What Is a Digital Currency?
Digital currency, also known as digital money or electronic money, exists solely in digital form without a physical counterpart. Unlike traditional cash, digital currencies cannot be touched, stored conventionally, or manipulated physically. Businesses and consumers leverage digital currencies for seamless transactions and trading across borders, although their adoption may vary globally.
Key Takeaways
- Digital currencies exist only in electronic form and can be used for transactions and trades without intermediaries.
- There are three main types of digital currencies: cryptocurrencies, virtual currencies, and central bank digital currencies (CBDCs).
- Digital currencies offer advantages such as fast transaction times and lower costs, but they also face challenges like hacking and volatility.
- Central banks worldwide are exploring CBDCs to enhance financial inclusion and improve payment systems.
- The future of digital currencies involves potential applications in stablecoins and regulated currency systems by central banks.
How Digital Currencies Work
Digital currencies exist only in digital form and lack physical attributes. These currencies are used through computers or digital wallets connected to the internet. Meanwhile, physical currencies like banknotes and coins are tangible and require physical possession for transactions.
Digital currencies have utility similar to physical currencies. They can be used to purchase goods and pay for services. They can also find restricted use among certain online communities, such as gaming sites, gambling portals, or social media networks.
Digital currencies also enable instant transactions that can be seamlessly executed across borders. For instance, someone in the United States may make payments to a counterparty in Singapore using digital currency, provided they are both connected to the same network.
Unique Features of Digital Currencies
Digital currencies exist purely in digital form without a physical counterpart. They can be centralized or decentralized. While fiat currencies are centralized by banks and governments, cryptocurrencies like Bitcoin and Ethereum operate in decentralized systems.
Digital currencies can transfer value. Using digital currencies requires a mental shift in the existing framework for currencies, where they are associated with sale and purchase transactions for goods and services.
Digital currencies, however, extend the concept. For example, a gaming network token can extend the life of a player or provide them with extra superpowers. This is not a purchase or sale transaction but, instead, represents a transfer of value.
Exploring the Different Types of Digital Currencies
Digital currency is a broad term for different kinds of electronic-only currencies. There are mainly three types:
Cryptocurrencies
Cryptocurrencies are digital currencies that use cryptography to secure and verify transactions in a network. Cryptography is also used to manage and control the creation of such currencies. Bitcoin and Ethereum are examples of cryptocurrencies. Depending on the jurisdiction, cryptocurrencies may or may not be regulated.
Important
Cryptocurrencies are considered virtual currencies because they are unregulated and exist only in digital form.
Virtual Currencies
Virtual currencies are unregulated digital currencies controlled by developers or a founding organization consisting of various stakeholders involved in the process. Virtual currencies can also be algorithmically controlled by a defined network protocol. An example of a virtual currency is a gaming network token whose economics is defined and controlled by developers.
Central Bank Digital Currencies
Central bank digital currencies (CBDCs) are regulated digital currencies issued by the central bank of a country. A CBDC can be a supplement or a replacement for a traditional fiat currency. Unlike fiat currency, which exists in both physical and digital form, a CBDC exists purely in digital form. England, Sweden, and Uruguay are a few of the nations that are considering plans to launch a digital version of their native fiat currencies.
The use of CBDCs has been suggested as a means of enhancing the speed and security of centralized payment systems, lowering the costs and dangers of handling cash, and promoting greater financial inclusion for people and companies without access to conventional banking services. They may also make cross-border payments easier and lessen the need for foreign exchange.
The introduction of a U.S. CBDC presents certain difficulties. For instance, for Congress to authorize the issuance of a CBDC, there must be robust privacy and security infrastructures put in place. The government must also weigh the possible impacts on monetary policy and the operational management of the switch from conventional money to a CBDC.
| Digital Currencies | Virtual Currencies | Cryptocurrencies |
| Regulated or unregulated currency that is available only in digital or electronic form. | An unregulated digital currency that is controlled by its developer(s), its founding organization, or its defined network protocol. | A virtual currency that uses cryptography to secure and verify transactions as well as to manage and control the creation of new currency units. |
Pros and Cons of Using Digital Currencies
Advantages
- Fast Transfer and Transaction Times: Transfers with digital currencies are very fast because they occur directly between parties without intermediaries. This makes them cheaper and quicker than traditional payments that involve banks. Digital currency transactions also enhance record-keeping and transparency.
- No Physical Manufacturing Required: Many requirements for physical currencies, such as the establishment of physical manufacturing facilities, are absent for digital currencies. Such currencies are also immune to physical defects or soiling that are present in physical currency.
- Monetary and Fiscal Policy Implementation: Under the current currency regime, the Fed works through a series of intermediaries (banks and financial institutions) to circulate money into an economy. CBDCs can help circumvent this mechanism and enable a government agency to disburse payments directly to citizens. They also simplify the production and distribution methods by obviating the need for physical manufacturing and transportation of currency notes from one location to another.
- Cheaper Transaction Costs: Digital currencies enable direct interactions within a network. For example, a customer can pay a shopkeeper directly as long as they are situated in the same network. Even costs involving digital currency transactions between different networks are relatively cheaper as compared to those with physical or fiat currencies. By cutting out middlemen who seek economic rent from processing the transaction, digital currencies can make the overall cost of a transaction cheaper.
- Decentralized: Digital currencies may be decentralized. This means they are not controlled by any government or financial institution. Decentralized digital currencies make them more resistant to government interference, censorship, and manipulation. Decentralization means true control over the digital currency is spread over a broader range of owners or users.
