Consultation outcome

Digital currencies: call for information

Updated 18 March 2015

1. Background

Earlier this year, the Chancellor of the Exchequer set out plans for making Britain the global centre of financial innovation, benefiting consumers and businesses. Among plans to increase investment in the sector, the Chancellor announced pro-innovation regulatory measures to unlock the potential of new technology, and allow new innovators to compete on a more level footing with established players. In parallel, the Financial Conduct Authority launched Project Innovate, which will help financial service firms navigate the regulatory system and identify where the regulatory system needs to adapt to new technology.

The government has already taken a number of steps to open up competition and promote innovation in payments and financial technology (FinTech). In December 2013, the government legislated to create a new Payment Systems Regulator (PSR) with strong powers to drive competition, innovation and a focus on consumer needs in UK payment systems. In particular, the PSR will ensure that banks and non-bank players can access the payment systems on fair terms, allowing them to deliver fresh competition and new, innovative approaches for UK consumers.

In June of this year, the government introduced legislation to allow banks and building societies implement “cheque imaging” – an innovation that speeds up cheque clearing times by allowing a digital image of a cheque to be presented for payment, instead of the original paper instrument.

In August, the Chancellor announced that the government would legislate to require UK banks to pass on information on small businesses they reject for finance, to give FinTech companies and alternative lenders the opportunity to step in and offer finance instead. He confirmed that the government would also complete a major new review examining how the technology that serves the financial sector will evolve in the future, to be led by the Government Office for Science.

Alongside this, the Chancellor announced a major programme of work looking into digital currencies and associated technologies, with a particular focus on whether they should be regulated. The government is now considering the benefits offered by digital currencies and the technology that underpins them, and whether it should take action to support innovation in this area. At the same time, the government is examining the risks presented by digital currencies, and assessing whether action is required to mitigate any concerns.

1.1 Scope

The scope of this call for information is digital currencies, with a focus on digital currencies in their function as a payment method, rather than as a speculative investment. For the purpose of this call for information, a digital currency scheme is one which incorporates both a decentralised payment system and a related currency. All the schemes exhibit a publicly visible ledger which is shared across a computing network. A key defining feature of each digital currency scheme is the process by which its users reconcile changes to its ledger (that is, on which transactions to accept as valid). Some digital currencies known as ‘cryptocurrencies’ seek consensus through means of techniques from the field of cryptography. Some however, seek consensus through non-cryptographic means.1

The government considers that virtual currencies differ from digital currencies, in that they are issued and usually controlled by their developers, and used and accepted among the members of a specific virtual community. Virtual currencies as defined are therefore out of the scope of this call for information.

The government has already published its position on the tax treatment of income received from, and charges made in connection with, activities involving digital currencies, specifically for VAT, Corporation Tax, Income Tax and Capital Gains Tax.2 The tax treatment of digital currencies is therefore also out of scope of this call for information.

1.2 Purpose

The purpose of this call for information is to enable the government to examine the potential benefits that digital currencies could bring to consumers, businesses and the wider economy, and look into the potential barriers that digital currency businesses face when trying to establish themselves in the UK. The government will also examine the risks presented by digital currencies in order to establish whether, at this point in time, the government needs to take action to counter these risks.

Once aware of the benefits and risks, the government can take a decision on whether it needs to intervene in the digital currency market. government interventions could take the form of regulation, for example, to curb financial crime risks or to create a more stable market.

The government is completing this call for information in the context of much ongoing international debate on digital currencies and how to treat them. For example, there are ongoing discussions in Europe and at the Financial Action Taskforce. The information gained through this call for information will be used to ensure the UK government’s own position on digital currencies is properly informed and in the best interests of UK consumers and businesses.

2. Benefits of digital currencies

There are a number of potential benefits that digital currencies can be seen as offering. A number of these flow from the fact that instead of relying on the transfer of money between financial institutions, digital currencies instead rely on the transfer of codes across the Internet. Digital currency users have argued that this creates a system that is cheaper, faster and safer than traditional payment systems.

