General Views on the Nature of Digital Currencies

Towards a General Understanding of Digital Currencies

This post is the first in a series in which I hope to explore the nature of digital currencies. In this post I will provide a general overview of digital currencies. In future posts I hope to explore central bank digital currencies and the economic, governance and social consequences resulting from central banks and financial systems adopting these currencies.

The Brookings Institute published a post on May 21, 2018. The Title is: UP FRONT Digital currencies: Five big implications for central banks. The article was written by Vivien Lee and David Wessel.

Lee and Wessel open their discussion with the observation that digital currencies are increasingly playing a role in the financial system. Potentially digital currencies can have profound impacts on these systems and the way central banks operate.

In the light of this phenomena Lee and Wessel pose the following questions:

“Will paper currency finally become obsolete? Will bitcoin and its siblings replace the dollar or the euro or the yen? Should central banks issue their own e-currencies? What opportunities do digital currencies present? What risks?”

Jake Frankenfield in an article entitled Digital Currency Types, Characteristics, Pros & Cons, Future Uses published by Investopedia on April 20, 2023 defines a digital currency as follows:

“Digital currency is a form of currency that is available only in digital or electronic form. It is also called digital money, electronic money, electronic currency, or cybercash.”

Mr. Frankenfield extends on this definition by writing:

“Transactions involving digital currencies are made using computers or electronic wallets connected to the internet or designated networks.”

Transactions based on the usage of physical fiat currencies such as notes and coins “…. are made possible only when their holders have physical possession of these currencies.”

Like physical currencies digital currencies “…. can be used to purchase goods and pay for services. They can also find restricted use among certain online communities, such as gaming sites, gambling portals, or social networks.”

Mr. Frankenfield lists the advantages and disadvantages of digital currencies as follows:

Advantages of Digital Currencies

Fast Transfer and Transaction Times
No Physical Manufacturing Required
Monetary and Fiscal Policy Implementation
Cheaper Transaction Costs
Decentralised
Privacy
Accessible Around the World

Disadvantages of Digital Currencies

Storage and Infrastructure Issues
Hacking Potential
Volatile Value
Limited Acceptance
Irreversibility

Mr. Frankenfield points out that the term digital currency is a general term that describes different kinds of electronic currencies. There are two broad types of digital currencies:

Virtual currencies
Central Bank Digital currencies

Virtual currencies

A related article, written by Mr. Frankenfield was published in Investopedia on March 24, 2023. This article is entitled: Virtual Currency: Definition, Types, Advantages & Disadvantages.

Mr. Frankenfield, in this article informs us that the designation “virtual currency” was coined in 2012 by the European Central Bank (ECB). The ECB used this term to classify types of digital money that are utilised within an unregulated environment. Control over these types of currencies is exercised by the people that develop them. Also, within the context of an unregulated environment the currencies are used as a payment method to support transactions within virtual communities hosted by these environments.

The Internal Revenue Service (IRS) an arm of the Federal Government of the United States of America (USA) describes virtual currencies as being “digital representations of value”. As such they operate as a “…. unit of account, a store of value and a medium of exchange.”

Mr. Frankenfield relates that, in general virtual currencies in terms of society in general have not been that successful as a medium of exchange. Their usage is confined to networks of gaming enthusiasts. They are also used by speculative investors who treat them as investment assets. It is difficult to make the case that they constitute, like gold or silver a source of value.

Virtual currencies are not usually regulated by a central authority. Rather they are based on software programs or applications running on mobile phones or computers. Virtual currency transactions are hosted within secure dedicated networks or happen across the internet.

These digital currencies are controlled by private organisational stakeholders such as groups of programmers.

Mr. Frankenfield elaborates on the general idea of virtual currencies by discussing two types of virtual currency:

Closed virtual currency
Open Virtual currency

Closed virtual currencies

The distinctive feature of a closed virtual currency is that such a currency runs in a managed and private environment. For example, gaming networks use network tokens the economic value of which is determined by the developers of the gaming software.

