The growing adoption of digital payments and interest in cryptocurrencies like Bitcoin and Ethereum has sparked a focus on digital currencies. The changing technological landscape has even led central banks around the world to explore the idea of government-backed digital currencies.
What is digital currency?
Digital currency is a purely digital form of money—meaning there’s no physical currency.
Most dollars already are solely digital. A paycheck might flow into a person’s checking account via direct deposit and then get spent when they use a card, payment app, or digital wallet. An annual McKinsey & Co. survey has shown people are also increasingly relying on digital payments—a trend that the pandemic accelerated.
Behind the scenes, the dollars aren’t physically moved around—rather, they simply live on a balance sheet and in banks’ computer records. When someone deposits money into a bank account, they’re buying an IOU from the bank. The bank doesn’t need to keep physical money on hand, it just needs to be sure it can pay back the IOU. And when money gets transferred or spent, the banks can shift the IOU to another bank without having to send physical money to the other bank’s vault.
But the expectation is that physical currency would be available to a depositor if they wanted to withdraw funds from the bank as cash, rather than spend them digitally. That’s because the dollar remains a physical currency, not a digital one, though most of the record-keeping is done on computers.
The definition of what is or isn’t a digital currency differs among governments and organizations. The U.S. Treasury department, for example, uses the term “digital currency” to encompass cryptocurrencies, virtual currencies, and the digital representation of fiat currency. Others limit the definition to government-issued or -approved digital currencies, which don’t exist in many places. But broadly speaking—and to differentiate it from the dollars that only exist as numbers on a screen—digital currency may be defined as a purely digital form of money.
3 Types of digital currencies
The three primary types of digital currency are:
1. Virtual currencies
A virtual currency is generally defined as any type of virtual money that a government doesn’t issue. These aren’t legal types of money, but they can still work as a form of payment between two parties who use the currency, or as a way to store value.
For example, some online games have their own currency—such as Roblox’s virtual Robux currency. Players can purchase the virtual currency and then use it for in-game purchases. With some games, such as Second Life, players may also be able to earn the virtual currency by playing the game and then sell it for dollars.
Whether virtual currencies are convertible into fiat currency and vice versa may depend on the market for the virtual currency and issuers’ terms and conditions.
Cryptocurrencies use cryptography to secure and verify transactions. Most cryptocurrencies run on a blockchain—a network of computers that records all transactions. Unlike some other types of virtual currencies, most crypto blockchains use a decentralized blockchain, meaning no single person, company, or government controls the crypto.
Buying and selling crypto is legal in the U.S., but countries and municipalities have taken different stances toward cryptocurrencies. In some places, including China and Russia, it’s illegal to use cryptocurrencies as a form of payment.
3. Central bank digital currencies (CBDCs)
A central bank digital currency (CBDC) is a digital currency that’s issued and controlled by a central bank. According to the Atlantic Council’s CBDC tracker, as of July 2022, 11 countries—including Nigeria and Jamaica—have launched a CBDC. The motivations can vary, and governments might launch a CBDC to reduce their cost of storing and handling cash, improve financial reporting or fight money laundering. An additional 86 are either in the research, development, or pilot phase of their CBDC programs.
In January 2022, the Fed released a paper on the potential benefits and risks to creating a CBDC in the U.S. It points out that many people already use digital forms of money, such as an online bank account. But with a bank account, the bank owes them the money. A CBDC is different in several ways and one of the most important is that the Fed issues the digital currency and holds the liability.
Potential advantages of digital currencies
Digital currencies as a whole can offer various advantages to users:
- Fast and cheap payments. Digital currencies may be moved between accounts faster than transfers through traditional channels, especially accounts in different countries.
- Availability. Digital currency transactions could be processed nearly instantly at any time. Money transfers with a more traditional method, such as ACH, may take hours—or even several business days—depending on when someone requests the payment.
There are also a few additional potential advantages to CBDCs in particular:
- Convenient and trusted. A CBDC is backed by the government, similar to fiat currencies. That ensures that a CBDC is readily available to all consumers and businesses and that it is as safe and trusted as traditional currency.
- Expand financial inclusion. The inexpensive and fast transfers, and potentially direct connection between the Fed and people, could create new opportunities for financial inclusion. For example, people might be able to receive and spend digital currencies without having to open a bank account or sign up for a prepaid card, which can sometimes be difficult or expensive.
Potential disadvantages of digital currencies
Digital currencies can also bring about new risks and issues:
- Can be difficult to understand. While some digital currencies are fairly simple to buy and use, others require special software and rely on complex systems. With cryptocurrencies, a simple mistake, such as sending crypto to the wrong wallet, could result in an irreversible loss of the funds.
- Cybersecurity concerns. A completely digital form of money could be susceptible to cyberattacks. Some attacks have already resulted in the loss of hundreds of millions of dollars in cryptocurrencies.
- Not always a reliable store of value. Many virtual currencies depend on a private company—a video game currency will be worthless if the video game shuts down. Decentralized cryptocurrencies can also be risky because of large price swings. Even some stablecoins, cryptocurrencies that try to maintain a fixed exchange rate with a fiat currency, have “lost their peg” and become worthless.
While many countries are looking into CBDCs because of the potential benefits, they also have to weigh the drawbacks:
- Could weaken the banking system. Money traditionally flows from a central bank to commercial banks and then to businesses and consumers. If people hold onto CBDCs rather than dollars, the commercial banks won’t have as many deposits. As a result, the banks won’t be able to lend as much—the amount they can lend depends, in part, on how much they have in deposits.
- Large startup costs. While a CBDC might offer the government cost-savings once a system is up and running, creating the physical, digital, and regulatory systems for a CBDC can be a long and expensive process. Central banks may decide it makes more sense to focus on upgrading the current systems for digital forms of money. Or creating a framework for private virtual currencies to thrive, such as more-regulated stablecoins.
The bottom line
Digital money isn’t necessarily new—many people use digital bank accounts and payments instead of holding and spending coins and bills. But digital currency takes digital money to a new level because it does without the physical manifestation of that currency. Today, thanks to the rise of digital payments and cryptos, individuals may be more likely to buy and spend virtual currencies. And governments around the world are looking into, or already issuing, government-sanctioned digital currencies. But digital currencies come with a host of risks that must be weighed against the potential benefits.