Hailed at the time by its advocates as a 'game changer' and,by its critics as a Ponzi scheme,the market for digital currencies has continued to evolve and grow,allowing users to trade digital currency units or goods and services without the need for a third party or central bank coordination.
Innovation in payments is not nothing new - note the long-standing trend towards paperless money transactions. But what mobile phone payments,credit cards and contactless payments all have in common is the use of a process which has remained unchanged since the 16th century: namely the central clearing process. The rise of digital currencies represents a break with that fundamental function of the monetary system. The Bank of England has noted that the shift from central ledgers to distributed ledgers,which underlie the new digital payment systems,is a significant innovation.1This allows a payment system to operate in an entirely decentralised way.
A successful digital currency needs many things to succeed: it lends heavily from cryptography (secure communications) to ensure that transactions are valid,incentivising users (miners) to gather and process blocks of transactions and compete to verify them; as well as peer-to- peer networking as buyers and sellers seek each other out in the absence of central coordination. Such innovations present major challenges.
Firstly,security. It is easy to share information on the Internet. It is also easy to steal it. Concerns about fraud and cyber security – already huge issues for modern corporates – are further amplified in the world of digital currencies. In any decentralised currency providing a medium of exchange (to be used in corporate payments) or as a unit of account (to facilitate corporates when buying or selling assets),the integrity of the system is critical. Who polices the market and how effectively they manage it remain unanswered by current models. The opportunities to game the system – hacking corporate IT systems,stealing corporate information,and using that information to generate fraudulent transactions on digital currency platforms and reap massive rewards – seems potentially huge.
Secondly,maintaining orderly markets in the absence of central coordination. Volatility has been a feature of the market. The price of Bitcoins rose 5,000% in the two years to 2014.2 Price is difficult to stabilise in the absence of a central authority to control supply and maintain market confidence. The need to build and maintaining market infrastructure,including appropriate incentives to prevent fraudulent attacks on the block chain,are vital for ensuring market efficiency and security.
The technology behind distributed ledgers isn't simply applicable to payment systems. In a financial world where most assets – including equities and bonds - exist in purely digital form,the prospect for distributed ledgers to transform the world of corporate fund raising is equally huge. Examples of non-currency block chains already exist,for example,the Estonian government and Nasdaq are trialling a shareholders e-voting system for companies listed on the Tallinn Stock Exchange3.
In the case of digital currencies major challenges remain. In the absence of the central bank's guiding hand,limited regulatory oversight and reporting,digital currencies still need a trusted third party – which may or may not be a financial institution – to manage the settlement process. Without a trusted party,transactions could be left open (unsettled) for a long period of time. This presents a major obstacle to corporates looking to raise finance as the process of trading securities becomes potentially more complex and less liquid. Fundamentally,it is difficult to place an accurate asset valuation. This highlights some of the concerns over the method of valuation for such currency units; focussing purely on liabilities marks a retreat from the traditional method of double entry accounting. Without this,can anyone really be certain whether the market value of currency units represents anything close to fair value.
While current digital currencies may have their limitations,the forces driving this market innovation are not going to fall away. If Bitcoin (and the other currently constituted digital currencies) do not provide a suitable answer,then it will be left to further innovations in technology and systems to overcome the existing hurdles. What has been called the "digital e-money vacuum"4 will be filled. It is now only a question of 'when' not 'if' this happens. The potential to disrupt current market behaviours will go much further than payments.