What is a digital currency and how are central banks getting involved?

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Cash is no longer king. A digital dynasty has rapidly usurped the paper throne, with global cashless transactions set to triple by 2030.

Enter digital currencies. The new face of payments today, digital currencies make cross-border transactions seamless. Central banks around the world have been proposing their own digital currencies, with India slated to join their ranks. You may also be familiar with cryptocurrencies, which similarly fall under the digital currency umbrella.

In this article, we explore what digital currencies are and how central banks are hopping aboard.

What are digital currencies?

Like their name suggests, digital currencies are monetary currencies that are entirely stored, traded, and managed in a digital space, often on the Internet. 

Two main types of digital currencies are available today: cryptocurrencies and central bank digital currencies (CBDCs). Of the two, cryptocurrencies were born first, setting the stage for the creation of CBDCs.

Let us proceed by first taking a look at cryptocurrencies.

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Cryptocurrencies: Where it all started

Cryptocurrencies are the best-known digital currencies – the chances are that you may have heard of more popular coins like Bitcoin (BTC), Ethereum (ETH), and Dogecoin (DOGE). 

So how do cryptocurrencies work? The first clue is in their name: the word “cryptocurrency” is derived from “cryptography”, which uses codes and encryption to secure cryptocurrencies. This is also why these digital currencies are difficult to duplicate and double-spend. 

Cryptocurrencies are especially popular because their networks are decentralised. This means that they are freely distributed across multiple computers. As a result, governments and central authorities are unable to control their creation and distribution. 

Similar to stocks, cryptocurrencies have no intrinsic values. Instead, market demand and supply determine their values, subject to fluctuations you can expect from a typical stock market. As the Bank for International Settlements (BIS) astutely observed, “cryptocurrencies are speculative assets rather than money.”

On top of all these traits, cryptocurrencies are partially anonymous, affording their users some level of privacy when they create and trade the currencies. 

However, it is this same anonymous nature that has caused criminals to use cryptocurrencies for activities like “money laundering, ransomware attacks, and other financial crimes.” (BIS)

As recently as July of this year, four people in Hong Kong were caught in an alleged $209 million crypto laundering scheme. And over in the United States, ransomware attacks involving cryptocurrencies are so widespread that the Biden administration wants to fight back via crypto tracing.

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The intervention of central banks

Given the danger that cryptocurrencies pose, central banks worldwide are responding with their own versions of cryptocurrencies: CBDCs.

Think of CBDCs as digital banknotes representing existing fiat currencies like the US dollar and the Chinese yuan. Like fiat currencies, CBDCs are regulated by central banks or monetary authorities. They are also backed by legitimate monetary reserves.

CBDCs aim to bring the convenience of cryptocurrency and the security of traditional banking together into one digital currency.

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Landmark CBDC projects

Bahamian Sand Dollar

Credited with being the first nationwide CBDC to be officially launched, the Bahamian Sand Dollar is issued by the Central Bank of the Bahamas. Beginning as a pilot on Exuma Island in December 2019, it was later expanded for use by all Bahamian citizens in October 2020.

According to the Central Bank of the Bahamas, a key reason for creating the Bahamian Sand Dollar was to “strengthen [their] national defences against money laundering, counterfeiting, and other illicit ends by reducing the ill effects of cash usage.” 

 

Digital Yuan

The People’s Bank of China (PBOC)’s push to create a CBDC dates as far back as 2017, where it began as a project called Digital Currency Electronic Payments (DCEP). The CBDC was intended to have “controllable anonymity”, allowing the Chinese government to maintain some level of privacy while it regulated money laundering and other illegal activities.

From April 2020, PBOC piloted e-CNY in four cities: Shenzhen, Suzhou, Xiong’an, and Chengdu. The pilot later expanded to 28 other major cities, with the PBOC reporting that total transactions made with e-CNY stand at around $5.39 billion

The PBOC has begun preparing e-CNY for use in cross-border transactions at the 2022 Beijing Olympics.

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CBDCs: The future of digital currency?

CBDCs have most certainly gained significant traction recently, with at least 81 countries, or more than 90% of the global GDP, having started to explore this digital currency. 

And with five countries having launched CBDCs fully and 14 others running pilots, it’s safe to say that CBDCs are here to stay. While it’s not possible for them to fully replace cryptocurrencies, it is still reassuring to know that we now have some semblance of a solution to online financial crime.

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