Digital Money: What It Is, How It Works, Types, and Examples (2023)

What Is Digital Money?

Digital money (or digital currency) refers to any means of payment that exists in a purely electronic form. Digital money is not physically tangible like a dollar bill or a coin. It is accounted for and transferred using online systems. One well-known form of digital money is the cryptocurrencyBitcoin.

Digital money can also represent fiat currencies, such as dollars or euros.Digital money is exchanged using technologies such as smartphones, credit cards, and online cryptocurrency exchanges. In some cases, it can be converted into physical cash through the use of an ATM.

Understanding Digital Money

A variant of digital money is already present in society today in the form of cash held in online bank accounts. This cash can be sent to others or received from them. It can also be used for online transactions.

Digital money is similar in concept and use to its cash counterpart in that it can be a unit of account and a medium for daily transactions. But it is not cash. For example, the dollars in your online bank account are not digital money because they take on a physical form when you withdraw them from an ATM.

Digital money is different from cash because it improves upon the process for monetary transactions. For example, the technological rails of digital money can make currency transfers across borders easier and faster as compared to standard money. This form of money also streamlines the process for monetary policy implementation for central banks. The use of cryptography in some forms of digital money makes transactions involving them tamper-proof and censorship-resistant, meaning they cannot be controlled by governments or private agencies.

Given these advantages, digital money has become a priority for several governments around the world. The central bank of Sweden, a country that is on its way to becoming a cashless society, has released several exploratory papers since 2017 that explore the benefits and drawbacks of introducing digital money into its economy. Meanwhile, China has already conducted pilot tests involving the DC/EP, the digital equivalent of its national currency, and is planning to release it soon. The Bahamas sand dollar is a digital iteration of the country's national currency. It was released in October 2020.

According to a February 2021 survey conducted by the International Monetary Fund (IMF), around 111 countries from its 159 member countries are researching or planning to introduce digital money in the near future.

What Problems Does Digital Money Solve?

Several systems already perform transactions with digital versions of money. For example, credit card systems allow users to purchase goods and services on credit. Wire transfer systems enable movement of cash across borders.

Such transactions are expensive and time-consuming because they involve the use of disparate processing systems. The SWIFT system, a payments systems network consisting of various banks and financial institutions across the globe, is an example of such an outfit. There are charges for each transfer conducted through the SWIFT network. The member institutions of SWIFT also function in a patchwork of regulation, each specific to a different financial jurisdiction. Moreover, these systems are built on the promise of future payments, ensuring a time lag for each transaction. For example, reconciliation for credit cards occurs at a later date, and users can file chargebacks for transactions.

One of the aims of digital money is to do away with the time lag and operating costs for such transactions by using distributed ledger technology (DLT). In a DLT system, nodes or shared ledgers connect to form a common network to process transactions. This network can also extend to other jurisdictions and minimize the processing time for transactions. It provides transparency to authorities and stakeholders, improving the resiliency of a financial network by eliminating the need for a centralized database of records.

Digital money also solves the double-spending problem by using an algorithmic consensus system.The problem, stated quite simply, relates to ensuring that a "note" of digital money is not spent twice by the same person.

A centralized setup of currency production and distribution, such as the one with central banks that exists currently, uses a system of serial numbers to ensure that each note is unique. Some forms of digital money like central bank digital currencies (CBDCs) or digital money issued by private parties replicate the role of a central authority in ensuring solvency and integrity of transactions, albeit in a digital context.

Other types of digital money are decentralized. They eliminate the function of central authorities to oversee production and intermediaries needed to distribute the currency. Cryptography is used. Blind signatures hide the identity of transacting parties, and zero-knowledge proofs encrypt transaction details. Examples of this type of digital money are cryptocurrencies like Bitcoin and Ethereum.

Types of Digital Money

Thanks to its technological underpinning, digital money can be adapted to suit multiple purposes and can take on various forms. The three adaptations of digital money that have emerged in recent times are as follows:

Central Bank Digital Currencies (CBDCs)

Central bank digital currencies (CBDCs) are currencies issued by the central bank of a country. They are separate from fiat currencies, which are also backed by the authority and credit of a central bank, and are another obligation of the institution. CBDCs ease monetary policy implementation by removing intermediaries from the policy by establishing a direct connection between the government and the average citizen. Banks and financial institutions responsible for distributing national currency are no longer required in the process.

Depending on their use and type of implementation in the economy, there can be two types of CBDCs. Retail CBDCs are designed to be used for daily transactions, much like fiat currencies. In a more limited implementation of the concept, Wholesale CBDCs are used for transactions conducted between banks and financial institutions.

