Digital money is money that exists in a completely digital form. This money is not a tangible physical asset like cash or other commodities like gold or oil.
Digital money may also represent fixed currencies such as dollars or euros. Digital money is exchanged using technologies such as smartphones, credit cards, and online digital currency exchanges.
In some cases, they can be converted into physical cash using an ATM.
Digital money may streamline the current financial infrastructure and enable monetary transactions in a cheaper and faster way. Digital money may also facilitate the implementation of monetary policies by central banks.
Examples of digital money are cryptocurrencies, central bank digital currencies, and stablecoins.
Digital money is vulnerable to hacking and may compromise users’ privacy.
In this article we will cover together:
- What is digital money?
- What problems does digital money solve?
- Different types of digital money
- Central Bank Digital Currencies (CBDC)
- Cryptocurrencies
- Stablecoins
- Advantages of digital money
- Disadvantages of digital money
- Frequently asked questions about digital currency
What is digital money?
Today, a form of digital money exists in society in the form of cash in people’s online bank accounts. This cash can be sent to or received from others. It can also be used for online transactions.
Digital money is similar in concept and use to its cash counterpart because it may be a unit of account and a means of daily transactions, but it is not cash. For example, the dollars in your online bank account are not digital money because they take physical form when you withdraw them from an ATM.
Digital money differs from cash because it improves the process of monetary transactions.
For example, digital currency technology rails may make cross-border currency transfers easier and faster compared to standard money. This form of money also makes it easier for central banks to implement monetary policies.
The use of cryptography in some forms of digital money makes their transactions tamper-proof and censorship-resistant, meaning that governments or private organizations cannot take full control of them.
Due to these advantages, digital money has become one of the priorities of several world governments. The central bank of Sweden, a country on its way to becoming a cashless society, has published several exploratory papers since 2017 examining the pros and cons of introducing digital money into the country’s economy.
Meanwhile, China has already conducted preliminary tests of DC/EP, the digital equivalent of its national currency, and plans to release it soon. The Bahamian sand dollar is a digital iteration of the country’s national currency, which was released in October 2020.
According to a February 2021 survey by the International Monetary Fund (IMF), about 111 of its 159 member countries are investigating or planning to introduce digital money in the near future.
What problems does digital money solve?
Several systems are now conducting their transactions with digital versions of money. For example, credit card systems allow users to purchase goods and services on credit. Bank transfer systems allow the movement of cash between different countries.
Such transactions are costly and time-consuming because they require the use of different processing systems.
The SWIFT system, which is a network of different payment systems consisting of different banks and financial institutions around the world, is an example of such equipment.
Fees are charged for every money transfer made through the SWIFT network. SWIFT member institutions also operate according to a set of regulations, each of which is dedicated to a different financial area.
In addition, these systems are built on the promise of future payments, and the creation of a time delay for each transaction is certain. For example, credit card balance reconciliation occurs on a different date, and users can submit transaction refund requests.
One of the goals of digital money is to eliminate the time delay and operational costs of such transactions using distributed ledger technology (DLT).
In a DLT system, nodes or shared ledgers are connected to form a shared network for processing transactions. The network may also expand to other jurisdictions, minimizing transaction processing times.
These networks provide transparency to authorities and interest groups and improve the flexibility of the financial network by eliminating the need for a centralized database of transaction records.
Digital money also solves the problem of double spending by using an algorithmic consensus system. This problem, simply stated here, has to do with ensuring that digital money “bills” are not spent twice by the same person.
Centralized currency production and distribution frameworks such as those currently in place at central banks use a system called serial numbers to ensure the uniqueness of each banknote.
Some forms of digital money, such as central bank digital currencies (CBDCs) or digital money issued by private entities, mimic the role of the central authority of paper currencies in ensuring financial validity and integrity of transactions in the digital context.
Other types of digital money are decentralized. They eliminate the central authority’s duties in overseeing production and intermediaries needed to distribute the currency, and use cryptography instead.
Blind signatures hide the identity of the parties to the transaction, and proof-of-concept encrypts transaction details. Examples of this type of digital money are cryptocurrencies such as Bitcoin and Ethereum.
Different types of digital money
Thanks to its technological backing, digital money can be shaped into many forms and adapted to serve many purposes. Three digital currency adaptations that have emerged in recent times are as follows:
Central Bank Digital Currencies (CBDC)
Central Bank Digital Currencies (CBDCs) are currencies issued by a country’s central bank. These currencies are separate from paper currencies that are supported by the authority and credit of the central bank and are considered one of the other obligations of this institution.
Digital currencies of the central bank facilitate the implementation of monetary policies by removing intermediaries from politics and establishing direct communication between the government and ordinary citizens.
The existence of special banks and financial institutions that are responsible for the distribution of national money will no longer be necessary in this process.
Depending on the application and type of implementation of the central bank’s digital money in the economy, there may be two types of these.
