Published in the Financial Post on May 10 2013

By Finn Poschmann

Digital currency holds potential for good and bad

When a commodity price or currency exchange rate quickly appreciates 11-fold, people notice. Hence an uptick in interest in Bitcoin – a digital currency launched in 2009. Six months ago, one Bitcoin could buy 10 Canadian dollars; now it can buy about 110.

Bitcoins, like similar digital currency systems, offer great potential. If they grow large, and they continue to operate outside the “real” financial system, they will pose important risks that need addressing. Less than two months ago, for instance, the U.S. Treasury Department issued formal guidance aimed at Bitcoin, saying that traders in virtual currencies who exchange them for real currencies, or for other digital ones, are in the money services business, and therefore captured within the department’s anti-money laundering regulations.

The appeal of Bitcoin and similar digital currencies is easy to understand. First, they are purely electronic – exchanging them is easy, and low cost. More important, people and businesses can exchange them without the financial infrastructure associated with debit and credit cards, or wire transfers, because people do it themselves through peer-to-peer systems. On the other hand, Bitcoins do not have legal tender status, nor legal foundation, meaning that there is no central bank backing the currency, nor liquidity backstop or lender of last resort.

Bitcoin, in this sense, is not a “real” currency – yet it is money. Money serves at least two roles: as a medium of exchange, and as a store of value. As a medium of exchange, all we need to know is that counterparties readily accept it in exchange for goods and services, or in settlement of debt. If enough potential counterparties are willing to accept a currency, then it is viable. A currency has network effects: The more potential counterparties are willing to accept the currency, the more useful it is and potentially the more durable.

A small network, such as Bitcoin, may be subject to the risk of a sudden withdrawal of counterparties with whom one might trade. If no one wants to trade with you in the currency you hold, the value of your holdings denominated in that currency are effectively nil. And recall that Bitcoin has no status as legal tender; when you hold dollars, you can at least count on government to accept them in payment of taxes due.

The fact that Bitcoin offers anonymity to its users makes it vulnerable to use in illicit activities, and that does not help it establish legitimacy among a broader group of users, or the “real” financial sector. Of course, cash and prepaid credit cards bear the same risks, but they are not seeking to establish their transactional legitimacy.

Likewise, as a store of value, holders of assets denominated in a given currency need to know that when push comes to shove, they can exchange their holdings for alternative stores of value, whether other currencies or real (physical or financial) assets. In other words, investors like predictability and liquid assets. The Bitcoin system, given its small size, is as of yet neither predictable nor liquid.

And what happens when things go wrong? Say, owing to a technological network collapse, or a denial of service attack that slows trading to a crawl, as happened to a primary Bitcoin server last month. In that instance, the trading value of Bitcoins plummeted; more generally the result is an implosion of counterparties’ willingness to accept the currency as a medium of exchange. The network, in figurative terms, collapses on itself and, as a medium of exchange, which is where Bitcoin’s value lays, the currency is destroyed.

When that happens, the currency as a store of wealth will almost certainly collapse, too. Where can holders go, if there is no deposit insurance or a central bank acting as a lender of last resort, as in Bitcoin world?

The external risks arise where holders of Bitcoins intersect with the traditional financial sector. If the collapsing medium is large enough, relative to competing media of exchange and stores of value, holders of the former may be unable to honour claims on them in traditional currency networks, with ripple effects. If the ripples turn into big waves, that is a systemic threat, whereby a financial shock can lead to the collapse of an entire financial system.

This ripple effect would be the more devastating the more entangled digital currencies become with the traditional financial system. Suppose the Bitcoin network evolves to the point where there are financial intermediaries within the system, who extend Bitcoin-denominated loans to people and businesses, with conservative leverage ratios.

Imagine, too, that some traditional banks take the decision to lend against collateral denominated in Bitcoins. In this scenario, a sharp fall in the Bitcoin exchange rate, or a dramatic contraction of the Bitcoin network – perhaps the same thing – could endanger the traditional lending banks’ health and, taken to sadly familiar extremes, destabilize the broader financial system.

Do these things happen in the world we know? Yes – this collapsing dynamic is familiar from Ponzi schemes that have evaporated, and from securitization markets that have imploded when traders no longer valued the financial claims that the securities seemed to represent.

Does that mean that developments such as Bitcoin are to be avoided or prevented? No, their emergence signals a market message: Existing media of exchange are not responding fully to social choices and needs.

Digital currencies are small compared to the traditional financial system, yet their appeal in an increasingly digital world signals a growth opportunity, one that will be seized.

The sensible course of action for financial regulators, lenders and deposit insurers is to monitor closely these new systems, and gain a better understanding of the implications for financial systems and the real economy. In due course, statutory and common law institutions, financial regulators and monetary authorities will need to respond, or bad outcomes will be inevitable.

Finn Poschmann is vice president, research, at the C.D. Howe Institute; Philippe Bergevin is senior policy analyst.