London must seize the opportunity and embrace bitcoins

Very soon, thanks to the statelet of Alderney in the Channel Islands, you may be able to have a bitcoin you can put in your pocket, rather than just hold on your smartphone. Alderney is working with the Royal Mint and the Treasury on a special issue of a physical version of the digital currency for the spring of next year.

Whether it gets the go-ahead, and whether there will be any demand, remains to be seen after all, the whole point about bitcoins is that they are virtual rather than real. The techno-nerds who are the greatest enthusiasts for computer-generated money may be as keen on an old-fashioned metal version as they are on typewriters, letters with stamps, or news that comes to them via dead trees.

Even so, there is a lesson in that for the City, and an important one. As the new digital currencies move into the mainstream, they will need financial markets to host them. The City, with its long tradition of expertise in innovative, global finance, is the natural centre for trading and investing in digital money. But to capture what is a potentially huge market it will need to get the right regulatory and legal framework in place and it will need to do so fast.

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Bitcoin is shaping up to be the financial sensation of the year. A digital currency, created in 2009, it is minted by a pre-set algorithm that means there will only ever be 21 million of them in circulation. At the start of 2013 you could pick up a bitcoin for just $13. Now each one will set you back $1,100, and the price is still climbing. The fact that bitcoins are soaring in value, while gold the more traditional alternative to paper money is falling, suggests it is gaining traction as a rival to the currencies printed and controlled by central banks. Like gold, it has a limited quantity and is outside political control, but with the added advantage that you can actually spend it.

But can it stay the course? There are plenty of other digital currencies being created, including one backed by gold, which may have more staying power. But industries have been turned upside down by the internet. Why should financial transactions be any different? To take off, money just needs to be widely accepted as a means of exchange and to have credibility as a store of value. It might be bitcoins or a rival that fills that need. But there seems little reason why a digital currency could not be at least as important as, say, the Swiss franc, or one day rival the dollar or euro. After all, it is not as if the central banks are doing such a great job of managing the existing currencies that there is no room for innovation.

However, they will eventually need a financial centre, just like the analogue kind. They might be minted by an anonymous algorithm, but that simply covers the creation of the coins the equivalent of the gold mines when metal was the standard form of money. As bitcoins move into the mainstream, there will be many digital financial markets. People will be trading bitcoins into a range of currencies. There will be bonds issued in bitcoins and in time equities as well some of the tech funds will no doubt be keen to tap that market. Investment funds will invest in digital instruments. And so on.

In a few years, that could be a huge market and London is the natural host. In many ways, bitcoin is the modern equivalent of the Euro-dollar market that boomed in the late 1960s and 1970s an offshore, lightly regulated and global financial product for which there was worldwide demand.

You could argue a digital currency doesn't need a physical home. There is some truth in that. Bitcoin exchanges can be purely virtual, and exist outside any legal or regulatory framework. But eventually investors will want to deal in bitcoins with institutions they can trust, and deals will need to be based in some legal jurisdiction. If Google wants to issue a bitcoin-denominated bond, for example, then there needs to be a court that can adjudicate if there is any dispute. Likewise, before buying a bitcoin fund, you'd want to know there was a system in place to prevent the managers from walking away with your money.

If London can provide that, it could be a big growth industry but it will need to move fast. What should it be doing? The government could make bitcoins legal tender, at least for electronic trades (much as the euro was for two years before the paper currency was introduced). The Bank of England could allow bonds and equities to be issued in bitcoins, and even issue a few gilts in the digital currency to give it its seal of approval. The framework could be put in place for a regulatory regime that was light enough to allow innovation to flourish, yet also strong enough to reassure investors their money was being properly looked after.

The likes of Alderney are already eyeing the digital currency market. More significantly, so will Switzerland and Singapore, and no doubt a host of other offshore centres. But London is its most natural home it just needs to make sure that conservatism and caution don't stop it from seizing that opportunity.