The Bank of England’s ability to govern monetary forces in the UK economy could be undermined if digital currency is broadly adopted, according to a new BoE report.

The study was the second issuance in a two-part publication on digital currency as part of the bank’s most recent Quarterly Bulletin. It follows a previous report in May, in which it called bitcoin a kind of commodity.

While acknowledging the bitcoin protocol as a “genuine technological innovation”, the Bank of England largely dismisses bitcoin’s ability to function on a wider scale, although it does suggest that broader adoption could take place in the future.

The report cites price volatility and the risk of diminishing returns for miners as systemic problems that, in its authors’ views, will keep digital currency from becoming more than an auxiliary payments infrastructure.

However, the report does look at the hypothetical mass adoption of digital currency. In a scenario in which the UK economy becomes, in the Bank of England’s words, “bitcoinized”, the central bank’s chief monetary authorities would become increasingly unable to influence prices and economic activity as a whole.

The report states:

“Since in this extreme scenario all payments would be conducted away from sterling as base money for essentially all of the economy, the Bank’s ability to influence price-setting and real activity would be severely impaired.”

The authors go on to say that “such an outcome is extremely unlikely” owing to the barriers to broader adoption cited in the report. Notably, the report concludes that this reduction in influence is “implausible absent a severe collapse in confidence in the fiat currency”, suggesting that digital currency could fill a monetary vacuum should a national currency experience a significant change in value.

Bitcoin ‘could serve as money’

One of the major questions explored in the Bank of England’s report is whether or not bitcoin is a form of money. The study relies on a common, three-part definition of money that involves three use cases: as a store of value, a medium of exchange and a unit of account.

The Bank of England explains that, under current conditions:

“Digital currencies could serve as money for anybody with an internet-enabled computer or device. At present, however, digital currencies fulfil the roles of money only to some extent and only for a small number of people. They are likely at present to regularly serve all three purposes for perhaps only a few thousand people worldwide, and even then only in parallel with users’ traditional currencies.”

However, this could be subject to change. The report highlights that, long-term, growing confidence in digital currencies could lead to broader use as a store of value and a medium of exchange.

For accounting purposes, the Bank of England acknowledges that few businesses, if any, denominate their records in bitcoin. Should this practice emerge, that element of the definition of money could become more relevant for digital currencies.

A ‘bitcoin economy’ would fail

The report contains a hypothetical scenario in which digital currency served as the basis currency for an economy. Suggesting that price deflation and poor economic performance would arise, the Bank of England concludes that a bitcoin economy would pale in comparison to one backed by a centralized, national currency.

Specifically, an economy based on digital currency would face the risk of “welfare-destroying volatility”. As the bank explains:

“In most existing digital currency schemes, the future path of supply is pre-determined and governed by a protocol that ensures that the eventual total supply will be fixed. This has the effect of removing any discretion from the determination of the money supply.”

The report goes on to say that certain steps could be taken to reduce volatility in an economy that uses digital currency. These includes making the coin supply growth rate more variable, pegging the block reward amount to the number of transactions or level of broad demand for bitcoins.

Too early to tell

According to the Bank of England, bitcoin and digital currencies do not – at present – pose a threat to the broader financial system. Yet it does suggest that, should broader adoption take place, the integration of bitcoin with complex financial instruments and global marketplaces could deepen the impact of any price volatility on the broader economy.

The report notes that there is “little incentive” currently for a major shift from fiat to digital currencies. However, the technology’s use as a form of money – and the broader applications of the decentralized ledger – could expand in the future.

The authors conclude:

“Digital currencies do not, at present, play a substantial role as money in society. But they may have the potential to come to exhibit at least some of the functions of money over time.”

Bank of England image via Shutterstock