was when they shut down.

Simply trying to shut down a currency because it could be used for illegal activities seems kind of stupid anyways. Guess what the most used currency is for illegal drug trading? The US dollar of course!

Another suspected (and oft-quoted) reason is that banks don’t want to run afoul of any anti-money laundering laws. Are banks really worried that terrorists inside the US are using bitcoin?

In that case, FINCEN, which is the treasury departments agency whose mission is to “safeguard the financial system from illicit use and combat money laundering” has clear guidelines for MSB (Money Service Businesses) and as long as you are registered as an MSB and in compliance with those laws (which usually involve KYC, — know your customer), then there really shouldn’t be a problem, should there?

Well I know of at least one company that is a registered MSB with strong KYC protections in place, and most banks still don’t want to give them a bank account because they deal in bitcoin!

Other than illegal activity or money laundering, the other major reason for discouraging bitcoin seems to be the speculative nature of the currency and its high volatility.

In fact, the central banks of both China and India have issued warnings about bitcoin, and this was one of the major reasons given. Because bitcoin is not supported by any central bank, consumers who buy it are liable to lose their money, they say in their warnings. In fact, many countries are classifying bitcoin as a “commodity” not unlike Gold or Silver. But these commodities, argue the central banks, have innate value, where bitcoin doesn’t and so while consumers are free to buy and sell bitcoins, they should be wary that they might lose all their money.

But are consumers really free to buy and sell bitcoin? Or are banks in the US in particular (and around the world) slowly trying to choke the life out of bitcoin? And why would they do this?

What’s really going on? Look at the value of “i”

We already know that payment transfer companies and credit card companies don’t like bitcoin because with bitcoin you can do almost instantaneous transfers across international borders without paying huge transaction fees. But transaction fees in general come down in every industry over time, so why should that be a problem in and of itself?

There may be something more insidious and fundamental at work here.

Thinking long-term, if bitcoin succeeds, then the crypto-currency genie would really be out of the bottle and it would be very difficult to ever put it back in. Which means that either bitcoin or a successor crypto-currency could become a significant portion of how payments are made (particularly across borders) and how value is stored. And the more you think about that, the more trouble that could mean for both private and central banks.

When I was a student at MIT, I took a few finance classes at the Sloan School of Management. This was the late 80’s/early 90’s, and I was eager to learn what all the fuss and Wall St hubbub was all about. In particular I took an options class thinking that I’d learn something about how to price options on stocks. I assumed that to trade options on a stock like Oracle, we’d spend a lot of time talking about the company, its competitors and financial results, and what we think the price of the stock should be, and that would naturally then lead to a discussion about what the option to buy or sell the stock was worth.

But there was no discussion about the value of the underlying asset. Instead, we were told to memorize and then calculate formulas which all seemed to rely on a weird parameter in them called simply i.

“i”, if we asked about it, was the interest rate at any given time. There was no discussion about where that parameter came from or what it was — it was just a given into every equation. You just plugged in the prevailing interest rate. This was before I really understood how the federal reserve and the banking system works but I was puzzled that no matter what we were calculating in finance, the only thing that really seemed to matter was i.

Years later, I was taking a finance class at the Stanford Graduate School of Business about currency exchange. Again, I had the naïve assumption that the price of a currency as measured in another currency might have something to do with the Gross Domestic Product of the country, its economy, currency and trade inflows/outflows/balances (i.e. things I had learned in economics class).

Instead, I found that it was pretty easy to figure out what the “correct” price of one currency in terms of the other should be. All you needed was two parameters — i1 and i2. i1 was the prevailing interest rate in country one and i2 was the prevailing interest rate in country two. If you knew these two numbers, said our professors, you could then calculate, using an arbitrage argument, exactly what the correct exchange rate between these two currencies should be.

Where’d all that money really come from?