The central bank’s retail digital money is designed to be used for everyday transactions just like paper currencies. Central bank digital money for wholesale is also used in a more limited implementation of this concept, for transactions between banks and financial institutions.
Cryptocurrencies
Cryptocurrencies are digital currencies designed using cryptography. The cryptographic coating around a digital currency provides more security and makes transactions resistant to manipulation by third parties.
The most popular digital currencies are Bitcoin and Ethereum. Since 2017, the popularity of cryptocurrencies as an investment category has increased their value and the overall value of the crypto markets.
As of July 2021, the market capitalization of cryptocurrencies has exceeded $2 trillion.
Stablecoins
Stablecoins are a type of cryptocurrencies that have been developed to counter the price fluctuations of regular digital currencies. Stablecoins can be likened to a form of private money whose price is tied to paper notes or a basket of goods to ensure their value is stable.
These currencies may be representative of paper currencies, except that they are not backed by government authorities. The market of stablecoins has grown explosively recently.
Advantages of digital money
The current financial infrastructure is a complex system consisting of many different entities. Conducting a transaction between financial institutions takes time and costs because they operate in different technology systems and regulatory regimes.
The main advantage of digital money is that it increases transaction speed and reduces costs.
Other advantages of digital money include the following:
- Digital money eliminates the need for physical storage and maintenance of banknotes, which are features of cash systems. You don’t need to invest in wallets or bank accounts to ensure your money isn’t stolen.
- Digital money simplifies the accounting and recording of transactions with the help of technology. Therefore, manual accounting and the use of separate books for each entity in order to keep transaction records is not necessary.
- While digital money has already reduced the time and cost required for cross-border money transfers, it has the capacity to revolutionize the remittance industry by eliminating intermediaries and further reducing costs related to cross-border transfers.
- Digital money removes intermediaries from the implementation of monetary policy and enables the inclusion of groups of people previously excluded from the economy. For example, those without a bank account can still participate in the economy using digital money in their online wallet or mobile phone.
- Digital money transactions in the context of cryptocurrencies may also make these currencies resistant to censorship, meaning they cannot be tracked by governments or other authorities.
Disadvantages of digital money
The disadvantages of digital money are as follows:
- Digital money is prone to hacking.
Although digital money eliminates the need for physical custody and protection of currency, its technological origins ensure that it becomes a target for hackers who can steal from digital wallets.
Hackers can disrupt an integrated financial infrastructure consisting of entities that are digitally connected to each other. The 2018 SWIFT hacks that affected several countries are a case in point.
Large-scale hacking of digital currency has the capacity to compromise a country’s financial infrastructure and become national security.
- The use of digital money may compromise users’ privacy.
Cash is anonymous and its users are almost impossible to track and trace. Digital money, on the other hand, is traceable. While the use of internet cookies has made targeted advertising possible, it has had much wider implications for tracking digital money.
For example, organizations or governments can blacklist or block accounts without users’ permission. They can also mandate a two-column accounting system for bank accounts, which increases fees and lowers the overall account balance.
- Digital money has its own costs.
For example, a digital wallet is needed to store digital money. Cryptocurrencies also need their own security solutions that act as infallible safeguards against hackers. Systems that use blockchain must also pay transaction fees or transaction processing fees to miners.
- Digital money poses several challenges in terms of governance and policy framework.
This form of money is an unknown territory for policy makers and many problems have emerged in the space of these money.
For example, after it emerged that Tether was the most widely used stablecoin in the cryptocurrency markets, it combined customer and company funds and from its own reserves to ensure that the currency exchange rate was maintained at 1:1.
The integrity of stablecoins has also been called into question.
Frequently asked questions about digital currency
What is digital money?
Digital money (or digital currency) refers to any means of payment that exists solely in electronic form. Digital money does not have a physical and tangible form like dollar bills or coins and is calculated and transferred using online systems.
What are the different types of digital money?
The technological basis of digital money means that its applications can be adapted for different purposes. In addition to digital money that may be used as a digital representation of paper currency, there are three other forms of digital money: cryptocurrencies, central bank digital currencies, and stablecoins.
What are some advantages of digital money?
Digital money facilitates and accelerates money transfer and remittance systems. It also facilitates the implementation of these policies by central banks by removing intermediaries such as banks from the process of implementing monetary policies. Cryptocurrencies are also censorship-resistant, meaning that the flow and use of digital money on their blockchains cannot be traced.
What are some disadvantages of digital money?
Digital money systems can be hacked. By skillfully targeting such systems, hackers can destroy important financial infrastructure and cripple a country’s economic foundations. Centralized digital money systems such as central bank digital money systems make it possible to track and trace user information and compromise their privacy.
Digital money is a major innovation in financial technology. This innovation overcomes liquidity problems and makes payment systems faster and cheaper.
However, it also comes with problems from its underlying technology, as digital money can be hacked and compromise people’s privacy. While digital money is still in its early days, it will play an important role in the future of the financial world.