As managed private networks closed virtual currencies cannot be changed into another virtual currency or an actual fiat currency. Currencies or in-game-tokens used to buy items within the specific economic environment of a gaming system are examples of closed virtual currencies as they can only be used by the private members of and within a gaming system itself. Also, they cannot be transformed into actual cash.

Open virtual currency

Open virtual currencies can be exchanged for other types of money. They function in open platforms. Also, open virtual currencies can be exchanged for other currencies within the host platform or on other platforms. Cryptocurrencies and stablecoins and are examples of open virtual currencies.

Cryptocurrencies

In terms of market capitalisation Bitcoin and Ethereum are the largest cryptocurrencies. They can be changed into other cryptocurrencies and can be exchanged for some fiat currencies. In the USA the process of conversion is deemed to be a transaction and incurs a tax.

Cryptocurrencies are unregulated digital currencies.

Cryptography and Blockchain technology are used to create and control the generation of the currencies. These currencies are used as the basis for transactions that occur within a computer network. These transactions are secured using cryptography. Examples of these currencies are Bitcoin and Ethereum.

As a brief aside a blockchain is created from distributed ledger technology (DLT). Blockchains are immutable ledgers. Blockchains store unique timestamped electronic transactional information. This ledger is shared between the individual nodes within a computer network. Cryptocurrencies are decentralised by virtue of the fact that they operate on this blockchain technology.

For more information regarding blockchain technology see the post published by IBM entitled: What is blockchain technology. Have a look at the brief videos in the section entitled Blockchain 101 in five minutes. A more detailed reference is a document (available in PDF) entitled “Blockchain Technology Overview. This document is published by the National Institute of Standards and Technology US Department of Commerce.

Stablecoins

Investopedia published. on May 24, 2023 an article authored by Adam Hayes entitled: Stablecoins: Definition, How They Work, and Types

With respect to stablecoins Mr. Hayes writes that they are cryptocurrencies that offer the potential to maintain their value in various ways.

Stablecoins maintain their stability by being pegged to another currency such as the US dollar, commodities, such as gold or financial instruments or asset classes such as stocks or loans. This is in contrast with highly volatile cryptocurrencies like Bitcoin that are not as suited for conventional consumer or business transactions.

By way of an example that illustrate this volatility, Mr. Hayes writes that in March 2020 the price of a Bitcoin was $5,000; by April 2021 the price rose to more than $63,000. Within two months the price dropped by 50%. This volatility occurs on a daily basis where the price can swing 10% over the course of a several hours.

As you can see the volatility in cryptocurrencies like Bitcoin makes them ideal for speculative traders However, when utilised as a basis for routine transactions involving the buying and selling of goods and services this volatility is problematic and full of risk.

Mr. Hayes illustrates this point as follows:

“All this volatility can be great for traders, but it turns routine transactions like purchases into risky speculation for the buyer and seller. Investors holding cryptocurrencies for long-term appreciation don't want to become famous for paying 10,000 Bitcoins for two pizzas. Meanwhile, most merchants don't want to end up taking a loss if the price of a cryptocurrency plunges after they get paid in it.”

If Cryptocurrencies, which are not legal tender, are to work as a medium of exchange they need to be relatively stable. As a medium of exchange those using them need to feel that these currencies maintain, at least in the short term their purchasing power. In comparison daily changes in the foreign exchange value of regular fiat currencies rarely exceeds 1%.

In this context stablecoins provide a promising solution to the problem of cryptocurrency volatility.

Mr. Hayes elaborates on the notion of stablecoins further by identifying the following types of stablecoins:

Fiat-Collateralized Stablecoins
Crypto-Collateralized Stablecoins
Algorithmic Stablecoins

Tether (USDT) and TrueUSD (TUSD) are amongst the largest fiat-collateralized stablecoins. They are supported by USD reserves. The price of these stablecoins is pegged at parity or same value with the USD. Apart from the USD precious metals and commodities such as oil are used as collateral to maintain a stablecoins value.

