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Annual Report 2021

Federal Reserve Bank of St. Louis

The Blockchain Revolution: Decoding Digital Currencies

By David Andolfatto and Fernando M. Martin

  • Introduction

Few people took notice of an obscure white paper published in 2009 titled “Bitcoin: A Peer-to-Peer Electronic Cash System,” authored by a pseudonymous Satoshi Nakamoto. The lack of fanfare at the time is hardly surprising given that innovations in the way we make payments are not known to generate tremendous amounts of excitement, let alone inspire visions of a revolution in finance and corporate governance. But just over a decade later, the enthusiasm for cryptocurrencies and decentralized finance spawned by Bitcoin and blockchain technology has grown immensely and shows no signs of abating.

Because cryptocurrencies are money and payments systems, they have naturally drawn the interest of central banks and regulators. The Federal Reserve Bank of St. Louis was the first central banking organization to sponsor a public lecture on the topic: In March 2014, presenters outlined the big picture of cryptocurrencies and the blockchain by discussing its possibilities and pitfalls. Since that time, the Bank’s economists and research associates have published numerous articles and explainers on these topics, all of which are freely available to the general public. This essay represents a continuation of our effort to help educate the public and offer our perspective of the phenomenon as central bankers and economists.

Understanding how cryptocurrencies work “under the hood” is a challenge for most people because the protocols are written in computer code and the data are managed in an esoteric mathematical structure. To be fair, it’s difficult to understand any technical language (e.g., legalese, legislation and regulation). Because we are not technical experts in this space, we spend virtually no time discussing the technology in detail. For an accessible introduction to the technology, see Fabian Schär and Aleksander Berentsen’s “ Bitcoin, Blockchain, and Cryptoassets: A Comprehensive Introduction ,” MIT Press, 2020. What we offer instead is an overview of cryptocurrencies and blockchain technologies, explaining the spirit of the endeavor and how it compares with traditional operations.

In this essay, we explore four key areas:

  • Money, digital money and payments
  • Cryptocurrencies, blockchain and the double-spend problem of digital money
  • Understanding decentralized finance
  • The makeup of a central bank digital currency
  • Money, Digital Money and Payments

It is sometimes said that money is a form of social credit. One can think of this idea in the following way: When people go to work, they are in effect providing services to the community. They are helping to make others’ lives better in some way and, by engaging in this collective effort, make their own lives better as well.

In small communities, individual consumption and production decisions can be debited and credited, respectively, in a sort of communal ledger of action histories. This is because it is relatively easy for everyone to monitor and record individual actions. A person who has produced mightily for the group builds social credit. Large social credit balances can be “spent” later as consumption (favors drawn from other members of the community).

In large communities, individual consumption and production decisions are difficult to monitor. In communities the size of cities, for example, most people are strangers. Social credit based on a communal record-keeping system does not work when people are anonymous. See Narayana Kocherlakota’s “ The Technological Role of Fiat Money ,” Federal Reserve Bank of Minneapolis, Quarterly Review , 1998. Producers are rewarded for their efforts by accumulating money balances in wallets or bank accounts. Accumulated money balances can then be spent to acquire goods and services (or assets) from other members of the community, whose wallets and bank accounts are duly credited in recognition of their contributions. In this manner, money—like social credit—serves to facilitate the exchange of goods and services.

The monetary object representing this social credit may exist in physical or nonphysical form. In the United States, physical cash takes the form of small-denomination Federal Reserve bills and U.S. Treasury coins. Cash payments are made on a peer-to-peer (P2P) basis, for example, between customer and merchant. No intermediary is required for clearing and settling cash payments. As the customer debits his or her wallet, cash is credited to the merchant’s cash register, and the exchange is settled. Hardly any time is spent inspecting goods and money in small-value transactions. Some trust is required, of course, in the authority issuing the cash used in transactions. While that authority is typically the U.S. government, there is no law preventing households and businesses from accepting, say, foreign currency, gold or any other object as payment.

