What Is a Digital Currency?
Digital currency is a form of currency that is available only in digital or electronic form. It is also called digital money, electronic money, electronic currency, or cybercash.
Key Takeaways
- Digital currencies are currencies that are only accessible with computers or mobile phones because they only exist in electronic form.
- Typical digital currencies do not require intermediaries and are often the cheapest method for trading currencies.
- All cryptocurrencies are digital currencies, but not all digital currencies are cryptocurrencies.
- Some of the advantages of digital currencies are that they enable seamless transfer of value and can make transaction costs cheaper.
- Some of the disadvantages of digital currencies are that they can volatile to trade and are susceptible to hacks.
Understanding Digital Currency
Digital currencies do not have physical attributes and are available only in digital form. Transactions involving digital currencies are made using computers or electronic wallets connected to the internet or designated networks. In contrast, physical currencies, such as banknotes and minted coins, are tangible, meaning they have definite physical attributes and characteristics. Transactions involving such currencies are made possible only when their holders have physical possession of these currencies.
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 networks.
Digital currencies also enable instant transactions that can be seamlessly executed across borders. For instance, it is possible for a person located in the United States to make payments in digital currency to a counterparty residing in Singapore, provided they are both connected to the same network.
Characteristics of Digital Currencies
- As mentioned earlier, digital currencies only exist in digital form. They do not have a physical equivalent.
- Digital currencies can be centralized or decentralized. Fiat currency, which exists in physical form, is a centralized system of production and distribution by a central bank and government agencies. Prominent cryptocurrencies, such as Bitcoin and Ethereum, are examples of decentralized digital currency 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.
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 to 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.
| 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 currencythat uses cryptography to secure and verify transactions as well as to manage and control the creation of new currency units. |
Advantages of Digital Currencies
The advantages of digital currencies are as follows:
Fast Transfer and Transaction Times
Because digital currencies generally exist within the same network and accomplish transfers without intermediaries, 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 that seek economic rent from processing the transaction, digital currencies can make the overall cost of a transaction cheaper.
Disadvantages of Digital Currencies
The disadvantages of digital currencies are as follows:
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.
Pros and Cons of Digital Currencies
Pros
Faster transaction times.
Do not require physical manufacturing.
Lower transaction costs.
Make it easier to implement monetary and fiscal policy.
Cons
They can be difficult to store and use.
Can be hacked.
Prices can be volatile.
Future of Digital Currencies
Cryptocurrencies like bitcoin have exploded in value, but they are largely used for speculation or to buy other speculative assets. Although there have been some signs of merchant adoption in countries like El Salvador, the high volatility and complexity of these currencies make them impractical for most daily applications.
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.
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 cities 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 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 digital currencies.
Article Sources
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Bank of England. "Central Bank Digital Currency: Opportunities, Challenges and Design."
Bank for International Settlements. "Impending Arrival – A Sequel to the Survey on Central Bank Digital Currency," Page 10.
Unchained Podcast. "Why its So Hard to Keep Stablecoins Stable."
China Briefing. "China Launches Digital Yuan App."
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