The emergence of digital currencies

Money and payment systems are intrinsically linked. In order for an asset to function as a medium of exchange, there needs to be a secure way of transferring that asset — a payment system. And for any system other than the exchange of physical banknotes or coins, a means of recording the values stored is also needed — a ledger. Modern payment systems are computerised and most money exists only as digital records on commercial banks’ accounts. The Bank of England, in a 2014 Q3 quarterly review article, considers recent innovations in payments technology, focusing on the emergence of privately developed, internet-based digital currencies such as Bitcoin.

Digital currency schemes combine both new payment systems and new currencies. Users can trade digital currencies with each other in exchange for traditional currency or goods and services, without the need for any third party (like a bank). Their creation is not controlled by any central bank. Bitcoin — currently the largest digital currency — was set up in 2009 and several thousand businesses worldwide currently accept bitcoins in payment for anything from pizza to web hosting. Most digital currencies, including Bitcoin, incorporate predetermined supply paths leading to fixed eventual supplies.

Much of the media focus to date has been on the new currencies themselves (such as ‘bitcoins’) and the large price swings that these have experienced. The review article argues, however, that the key innovation of digital currencies is the ‘distributed ledger’ which allows a payment system to operate in an entirely decentralised way, without intermediaries such as banks. This innovation draws on advances from a range of disciplines including cryptography (secure communication), game theory (strategic decision-making) and peer-to-peer networking (networks of connections formed without central co-ordination).

When payment systems were first computerised, the underlying processes were not significantly changed. Distributed ledger technology represents a fundamental change in how payment systems could work. In principle, this decentralised approach is not limited to payments. For instance, the majority of financial assets such as shares or bonds already exist only as digital records, stored on centralised databases.

In Summary:

  • Modern electronic payment systems rely on trusted, central third parties to process payments securely. Recent developments have seen the creation of digital currencies like Bitcoin, which combine new currencies with decentralised payment systems.
  • Although the monetary aspects of digital currencies have attracted considerable attention, the distributed ledger underlying their payment systems is a significant innovation.
  • As with money held as bank deposits, most financial assets today exist as purely digital records. This opens up the possibility for distributed ledgers to transform the financial system more generally.

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