For something that may be the hottest topic in finance and technology this year, digital currencies are the subject of a surprising amount of misunderstanding. Much of this misunderstanding is the result of some basic conceptual confusion so let’s try to clarify what we mean when we talk about money, currencies and crypto:
- Money is a type of value that is tangible, like gold, silver or diamonds. It is used as a means of exchange, something that can be used to buy goods and services. Money has intrinsic value.
- The euros and dollars you hold in your wallet are not, technically speaking, money. They are currencies. Currencies are a vehicle for transferring money value, for example to buy something or pay someone. They represent value.
Whether money itself can ever be digital is an interesting question. Currencies certainly can be. For many years, we have been using digital transactions to transfer representations of value. How many of us still sign card receipts to confirm a payment?
The most recent step in the digital transformation of payment is the digital currency, often called as cryptocurrencies.
A small group of technological building blocks make cryptocurrency possible: Bitcoin is the best-known example of this. The Blockchain protocol supports Bitcoin and many other cryptocurrencies. It is based on a smart mix of existing technologies such as cryptographic signature (hence the word crypto), peer-to-peer networks and hash functions. Blockchain is often referred to as distributed ledger technology (DLT). It creates trust and traceability in a digital workflow – in the case of Bitcoin, for payments.
The first generation of cryptocurrencies, such as Bitcoin, attracted a lot of excitement as well as some critical attention because of a number of issues, including:
- The high volatility of their market value
- The pseudo-anonymity they offer has made them popular with criminals who want to launder money
Now we are seeing the development of more stable and efficient digital currencies, so-called stablecoins. Central banks and commercial entities have already begun to issue these currencies.
Stablecoins avoid price swings by pegging their value to real-world assets such as fiat, gold and other commodities. They are based on blockchains that are private and permissioned: these blockchains are open only to identified users.
The new breed of digital currencies has been hailed for their perceived advantages when compared with any other currency or form of digital payment, on the basis they are safer to store, easier to manage and faster to transfer.
Current and future applications for stablecoins include:
- Central Bank Digital Currencies (CBDCs). An estimated 80% of central banks are already working on CBDCs, potentially transforming their monetary systems.
- Local currencies issued by regional governments to reward good citizenship.
- Loyalty and retailing schemes to reward people for their custom.
- Safe havens with intrinsic value. Tokenisation will also increase the liquidity of the market for the collateral asset.
Today, there is extensive debate about the social and economic consequences of digital currencies.
Implemented responsibly, they could pave the way towards a more democratic, decentralised and efficient financial ecosystem. This could transform the way we make payments and transfer value.
The long-term impact of digital currencies is still uncertain. But the technologies underlying them are proven and the starting gun has been fired.