Cryptocurrencies

Cryptocurrencies are digital currencies designed using cryptography. The crypto wrapper around a digital currency provides enhanced security and makes transactions tamper-resistant. The most popular cryptocurrencies are Bitcoin and Ethereum. Since 2017, the popularity of cryptocurrencies as an investment class has skyrocketed their value and the overall market capitalization of crypto markets. By July 2021, the market cap of cryptocurrencies had surpassed $2 trillion.

Stablecoins

Stablecoins are a variation of cryptocurrencies and were developed to counter the price volatility of regular cryptocurrencies. Stablecoins can be likened to a form of private money whose price is tied to that of a fiat currency or a basket of goods to ensure that they remain stable. They can be a proxy for fiat currencies, except they are not backed by governmental authority. The market for stablecoins has exploded in recent times. As of February 2021, 200 stablecoins had been released or were in development.

Advantages of Digital Money

The current financial infrastructure is a complex system of many entities. Conducting a transaction between financial institutions takes time and money because they work in different technological systems and regulation regimes. The main advantage of digital money is that it speeds up transaction speed and cuts back on costs.

Other advantages of digital money are as follows:

• Digital money eliminates the need for physical storage and safekeeping that is a characteristic of cash-intensive systems. You do not need to invest in a wallet or bank vaults to ensure that your money is not stolen.
• Digital money simplifies accounting and record-keeping for transactions through technology. Therefore, manual accounting and separate entity-specific ledgers are not necessary to maintain records of transactions.
• While it has already shortened the amount of time and the cost required to transfer money across borders, digital money has the potential to further revolutionize the remittance industry by eliminating intermediaries and further reducing the costs associated with cross-border transfers.
• Digital money removes intermediaries in the implementation of monetary policy and makes it possible to include groups of people who were previously excluded from the economy. For example, those who are unbanked can still participate in an economy by using digital money present in their online wallet or mobile phones.
• In the case of cryptocurrencies, digital money transactions can become censorship-resistant, meaning they can be impervious to tracking by government or other authorities.
  

Disadvantages of Digital Money

The disadvantages of digital money are as follows:

• Digital money is susceptible to hacking. Even as it removes the need for physical safekeeping, digital money's origins in technology ensure that this form of money becomes a target for hackers, who can steal from digital wallets. A seamless financial infrastructure consisting of digitally connected entities can be brought down by hackers. The 2018 SWIFT hacks, which affected multiple countries, are an example. Hacks of digital money on a large scale have the potential to bring a country's financial infrastructure to heel and become a national security threat.
• Digital money use can compromise user privacy. Cash is anonymous, and it is nearly impossible to track and trace its users. On the other hand, digital money can be traced. While the use of internet cookies enables targeted advertising, the implications for digital money tracking are more far-reaching. For example, organizations or governments could blacklist or freeze accounts without the permission of users. They could also instigate double-accounting in bank accounts, inflating expenses and reducing the overall total.
  
• Digital money has its own set of costs. For example, digital wallets are required to store digital money. Cryptocurrencies also require custody solutions that act as a failsafe against hackers. Systems that use blockchains also have to pay transaction fees, or the costs associated with processing the transaction, to miners.
• Digital money presents several challenges on the governance and policy framework front. This form of money is uncharted territory for policymakers, and problems have already begun emerging in its ecosystem. For example, the integrity of stablecoins is already under a cloud after Tether, the most widely used stablecoin in cryptocurrency markets, was found to have co-mingled client and corporate funds and used funds from its reserve backup – to ensure a 1:1 peg to the U.S. dollar – to cover up its debt obligations.

Digital Currency FAQs

What is digital money?

Digital money (or digital currency) refers to any means of payment that exists purely in electronic form. Digital money does not have a physical and tangible form, such as a dollar bill or a coin, and is accounted for and transferred using online systems.

What are the different types of digital money?

Its technological underpinnings mean that digital money can be adapted to suit various purposes. Apart from being a digital representation of fiat 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 eases and expedites money transfer and remittance systems. It also simplifies the implementation of monetary policy by central banks by removing intermediaries like banks from the process. Cryptocurrencies are also censorship-resistant, meaning that the flow and use of digital money on their blockchains cannot be tracked.

What are some disadvantages of digital money?

Digital money systems are susceptible to hacks. Through skillful targeting of such systems, hackers can bring down important financial infrastructure and cripple the economic foundations of a country. Centralized digital money systems, such as those for CBDCs, can enable the tracking and tracing of user information and compromise their privacy.

The Bottom Line

Digital money is a major innovation in financial technology. It overcomes the problems of cash and makes payment systems faster and cheaper. But it has the attendant problems of technology, as digital money can be hacked and can erode privacy. While it is still early days for digital money, it will play an important part in the future of finance.