Alternative currencies are not new. But digital or virtual currencies are. The first, biggest and best-known ‘crypto currency’ – Bitcoin – was launched in 2009, by a mysterious person or group of people known as Satoshi Nakamoto.
Created to offer a medium of exchange for online transactions outside of existing nationally issued currencies, crypto currencies have attracted considerable media interest. High-profile business figures such as Bill Gates and Richard Branson are said to have spoken positively about the development of Bitcoin as a flexible and secure means of buying an selling goods online, with lower charges than other transaction methods such as Paypal and American Express.
Others have pointed towards the volatility of crypto currencies and towards vulnerabilities exposed by the collapse of the Mt Gox Bitcoin exchange in February 2014. Mt Gox was launched in Tokyo in July 2010, and by 2013 was handling 70 per cent of all Bitcoin transactions. However, following a major hacking operation which skimmed off 850,000 Bitcoins worth more than US$460 million at the time, Mt Gox suspended trading and in April went into liquidation.
Exchange interviewed Victoria Cleland, Chief Cashier of the Bank of England, about virtual currencies.
Is crypto or virtual currency actually money – taking Bitcoin as an example?
One normally thinks of money as having three core functions – as a store of value, as a medium of exchange and as a unit of account. Typically when we are thinking about money it needs to fulfil all three of these functions. Bitcoin is one of thousands of different digital currencies but it is the largest so we can look at it as an example. If we ask whether people use it as a store of value we need to consider the fact that it is very volatile at the moment so it is not clear that people are using it as a store of value except at the more speculative end of the spectrum.
Another core function is as a medium of exchange which comes down to how many places accept digital currencies and the ease with which they can be used and spent. At the moment this is fairly limited, so they can act as a medium of exchange but not very frequently. The number of people who use it and how many places accept it suggest limited usage.
Finally, digital currencies are used as a unit of account because each of the digital currencies out there is denominated in their own way. The work the Bank of England has done so far has looked at how many people have used digital currencies on a daily basis in the UK and at the moment this is very small. Other work has been done on whether you can survive using digital currencies alone in which it was found that though you may be able to get by for a couple of weeks you would be very limited in what you could buy. Overall it only fulfils the core functions of money to a very limited extent and for relatively few people.
Singapore and Germany have classified Bitcoin as private currency. What are the barriers to it becoming legal tender? Does theirreversible nature of a Bitcoin transaction act against it being recognised as a currency?
Legal tender has a very narrow legal meaningwhich relates to whether a currency can be used to settle debt. It is not useful to define currencies in this way. For example, while Scottish and Northern Ireland banknotes are accepted as payment, and there is legislation in place that regulates their issuance, they arenot legal tender.
One of the key things here is the extent to which a currency is trusted and how it is backed. In the UK, for example, the Bank of England issues notes which are fully backed by the state, which instils trust as far as the public is concerned. The main challenge facing digital currencies is generating this level of trust, the irreversible nature of transactions is not the key issue.
The US and Canadian revenue services have categorised Bitcoin as property rather than currency. Do you share their view?
It is the revenue services in US and Canada, not the central banks that have done this as it is a question of tax treatment. Revenue & Customs (HMRC) would be the equivalent organisation in the UK rather than the Bank of England. Currently, HMRC’s view is that digital currencies are treated in broadly the same way as foreign exchange rather than pure property.
Historically, innovations in currency have come from private sector activity that has later been absorbed by the central authority as official currency – copper token coinage in England at the beginning of the 19th century and paper banknotes in Sweden in the 17th century are examples. Could there be a tipping point at which the number of Bitcoin transactions in the economy reaches a mass where central banks would feel obliged to step in and take control? What might that tipping point be?
The two Quarterly Bulletin articles that the Bank issued in September 2014 looked at the extent to which digital currencies could impact on our role as a central bank in terms of monetary policy and financial stability. At the moment, digital currencies are too small to have an impact on our remit an would need to grow incredibly large to start to have an impact on how we implement monetary policy. Likewise, we found that it was unlikely but not impossible that digital currencies would, in the near future, be big enough to have implications for financial stability. There are PST 60bn worth of banknotes in circulation in the UK today, but we estimate only a tiny fraction of the population use digital currencies. Usage would have to grow substantially before it would have an impact. There are other areas of concern such as tax and money laundering but these lie outside the Bank’s responsibility.
