Digital money (or digital currency) means any payment instrument that exists in purely electronic form. A digital currency is not physically tangible like a five-pound note or coin. It is accounted for and transferred using online systems.
Digital currency can also represent fiat currencies such as dollars or euros. Digital money is exchanged using technologies such as smartphones, credit cards, and online cryptocurrency exchanges. In some cases, it can be converted into physical cash using an ATM.
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- Digital money is money in purely digital form. It is not a physically tangible asset like cash or other commodities like gold or oil.
- Digital money can streamline existing financial infrastructure, making it cheaper and faster to conduct monetary transactions. It can also facilitate central banks’ monetary policy implementation.
- Examples of digital currencies include cryptocurrencies, central bank digital currencies and stablecoins.
- Digital currency is vulnerable to attacks and can compromise user privacy.
What is Digital Currency?
Today, a form of digital currency already exists in society in the form of cash held in online bank accounts. This cash can be sent to or received from others. It can also be used for online transactions.
Digital currency is similar in concept and usage to cash equivalent in that it can be a unit of account and a tool for daily transactions. But not cash. For example, dollars in your online bank account are not digital money because when you withdraw them from an ATM, they take a physical form.
Digital money differs from cash in that it improves the process of monetary transactions. For example, the technological rails of digital money can make cross-border money transfers easier and faster compared to standard money. This form of money also streamlines the monetary policy implementation process for central banks. The use of cryptography in some forms of digital money makes transactions involving them resistant to tampering and censorship, meaning they cannot be controlled by governments or private institutions.
Given these advantages, digital money has become a priority for many governments around the world. Sweden’s central bank, a country on its way to becoming a cashless society, has published several research papers since 2017 exploring the benefits and drawbacks of introducing digital money into its economy. Meanwhile, China has conducted pilot tests involving DC/EP, the digital equivalent of the national currency, and plans to launch it soon. The Bahamas dollar is a digital iteration of the country’s national currency. It was released in October 2020.
According to the February 2021 survey conducted by the International Monetary Fund (IMF), about 111 countries from 159 member states are planning to introduce digital money in the near future.
What Problems Does Digital Money Solve?
A few systems already trade digital versions of money. For example, credit card systems allow users to purchase goods and services on credit. Wire transfer systems enable the cross-border movement of cash.
Such operations are expensive and time consuming because they involve the use of different processing systems. An example of such equipment is the SWIFT system, a network of payment systems made up of various banks and financial institutions around the world. A fee is charged for each transfer made over the SWIFT network. SWIFT’s member bodies also function in a piece of regulation, each specific to a different financial jurisdiction. Also, these systems are built on the promise of future payments, providing a latency period for every transaction. For example, credit cards are reconciled at a later date and users can file chargebacks for transactions.
One of the purposes of digital currency is to eliminate the time delay and operating costs for such transactions by using distributed ledger technology (DLT). In a DLT system, nodes or shared ledgers are connected to form a common network to process transactions. This network can also spread to other jurisdictions, minimizing processing time for transactions. It provides transparency to authorities and stakeholders, increases the flexibility of a financial network by eliminating the need for a centralized database of records.
Digital currency also solves the problem of double spending by using an algorithmic consensus system. Quite simply put, the problem has to do with ensuring that a “note” of digital currency is not spent twice by the same person.
A centralized currency generation and distribution setup, such as the currently existing central banks, uses a serial number system to ensure that each banknote is unique. Some forms of digital money, such as central bank digital currencies (CBDCs) or digital money issued by private parties, repeat the role of a central authority in ensuring solvency and integrity of transactions, albeit in a digital context.
Other types of digital currencies are decentralized. They remove the function of central authorities to oversee production and intermediaries necessary to distribute the currency. Cryptography is used. Blind signatures hide the identity of transacting parties, and zero-knowledge proofs encrypt transaction details. Examples of such digital money are cryptocurrencies such as Bitcoin and Ethereum.
Types of Digital Money
Digital money can be made suitable for many purposes thanks to its technological infrastructure and can take various forms. Three recent adaptations of digital currency are as follows:
Central Bank Digital Currencies (CBDCs)
Central bank digital currencies (CBDCs), Currencies issued by a country’s central bank. Again, it is separate from the fiat currencies backed by the authority and credit of a central bank and is another obligation of the institution. CBDCs facilitate monetary policy implementation by removing intermediaries from policy by establishing a direct link between the government and the average citizen. Banks and financial institutions responsible for issuing the national currency are no longer required in the process.
