Bank of England releases papers exploring emergence, economics of virtual currencies

The Bank of England in Threadneedle Street, London.

Prior to the release of its latest Quarterly Bulletin on Tuesday, the Bank of England (BoE) has published two articles that delve into digital currencies such as Bitcoin.

The first paper, titled “Innovations in payment technologies and the emergence of digital currencies,” considers advances in payments technology, focusing on the emergence of privately-owned, Internet-based virtual currencies like Bitcoin.

The paper states that much of the media focus to date has been on the new virtual currencies themselves, as well as their significant price volatility. The article argues, however, that the key innovation of cryptocurrencies like Bitcoin is the “distributed ledger,” which allows a payment system to operate in a completely decentralized manner, without intermediaries like banks. The BoE says this innovation, which draws on advances from a range of disciplines such as cryptography, game theory, and peer-to-peer networking, signifies a fundamental change in how payment systems can be made to operate.

The second article, “The economics of digital currencies,” explores the following question: to what extent could digital currencies be considered as money? The paper argues that while virtual currencies could theoretically serve as money for anyone with an Internet-enabled device, currently they serve the roles of money only to a limited extent and only for a relatively few individuals. The BoE estimates that as few as 20,000 individuals in the UK currently possess any Bitcoins, and that as few as 300 transactions may be conducted by those people daily.

The paper argues that economics of virtual currencies, as currently designed, pose significant challenges to their widespread adoption. At a microeconomic level, a main attraction of some virtual currencies is their low transaction fees. However, the BoE suggests the incentives embedded in these currencies’ current design mean that such fees may eventually need to increase significantly, as usage rises. The BoE says that at a macroeconomic level, most virtual currencies, in their current design, include a predetermined path toward a fixed eventual supply. For example, only 21 million Bitcoins will ever be mined. In a purely hypothetical situation in which virtual currency were used as the predominant form of money, the fixed eventual supply feature would likely cause greater price volatility and real activity of the money supply to vary in response to aggregate demand.

However, says the BoE, both virtual currencies’ status as money and the distributed ledge technology they use have potential to develop over time. The second paper notes that a fixed eventual supply is not an inherent technical feature of cryptocurrencies. The first article states that, since the majority of financial assets like bonds or shared already exist only as digital records, this opens up at least the potential for distributed ledgers to transform the financial system more generally.

The BoE does not believe that virtual currencies currently pose a material risk to monetary or financial stability in the UK, given the small size of such currencies. The BoE estimates that there is less than £60 million worth of Bitcoins circulating within the UK economy, representing less that 0.1 percent of sterling notes and coin and just 0.0003 percent of broad money balances. The second paper explores possible future risks to monetary and financial stability, but notes that, while conceivable, such risks could only rise should the size of digital currency rise significantly. The BoE says it continues to watch virtual currencies and the risk they pose to its mission.

The BoE has also produced two short videos discussing the articles’ topics, which are available on the Bank’s YouTube channel.