The technology behind digital currency bitcoin (:BTC=) could have far-reaching implications and the potential to reshape the financial industry, according to a new report by the Bank of England (BoE).
The reason for the BoE's excitement? Virtual currencies - most notably bitcoin - have at their heart a publicly distributed ledger system called the "block chain" that makes sure all transactions are verified in a transparent, decentralized and secure fashion without imposing hefty transaction fees. This system is a "genuine technological innovation", according to a new report by the U.K.'s central bank, which details the negative and positive aspects of cryptocurrencies.
"The key innovation of digital currencies is the 'distributed ledger' technology that allows a payment system to operate in an entirely decentralized way, with no intermediaries such as banks," the BoE's quarterly report, released on Thursday afternoon, said.
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The BoE went on to say that the ledger system is a fundamental change in how payment systems can be made to work, demonstrates that digital records can be held securely without any central authority and has the potential to develop further.
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The BoE says that, since the majority of financial assets such as shares or bonds already exist only as digital records, distributed ledgers could possibly transform the financial system.
"It may be possible in the future - in theory, at least - for the existing infrastructure of the financial system to be gradually replaced by a variety of distributed systems," the BoE said, although it made no predictions that this would happen.
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"This development could allow any type of financial asset, for example shares in a company, to be recorded on a distributed ledger. Distributed ledger technology could also be applied to physical assets where no centralized register exists, such as gold or silver."
Bitcoin is the most popular of the "virtual" currencies which allow users to exchange online credits for goods and services. While there is no central bank that issues them, bitcoins can be created online by using a computer to complete difficult tasks, a process known as mining. Some 13 million bitcoins are believed to be in circulation, with a cap of 21 million - meaning no more bitcoins can be created after that point.
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In New York, regulators are currently weighing up a raft of new rules to regulate bitcoin and other virtual currencies. In China, the central bank has been busy warning people of the risks associated with holding bitcoin and online exchanges have been hit with a number of regulatory issues.
Meanwhile, in the U.K., the government has shown encouraging signs that it is willing to embrace the industry and the Bank of England's report on Thursday marks a major new piece of research into the world of digital currencies.
The BoE concludes that digital currencies do not currently pose a material risk to monetary or financial stability in the UK., given the small size of such schemes, but poses a series of hypothetical risks that it could have in the future.
Among these risks, it says that the price of digital currencies can be very volatile and that a price crash is not inconceivable. If marked increases in prices do occur, it said that it would be possible that a crash might have implications for U.K. financial stability, it said, especially with unhedged exposures by important financial institutions and if investors became leveraged via derivative contracts.
It also warned on the possibility of system-wide fraud with the potential for a single miner, or coalition of miners, to come under control of which payments were permitted. Additionally, it believes that if digital payments become more popular within a small group of the population then it could lead to economic fragmentation and affect the Bank's ability to influence demand with monetary policy.
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It also notes a situation it dubs "bitcoinized", where every member of the population conducting the totality of their day-to-day transactions entirely within the alternative currency, meaning the central bank's ability to influence price-setting and real activity would be "severely impaired."
"Such an outcome is extremely unlikely given the current impediments to the widespread adoption of current digital currency schemes imposed by their designs," it said, adding that it believes transaction fees for bitcoin would eventually need to rise significantly, as usage increases.
"It is much more likely that, if further adopted, digital currencies will be used in a limited fashion alongside traditional currencies," it concluded.