In discussions with industry to date, low transaction costs and faster processing times have been highlighted as a particular advantage, with users being able to make cheaper and quicker domestic and international payments. Added to this is the user convenience of being able to make payments from any location via a digital wallet on a mobile phone or other device.

The fact that digital currencies revolve around a decentralised payment system with no intermediaries has also been highlighted as benefit, as it means that they are removed from bank failure. Digital currency users have also commented that the currency cannot be forged, and is easier to trace than physical cash due to the ‘distributed ledger’ technology it employs. Another potential benefit is that digital currencies could offer more security and privacy. Unlike debit cards, for instance, there is no number to link to a customer’s bank account.

However, there may also be reasons why the benefits of digital currencies are limited. Such reasons include the fluctuating price of digital currencies, meaning that they are not a stable store of value, and also the fact that digital currencies are accepted by a very limited number of merchants. There is also very limited buyer protection: when goods are bought using a digital currency and the merchant doesn’t send the promised goods, no action can be taken to reverse the transaction.

Question 1

What are the benefits of digital currencies? How significant are these benefits? How do these benefits fall to different groups e.g. consumers, businesses, government, the wider economy? How do these benefits vary according to different digital currencies?

Question 2

Should the government intervene to support the development and usage of digital currencies and related businesses and technologies in the UK, or maintain the status quo? If the government were to intervene, what action should it take?

Question 3

If the government were to regulate digital currencies, which types of digital currency should be covered? Should it create a bespoke regulatory regime, or regulate through an existing national, European or international regime? For each option: what are the advantages and disadvantages? What are the possible unintended consequences (for instance, creating a barrier to entry due to compliance costs)?

Question 4

Are there currently barriers to digital currency businesses setting up in the UK? If so, what are they?

2.1 New technology

A key innovation of digital currencies is the ‘distributed ledger’ technology (for example, the technology used in the ‘blockchain’) that allows a payment system to operate in an entirely decentralised way, with no intermediaries such as banks. This innovation could represent a fundamental change in how payment systems can be made to work.

Question 5

What are the potential benefits of this distributed ledger technology? How significant are these benefits?

3. Risks of digital currencies

3.1 User detriment

There are a number of potential risks faced by users of digital currencies (for example, consumers and merchants). A number of risks flow from the fact that digital currencies are stored in digital wallets, which can be vulnerable to fraud or hacking. If a digital currency user’s digital wallet was hacked, for instance, this would result in a loss of funds for the user. Funds could also be lost if these wallet providers or the exchanges through which digital currencies are converted into fiat currencies fail. Users would be unable to recover these funds, as there are currently no protections in place. Digital currency users are also unprotected from a loss of value due to the fluctuating price of digital currencies.

The internet-based nature of digital currency schemes does not respect national, and therefore jurisdictional borders. This has led certain industry players to call for a common international approach to digital currency regulation.

Question 6

What risks do digital currencies pose to users? How significant are these risks? How do these risks vary according to different digital currencies?

Question 7

Should the government intervene to address these risks, or maintain the status quo? What are the outcomes of taking no action? Would the market be able to address these risks itself?

Question 8

One of the ways in which the government could take action to protect users is to regulate. Should the government regulate digital currencies to protect users? If so, should it create a bespoke regime, or regulate through an existing national, European or international regime?

For each option: what are the advantages and disadvantages? What are possible unintended consequences (for instance, creating a barrier to entry due to compliance costs)? What other means could the government use to mitigate user detriment apart from regulation?

3.2 Crime

Certain features of digital currencies may lend them to use in illicit and illegal activities due to their degree of anonymity and borderless nature. Transactions are made on a peer-to-peer basis, avoiding regulated financial systems. Discussion with industry and regulators have highlighted that the key crime risks are the purchase of illegal goods and services; fraud; anonymous extortion; money laundering; and terrorist financing. The European Banking Authority recently published a report that listed over 70 risks arising from digital currencies.

However, discussions have also highlighted that there may also be reasons why the crime risks of digital currencies are limited due to the limited anonymity of digital currencies and the fact that the ‘distributed ledger’ technology employed by decentralised digital currencies records all transactions.

