Digital currency has the potential to completely change how society thinks about money. The rise of Bitcoin (BTC), Ethereum (ETH) and thousands of other cryptocurrencies that exist only in electronic form has led global central banks to research how national digital currencies might work.
What Is Digital Currency?
Digital currency is any currency that’s available exclusively in electronic form. Electronic versions of currency already dominate most countries’ financial systems. What differentiates digital currency from the electronic currency that’s already in bank accounts is that digital currency never takes physical form.
You can go to an ATM right now and easily transform the electronic record of your currency holdings into physical dollars. Digital currency, however, never leaves a computer network, and it is exchanged exclusively via digital means.
There are three main varieties of digital currency: cryptocurrency, stablecoins and central bank digital currency, known as CBDCs.
Blockchain technology, which provides the foundation for cryptocurrency, is the most common form of distributed ledger used by digital currencies. According to CoinMarketCap, there are more than 9,000 cryptocurrencies available.
What Is a Central Bank Digital Currency (CBDC)?
A central bank digital currency is a digital currency that is issued and overseen by a country’s central bank. More than 100 countries are exploring CBDCs at one level or another, according to the IMF. But as of 2022, only a handful of countries and territories have CBDC or have concrete plans to issue them.
Some places CBDC is already available include the Central Bank of The Bahamas (Sand Dollar), the Eastern Caribbean Central Bank (DCash), the Central Bank of Nigeria (e-Naira) and the Bank of Jamaica (JamDex), to name just a few.
Even The U.S. Federal Reserve issued a report earlier this year that “a CBDC could fundamentally change the structure of the U.S. financial system.
Currently, the Federal Reserve Bank of Boston and the Massachusetts Institute of Technology’s Digital Currency Initiative are jointly conducting research into a CBDC through Project Hamilton. They describe it as a “multiyear research project to explore the CBDC design space and gain a hands-on understanding of a CBDC’s technical challenges and opportunities.”
India’s E-Rupee Launch
With the advent of smartphones and rise of digital payment systems, India has also rolled out its own CBDC, known as e-rupee (e₹-R). This e-rupee is in the form of a digital token which represents legal tender in India. The Reserve Bank of India has launched its pilot in 2022 and thus marked a new milestone for digital payments. Presently, the CBDC pilot launched by the RBI in the retail segment which has its components based entirely on blockchain technology.
Related Article: What Is Digital Rupee? How Is It Different From Cryptocurrency?
How Would a CBDC Work?
CBDC would function similarly to actual cash. With transfers through CBDC, the funds would be sent close to instantly and the other party couldn’t cancel after.
Another key advantage of CBDC is that it could be deemed legal tender. That means all economic actors must accept it for any legal purposes. You can pay your taxes with it, and anyone who lends you money is legally required to accept it for repayment.
This contrasts with other digital currencies, which are not legal tender in India and many other countries. Only certain vendors accept crypto directly, so people may need to convert their cryptocurrency into fiat currencies before making most transactions.
When you use crypto as a form of payment, you also create a taxable event, which means you may owe capital gains taxes each time you purchase something with Bitcoin or Ethereum’s Ether token. This is in addition to any sales taxes. With CBDC, you would only owe any applicable sales tax, just like using a physical currency.
How Have Digital Currencies Worked Around the World?
Despite the potential benefits of a U.S. CBDC, it remains a concept for now. Around the world, other countries are a little further along with digital currencies.
According to the Atlantic Council’s GeoEconomics Center’s Central Bank Digital Currency (CBDC) Tracker, 10 countries have fully launched a digital currency, and China is on course to expand from its pilot CBDC in 2023.
China’s digital yuan, one of the largest CBDC programs, launched its pilot project in 2014.
“They are testing a pilot in five cities. They gave out millions in currency through lotteries just to prove it works,” according to Cunha. People who win the lottery receive free CBDC, which they can spend at local shops that accept it.
While it’s not at a national scale yet, once China has the platform ready, it will expand through banks and mobile providers like Alipay.
The central banks of China and the United Arab Emirates are also working on a project to use blockchain and CBDC for regional payments between nations. If these projects are a success, they could give more motivation to other nations to create their own CBDC.
Because of these trends, Lilya Tessler, head of Sidley’s FinTech and Blockchain group, is optimistic about the future use of digital currencies. “We certainly will see mass adoption of digital currencies, but it is difficult to predict how it will look. CBDC may replace the paper version of the U.S. dollar. At the same time, society may focus on mainstream adoption of a decentralized cryptocurrency.”
