What is digital money? An ultimate guide
Discover what digital money is, its types, and the differences from cryptocurrency. Explore the future of digital currencies, including the digital dollar.
Understanding digital money
Digital money refers to any payment method that exists solely in electronic form. Unlike physical currency like coins or banknotes, it is managed and transferred through online systems.
Typically, digital money represents fiat currencies, such as dollars or euros. It can be exchanged using computers, smartphones, cards, and online cryptocurrency platforms. In some instances, it can also be converted into physical cash at ATMs.
Digital money functions similarly to cash, serving as both a unit of account and a means for everyday transactions. It is treated like physical currency. For instance, the dollars in your bank account are digital since banks no longer hold physical cash for customers. When you deposit cash, the bank simply increases your account balance and redistributes those bills to other clients. Conversely, when you withdraw cash, the bank converts your digital dollars to physical cash and deducts the amount from your account.
This system makes financial transactions significantly faster and cheaper, especially for cross-border payments and remittances. Due to these benefits, digital money has become a priority for many governments globally.
For example, Sweden's central bank has been exploring a cashless society and has published several papers since 2017 examining the advantages and disadvantages of implementing digital money in its economy. Similarly, China launched the digital renminbi (e-CNY), the digital version of its national currency, and has started using it to pay government employees. The Bahamas also introduced the sand dollar in 2020.
What issues does digital money address?
Digital money can solve various problems by utilizing existing systems for transactions. For instance, credit card systems allow you to buy goods and services on credit, while wire transfer systems facilitate cash transfers across borders. However, these transactions can be costly and slow due to the involvement of different processing systems. A prime example is the SWIFT network, which connects banks and financial institutions globally; each transfer through SWIFT incurs fees, and member institutions operate under a complex web of regulations specific to various financial jurisdictions. Additionally, these systems often rely on future payment promises, leading to delays in transaction finalization. For example, credit card reconciliations happen later, and users can dispute transactions through chargebacks.
One of the primary goals of digital money is to eliminate these delays and operational costs by utilizing distributed ledger technology (DLT). In a distributed ledger system, shared ledgers are interconnected over a common network to record transactions, allowing entities across different jurisdictions to connect and significantly reduce processing times. This setup also enhances transparency for authorities and stakeholders. Since the ledger is maintained across multiple machines, it becomes challenging to alter, especially when secured with cryptographic methods.
Innovations in digital money
A significant advancement in distributed ledger technology (DLT) is the use of historically linked encryption methods to connect blocks, known as blockchain. This technology enhances the resilience of financial networks by making it extremely difficult to alter or access records.
Blockchain's decentralized and distributed validation system also addresses the double-spending issue, where a digital asset could be spent multiple times due to the absence of physical transfer. With a vast network of automated validators verifying encrypted transactions through historical data, double-spending becomes impossible. Larger networks operate at speeds vastly superior to individual computers or small groups, making them more efficient and much harder to compromise.
Additionally, blockchains and distributed ledgers can eliminate the need for third parties in transactions. Techniques like blind signatures protect the identities of the parties involved, while zero-knowledge proofs encrypt transaction details, enhancing security. Cryptocurrencies such as Bitcoin and Ethereum are prime examples of this form of digital money.
Types of digital money
Thanks to its technological foundation, digital money can be adapted for various uses and can take on multiple forms. In addition to the digital representation of cash currently in use, several other types exist, with more likely to emerge.
1. Central Bank Digital Currencies (CBDCs)
Central Bank Digital Currencies (CBDCs) are currencies issued by a nation's central bank. They are distinct from traditional fiat currencies, backed by the authority and credit of the central bank, and represent another obligation of the institution.
CBDCs are relatively new in the realm of digital money. While some countries have already implemented them, many are observing closely to see how the initiative unfolds in those experimenting with CBDCs.
There are suggestions for different kinds of CBDCs. For example, wholesale CBDCs could facilitate transactions between banks and financial institutions for large-value payments, while retail CBDCs would be aimed at everyday transactions by consumers and businesses, similar to fiat currencies.
2. Cryptocurrencies
Cryptocurrencies are digital currencies that use cryptography for security. They are increasingly referred to as virtual currencies, a subset of digital currencies, to differentiate them from officially recognized forms of money.
The cryptographic framework enhances security and makes transactions resistant to tampering. Since 2017, the popularity of cryptocurrencies as an investment class has significantly boosted the market capitalization of crypto markets. By November 2021, the total market cap of cryptocurrencies exceeded $2.7 trillion. Although the crypto winter in 2022 saw the market cap drop below $1 trillion, it began recovering in 2023, reaching over $2.5 trillion by March 2024.
