The Treasury Committee has launched an inquiry into the role of digital currencies in the UK with the view to regulating the emerging asset class.
The inquiry will examine the potential impact of the technology on financial institutions and infrastructure, and how regulation can provide protection for consumers and businesses without "stifling innovation".
It will also scrutinise the regulatory response from the government, Financial Conduct Authority and Bank of England to digital currencies.
Nicky Morgan MP, chair of the Treasury Committee, said: "People are becoming increasingly aware of cryptocurrencies such as Bitcoin but they may not be aware they are currently unregulated in the UK and there is no protection for individual investors.
"Striking the right balance between regulating digital currencies to provide adequate protection for consumers and businesses, whilst not stifling innovation, is crucial. As part of the inquiry, we will explore how this can be achieved."
Alison McGovern MP, member of the Treasury Committee, said: "This inquiry comes at the right time, as regulators and governments wrestle with recent events in cryptocurrency markets. New technology offers the economy potential gains, but as recently demonstrated, it may also bring substantial risks.
"It is time that Whitehall and Westminster understood cryptocurrency better and thought more clearly about the policy environment for blockchain technology."
Bitcoin has seen a sharp spike in demand in recent months and there are concerns over consumers' interest and knowledge of the digital currency.
Some banks have already stopped clients from using credit cards to buy the currency as they are an unregulated investment.
The cryptocurrency rose to $20,000 at the end of last year but has since fallen back to around $11,000.
Regulation counsel at law firm Ashurst Lorraine Johnston, said the inquiry "signals yet another step towards the what-seems-like inevitable regulation of digital currencies".
She added: "Yet again the conflicting interests of supporting innovation vs consumer protection are being put under scrutiny, this time by the Treasury.
"But surely this is a crypto-conundrum that no country has yet solved adequately? I wouldn't, however, bet against some form of quasi-regulation of digital currencies coming out of this."
Meanwhile, CEO at trading comparison site BrokerNotes Marcus Taylor said "the cryptocurrency market is, quite frankly, a distraction".
He added: "Until we move beyond viewing cryptocurrencies purely as a tradable asset, to understanding the different applications of the underlying technology and the potential to make cryptocurrencies a viable alternative to fiat currency, it's going to be difficult to make any meaningful progress.
"The UK has a great opportunity to embrace blockchain technology and lead the way in building innovations that can help the UK economy. This is inevitable with or without government intervention.
"However, with the right level of regulation, funding, and support the government can certainly make things happen faster."