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Digital Currencies - The Past, Present and a Safe Future

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The newspapers and airwaves have been full of comment about digital currencies (especially Bitcoins) over recent months. Many of these are full of "shock and awe" statements with prophesies of doom and the imminent collapse of society.

The press coverage has created some fear, uncertainty and doubt in the minds of the public without necessarily examining why digital currencies have emerged and the potential benefits that they could offer.

To try to address this issue, I am going to draw an analogy to Roland Hill's introduction of the Penny Post in 1839.

The need to guarantee safe delivery and receipt of a message from one individual to another was satisfied for well over a century and a half through the postal service. The cost of that service has risen of course over 150 years and time taken for delivery has settled on anywhere between one and three working days.

Towards the end of the last century, the internet emerged as a disruptive technology and today, secure messages are delivered anywhere in the world virtually instantaneously and virtually free.
Payments have evolved from barter trade to using cowry shells as a "currency"; from precious metals to the introduction of government issued coins and banknotes. Transfer of money then evolved into payments by cheque and then bank transfer. Costs have steadily risen for processing transactions and when we then move to the area of credit/debit card transactions, the costs are still extremely high and the problems of charge backs to e-Businesses make this a major concern for CFOs worldwide.

Should we be surprised therefore that technology has emerged to use the power of the internet to securely deliver payment or transfer value virtually instantaneously and virtually free?

So how does this new technology work and how can authorities protect consumers and keep crime out?

Much has been written about how Bitcoins are created or "mined", and much of this writing places the process in the same category as matter created in a cauldron somewhere in Hogwarts. Very simply, the mining process delivers a Bitcoin as a reward for solving a complex mathematical problem and has delivered a steady stream of coins into the market since 2009. Eventually the number of coins mined will reach a maximum of just under 21 million. These coins are not backed by a government issued legal tender (referred to as a Fiat currency) or by a commodity such as gold or silver. In addition to mining the coins anyone can acquire them by accepting them in exchange for goods or services or by exchanging Fiat currencies for Bitcoins.

One major area where digital currencies differ from Fiat currencies is that each Bitcoin and the transactions that are attached to it are recorded on what is called a "blockchain".

The recording of transactions is achieved without the intermediation of any single, central authority. Instead, multiple intermediaries exist in the form of computer servers running Bitcoin software. By connecting over the Internet, these servers form a network that anyone can join and transactions are broadcast using readily available software.

It can be argued that tracing the transactions relating to digital currencies is therefore much easier than trying to track movements of physical cash.

The supply side is strictly controlled, some would say more so than where a country "prints more money". The demand side is therefore the area that will really affect the "price" of Bitcoins. Demand has fluctuated with large periods of sustained growth, dented on occasions when a negative story has broken in the press. With Fiat currencies, governments use interest rates to control the economy and the respective attractiveness of one currency against another will determine the exchange rate or "price" of that currency.

With "commodity currencies" such as gold and silver, their prices tend to fluctuate in response to changes in global economic stability and can also therefore be volatile.

So what should be made of the various negative headlines relating to digital currency and how can a responsible authority seek to protect consumers?

In February this year the largest Bitcoin Exchange, based in Japan, ceased trading and filed for bankruptcy. On investigation, around 850,000 Bitcoins that they held were apparently "missing" although 200,000 of these have now been found. If any of these were to be offered back to the market perhaps they could be tracked through the blockchain mechanism. Suggestions have been made that management controls in the company were not sufficient and that their software storage mechanisms were not secure enough allowing the possibility that Bitcoins could have been stolen.

This is not a fault of "digital currencies" per se or as one analyst put it, "If someone stole some gold from a safe, it is not the gold's fault but a lack in the security controls of the owner of the gold". Bitcoin itself is not the problem.

Understanding these issues whilst establishing a regime whereby robust safeguards are put in place is therefore key to allowing responsible companies to operate in this emerging market.

To achieve this it is vital that:
  • Companies are well managed and run by appropriately skilled and knowledgeable people.
  • The company has to implement extensive Know Your Customer, Anti-Money Laundering and Anti-Terrorist Financing controls
  • The company would have to adhere to the Data Protection regulations in respect of any personal information held
  • The company adheres to any requests for due diligence information, cease or desist instructions etc.

If you were tempted to think that digital currencies represent "wild and visionary schemes" and that a plan to propose a form of regulation "is a preposterous one, utterly unsupported by facts and resting entirely on assumption" these quotes were actually made to Roland Hill in the debate before his ideas for the Penny Post were accepted.

The Isle of Man Department of Economic Development recently announced a move to control digital currencies.