When people hear the word “money,” they often think of cash. But, in fact, most of the U.S. money supply consists of digital dollars held in bank accounts. The digital money supply is created as a byproduct of commercial bank lending operations and central bank open market operations. Digital money is converted into physical form when depositors choose to withdraw cash from their bank accounts. Most people hold both forms of money. The reasons for preferring one medium of exchange over the other are varied and familiar.

Digital dollar deposits in the banking system are widely accessible by households and businesses. This digital money flows in and out of bank accounts in the form of credits and debits whenever a party initiates a purchase. Unlike with cash, making payments with digital money has traditionally required the services of a trusted intermediary. A digital money payment is initiated when a customer sends an encrypted message instructing his or her bank to debit the customer’s account and credit the merchant’s account with an agreed-upon sum. This debit-credit operation is straightforward to execute when both customer and merchant share the same bank. The operation is a little more complicated when the customer and merchant do not share the same bank. In either case, clearing and settling payments boils down to an exercise in secure messaging and honest bookkeeping.

  • Cryptocurrencies, Blockchain and the Double-Spend Problem of Digital Money

One can think of cryptocurrencies as digital information transfer mechanisms. If the information being transferred is used as an everyday payment instrument, it fulfills the role of money. In this case, a cryptocurrency can be thought of as a money and payments system.

Every money and payments system relies on trust. The difference between cryptocurrencies and conventional money and payments systems lies in where this trust is located. In contrast to conventional systems, no delegated legal authority is responsible for managing and processing cryptocurrency information. Instead, the task is decentralized and left open to “volunteers” drawn from the community of users, similar in spirit to how the internet-based encyclopedia Wikipedia is managed. These volunteers—called miners—work to update and maintain a digital ledger called the blockchain. The protocols that govern the read-write privileges associated with the blockchain are enshrined in computer code. Users trust that these rules are not subject to arbitrary changes and that rule changes (if any) will not benefit some individuals at the expense of the broader community. Overall, users must trust the mathematical structure embedded in the database and the computer code that governs its maintenance.

Managing a digital ledger without a delegated accounts manager is not a trivial problem to solve. If just anyone could add entries to a public ledger, the result likely would be chaos. Malevolent actors would be able to debit an account and credit their own at will. Or they could create social credit out of thin air, without having earned it. In the context of money and payments systems, these issues are related to the so-called double-spend problem.

To illustrate the double-spend problem, consider the example of a dollar stored in a personal computer as a digital file. It is easy for a customer to transfer this digital file to a merchant on a P2P basis, say, by email. The merchant is now in possession of a digital dollar. But how can we be sure that the customer did not make a copy of the digital file before spending it? It is, in fact, a simple matter to make multiple copies of a digital file. The same digital file can then be spent twice (hence, a double-spend). The ability to make personal copies of digital money files would effectively grant each person in society his or her own money printing press. A monetary system with this property is not likely to function well.

Physical currency is not immune from the double-spend problem, but paper bills and coins can be designed in a manner to make counterfeiting sufficiently expensive. Because cash is difficult to counterfeit, it can be used more or less worry-free to facilitate P2P payments. The same is not true of digital currency, however. The conventional solution to the double-spend problem for digital money is to delegate a trusted third party (e.g., a bank) to help intermediate the transfer of value across accounts in a ledger. Bitcoin was the first money and payments system to solve the double-spend problem for digital money without the aid of a trusted intermediary. How?

The Digital Village: Communal Record-Keeping

The cryptocurrency model of communal record-keeping resembles the manner in which history has been recorded in small communities, including in networks of family and friends. It is said that there are no secrets in a small village. Each member of the community has a history of behavior, and this history is more or less known by all members of the community—either by direct observation or through communications. The history of a small community can be thought of as a virtual database living in a shared (or distributed) ledger of interconnected brains. No one person is delegated the responsibility of maintaining this database—it is a shared responsibility.

