BoE warns higher uptake of Bitcoin could risk Britain's financial stability

12 September 2014 -

Finance gurus say UK would be more open to fraud and deflation if Bitcoin and other virtual currencies became more prominent payment methods

Jermaine Haughton

Volatility in the Bitcoin market could expose users to fraud and a potential price crash if its usage becomes more widespread in the UK, the Bank of England has announced. In a two-part report, the BoE described the current digital currency market as too small to have any discernable affect – but warned that if the system were expanded to underpin the economy, there would be a host of substantial risks to account for.

Created in 2009, Bitcoin is one of several online currencies that function outside the traditional banking system. According to BoE estimates, at present just 20,000 people in Britain have significant Bitcoin holdings, with a combined value of less than £60 million (or 0.1% of sterling notes and coins). The currency chalks up fewer than 300 transactions a day nationwide.

Getting down to macroeconomic brass tacks, the BoE cited a flaw in the design of most digital currencies – namely that they tend to include a pre-set path towards a fixed eventual supply. That, it said, could spawn greater volatility in value and real activity, as greater demand would place huge pressure on monetary supply. For example, Bitcoin has more than 13 million coins in circulation, but is designed to have an upper limit of 21m – and increasing usage of the payment system has already triggered extreme changes in value. One Bitcoin is currently worth about £291.97, but in the past year the price has wavered considerably between £223.34 and £565.38.

Further to that, said the BoE, unpredictable exchange rates and the prospect of rising transaction costs may limit a more widespread adoption of Bitcoin and similar currencies.

The report explains: “The total value of all digital currencies is too small to pose a threat in this way at present, but further increases in their prices cannot be ruled out. If marked increases in prices were to occur, it is possible that the total valuation may become large enough, such that a price crash may have implications for financial stability in this manner.”

In the BoE’s view, the biggest hypothetical risk to financial stability would be if the country became “Bitcoinised” – in other words, if the currency ended up replacing sterling as the base underpinning the entire economy. While the intentional restricted supply to maintain value makes that unlikely, such an extreme scenario would negate “the Bank’s ability to influence price setting and real activity would be severely impaired”.

BoE researchers are particularly concerned that a greater adoption of digital currencies would increase the possibility of system-wide fraud. The report notes: “If a single [Bitcoin] miner, or coalition of miners, came to control a sustained majority of the computing power in a digital currency, that group would be able to control which payments were permitted, or even to create fraudulent ‘double-spend’ payments.”

Another major worry for the BoE is the prospect of a price crash. Although such problems are presently limited to the direct holders of alternative currencies, the report outlines three potential scenarios in which widespread damage and instability could rock the country’s financial system:

1. If a holder of a digital currency increases exposure by first borrowing money from (an)other holder(s). A price crash in this circumstance would have the potential to impose losses not only on the direct holders of digital currencies, but on those who had lent to them.

2. If a systemically important financial institution were to have a significant unhedged exposure to a digital currency.

3. If a digital currency were to become entwined with financial instruments, such as derivatives contracts, creating a mechanism in which both the direct users of a digital currency and other financial-market participants could hold leveraged positions against it. That could result in the total market exposure to digital currencies far exceeding their market value – to the extent that a price crash would have a magnified impact on the economy, ranging beyond direct participants.

In a recent interview with CMI Insights, Alastair Lukies – non-executive chairman of Innovate Finance, a trade body for financial technology (or “fintech”) firms – argued that thorough regulation of digital currencies must be applied if they are to be used more widely. “Cyptocurrencies are an exciting development for fintech,” he said, “and have certainly raised the profile of the industry – they’re the perfect example of finance and technology colliding. But it’s crucial for the protection of the consumer that these are properly regulated.”

He added: “Innovations such as Bitcoin have huge potential, but getting them right is about striking a balance between finance, technology and regulation. To do that, you need [to gather] experts in each of those fields.”

Read the full BoE report: part one here and part two here.

For more on these issues, pick up a copy of CMI’s Checklist guide, Managing Finance.