Digital currencies and cryptocurrencies have been all the rage for the past few years, with financial institutions, banks and even entire nations adopting its use. So why exactly are they so popular, and are they important in the first place? Is there any difference between crypto and digital currencies, and if so, what are they? In this article, we will explore five things you should know about digital currencies, and whether you should invest in them.
But first, what exactly are digital currencies? Digital currency is an overarching term that can be used to describe different types of currencies that exist in the electronic realm. Broadly, there are three different types of currencies:
Cryptocurrencies
A cryptocurrency is a digital currency that is secured by cryptography, which makes it nearly impossible to counterfeit or double-spend. Sounds confusing? In essence, cryptocurrency ensures people cannot duplicate the cryptocurrency so they can spend it more than once. Think of it as how banknotes have various security features (transparent windows and three-dimensional watermark portraits) to prevent counterfeiters from duplicating them.
Cryptography also ensures your transactions are one-way, and malicious parties are not able to ‘reverse’ transactions on their whims. This is similar to how bank transactions made by one person cannot be easily reversed by the same person.
A defining feature of cryptocurrencies is that they are generally not issued by any central authority, rendering them theoretically free from government manipulation. This freedom from a central authority is also known as ‘decentralisation’. Web 3.0 is an example of decentralisation as well. Many cryptocurrencies base this on blockchain technology — a distributed ledger enforced by a network of computers.
Examples of cryptocurrencies are Bitcoin, the oldest and most established cryptocurrency, Ethereum, Tether USD and Binance Coin. Almost each of these cryptocurrencies serve a different purpose: bitcoin is traditionally seen as a store of value and appreciating asset.
Ethereum meanwhile, is commonly used in smart contracts, DeFi applications and NFT transactions (which all run on the Ethereum blockchain). Ether is also used in DAO contracts. Binance Coin, however, is more centralised — it is primarily only used within the Binance ecosystem.
Virtual Currencies
A virtual currency is a digital representation of value. It is stored and transacted through designated software, mobile, or computer applications. Transactions involving virtual currencies occur through secure, dedicated networks or over the Internet. Mostly unregulated, they are issued by private parties or developers.
There are two types of virtual currencies: open and closed environments. As the name suggests, a closed virtual currency operates in a controlled and private ecosystem. It cannot be converted into another virtual currency or into real-world money.
Most people would have interacted with a closed virtual currency — a common example would be game currency. Remember those mobile phone games that have their own currencies that can only be used to spend on in-game rewards or purchases? Those are a prime example of a closed virtual currency.
Meanwhile, an open environment virtual currency allows for the conversion to other forms of money. They operate in open ecosystems and can be converted into another currency either within the platform or outside it. Examples of open virtual currencies are stablecoins and cryptocurrencies. Bitcoin and Ethereum, the two biggest cryptocurrencies by market capitalisation, can be converted into other cryptocurrencies or certain fiat currencies.
Certain game currencies are also open-environment. For instance, in Counter Strike: Global Offensive (CSGO), a popular first-person online shooter game, certain weapon ‘skins’ (cosmetics that modify the appearances of weapons) have been sold for tens of thousands of real-life dollars!
Central Bank Digital Currencies (CBDCs)
CBDCs are a relatively new entity to emerge as compared to virtual and crypto currencies. As its name implies, CBDCs are issued by a central bank. They are pegged to the value of that country's fiat currency.
Many countries are developing CBDCs, and some have even implemented them. Traditionally, fiat money comes in the form of banknotes and coins, but technology has allowed governments and financial institutions to supplement physical fiat money with a credit-based model in which balances and transactions are recorded digitally.
Physical currency is still widely exchanged and accepted; however, some developed countries have experienced a significant decrease in its use, and this trend was especially accelerated by COVID-19, where physical transactions of currency were discouraged.
The introduction and evolution of cryptocurrency and blockchain technology have created further interest in cashless societies and digital currencies. Thus, governments and central banks worldwide are exploring the possibility of using government-backed digital currencies. When, and if, they are implemented, these currencies should have the full faith and backing of the government that issued them, just like fiat money.
The main goal of CBDCs is to provide businesses and consumers with privacy, transferability, convenience, accessibility, and financial security. CBDCs could also decrease the maintenance a complex financial system requires, reduce cross-border transaction costs, and provide those who currently use alternative money transfer methods with lower-cost options.
Advantages of Digital Currencies
Digital currencies often have fast transfer and transaction times. As digital currencies generally exist within the same network and operate without middlemen, the amount of time required for transfers involving digital currencies is extremely fast, sometimes even instantaneous. In comparison, international bank wire transfers might take a few days to process, and longer if it is done over the weekend, or involves large sums of money.
These transactions are usually low-cost as well. This fares better compared to traditional payment methods that involve banks or clearinghouses. Electronic transactions also bring in the necessary record keeping and transparency in dealings, especially for cryptocurrencies, where transactions are stored on the blockchain and cannot be easily altered.
Digital transactions do not require physical manufacturing and cannot be ‘destroyed’. Many requirements for physical currencies, such as the establishment of physical manufacturing facilities, are absent for digital currencies. For instance, to create coins and banknotes, governments require large buildings such as mints or treasuries. Such currencies are also immune to physical defects or soiling that are present in physical currency.
Digital currencies might also be the method of transactions on Web 3.0, the possible future of the Internet.
Disadvantages of Digital Currencies
Digital currencies often have infrastructure problems of their own. While they do not require physical wallets, digital currencies have their own set of requirements for storage and processing. For example, an Internet connection is necessary as are digital devices like a smartphone or a computer. Online wallets with robust security are also necessary to store cryptocurrencies. However, with the advent of the Internet and prevalence of mobile phones, this limitation is often not a problem for many people.
Certain digital currencies are also susceptible to hacking. Hackers can steal digital currencies from online wallets or change the protocol for digital currencies, making them unusable. For instance, one infamous incident was the DAO hack in 2016. $60 million of Ether was stolen, due to vulnerabilities in its code base on the blockchain. As such, it is important to understand Decentralised Autonomous Organisations (DAO) to better be aware of the vulnerabilities of cryptocurrencies.
Volatility in value is also a problem. Digital currencies used for trading can have wild price swings. For example, the decentralised nature of cryptocurrencies has resulted in prices which are prone to sudden changes based on investor whims. For instance, Bitcoin has lost more than two-thirds its value since its high of $69,000 in November 2021. Other digital currencies have similar price volatility issues as well, increasing the risk of crypto investments.
Conclusion
With digital currencies and decentralisation becoming a big part of our lives whether you like it or not, it is therefore crucial to be knowledgeable about it. A good example is Web 3.0 and DAO, where they are often heralded as the third generation of web technology. Therefore, having an advanced certificate in Web 3.0 is a good addition to one’s existing knowledge, and to be better prepared for the upcoming changes that decentralisation and digital currencies will bring to the world.
Before joining the new digital currency trend, it is crucial to equip yourself with sufficient knowledge in this field in order to make the most informed decisions. Join SMU Academy and TechFin on the 1st of February 2023 in the upcoming Understanding Decentralised Autonomous Organisation (DAO) course to explore the world of DAOs and digital currencies! Sign up here today!