In this article, we discussed the meaning of digital currencies, the types, the advantages and disadvantages about the rise of digital currencies.
Definition
Digital money (or digital currency) refers to any means of payment that exists purely in electronic form. Digital money does not have a physical and tangible form, such as a dollar bill or a coin, and is accounted for and transferred using online systems.
Digital currency is a payment system that is not based on fiat currency, but rather an alternative non-tangible currency. In practice, digital currency serves a similar practice to other currencies in terms of acting as payment in transactions.
Types of Digital Currencies
Digital currency is an overarching term that can be used to describe different types of currencies that exist in the electronic realm. Broadly, there are three different types of currencies:
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.
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 Advantages and Disadvantages of Digital Currencies
Advantages
Fast Transfer and Transaction Times: The amount of time required for transfers involving digital currencies is extremely fast. As payments in digital currencies are made directly between the transacting parties without the need for any intermediaries, the transactions are usually instantaneous and low-cost. This fares better compared to traditional payment methods that involve banks or clearinghouses. Digital-currency-based electronic transactions also bring in the necessary record-keeping and transparency in dealings.
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 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 it 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: It is 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 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 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.
The Rise of Digital Currency
Every day the world financial system is moving closer to a cashless future, where money in coins or notes is replaced with digital currency such as Bitcoin.
When you spend money or make a withdrawal from an ATM using the traditional monetary system, it is recorded as a transaction in your bank account. Unlike fiat currencies that central banks recognize as legal tender, Bitcoins are not secured by a financial group, but rather by public/private key cryptography. (A public key is a long, random string of numbers). Users, known as “miners” are the decentralized authority enforcing the credibility of the Bitcoin network.
There are no physical Bitcoins. With Bitcoins your transaction is recorded in a “block” once it’s been verified. Bitcoins sent across the network are recorded as belonging to a given address, which is generated once you install a Bitcoin wallet on your mobile phone or computer. This wallet can create more addresses when needed and you can disclose your addresses to others so that they can pay you or vice versa.
Blockchain
The software platform that powers Bitcoin, called Blockchain, is a list of records (called blocks) that represents a distributed public ledger of all Bitcoin transactions that have been executed. The Blockchain grows as “completed” blocks, meaning updates, are added to it in chronological order. Each block contains a timestamp and entries are permanent and searchable.
Everyone using the system can see what’s going on, yet Blockchain technology makes it difficult to hack into, doctor or destroy accounts. Think of it as a wall under construction. You place a block at the bottom and each time a block gets completed, a new block is generated so other blocks are placed on top of the one representing your transaction. As a result, it is difficult to tamper with your finances because of the other blocks on top.
As a distributed ledger, Blockchain reduces the costs involved in verifying transactions, and by removing the need for trusted third parties such as banks to complete transactions, the technology also lowers the cost of financial networking. Bankers like the idea of fast, efficient, digital money that does not carry the cost of handling cash, and can be tracked. Banks and governments spend roughly $200 billion each year to securely store cash. As a result, many countries are examining how to mint their own digital currencies and put money on the Blockchain.
Conclusion
Digital currencies are assets that are only used for electronic transactions. They do not have any physical form, although they can be exchanged for regular money or other assets. Although the most popular digital currencies are cryptocurrencies like bitcoin, many national governments are considering issuing their own centralized.
READ: The Future of Digital Currencies.