After a brief explanation of what digital currency is, this blog will summarise some of the key risks and benefits currently associated with digital currency. It is a combination of these factors that has caused the Government and possibly the Bank of England to intervene in the digital currency market with the aim of encouraging its growth and to protect users against some of the inherent dangers.
What is digital currency?
A digital currency is an internet based payment scheme that incorporates a decentralised payment system and a related currency. Digital currency exhibits properties similar to physical currencies but allows for instantaneous transactions and borderless transfer of ownership.
Perhaps the best known example of a digital currency is Bitcoin, which came to prominence in late 2013 when the price of a Bitcoin briefly soared to $1230, from around $10 only 18 months previously. Bitcoin is a peer-to-peer system that allows users to transact directly. These transactions are verified and recorded in a public ledger (known as the block chain). Entries are verified and recorded into the block chain by users (miners) who offer their computing power to verify transactions (in exchange for payment in Bitcoins).
What are its potential benefits?
In a digital currency transaction the parties may benefit from a fast (or even instantaneous) verification and settlement of the payment system. The speed of a digital currency transaction is not affected by the geographical location of the payer or payee. The global reach of digital currency is another of its advantages; it allows parties to conduct borderless international transactions with greater simplicity, foreign exchange issues fall away. This of course means that there are no foreign-exchange cost implications and indeed the other related costs of a digital currency transaction are also normally low. With a digital currency payment there aren't usually any account-holding fees, and transaction fees are either not applied or are comparatively low. Finally, the technology that is used by digital currencies such as Bitcoins to verify transactions has (so far) proved to have an unprecedented reliability and security.
What are the risks?
There are currently numerous risks relating to digital currency. Use of digital currency, given its lack of transparency and lack of regulation, is susceptible to fraud and digital wallets are open to hacking. To compound these issues there are currently no compensation mechanisms in place, in the event a counterparty does not meet its obligations (including in cases of fraud or bankruptcy).
Other than the criminal undertone and the lack of protection, the other most serious drawback to digital currency is their potentially highly volatile exchange rate. Rapid fluctuations in value will inevitably put businesses and consumers off transacting in digital currency.
What is the Government and the Bank of England doing?
Back in November 2014 the Government sent out a call for information on the use of digital currency: the stated aim being to make Britain a global centre of financial innovation. To that end the Government wanted to better understand digital currencies as a payment method (rather than a speculative investment), this information has now been gathered and assessed.
The Government has recently confirmed it intends to apply anti-money laundering regulation to digital currency exchanges, with the aim of supporting innovation and preventing criminal use. A full consultation is proposed in the next Parliament and it will include trying to ensure that law enforcement bodies have the correct skills, tools and legislation to be able to tackle criminal activity. The Government also wants to develop a best practice standards framework, by working with BSI (British Standards Institution). Finally, the Government is launching a new research initiative to address research opportunities and the challenges facing digital currency technology; funding in this area is increasing by £10million.
Meanwhile the Bank of England, at the end of February, announced it had begun considering the issue of introducing its own digital currency. The Bank said: "While 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. This raises the question of whether central banks should themselves make use of such technology to issue digital currencies."
What to expect next?
For most, the transition to the regular use of digital currency is not likely to be a quick one, there is currently only around £60m of Bitcoin circulating in the UK. However, the underlying technology that underpins the security of Bitcoin (along with its low transaction costs and global reach) is what has attracted the Government and the Bank of England to consider the digital currency industry further.
Given the obvious potential benefits associated with the use of digital currency, by providing the legitimacy and confidence that may currently be lacking, any bank backed digital currency (allied with the Government's promise of regulation and legislation), could be the catalyst that accelerates the use of digital currency into the mainstream. Ultimately, it seems inevitable that digital currency will become increasingly important to businesses and consumers in the coming years.