If India adopts a digital currency, it would work as an alternative to cash but would also have the built-in advantage of quick money transfer since it’s electronic. Even though a digital currency would be electronic, it still needs to be as accessible as cash.
There’s a lot to be done and a lot of industry input needed, but it could be well worth the investment.
Benefits of Digital Currency
Faster payments. Using digital currency, you can complete payments much faster than current means, like ACH or wire transfers, which can take days for financial institutions to confirm a transaction.
Cheaper international transfers. International currency transactions are very expensive. Individuals are charged high fees to move funds from one country to another, especially when it involves currency conversions. Digital assets could disrupt this market by making it faster and less costly.
24/7 access. Existing money transfers often take more time during weekends and outside normal business hours because banks are closed and can’t confirm transactions. With digital currency, transactions work at the same speed 24 hours a day, seven days a week.
Support for the unbanked and underbanked. If the country launched a CBDC, unbanked individuals could access their money and pay their bills without extra charges.
More efficient government payments. If the government developed a CBDC, it could send payments like tax refunds, child benefits and food stamps to people instantly, rather than trying to mail them a check or figure out prepaid debit cards.
Disadvantages of Digital Currency
Too many options. The current popularity of cryptocurrency is a downside. There are so many digital currencies being created across different blockchains that all have their own limitations. It will take time to determine which digital currencies may be appropriate for certain use cases, including whether some are designed to scale for mass adoption.
Steep learning curve. Digital currencies require work on the part of the user to learn how to perform fundamental tasks, like how to open a digital wallet and properly store digital assets securely. The system needs to get simpler for digital currencies to be more widely adopted.
Expensive transaction. Cryptocurrencies use blockchain, where computers must solve complex equations to verify and record transactions. This takes considerable electricity and gets more expensive as there are more transactions. However, this would probably not exist for CBDC since the central bank would likely control it and complex consensus processes are not needed.
Price volatility. Cryptocurrency prices and values can change suddenly. This is why businesses are reluctant to use it as a medium of exchange. With CBDC, though, the value is much stable, like paper currency, and cannot fluctuate like this.
Slow progress. A CBDC in India is still hypothetical, and if the government decides to create one, there will be costs associated with its development.
How to Invest in CBDC?
CBDCs are no different than an issuing nation’s existing monetary supply. This means the only way to invest in a CBDC is to hold the currency in your account. In other words, investing in CBDCs is just like holding a nation’s physical cash in your hand today.
However, right now, foreign nationals can’t hold the CBDCs of any other government in their digital wallets.
You need a verified username and bank account to hold a CBDC from any nation today, you need a verified username and bank account. This means citizens of different countries can’t have a foreign nation’s CBDC distributed to them. Most experts believe, though, that this will change as more CBDCs are implemented worldwide.
Digital Currency FAQs
What’s the difference between cryptocurrency and digital currency?
Cryptocurrency is a form of decentralized digital currency. The reason it’s referred to as a “crypto” currency is that it requires cryptography rather than a central authority to manage its ledgers and balances since the currency is decentralized. Today, the most common form of ledger system for cryptocurrencies to use is blockchain technology.
Digital currency, on the other hand, is any form of currency that exists solely in digital form.
How many types of digital currency are there?
There are three types of digital currency: cryptocurrency, stablecoins and CBDCs.
Cryptocurrency is a form of decentralized digital currency that isn’t pegged to any fiat currency. It uses cryptography to manage its ledger systems, and the market determines its value. Bitcoin was the first cryptocurrency.
Stablecoins are similar to cryptocurrencies; some experts even consider them a subset of cryptocurrency. They have no central authority to keep track of their ledgers. However, the major difference between stablecoins and cryptocurrencies is that stablecoins are usually pegged to a fiat currency.
On the other hand, CBDCs are a form of digital currency issued by a nation’s central bank. This makes them a form of digital currency controlled by a central authority. Governments issue them, and the particular nation’s monetary policy sets their value.
How do you buy digital currency?
You can buy most digital currencies (cryptocurrencies and stablecoins) on the world’s existing crypto exchanges. However, not all exchanges offer every cryptocurrency. So you’ll want to research the exchange to ensure it offers the currency you’re interested in.
As far as CBDCs go, those are currently only available to residents of the countries where the specific CBDC is offered. In other words, only citizens of the Bahamas can access that nation’s sand dollar, and only Chinese citizens can access the digital yuan.
Cryptocurrencies are highly volatile investments. It’s recommended that investors speak with a financial professional before committing their money to these or any other asset classes.
How to create digital currency?
CBDCs can only be authorized and created by the world’s governments. A central bank must issue them with the full backing of that government’s treasury. Private individuals and corporations cannot create CBDCs.