The European Commission is currently considering regulating digital currencies via the Anti-Money Laundering Directive, and the USA’s Financial Crimes Enforcement Network (FinCEN) has already applied rules relating to anti-money laundering to administrators and exchangers of digital currencies.

Question 9

What are the crime risks associated with digital currencies? How significant are these risks? How do these risks vary according to different digital currencies?

Question 10

Should the government intervene to address these risks, or maintain the status quo? What are the outcomes of taking no action?

Question 11

If the government were to take action to address the risks of financial crime, should it introduce regulation, or use other powers? If the government were to introduce regulation, should it create a bespoke regime, or regulate through an existing national, European or international regime? For each option: what are the advantages and disadvantages? What are possible unintended consequences (for instance, creating a barrier to entry due to compliance costs)?

What has been the impact of FinCEN’s decision in the USA on digital currencies?

Question 12

What difficulties could occur with digital currencies and financial sanctions?

3.3 Monetary and financial stability

Digital currencies, as an alternative to fiat currencies issued by central authorities, could conceivably pose financial stability risks and weaken monetary policy making, if wide enough circulation was reached.

However, there may also be reasons which prevent the widespread uptake of digital currencies in their present form meaning that the financial stability risks currently posed are limited. Such reasons may include:

  • price volatility, and resulting limited use of digital currencies
  • low liquidity
  • the prospect of higher transaction costs in the future
  • the finite amount of digital currencies such as Bitcoin that will be released

Question 13

What risks do digital currencies pose to monetary and financial stability? How significant are these risks?

4. List of questions

Question 1

What are the benefits of digital currencies? How significant are these benefits? How do these benefits fall to different groups e.g. consumers, businesses, government, the wider economy? How do these benefits vary according to different digital currencies?

Question 2

Should the government intervene to support the development and usage of digital currencies and related businesses and technologies in the UK, or maintain the status quo? If the government were to intervene, what action should it take?

Question 3

If the government were to regulate digital currencies, which types of digital currency should be covered? Should it create a bespoke regulatory regime, or regulate through an existing national, European or international regime? For each option: what are the advantages and disadvantages? What are the possible unintended consequences (for instance, creating a barrier to entry due to compliance costs)?

Question 4

Are there currently barriers to digital currency businesses setting up in the UK? If so, what are they?

Question 5

What are the potential benefits of this distributed ledger technology? How significant are these benefits?

Question 6

What risks do digital currencies pose to users? How significant are these risks? How do these risks vary according to different digital currencies?

Question 7

Should the government intervene to address these risks, or maintain the status quo? What are the outcomes of taking no action? Would the market be able to address these risks itself?

Question 8

Should the government regulate digital currencies to protect users? If so, should it create a bespoke regime, or regulate through an existing national, European or international regime? For each option: what are the advantages and disadvantages? What are possible unintended consequences (for instance, creating a barrier to entry due to compliance costs)? What other means could the government use to mitigate user detriment apart from regulation?

Question 9

What are the crime risks associated with digital currencies? How significant are these risks? How do these risks vary according to different digital currencies?

Question 10

Should the government intervene to address these risks, or maintain the status quo? What are the outcomes of taking no action?

Question 11

If the government were to take action to address the risks of financial crime, should it introduce regulation, or use other powers? If the government were to introduce regulation, should it create a bespoke regime, or regulate through an existing national, European or international regime? For each option: what are the advantages and disadvantages? What are possible unintended consequences (for instance, creating a barrier to entry due to compliance costs)? What has been the impact of FinCEN’s decision in the USA on digital currencies?

Question 12

What difficulties could occur with digital currencies and financial sanctions?

Question 13

What risks do digital currencies pose to monetary and financial stability? How significant are these risks?

  1. Bank of England, ‘Innovations in payment technologies and the emergence of digital currencies’, 11 September 2014

  2. ‘Revenue and Customs Brief 9 (2014): Bitcoin and other cryptocurrencies’, 3 March 2014