Video - Digital currencies - How Do They Work And What Makes Them Different?

This short video explains: what are digital currencies such as Bitcoin? How do they work to make payments in a decentralized way – without the need for banks? And how does this differ from making electronic payments using traditional currencies?

The video also considers some more far-reaching potential applications of the ‘distributed ledger’ technology underpinning digital currency systems. A Quarterly Bulletin article explores these issues in more detail, as well as other topics such as how fraud-proof digital currency schemes are.


MR. NIXON: Rob, you've written an article on the emergence of digital currencies like Bitcoin and the developments in payment technologies which under pin them. Now, before coming on to discuss this further could you talk us through electronic payment with traditional currencies such as Sterling's say?

MR. ALI: Well, if we start by thinking about what money is. Money in modern economies typically takes the form of bank notes and coins. And in the vast majority of cases deposits held in bank accounts. These are digital records and money balances. Essentially, they only exist as data in a computer. Making payments is a matter of agreeing system to make changes to these records securely. So, let's take a very quick example. Imagine Ann want to transfer money to Fred electronically. Let's assume they use different banks in which case the payment goes from Ann's bank to Fred's by some central entity. Typically, a central bank and the Bank of England sits at the center of most payment systems in the UK.

MR. NIXON: Increasingly people want to make payments online or on the move and your article discusses some recent innovations which allows people to make payments in a more convenient way.

MR. ALI: Yes, this includes services like Paym in the UK which allows users to access existing payment systems using their mobile phones. And M-Pesa in Kenya which also uses mobile phones but the difference is the M-Pesa users don't need access to a bank account. These systems still rely on a trusted central entity be a bank or a mobile phone company. Most recently digital currencies have emerged which are structurally different to other innovations.

MR. NIXON: Your article explains what digital currencies like bitcoin are and how they work?

MR. ALI: That's right. And a key point to note is that a digital currency is both a payment system and a currency. This can't get lost because a lot of the media attention focuses on swings in the price of the currency but the real innovation is the decentralized payment system. To see this, if we go back to the example Ann wants to transfer money to Fred. But this time she's transferring a digital currency like Bitcoin. This is paid direct from Ann to Fred. There are no banks involved. Without a central third party, there needs to be a secure way for everyone to agree changes to the ledger since digital information is in principle easy to change and copy. Digital currencies overcome this by making it possible for a reliable copy of the ledger to be distributed to everybody in the system. This rethinking of payments is made possible by combining existing technologies like the Internet, cryptography and high-volume data storage. The article explained how this works in more detail.

MR. NIXON: So a key difference then is that where a centralized systems rely on everyone to trust some third party to keep a digital record that's correct. A Bitcoin transaction relies on there being many copies of this digital record which are distributed to many users across the network.

MR. ALI: That's right. And this means you don't have to rely on the trustworthiness of any single entity just let the cryptography works.

MR. NIXON: You also discuss some possible applications of the distributed ledger technology beyond payments. What are some of these possibilities?

MR. ALI: Like money most financial assets are just digital records. So, for example, if you own a share in a company you don't have a physical certificate anymore. What you actually own is a record in the database managed by trusted third party. We don't make any predictions about this in the article but we make the point that given these records are already digital it is at least conceivable that over time the centralized infrastructures of the financial system could gradually be replaced by data decentralized systems.

MR. NIXON: And so how does this affect the Bank of England?

MR. ALI: Given its role in protecting monetary and financial stability in the UK, the bank monitors closely any developments in new technology as well as any risk posed to its objectives.

MR. NIXON: Rob. Thanks very much.

MR. ALI: Thanks.

Written by Melvin Draupnir on September 11, 2014.