Bitcoin has dominated headlines in the financial world in recent months with a return of over 1,700% so far this year. Rising prices are attracting more investors, though some experts see the increasing level of interest as a sign of a bubble. But this is not the only problem.

Bitcoin is an unregulated cryptocurrency which is administered by a network of users through an open and distributed ledger known as blockchain. Each transaction is verified by the network. Since it is a distributed ledger and no one person or organization controls it, technically, chances of someone manipulating the system are very low. There are multiple reasons why people around the world are getting attracted to bitcoin or other such virtual currencies. Some people like the idea that it is actually possible to make electronic transactions without involving the formal system of banks and financial institutions. The possibility that demand for such an instrument will increase over time is pushing prices. In different parts of the world, some people also wish to take their savings out of domestic currency owing to economic and political instability. However, a large number of investors are buying just to ride the momentum and make quick returns. Rising prices of unregulated cryptocurrencies could pose a number of problems for the formal financial system.

First, if the prices of bitcoin and other such currencies keep going up for a considerable period, the fall could be painful. Prices are clearly being driven by speculation, as there is no underlying asset to back them. Further, rising prices will attract more people to start such currencies and invest in them. This will increase the contact of virtual currencies with formal finance, and developments in this market would affect the financial system. The beginning of futures trading in bitcoin is a major step towards making it more mainstream, even though its consequences are not well understood.

Second, if adoption of bitcoin or other such instruments actually increases significantly, it will make things difficult for central banks. A central bank manages the supply and cost of money in the system to attain maximum growth with price stability. But in the world of unregulated cryptocurrencies, central banks may find it difficult to manage the level of economic activity. Bitcoin, for example, is deflationary by design. Greater adoption could also alter the dynamics of capital control, especially in developing economies.

Third, an increase in the use of such instruments could also affect financial intermediation, investment and growth. Therefore, it is important for policymakers to carefully evaluate the potential costs and benefits of a possible rise in the use of unregulated cryptocurrencies. However, as things stand today, the high level of volatility shows the limitation of bitcoin and other such instruments. It is highly unlikely that individuals or firms would be willing to write contracts in a currency whose value changes by 20-30% in either direction in no time. But it is possible that some virtual currencies may become more stable over time.

Although the outlook for bitcoin is fairly uncertain at this stage, the technology on which it works has a much wider appeal and could be useful in a number of areas. For instance, as we have argued in these pages before, blockchain has the potential to end property-related litigation in a country like India. The government can have a blockchain where ownership and transactions can be tracked easily. Similarly, blockchain can make government spending more efficient in areas such as the social sector, as it will increase transparency. The technology is also being tested in the financial sector to settle transactions. This could help reduce costs for financial institutions and the working capital requirement for other firms. The distributed ledger can have other usage such as smart contracts.

While blockchain can help reduce cost and increase transparency in various sectors, it could also pose challenges for risk management in the system. In a speech earlier this year, Federal Reserve chair nominee Jerome Powell, for example, noted: “If automated risk management, smart contracts, and similar tools are deployed across a network, cascades of rapid and hard-to-control obligations and liquidity flows could propagate across a network....This interdependence will likely call for creative organizational thinking to address the need for governance and strong risk management."

Even though the future of cryptocurrencies is uncertain at this stage, it is the idea of blockchain that deserves more attention, as it could potentially transform the way transactions are settled. Regulators would do well to closely track developments in this area so that financial stability risks can be avoided if adoption increases in the system.

Can blockchain be used to reduce costs and increase efficiency? Tell us at views@livemint.com

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