Finance is one of the areas that has been most affected by disruptive technological innovations. Blockchain, cryptocurrencies, P2P transfers, crowdsourcing, micropayments – just the new names and concepts and their diversity make your head spin.
Today, even any casino bonus can be paid in virtual currency. While most financial innovations concern the private sector, national banks have decided to keep up and bring digital currencies to the forefront of fintech.
What is digital currency?
Digital currency is an electronic form of existing fiat money issued by a central bank and can function as legal tender. The definition can be given by analyzing the understanding of digital currency by the European Central Bank, the International Monetary Fund, and the Bank for International Settlements.
An analysis of its attributes will help a better understanding of digital currency.
Digital currency is electronic; it is a set of zeros and ones. It distinguishes it from banknotes and coins and is similar to non-cash, cryptocurrencies, and electronic money.
It is assumed that the digital currency will be stored in an electronic wallet installed on the user’s device, such as a smartphone. It will also be possible to refill such an electronic wallet in advance to pay with digital currency where there is no Internet.
The technological basis of digital currency can be either traditional databases or distributed ledger technology (DLT), better known as the blockchain.
Existing fiat money
A digital currency is the electronic counterpart of existing cash. E- hryvnia is the hryvnia we hold dear in digital form, not new money. The digital currency will take its place alongside cash and non-cash documents. A unit of digital currency will be equal to a team of the same coin in other forms. Thus, one e-grivna will correspond to one cash hryvnia or hryvnia in non-cash form.
Linking digital currency to traditional money is similar to the so-called stablecoins – cryptocurrencies whose rates are tied to conventional currencies (such as Tether or Diem). The difference is that a central bank can only create digital cash.
Issuance by a central bank
Only the central bank can issue digital currency. This feature of digital currency distinguishes it from cryptocurrencies. Anyone can mine a cryptocurrency, while only the central bank can issue a digital currency.
Acting as legal tender
Digital currency will be legally incorporated into the existing monetary payment landscape. Law requires it to accept goods, services, or works for payment.
Distinguishing digital currency from non-cash funds
After analyzing the attributes of digital currency, the question arises: what is its difference from non-cash funds?
Do non-cash funds exist in electronic form? Yes, they are, by and large, just a record in a bank database. Is non-cash an analog of existing fiat money? Undoubtedly, with the help of the nearest ATM, they are converted into cash. Does the central bank issue it? Again, yes, because it is the same currency issued by the central bank, only not in your pocket but in your bank account. Does non-cash perform the function of legal tender? Of course, they do, as it is becoming more accessible and easier to pay with a bank card or smartphone.
So what is the difference between digital currency and traditional non-cash funds? The answer is in the payment infrastructure. For example, suppose we pay with a bank card for groceries in a supermarket.
The issuing bank of our card first interacts with the bank that owns the POS terminal. Then, the funds debited from our card are sent to the merchant’s account, often opened at another bank. An interbank transfer takes place for this purpose. The process also involves payment systems like Visa or Mastercard, interbank electronic payment systems, and – in the case of paying with a gadget – also services like Apple Pay or Google Pay.
The situation with digital currency is entirely different. If payment were made with it, the funds from the buyer’s digital wallet would be immediately sent to the same digital wallet of the seller. Since only a central bank can be the digital currency issuer, we are talking about the movement of funds between accounts opened in the same bank.
Benefits of digital currencies
- From the point of view of the end consumer, the advantage is increased reliability and cheaper payments.
- The central bank, as the issuer and custodian of the digital currency, will always be solvent and will not go bankrupt, unlike conventional commercial banks. Accordingly, funds in a central bank account are always more secure than in a commercial bank account.
- The elimination of intermediaries in the part of payment operations must make them cheaper. We are talking, in particular, about cross-border payments, transfers between cards of different banks, cash withdrawals from ATMs of other banks, etc.
- Central banks can benefit more from the introduction of digital currencies – it is not for nothing that they are the leading proponents of digital currencies.
- Digital currencies are a convenient tool for monetary policy. Digital currency issuance can be done in a few clicks, much faster than influencing the money supply with a discount rate or buying government debt. In such a scenario, central banks strengthen their role in monetary policy, taking influence away from commercial banks.
- Another advantage of digital currency is its ease of accounting, or, in other words, its complete lack of anonymity. Each unit of digital currency can have its unique identifier (analogous to the serial number on a banknote), making it possible to track its movement. Proponents of digital currencies argue that this will make it easier to fight corruption and the laundering of illicit funds.
- After all, digital currencies can be “programmed” in specific ways. For example, a central bank could issue a digital currency with a particular date of expiration, which would encourage the consumer to spend it as quickly as possible and thus stimulate the economy. Or the digital currency could be programmed to be spent only on specific goods or services. In this case, digital currency can be used, for example, to pay targeted social assistance and ensure that it is not spent in any other way.
- From an end-user perspective, the main drawback of digital currency is the lack of anonymity. In countries with fragile democracies, this may result in state surveillance of oppositionists, activists, and other undesirables and using financial information to harass them.
- The ability to program digital currency so that it can be spent to buy certain goods/services from specific vendors/suppliers in corrupt countries can lead to favoritism by businesses close to the government.
- From the point of view of central banks, the risks of the widespread use of digital currencies lie in the fact that central banks will be charged with the functions of working with citizens, as well as in the potential decrease in the liquidity of commercial banks due to the outflow of funds from them in favor of digital currencies.
- Today we have to state that the relatively limited benefits of digital currencies do not exceed the risks of their introduction and the enormous costs of creating the relevant infrastructure. Not surprisingly, most countries are still cautiously exploring the possibility of introducing digital currencies. In one way or another, this has been done in Venezuela, Tunisia, and Senegal, hardly exemplary economies.
Digital currencies are relatively new and not legally regulated in developed countries. Lawmakers and regulators in the U.S. and EU countries are still only cautiously studying the potential of digital currencies and assessing the risks of their introduction. Soon, digital currencies will likely be unable to displace traditional cash and non-cash funds and will have a limited scope of use.