Crypto-Collateralized Stablecoins are as the name suggests backed by other cryptocurrencies called reserve cryptocurrencies. Given the inherent high volatility of the reserve cryptocurrencies crypto-collateralized stablecoins are also prone to volatility. The volatility is mitigated through stablecoin overcollateralisation. This means that the value of the reserve cryptocurrency backing the stablecoin is higher than the value of the stablecoin. So, a stablecoin issue of $1 million may be backed by $2 million reserve cryptocurrency.

Algorithmic stablecoin cryptocurrencies can hold asset reserves to mitigate volatility. However, their main feature lies in their power to minimise the volatility of stablecoins with the aid of an algorithm that runs a pre-programmed formula. The algorithm control’s the coin’s supply and demand determined by what are called smart contracts.

A smart contract is coded directly into the algorithms and is always running in the background to enforce and execute the terms of an agreement between the buyer and the seller of the stablecoin. The resulting transaction once executed can be tracked and cannot be altered or undone. The code and agreement and the immutable audit footprint are stored within a distributed and decentralised blockchain network.

Central Bank Digital currencies (CBDCs)

Returning to the previously referenced article of April 20, 2023 published in Investopedia by Mr. Frankenfield entitled: Digital Currency Types, Characteristics, Pros & Cons, Future Uses.

Mr. Frankenfield informs us that CBDCs are digital currencies that are regulated by central banks. They can supplement and replace physical fiat currency. They could be used to improve the security and speed of centralised payment systems.

Mr Frankenfield writes:

“Unlike fiat currency, which exists in both physical and digital form, a CBDC exists purely in digital form. England, Sweden, and Uruguay are a few of the nations that are considering plans to launch a digital version of their native fiat currencies.”

Furthermore:

“The use of CBDCs has been suggested as a means of enhancing the speed and security of centralized payment systems, lowering the costs and dangers of handling cash, and promoting greater financial inclusion for people and companies without access to conventional banking services. They may also make cross-border payments easier and lessen the need for foreign exchange.”

By way of a conclusion, I draw your attention to Tony Richards, Head of Payments Policy for the Reserve Bank of Australia (RBA). Mr. Richards delivered an address to the Australian Corporate Treasury Association on November 18, 2021 entitled: The Future of Payments: Cryptocurrencies, Stablecoins or Central Bank Digital Currencies? The Speech has been posted on the RBA website.

Mr. Richards informed his audience of the large degree of interest in CBDCs across the globe. He cites surveys by the Bank of International Settlements as indicating that most central banks are conducting work in this area.

Mr. Richards discusses the various ways that the three types of digital assets – cryptocurrencies, stablecoins and CBDCs can be distinguished. The distinctions can be conceived as two dimensions:

Denomination and Backing
Governance and Technology

Denomination and Backing

Within this dimension there is a continuum that commences at one end of the denomination and backing spectrum with cryptocurrencies which have no asset or fiat currency backing. The value of cryptocurrencies is determined solely what people are willing to pay for them. Further along this spectrum are stablecoins, denominated in fiat currencies, backed by assets with aim of minimising volatility. Ranging towards the other end of the spectrum are CBDCs. CBDCs are denominated in fiat currencies and fully changeable at par into other forms of money.

Governance and Technology

Within this dimension there is a governance spectrum based on the degree of centralisation involved. CBDCs would reside on the centralised end of the spectrum in that the arrangements require permissions. Some stablecoins ranging towards the centralised end. In a more centralised system such as CBDCs and stablecoins, permissions that verify transactions are based on a small number of trusted entities.

Cryptocurrencies reside at the decentralised end of the governance spectrum because system governance does not require permissions because it is based on consensus that arises from programmed software protocols.

This completes my overview of digital currencies. I would like to know return to the Brookings Institute discussion I referenced at the beginning of my post entitled: UP FRONT Digital currencies: Five big implications for central banks. In the discussion the authors highlight five big implications that digital currencies have for central banking systems: