Video - The Economics Of Digital Currencies

A key question surrounding digital currencies like Bitcoin is: to what extent should they be considered as money? This video answers that question by considering the roles we expect money to serve, and how much digital currencies are currently used in those ways.

The video also discusses: how might the economics of the schemes – and the low transaction fees in particular – play out in the long run? And what risks might digital currencies pose to the Bank of England’s objectives for monetary and financial stability?

A Quarterly Bulletin article explores these issues in more detail, as well as other topics such as the parallels between digital currencies and free banking.


MR. NIXON: We're here in this cafe in East London next to this Bitcoin ATM. What is Bitcoin and what can I get from this ATM?

MR. BARRDEAR: 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 cafe 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.

MR. NIXON: You called Bitcoin a currency. Does that mean it's a type of money then?

MR. BARRDEAR: 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.

MR. NIXON: How many people actually use Bitcoins?

MR. BARRDEAR: It's difficult to be sure. But we think there might be one or two million people worldwide that holding a Bitcoins. And in the UK at the moment no more than 200,000 people. But these people don't seem to be using them to buy things though.

MR. NIXON: So a lot of people are essentially just holding them then?

MR. BARRDEAR: 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% in a single day.

MR. NIXON: You also consider how some of the economics of digital currencies might play out in the long run.

MR. BARRDEAR: That's right. Now, one of the aspects that's been driving interest in digital currencies is that a 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.

MR. NIXON: I see.

MR. BARRDEAR: 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 overtime. 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 the transaction fees from the transactions they check. But they also receive newly created Bitcoins as a reward for the verification process.

MR. NIXON: So as long as these miners continue receiving newly created Bitcoins as a reward for the transactions they verify. The fees associated with using Bitcoin it might be expected to remain low.

MR. BARRDEAR: 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 service.

MR. NIXON: Now your article also discusses what all of this means for the Bank of England.

MR. BARRDEAR: That's right. The bank has 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.

MR. NIXON: Could digital currencies pose a risk to the stability of the financial system in the future?

MR. BARRDEAR: In theory, they could but only if they obtained widespread usage first. For example, if household businesses or the financial sector would 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 discussed in the article to materialize.

MR. NIXON: And on the monetary side.

MR. BARRDEAR: 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.

MR. NIXON: That's great, John. Thanks very much.

MR. BARRDEAR: No worries.

Written by Melvin Draupnir on September 11, 2014.