Among other things, such a database contains the contributions that individuals have made to the community. As we described above, the record of these contributions serves as a reputational history on which individuals can draw; the credit they receive from the community can be considered a form of money. There is a clear incentive to fabricate individual histories for personal gain—the ability to do so would come at the expense of the broader community in the same way counterfeiting money would. But open, shared ledgers are very difficult to alter without communal consensus. This is the basic idea behind decentralized finance, or DeFi.

Governance via Computer Code

All social interaction is subject to rules that govern behavior. Behavior in small communities is governed largely by unwritten rules or social norms. In larger communities, rules often take the form of explicit laws and regulations. At the center of the U.S. money and payments system is the Federal Reserve, which was created in 1913 through an act of Congress. The Federal Reserve Act of 1913 specifies the central bank’s mandates and policy tools. There is also a large body of legislation that governs the behavior of U.S. depository institutions. While these laws and regulations create considerable institutional inertia in money and payments, the system is not impervious to change. When there is sufficient political support—feedback from the American people—changes to the Federal Reserve Act can be made. The Humphrey-Hawkins Act of 1978 , for example, provided the Fed with three mandates: stable prices, maximum employment and moderate long-term interest rates. And the Dodd-Frank Act of 2010 imposed stricter regulations on financial firms following the financial crisis in 2007-09.

Because cryptocurrencies are money and payments systems, they too must be subject to a set of rules. In 2009, Satoshi Nakamoto brought forth his aforementioned white paper, which laid out the blueprint for Bitcoin. This blueprint was then operationalized by a set of core developers in the form of an open-source computer program governing monetary policy and payment processing protocols. Adding, removing or modifying these “laws” governing the Bitcoin money and payments system is virtually impossible. Relatively minor patches to the code to fix bugs or otherwise improve performance have been implemented. But certain key parameters, like the one that governs the cap on the supply of bitcoin, are likely impervious to change.

Concerted attempts to change the protocol either fail or result in breakaway communities called “forks” that share a common history with Bitcoin but otherwise go their separate ways. Proponents of Bitcoin laud its regulatory system for its clarity and imperviousness, especially relative to conventional governance systems in which rules are sometimes vague and subject to manipulation.

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Bitcoin: Beyond the Basics

Learn about the structure and fundamentals of Bitcoin in this Timely Topics podcast with St. Louis Fed economist David Andolfatto. During the 16-minute episode , Andolfatto examines how distributed ledgers work and explains the mining process. This podcast was released Aug. 27, 2018.

How Blockchain Technology Works

As with any database management system, the centerpiece of operations is the data itself. For cryptocurrencies, this database is called the blockchain. One can loosely think of the blockchain as a ledger of money accounts, in which each account is associated with a unique address. These money accounts are like post office boxes with windows that permit anyone visiting the post office to view the money balances contained in every account. Beyond viewing the balances, one can also view the transaction histories of every monetary unit in the account (i.e., its movement from account to account over time since it was created). These windows are perfectly secured. It is important to note that many cryptocurrency users hold their funds via third parties to whom they relinquish control of their private keys. If an intermediary is hacked and burgled, one’s cryptocurrency holdings may be stolen. This has nothing to do with security flaws in the cryptocurrency itself—but with the security flaws of the intermediary. While anyone can look in, no one can access the money without the correct password. This password is created automatically when the account is opened and known only by the person who created the account (unless it is voluntarily or accidentally disclosed to others). The person’s account name is pseudonymous (unless voluntarily disclosed). These latter two properties imply that cryptocurrencies (and cryptoassets more generally) are digital bearer instruments. That is, ownership control is defined by possession (in this case, of the private password). It is worth noting that large-denomination bearer instruments are now virtually extinct. Today, bearer instruments exist primarily in the form of small-denomination bills and metal coins issued by governments. For this reason, cryptocurrencies are sometimes referred to as “digital cash.”

