Digital currencies: how do they work and what makes them different? – Quarterly Bulletin article

Rob, you’ve written an article on the emergence
of digital currencies like Bitcoin, and the developments in payment technologies which
underpin them. Now before coming on to discuss this further, could you talk us through an
electronic payment with a traditional currency such as sterling. Well if we start by thinking
about what money is, money in modern economies typically takes the form of banknotes and
coins, and in the vast majority of cases, deposits held in bank accounts. These are
digital records of money balances, essentially they only exist as data in a computer. Making
payments is a matter of agreeing a system to make changes to these records securely.
So let’s take a very quick example. Imagine Anne wants to transfer money to Fred electronically.
Let’s assume they use different banks, in which case the payment goes from Anne’s bank
to Fred’s via some central entity, typically a central bank and the Bank of England sits
at the centre of most payment systems in the UK. Increasingly people want to make payments
online or on the move, and your article discusses some recent innovations which allows people
to make payments in a more convenient way. Yes. This includes services like Paym in the
UK which allows users to access existing payment systems using their mobile phones, and M-Pesa
in Kenya, which also uses mobile phones but the difference is that M-Pesa users don’t
need access to a bank account. These systems still rely on a trusted central entity, be
it a bank or a mobile phone company. Most recently digital currencies have emerged which
are structurally different to other innovations. Your article explains what digital currencies
like Bitcoin are, and how they work. That’s right, and a key point to note is that digital
currency is both a payment system and a currency. This can get lost because a lot of the media
attention focuses on swings in the price of the currency but the real innovation is the
decentralised payment system. To see this, if we go back to the example that Anne wants
to transfer money to Fred, but this time she’s transferring a digital currency like Bitcoin.
This is paid direct from Anne to Fred, there are no banks involved. Without a central third
party, there needs to be a secure way for everyone to agree changes to the ledger, since
digital information is, in principle, easy to change and copy. Digital currencies overcome
this by making it possible for a reliable copy of the ledger to be distributed to everybody
in the system. This rethinking of payments is made possible by combining existing technologies
like the internet, cryptography and high volume data storage. The article explains how this
works in more details. So a key difference then is that whereas centralised systems rely
on everyone to trust some third party to keep a digital record that’s correct. A Bitcoin
transaction relies on many copies of this digital record which are distributed to many
users across the network. That’s right, and this means you don’t have to rely on the trustworthiness
of any single entity, just that the cryptography works. You also discuss some possible applications
of the distributed ledger technology beyond payments, what are some of these possibilities?
Like money, most financial assets are just digital records, so for example if you own
a share in a company, you don’t have a physical certificate anymore. What you actually own
is a record in a database managed by a trusted third party. We don’t make any predictions
about this in the article, but we make the point that given these records are already
digital, it is at least conceivable that over time, the centralised structures of the financial
system could gradually be replaced by decentralised systems. So how does this affect the Bank
of England? Given its role in protecting monetary and financial stability in the UK, the Bank
monitors closely any developments in new technology as well as any risks posed to its objectives.
Rob, thanks very much. Thanks

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