The economics of digital currencies – Quarterly Bulletin article

We’re here in this café in East London next
to this Bitcoin ATM. What is Bitcoin and what can I get from this ATM?
Sure, Dan. So, Bitcoin is an Internet-based currency and payment system. It was designed
to remove any need for a third party, such as a bank, when making payments either online
or, since we’re in a café, for a coffee. And no central bank, including the Bank of
England, is involved in its creation. Now, there have been several hundred digital currencies
set up over the last few years, but the first of these was Bitcoin and it remains the largest
today. This machine lets you buy and sell bitcoins
in return for banknotes. You called Bitcoin a currency. Does that mean
it’s a type of money, then? That’s actually a tough question. Most money
these days is an IOU, a promise to pay, but Bitcoin is not backed up by any assets. So
to that extent, it’s perhaps more like a digital commodity. Economists define money by the role that it
plays in society. And in particular, we look at the extent to which it serves as a store
of value, as a medium of exchange, and whether it’s used to price a great many goods and
services. Now, Bitcoin plays these roles to some extent, at least for some people, but
not generally all of them. How many people actually use bitcoins? Most of them, yes. The price of bitcoins has
risen quite a lot over the last few years, which has got a lot of attention. There have
also been quite sudden and sizable swings in the price of bitcoins, though. There have
been several occasions when the price has fallen by more than 10 percent in a single
day. You also consider how some of the economics of digital currencies might play out in the long run. That’s right. Now, one of the aspects that’s
been driving interest in digital currencies is that the transaction fees involved are
quite low, particularly for making payments overseas or for low value payments. In the
article, we look at whether these low fees are sustainable in the long run. I see. Now, the underlying cost of processing a transaction
in a digital currency, a process called “mining”, is actually higher than that for a normal
card payment, for example, and there are good reasons to believe that the cost of mining is going to continue to rise over time. Since digital currencies, including Bitcoin, operate without any central authority, they need people, miners, to check that the transactions are
valid. Now, these miners receive transaction fees from the transactions they check, but
they also receive newly created bitcoins as a reward for the verification process. So as long as these miners continue receiving newly created bitcoins as a reward for the transaction they verify, the fees associated with using Bitcoin might be expected to remain low? Well, here’s the important point. Most of
these schemes, including Bitcoin, are designed to have a fixed eventual supply, so this reward
can’t last forever. And once that point is reached, the fees will have to reflect the
underlying cost of providing the service. Now, your article also discusses what all
of this means for the Bank of England. That’s right. The Bank has a responsibility
for maintaining the monetary and financial stability of the United Kingdom. At present,
especially given their small size, digital currencies do not pose a material threat to
either of those objectives. Could digital currencies pose a risk to the
stability of the financial system in the future? In theory they could, but only if they obtained
widespread usage first. For example, if households, businesses, or
the financial sector were to be sufficiently exposed to digital currencies and their prices
would arise far enough, then a subsequent price crash might have ripple effects for
stability in the financial system. But there would need to be a significant increase in
the usage of these schemes for this risk, or the others that we discuss in the article,
to materialise. And on the monetary side? So long as prices continue to be quoted in
pounds and pence, and so long as people only use digital currencies alongside traditional
sterling-based means of making payment, then the Bank’s ability to deliver price stability,
as defined by the 2 percent target for CPI inflation, isn’t likely to be affected.
The Bank of England will continue to monitor any development in payment technologies or
alternative currencies that have the potential to affect its ability to achieve its objectives
for monetary or financial stability. That’s great. John, thanks very much. No worries.

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