Banks in the European Union should stop offering customer accounts in virtual currencies like bitcoins until regulatory safeguards are in place, the bloc's banking watchdog said today.
Bitcoin, the best known of the 200 or so computer-generated currencies, started circulating in 2009.
Its acceptance has been growing as more merchants allow customers to pay for goods and services in the currency.
Virtual currencies, which unlike conventional money are not backed by a central bank or government, have come under scrutiny after Tokyo-based exchange Mt Gox went bankrupt in February after losing an estimated $650m worth of customer bitcoins.
The European Banking Authority, in a study published today, proposed a new regulatory framework along with the advice to banks to steer clear of virtual currencies until rules are in place.
"This immediate response will 'shield' regulated financial services from virtual currency schemes, and will mitigate those risks that arise from the interaction between virtual currency schemes and regulated financial services," the EBA said.
The advice to banks would still allow financial firms to maintain a current account relationship with businesses active in virtual currencies, it added.
Among the new rules it wants to see in place is a requirement for the currency exchanges to hold capital so that if they go bust as in the case of Mt Gox, there are resources to cushion customers.
The EBA study identifies over 70 risks to users, market participants and to the financial system such as money-laundering and other financial crimes from using virtual currencies in an unregulated market.
The watchdog is particularly alarmed at how a group of so-called miners - who unlock new bitcoins online - have taken control of the currency, allowing them to block transactions if they want to.
The EBA said rules are needed so that when a virtual currency scheme is created, it cannot be changed at a whim just because someone has enough computer power.
It is also concerned that miners, payers and payees can remain anonymous, while IT security cannot be guaranteed and the financial viability of some market participants remains uncertain.
Rules were also needed on how virtual currencies are operated, ensure that customer money is kept separate, and require the setting up of bodies that are accountable for each virtual currency, the EBA said.
"Based on this assessment, the EBA is of the view that a regulatory approach to address these risks would require a substantial body of regulation," the watchdog said.
EBA said daily transactions in virtual currencies has never exceeded 100,000 globally compared with 295 million conventional payments a day in Europe alone.
It will be up to the EU's executive body, the European Commission, to propose draft rules that would need approval from the bloc's member states and European Parliament.
Given that such steps would take time, the EBA decided an immediate response. Banking regulators from all 28 EU states have approved the EBA advice.
So far there is no coordinated, global approach to regulating virtual currencies, making the EBA plans the first comprehensive approach.
No country has given virtual currencies legal tender status.
A senior Central Bank official here yesterday warned that virtual and digital currencies have the potential to challenge the sovereignty of states.
Addressing Bitfin 2014, a conference on digital money in Dublin, Gareth Murphy said rivals to national legal tender pose challenges to central banks' ability to influence the price of credit for the whole economy.
Mr Murphy also warned that there would be a substantial threat to the country's finances if more and more transactions for goods and services disappear from the tax net through the use of digital currencies.