3. Stablecoins
Stablecoins are a type of cryptocurrency designed to mitigate the price volatility commonly associated with regular cryptocurrencies. They function as a form of private money, with their value linked to a fiat currency or a basket of goods to maintain stability. While they serve as a proxy for fiat currencies, stablecoins lack backing from government authorities. Recently, the stablecoin market has experienced significant growth. As of January 2024, there were 168 stablecoins listed on CoinMarketCap, a well-known cryptocurrency data aggregator, although some were inactive.
Advantages of digital money
The current financial system is a complex network of various entities. Transactions between financial institutions often require time and incur costs due to differing technological systems and regulatory environments. The primary benefit of digital money is its ability to speed up transaction processes and reduce expenses.
Additional advantages of digital money include:
- Elimination of physical storage: Digital money removes the need for physical safekeeping, which is essential in cash-based systems. There’s no requirement to store it in a wallet, safe, or bank vault to prevent theft.
- Simplified accounting and record-keeping: Digital money streamlines accounting processes, making manual bookkeeping and separate entity-specific ledgers less relevant through standardization and automation.
- Revolutionizing the remittance industry: It has the potential to transform the remittance sector by removing intermediaries and lowering costs associated with cross-border transactions.
- Inclusion of excluded groups: Digital money eliminates the need for intermediaries, enabling participation from groups previously excluded from the economy, including the unbanked population.
- Enhanced privacy: Certain forms, such as cryptocurrencies, offer greater privacy, which can be advantageous for retail users, although it poses challenges for regulators and law enforcement agencies.
Disadvantages of digital money
The drawbacks of digital money include the following:
- Vulnerability to hacking: Despite eliminating the need for physical storage, digital money's reliance on technology makes it a target for hackers. A network of interconnected financial entities can be compromised, and large-scale hacks can threaten a country's financial infrastructure and national security.
- Privacy concerns: Unlike cash, which is anonymous and difficult to trace, digital money leaves a record that can be followed. This traceability poses a disadvantage for those valuing privacy, but it offers benefits for law enforcement and regulators seeking transparency.
- Associated costs: Digital money can incur expenses. For instance, cryptocurrencies require custody solutions to prevent hacks, and blockchain systems often charge transaction fees to compensate network participants for their resources.
- Governance and policy challenges: In the case of cryptocurrencies, there are significant challenges regarding governance and regulatory frameworks. This area remains largely unexplored for policymakers, although some jurisdictions have begun to develop initial regulatory approaches.
Digital money and digital wallets
Digital wallets are fundamental to the digital money ecosystem, serving as the primary interface for users to manage and interact with their digital currencies. They offer a secure environment for storing and handling digital funds.
A key function of digital wallets is facilitating transactions involving digital money. Users can send and receive payments through their wallets using various software interfaces. For example, when you transfer money to a friend using popular banking or finance apps, those applications often utilize digital wallet technologies to process the transaction.
One major advantage of digital wallets is their accessibility and portability. Users can access their digital money anytime and anywhere, provided they have an internet connection. This mobility allows for on-the-go transactions using smartphones or other connected devices. This accessibility is a significant benefit of cryptocurrency, enabling individuals around the world to access banking services that might otherwise be unavailable in many regions.
Finally, security is crucial in the digital money landscape. While easy access to funds is important, it also raises concerns about unauthorized access to accounts. Digital wallets often employ encryption techniques, multi-factor authentication, and biometric authentication methods to protect digital assets.
What is digital money?
Digital money (or digital currency) refers to any form of payment that exists entirely in electronic form. Unlike physical cash, such as dollar bills or coins, digital money is accounted for and transferred through online systems.
What are the different types of digital money?
Due to its technological foundation, digital money can serve various purposes. In addition to representing fiat currencies, there are other forms of digital money, including central bank digital currencies (CBDCs) and stablecoins.
What is the difference between digital money and cryptocurrency?
Cryptocurrency is a specific type of digital money that operates on blockchain networks and utilizes cryptography. However, there are various forms of digital money beyond cryptocurrencies.
Is the digital dollar going to happen?
Central bank digital currencies (CBDCs) are government-backed digital currencies regulated by official agencies. Although discussions about a digital dollar have been ongoing for several years, it appears unlikely to be implemented in the U.S. in the near future.