- Privacy: Because transactions with digital currencies are not linked to personal data, users are given a high level of privacy and anonymity. They are therefore very helpful for those who want to protect the confidentiality of their financial dealings.
- Accessible Around the World: Anyone with an internet connection can utilize digital currencies from anywhere in the globe. These services are therefore particularly helpful for people who do not have access to conventional banking institutions. In addition, many of these banking services only need access to an internet connection; for geographical areas that are not as developed with a strong financial infrastructure, digital currencies may be a stronger option.
Disadvantages
- Storage and Infrastructure Issues: While they do not require physical wallets, digital currencies have their own set of requirements for storage and processing. For example, an internet connection is necessary as are smartphones and services related to their provisioning. Online wallets with robust security are also necessary to store digital currencies.
- Hacking Potential: Their digital provenance makes digital currencies susceptible to hacking. Hackers can steal digital currencies from online wallets or change the protocol for digital currencies, making them unusable. As the numerous cases of hacks in cryptocurrencies have proved, securing digital systems and currencies is a work in progress.
- Volatile Value: Digital currencies used for trading can have wild price swings. For example, the decentralized nature of cryptocurrencies has resulted in a profusion of thinly capitalized digital currencies whose prices are prone to sudden changes based on investor whims. Other digital currencies have followed a similar price trajectory during their initial days. For example, Linden dollars used in the online game Second Life had a similarly volatile price trajectory in its early days.
- Limited Acceptance: Digital currencies are still not commonly used as a means of payment by retailers and other enterprises. Because of this, using them for routine transactions may be challenging. Though digital currencies have gained in popularity, there are still limited functionalities in everyday transactions in many places.
- Irreversibility: On a digital currency network, transactions are irreversible. This means that once a transaction has been completed, it cannot be undone. In circumstances where a mistake or fraud has taken place, this may be a disadvantage. This is also a tremendous disadvantage for those new to the digital currency space, as there is a substantial learning curve. Because there is no central oversight area for many digital currencies, new users can’t simply go to their local branch to receive help for many digital currencies.
Pros and Cons of Digital Currencies
Pros
-
Faster transaction times
-
No physical manufacturing required
-
Lower transaction costs
-
Make it easier to implement monetary and fiscal policy
-
Greater privacy than other forms of currency
Cons
-
Can be difficult to store and use
-
Prone to hacking
-
Volatile prices that result in lost value
-
May not allow for irrevocability of transactions
-
Limited acceptability
The Future Landscape of Digital Currencies
Bitcoin and similar cryptocurrencies have greatly increased in value, but they are often used for speculation. While some places like El Salvador show merchant adoption, their volatility and complexity are not practical for daily use.
Many companies have tried to reduce volatility by introducing stablecoins, whose value is fixed to the price of fiat currency. This is usually done by depositing an equivalent amount of fiat, which can be used to redeem the tokens. However, stablecoin issuers such as Tether have used these deposits on more speculative investments, raising concerns that they are vulnerable to a market crash.
Another possible application is in central bank digital currencies, which could be issued by a country’s bank or monetary authority. These would be used and stored in online wallets, similar to cryptocurrencies, but allowing the central bank to issue and freeze tokens at will. Several countries, such as China, have proposed digital versions of their currencies.
Examples of Digital Currencies
Some major central banks around the world have looked into issuing their digital currencies. Some of the larger, more notable examples include the countries below.
- China: The People’s Bank of China (PBOC) is testing the digital yuan, or e-CNY, for retail transactions. Millions in China are already using it.
- Sweden: Also since 2020, Sweden’s Riksbank has been testing the e-krona digital currency. The e-krona is being created to complement Sweden’s diminishing use of currency and to give the general public access to a safe and effective payment system.
- EU: A digital euro that may be issued by the European Central Bank (ECB) and used for retail transactions within the Eurozone is being investigated.
- England: The Bank of England is looking into the prospect of launching the Britcoin cryptocurrency. The U.K.’s payment system would be backed by a digital currency, which could also reduce the nation’s dependence on cash.
- Canada: The Bank of Canada has conducted research and consultations on the idea of creating a CBDC.
Can You Invest in Central Bank Digital Currencies?
CBDCs are unlikely to be useful for speculative investments since they will likely be pegged to the value of an underlying currency. However, it will still be possible to invest in those currencies through the forex markets.
How Do You Buy China’s Digital Yuan?
The digital yuan, or e-CNY, is only available to Chinese citizens living in 23 major cities. Users can buy digital yuan by downloading an app and connecting it to their bank accounts.
How Do You Make a Digital Currency?
Most digital currencies are created by issuing them on Ethereum or another blockchain capable of running smart contracts. The issuer must first decide how many tokens to issue, and any special rules that limit transactions or ownership. Once these choices are coded into the smart contract, the issuer pays a small amount of cryptocurrency to pay for the computational cost of issuing the tokens.
The Bottom Line
Digital currencies exist solely in electronic form and facilitate fast, cost-effective transactions without intermediaries. While popular cryptocurrencies like Bitcoin showcase decentralized systems, central banks worldwide are exploring centralized digital currencies (CBDCs) to enhance current fiscal systems and promote inclusion. Despite their benefits and growing interest, challenges like volatility, limited acceptance, and potential security risks demand careful consideration before widespread adoption.