Digital currencies may be vulnerable to cyber attacks.

One of the often extolled virtues of digital currencies such as bitcoin is their perceived security.  Conventional payment systems are exposed to a number of inherent risks including credit risk (the paying bank may become insolvent), liquidity risk (an otherwise solvent bank may not have sufficient funds to settle a required payment at a particular point in time) and operational risk (a bank may suffer an IT failure frustrating a transaction).

Digital currencies are internet based, they require no banking intermediaries and a primary motivation for early digital currencies was to minimize the degree of trust that participants needed to place in any third party.  A number of digital currencies rely on techniques taken from the field of cryptography to ensure the secure validation of transactions.  Whereas conventional payment systems rely on the closely guarded private in-house ledgers of the participating financial institutions, digital currencies rely on block chains, publicly distributed ledgers, which are distributed among the system’s users and record all transactions.  These block chains are kept up to date by a large number of computers known as “miners”.

The jury, however, is still out on whether digital currencies are delivering the security they promise.  Whilst the core program that runs bitcoin appears to have so far resisted hacking attempts, there have been successful attacks on associated businesses using the digital currency which has served to undermine confidence.    More recently (on June 17^th) an investment fund (DAO) lost 3.6m of the digital currency ‘ether’ following a cyber-attack.  The amount lost was worth around $55million, equivalent to more than 30% of the investment fund’s assets.   Whereas bitcoin’s block chain handles mainly financial transactions, ether’s block chain runs computer code including code required to give effect to self-executing contracts. A cyber attacker was able to withdraw the ether in question by taking advantage of a defect in the code.

Cyber-attacks are unlikely to arrest the development of digital currencies which, among other things, offer the potential to substantially reduce the financial fees payable on payment transactions.  At the moment, however, digital currencies are used by a relatively small number of people and delivering the virtue of security is likely to be critical to their more widespread use.