Bitcoin and other virtual currencies can contribute positively to financial innovation but also subject users to various risks, according to a report published recently by the European Central Bank.
According to the report, the growing use of the Internet, an increase in electronic commerce, the appeal to merchants and consumers of low transaction costs, and the value virtual communities place on speed all can be expected to spur the growth of Bitcoin and other alternatives to government currencies.
"This report is a first attempt to provide the basis for a discussion on virtual currency schemes," the ECB writes in the report, which the regulator published this month. "Although these schemes can have positive aspects in terms of financial innovation and the provision of additional payment alternatives to consumers, it is clear that they also entail risks."
"Owing to the small size of the virtual currency schemes, these risks do not affect anyone other than users of the schemes," the report adds.
The report reviews Bitcoin's history and basic features, including its monetary aspects and technical operation.
According to the report, Bitcoin traces its theoretical roots to the Austrian school of economics, which holds that the current monetary system and actions of central banks exacerbate business cycles and spur inflation.
It also explains how Bitcoin verifies the validity of transactions and regulates its money supply via so-called mining. "'Mining' is … the process of validating transactions by using computing power to find blocks (i.e. to solve complicated mathematical problems) and is the only way to create new money in the Bitcoin scheme," according to the ECB.
According to the report, Bitcoin remains immature and illiquid, which works against its adoption. "Secondly, Bitcoin is not the currency of a country or currency area and is therefore not directly linked to the goods and services produced in a specific economy, but linked to the good and services provide by merchants who accept Bitcoins," the ECB writes.
The report also reviews risks that Bitcoin can entail. Bitcoin is complex and difficult for all potential users to understand, according to the report. Users also can start using Bitcoin without actually knowing how the system works. "This fact, in a context where there is clear legal uncertainty and lack of close oversight, leads to a high-risk situation," the ECB writes.
The ECB cites a decision by the Electronic Frontier Foundation in July 2011 to discontinue accepting donations in bitcoins, citing the currency's legal status. "Bitcoin raises untested legal concerns related to securities law, the Stamp Payments Act, tax evasion, consumer protection and money laundering, among others," Cindy Cohn, the group's legal director, wrote in a blog post that explained the decision.
The ECB report notes that some of the same concerns can arise with cash.
Though the report finds that Bitcoin and other virtual currency schemes present little risk to financial stability as a result of their limited ties to the real economy, it concludes they do fall within central banks' responsibility to monitor.
"Given that the current assessment of risks is highly dependent on relatively small-sized virtual currency schemes, the assumption that virtual currency schemes will continue to grow means that a periodical examination of the developments is needed in order to reassess the risks," the ECB writes.