As with physical cash, no permission is needed to acquire and spend cryptoassets. Nor is it required to disclose any personal information when opening an account. Anyone with access to the internet can download a cryptocurrency wallet—software that is used to communicate with the system’s miners (the aforementioned volunteer accountants). The wallet software simultaneously generates a public address (the “location” of an account) and a private key (password). Once this is done, the front-end experience for consumers to initiate payment requests and manage money balances is very similar to online banking as it exists today. Of course, if a private key is lost or stolen, there is no customer service department to call and no way to recover one’s money.

Cryptocurrencies have become provocative and somewhat glamorous, but their unique and key innovation is how the database works. The management of money accounts is determined by a set of regulations (computer code) that determines who is permitted to write to the database. The protocols also specify how those who expend effort to write to the database—essentially, account managers—are to be rewarded for their efforts. Two of the most common protocols associated with this process are called proof-of-work (PoW) and proof-of-state (PoS). The technical explanation is beyond the scope of this essay. Suffice it to say that some form of gatekeeping is necessary—even if the effort is communal—to prevent garbage from being written to the database. The relevant economic question is whether these protocols, whatever they are, can process payments and manage money accounts more securely, efficiently and cheaply than conventional centralized finance systems.

Native Token

Recording money balances requires a monetary unit. This unit is sometimes referred to as the native token. From an economic perspective, a cryptocurrency’s native token looks like a foreign currency, albeit one whose monetary policy is governed by a computer algorithm rather than the policymakers of that country. Much of the excitement associated with cryptocurrencies seems to stem from the prospect of making money through capital gains via currency appreciation relative to the U.S. dollar (USD). (To see how the prices of bitcoin and ethereum, another cryptocurrency, have changed over the past decade, see the FRED charts below.) It seems to have less to do with the promise of the underlying record-keeping technology stressed by Nakamoto’s white paper. To be sure, the price of a financial security can be related to its underlying fundamentals. It is not, however, entirely clear what these fundamentals are for cryptocurrency or how they might generate continued capital gains for investors beyond the initial rapid adoption phase. Moreover, while the supply of a given cryptocurrency such as Bitcoin may be capped, the supply of close substitutes (from the perspective of investors, not users) is potentially infinite. Thus, while the total market capitalization of cryptocurrencies may continue to grow, this growth may come more from newly created cryptocurrencies and not from growth in the per-unit price of any given cryptocurrency, such as Bitcoin. See David Andolfatto and Andrew Spewak’s “ Whither the Price of Bitcoin? ” Federal Reserve Bank of St. Louis, Economic Synopses , 2019.

digital currency essay

SOURCE: Coinbase, retrieved from FRED (Federal Reserve Economic Data).

NOTE: Gray shaded areas indicate U.S. recessions. For more data from Coinbase, see these series .

In any case, conceptually, there is a distinction to be made between the promise of a cryptocurrency’s underlying technology and the market price of its native token. Bitcoin (BTC) as a payments system could, in principle, function just as well at any given BTC/USD exchange rate.

Cryptocurrency Applications

Cryptocurrencies designed to serve as money and payments systems have continued to struggle in their quest for adoption as an everyday medium of exchange. Their main benefit to this point—at least for early adopters—has been as a long-term store of value. But their exchange rate volatility makes them highly unsuitable as domestic payment instruments, given that prices and debt contracts are denominated in units of domestic currency. While year-over-year returns can be extraordinary, it is not uncommon for a cryptocurrency to lose most of its value over a relatively short period of time. How a cryptocurrency might perform as a domestic payments system when it is also the unit of account remains to be seen. El Salvador recently adopted bitcoin as its legal tender, and people will be watching this experiment closely. Legal tender is an object that creditors cannot legally refuse as payment for debt. While deposits are claims to legal tender (they can be converted into cash on demand), they also constitute claims against all bank assets in the event of bankruptcy.