There can be two types of CBDCs, depending on their use in the economy and the type of application. Retail CBDCs are designed to be used for day-to-day transactions such as fiat currencies. In a more limited application of the concept, wholesale CBDCs are used for transactions between banks and financial institutions.
Cryptocurrencies
Cryptocurrencies are digital currencies designed using cryptography. The crypto wrapper around a digital currency provides enhanced security and makes transactions tamper-proof. The most popular cryptocurrencies are Bitcoin and Ethereum. Since 2017, the popularity of cryptocurrencies as an investment class has rapidly increased their value and the overall market value of crypto markets. By July 2021, the market cap of cryptocurrencies had exceeded $2 trillion.
Stable Coins
Stablecoins are a variant of cryptocurrencies and were developed to counter the price volatility of regular cryptocurrencies. Stable currencies can be likened to a form of private money whose price depends on the price of a fiat currency or a basket of goods to keep them stable. They can be a proxy for fiat currencies as long as they are not backed by government authority. The stablecoin market has exploded recently. As of February 2021, 200 stablecoins were released or in development.
Advantages of Digital Money
The current financial infrastructure is a complex system of many assets. Transacting between financial institutions requires time and money as they operate in different technological systems and regulatory regimes. The main advantage of digital money is that it speeds up the transaction speed and reduces costs.
Other advantages of digital money are:
- Digital money eliminates the need for physical storage and storage, which is a feature of cash-intensive systems. You don’t need to invest in a wallet or bank vault to ensure your money isn’t stolen.
- Digital money simplifies accounting and record keeping for transactions through technology. Therefore, manual accounting and separate entity-specific ledgers are not required to keep records of transactions.
- While digital money has already reduced the time and cost required for cross-border money transfers, it has the potential to further revolutionize the remittance industry by eliminating intermediaries and further reducing the costs associated with cross-border transfers.
- Digital money eliminates intermediaries in the implementation of monetary policy and makes it possible to include groups of people who were previously excluded from the economy. For example, those without a bank account can participate in the economy using digital money in their online wallets or mobile phones.
- In the case of cryptocurrencies, digital currency transactions can become censorship resistant, that is, resistant to tracking by the government or other authorities.
Disadvantages of Digital Currency
Disadvantages of digital money are:
- Digital money is vulnerable to hacking . Even if it eliminates the need for physical protection, digital money’s origins in technology make this form of money a target for hackers who can steal from digital wallets. A seamless financial infrastructure made up of digitally interconnected assets can be smashed by hackers. The 2018 SWIFT attacks that affected multiple countries are an example. Large-scale digital currency hacks have the potential to bring a country’s financial infrastructure to its knees and pose a national security threat.
- The use of digital currency can compromise user privacy. Cash is anonymous and almost impossible to track and trace its users. On the other hand, digital money can be tracked. While the use of internet cookies enables targeted advertising, their impact on digital currency tracking is broader. For example, organizations or governments can blacklist or freeze accounts without users’ consent. They can also initiate double accounting on their bank accounts, inflating expenses and reducing the overall total.
- Digital money has its own costs. For example, digital wallets are required to store digital money. Cryptocurrencies also require storage solutions that act securely against hackers. Systems using blockchains also have to pay transaction fees or costs associated with processing the transaction to miners.
- Digital money presents several challenges on the governance and policy framework front. This form of money is uncharted territory for policymakers, and problems are already starting to emerge in its ecosystem.
What is Digital Currency in Short?
Digital currency (or digital currency) means any payment instrument that exists in purely electronic form. Digital money does not have a physical and tangible form like notes or coins and is accounted for and transferred using online systems.
What are the Different Types of Digital Currency?
Its technological fundamentals mean that digital money can be adapted to suit a variety of purposes. Besides being a digital representation of fiat currency, there are three other forms of digital money: cryptocurrencies, central bank digital currencies, and stablecoins.
What Are Some Advantages of Digital Currency?
Digital money simplifies and speeds up money transfer and remittance systems. It also simplifies the monetary policy implementation of central banks by removing intermediaries such as banks from the process. Cryptocurrencies are also censorship resistant, meaning the flow and use of digital money on blockchains cannot be traced.
What are the Disadvantages of Digital Currency?
Digital currency systems are vulnerable to attacks. Through the deft targeting of such systems, hackers can bring down important financial infrastructure and cripple a country’s economic foundations. Centralized digital currency systems, such as those for CBDCs, can provide tracking and monitoring of user information and compromise their privacy.
Final Words
Digital currency is an important innovation in financial technology. It overcomes cash problems and makes payment systems faster and cheaper. But technology also has its problems, as digital currency can be hacked and erode privacy. While it is still early for digital money, it will play an important role in the future of finance.