Our banking (and to a certain extent our entire financial) system is built on the parameter i, which is the interest rate for borrowing. The central banks (or the Federal Reserve in the case of the US) set the interest rates at which banks can borrow from them. The banks then set the interest rate at which businesses and individuals can borrow money.

Now, most people assume that central banks are the only ones who can “create money” by printing it. What they don’t realize is that private banks also create money, with a multiplier effect that is truly shocking when you think about it.

So let’s say you put $100 in the bank. Let’s suppose banks have a reserve requirement of 10%. This means that the bank can then lend out $90 to someone else. Let’s say they lend to Al. What does Al do with it? Well he either puts it in his bank account (perhaps at another bank) or pays for a car or something else with it (in which case it ends up in the dealerships bank account, probably at another bank but in the same country). So now, the banking system has $190 in it.

Where did the other $90 come from? The Federal Reserve didn’t print another $90 in notes — the money was just ‘created’ out of thin air — digitally in this day and age.

But wait, it gets worse. Now the second bank has $90, and it can lend out $81 of that (per the same 10% reserve requirement). Let’s say it lends out the $81 to George, which eventually gets deposited in bank 3. Now the banking system has $271 in it, when there was only $100 to begin with. And it goes on and on.

The recent film Thrive: What on Earth Will It Take? (which I was an executive producer on — www.thrivemovement.com) has a great graphic/clip on how this works — it’s kind of jaw-dropping when you stop to think about, but most people don’t stop to think about it (you can see the clip at youtube starting at 2:00)

So with this multiplier, banks are essentially creating money by lending it. The more they lend, the more “fake money” is in the system.

And don’t think this only started when we got off the gold standard. While gold may have been the standard for a given note of currency, the dirty little secret was that as long as people kept their money in banks, who lent that money out aggressively there wasn’t enough gold to pay back all the notes. In fact, the total amount of “money” (US Dollars) in the banking system, if you added up all the bank accounts was way more than the total amount of “currency” issued by the Federal Reserve and backed by Gold. In fact, the US didn’t have enough to even pay back all the foreign bank accounts held in US Dollars, let alone all the USD in circulation domestically.

So what does bitcoin have to do with “i” ?

Now back to Bitcoin. A system like bitcoin has a fixed number of currency units which will ever be generated. This means that banks can’t really lend it out. Well, they could, but since the bitcoins are tracked from the point where they are created to wherever they go, there would need to be a trail, so you could see exactly where your bitcoins ended up. And you could potentially see that the bank doesn’t have your bitcoins anymore!

But essentially in a fixed currency system, there is no way to double-lend or triple-lend or quadruple-lend your money. And once the bank transfers those funds to someone else, they are essentially gone — there is no way to reverse the transaction.

So in a world where a crypto-currency that has a fixed number of units is a significant part of the economic transactions, the importance of the current system of banks (including central banks) starts to corrode, since they are all built on the concept of “multiple-lending” (essentially creating “fake money” which interest needs to be paid on).

No lending means no interest rate. The great wheels of financial industry which are being greased by the value of “i” would slow down and eventually cease turning if crypto-currencies became a significant store of value in the world.

There are some who would cheer this. For example, many religions talk about the “evils” of usury — which essentially means lending money, though it has come to take on a meaning of lending at exorbitant interest rates.

In fact, there are many Islamic banks that are forbidden to lend out money using interest rate in the middle east. These banks usually get around this restriction by coming up with some kind of shared risk/shared reward model that ends up looking to the consumer a lot like “i” without an explicit “i”.

So, if bitcoin (or a successor crypto currency with a fixed number of units) is successful, it could mean the end of the banking system as we know it.

Since I, like everyone else, store money in the current banking system, it’s not clear to me whether this would be a good thing or bad thing by itself.

But I do know there are a lot of people who benefit from the current system who would want to make sure that never happens. From their point of view, shutting down a few startups’ bank accounts to nip this possibility in the bud doesn’t seem like such a big price to pay for the survival of an entire way of life and business!