Digital currencies are a hot topic these days, with their anonymity, freedom from control by centralised banks, and avoidance of merchant transaction fees appealing to various groups around the world.  The best-known example of a digital currency is bitcoin, which as recently as last month was trading at over US$1000 per bitcoin (but has since fallen to a far more reasonable average of US$570 per bitcoin at time of writing), though other kinds exist, such as litecoin or namecoin.  The legal status of bitcoins as property or currency is unclear, but the appeals of this kind of digital medium of exchange are enough that JP Morgan recently filed a patent application for something very similar.

Digital currency like bitcoin works by using a cryptographic “proof-of-work” scheme, where participants use computers to solve increasingly-difficult computational problems, with each solution effectively forming a new piece of currency.  The solution is added to a secure hash algorithm with the other solutions, creating a single unique value describing all of the known solutions, which can then be used to verify that a given piece of currency is real.  The currency is then associated with numbered accounts or “wallets”, between which transactions can occur, and those transactions are recorded in a publically accessible file.

JP Morgan’s patent application describes a method and system for conducting anonymous transactions.  A central host server stores payer information.  A payee submits to that server a payment request and a unique transaction ID.  The transaction ID is provided to the payer, who can then authorise the payment by submitting an authorisation along with the transaction ID to the server.  The server then makes the payment by transferring the relevant amount from the payer’s account to the payee.  Neither party ever needs to provide their account details to the other, since the transaction is identified by the transaction ID, thus maintaining anonymity towards each other (but not to the entity that controls the central host server).  This also facilitates peer-to-peer digital transfers of money without the two parties having a prior relationship, as a utility company and consumer would, and without providing account numbers (which can be a security risk).

If granted, this patent will protect a method that provides a new alternative to credit or debit cards, PayPal, and even bitcoin for transacting anonymously over the internet.  The patent application notes that this process avoids the significant merchant fees that attach to EFT payments presently, although the business efficacy of this would depend on the licence fees JP Morgan charges for the use of the patented method.  Some of the appeal of anonymity is also likely to be lost when the controller of the central server can identify the parties to the transaction if its security is compromised or in response to a court or government demand.

While JP Morgan’s involvement adds more legitimacy to the concept of anonymous digital transactions, the realm of digital currencies are still tinged with controversy.  The anonymity provided by bitcoin makes it popular with criminals for purchasing illegal goods and services (like drugs, weapons, stolen bank account information, or murder-for-hire) or laundering ill-gotten gains.  In October of this year, the FBI shut down “Silk Road”, an anonymous online black market that operated only on bitcoin.  Following the shutdown, the value of bitcoin dropped significantly.

Some have also suggested that some or all digital currencies are investment scams, where bitcoin holders encourage others to buy in to the market, pushing the bitcoin price up like a stock market bubble, before selling out their holdings and letting the price crash again, colloquially referred to as a “pump and dump” scheme. 

Others have commented that bitcoins and related digital currencies are unsuitable for use as a true currency.  The lack of government backing or a central bank makes bitcoins a target for hackers, and means that insolvency or collapse of an exchange platform could mean that bitcoin owners lose their money, as the European Banking Authority warned last week

Bitcoins and other digital currencies also have other undesirable properties for a currency.  For example, they are often inherently deflationary (there are only a fixed number of bitcoins that can ever exist), which means that a bitcoin is generally going to be worth more in the future than it is in the present (assuming demand for bitcoins doesn’t decrease).  This creates incentives to horde bitcoins, reducing the number in circulation and making it increasingly difficult to use them as a medium of exchange. Indeed, there are some suggestions this is already happening.

Furthermore, the bitcoin price is extremely volatile (historic price graphs are available here – a single day can see the USD bitcoin price shift by 50% or more.  This means using bitcoins as currency is risky, since it’s hard to predict how much value is actually changing hands when bitcoins are exchanged. 

The process of “mining” new bitcoins is also very computationally and electricity intensive, meaning it carries a large carbon footprint.  These various economic factors have led some commentators to describe bitcoin as a digital commodity, like virtual metals, rather than a currency.

The legal status of bitcoins is also a risk.  This month, the Chinese government forbade exchanges of bitcoins into yuan (though bitcoin transactions between users within China remains legal), in response to which the bitcoin price dropped by roughly 20%.  The Norwegian government has also stated that they will be treating bitcoins as a capital asset, subject to capital gains tax. This follows Germany earlier this year confirming that bitcoins are “units of account”, subject to capital gains tax and potentially sales tax. 

The fate of bitcoins remains uncertain, but despite the significant hindrances to adoption as a legitimate currency, interest in them remains high.  The public desire for anonymous peer-to-peer transactions over the internet is clearly big enough to interest large commercial parties like JP Morgan to get into the game as well, and we will watch the progress of their patent application with interest.