Crypto currencies would appear to be more difficult to regulate because of the anonymity surrounding participation in the schemes and the decentralised nature of the mining operation (see panel). Is it possible for the Bank to regulate them effectively?
The initial question is whether digital currencies should be regulated and, then who should have responsibility for that regulation. The choice of regulator would depend on the type of regulation being applied. In the UK, the Bank of England’s mandate relates to maintaining monetary and financial stability so it would not necessarily be the Bank’s responsibility, or solely the Bank’s responsibility, to regulate digital currencies, were such a decision taken.
Some countries – Bolivia, Ecuador, Kyrgyzstan, Iceland and Bangladesh – have already moved to ban Bitcoin outright. What circumstances might prompt the Bank of England or HM Treasury to ban the use of crypto currencies? How could such a ban be implemented technically?
The Bank of England is working with colleagues in the UK government and other central banks to understand both the risks of digital currencies and the potential the technology carries. Banning anything would require extremely good reasons and detailed risk analysis.
The collapse of the Mt Gox exchange highlighted a vulnerability in software security. Does the Bank consider unregulated crypto currencies to be particularly vulnerable to cyber attack, or no more so than other digital payment systems?
We are looking at a range of risks, as we do with any sort of payment mechanism. There are some instances where having a distributed ledger, as used in digital currencies, can reduce risks like liquidity and capital risks. But any technological system could be subject to cyber attacks, and there doesn’t seem to be a reason why digital currencies would be any more or less vulnerable to this. However, a lot of the key infrastructure we have in the UK, be it the stock exchanges, clearing houses or the Real Time Gross Settlements system here in the Bank, have incredibly detailed and robust business continuity plans and back systems and resilience. It’s not clear that you get that with a lot of the digital currency platforms.
Do digital currencies threaten the future of cash?
At the moment, in line with most other central banks, we are still seeing an increase in demand for cash year on year. There are a variety of reasons people like to use cash; it is anonymous, it is easy to use and some people like to hoard cash. There are a lot of alternatives to cash out there – credit cards, cashless payment and so on – yet the demand for cash continues to pick up. Digital currencies could perhaps nibble away at the edges but perhaps they would more likely be used as a substitute for other electronic cash alternatives.
Victoria Cleland provides details on polymer banknotes
How Does Bitcoin Work?
- A subscriber must install a Bitcoin ‘wallet’ on a computer or mobile phone. The wallet will generate a Bitcoin address which can be used by the subscriber’s friends or trading partners to make Bitcoin transfers.
- Transactions between subscribers’ wallets are secured by signing the transaction with a private key which locks down the data being transferred. A number of transactions will be packed into a ‘block’.
- At the centre of the Bitcoin network is a ‘block chain’ which acts as an accounting ledger, recording transactions and confirming that the subscriber really does own the Bitcoins being spent. It also ensures that transactions are conducted in an appropriate sequence so that one subscriber cannot manipulate the timing of blocks of transactions going through the block chain. This is designed to ensure that a malicious subscriber cannot alter transactions by quickly inserting another transaction into the block chain before earlier transactions have been authenticated and approved.
- The sequence of transactions conducted through the block chain is overseen by a collective process called mining which is undertaken by a community of ‘miners’ engaged in the checking process rather than the transaction process itself. Mining involves a series of mathematical checks on each block which confirm the legitimacy of the transaction.
- On the whole, Bitcoins are paid for with harcurrency. Purchases can be made with Vand Mastercard, but are difficult using other credit cards or Paypal. They can also be made through exchanges (such as the former Mt Gox exchange) or from other individuals who already hold Bitcoins.
- In some cases direct bank transfers to exchanges are possible, though sometimes only if the bank is located in the same country as the exchange itself.
- Complex three-way transactions are possible where one person uses a credit card to pay a supplier and receives reimbursement from a third party in the form of Bitcoins. Thus, one individual is paid in standarcurrency for his goods or services; a second person receives those goods or services, but pays for them in Bitcoins to a third person who acts as the exchange, converting the Bitcoins into currency and vice versa.
This is more difficult to do than buyingBitcoins, but can be done on trading sites, or via the Single European Payments Area (SEPA) system.