A use case touted early in Bitcoin history was its potential to serve as a vehicle currency for international remittances. One of the attractive attributes of Bitcoin is that anyone with access to the internet can access the Bitcoin payments system freely and without permission. For example, a Salvadoran working in the United States can convert his or her USD into BTC at an online exchange and send BTC to a relative in El Salvador in minutes for (usually) a relatively low fee, compared with sending money through conventional channels.

As with any tool, bitcoin may be used for good or ill purposes. Because BTC is a permissionless bearer instrument (like physical cash), it may become a popular way to finance illegal activities, terrorist organizations and money laundering operations. Recently, it has been used in ransomware attacks, in which nefarious agents blackmail hapless victims and demand payment in bitcoin, thereby bypassing the banking system.

But possibly the most attractive characteristic of Bitcoin is that it operates independently of any government or concentration of power. Bitcoin is a decentralized autonomous organization (DAO). Its laws and regulations exist as open-source computer code living on potentially millions of computers. The blockchain is beyond the (direct) reach of government interference or regulation. There is no physical location for Bitcoin. It is not a registered business. There is no CEO. Bitcoin has no (conventional) employees. The protocol produces a digital asset, the supply of which is, by design, capped at 21 million BTC. Participation is voluntary and permissionless. Large-value payments can be made across accounts quickly and cheaply. It is not too difficult to imagine how these properties can be attractive to many people.

Policy Considerations of Cryptocurrency

To a central bank, a cryptocurrency looks very much like a foreign currency. From this perspective, there is nothing revolutionary here. Foreign currency is sometimes seen as a threat by governments. This is not the case for the United States, since the U.S. dollar remains the world’s reserve currency, but many other countries often take measures to discourage the domestic use of foreign currency. Citizens may be prohibited, for example, from holding foreign currency or opening accounts in foreign banks. Because cryptocurrencies are freely available and permissionless, it would likely be considerably more difficult to enforce cryptocurrency controls. The cryptocurrency option may also serve to constrain domestic monetary and fiscal policies—in particular, by imposing a more stringent limit on the amount of seigniorage (i.e., the “printing” of more money to finance government spending).

A dominant foreign currency may cause another problem: As it turns out, it is often cheaper to issue debt denominated in a dominant foreign currency. The problem with this activity is that when the domestic currency depreciates, debtors may have trouble repaying, and a financial crisis may ensue. When that dominant foreign currency is the U.S. dollar, the central bank of a foreign country can sometimes find relief by borrowing dollars from the Federal Reserve through a currency-swap line. But if debt instruments are denominated in cryptocurrency, there is no negotiating with the DAO of that cryptocurrency. Because this is the case, domestic regulators might want to regulate the practice of issuing cryptocurrency-denominated debt more stringently, if the practice ever became sufficiently widespread to pose significant systemic risk.

  • Understanding Decentralized Finance

Decentralized finance broadly refers to financial activities that are based on a blockchain. Unlike conventional or traditional finance that relies on intermediaries and centralized institutions, DeFi relies on so-called smart contracts. The removal of those intermediaries in transactions between untrusted parties would significantly reduce costs and grant the parties more control over the terms of such agreements. Still, intermediaries oftentimes play meaningful roles beyond verification and enforcement, which means they would not altogether disappear. Here, we examine some of these concepts to explain what DeFi means and implies. For a more extensive review, see Fabian Schär’s “ Decentralized Finance: On Blockchain- and Smart Contract-Based Financial Markets ,” Federal Reserve Bank of St. Louis, Review , 2021; also see an analysis by Sara Feenan et al. in “ Decentralized Financial Market Infrastructures: Evolution from Intermediated Structures to Decentralized Structures for Financial Agreements ,” The Journal of FinTech , 2021.

What Are the Benefits and Challenges of Decentralized Finance?

DeFi allows parties to engage in financial transactions without the need for intermediaries. In this short video, St. Louis Fed economist Fernando Martin looks at how DeFi works with smart contracts and digital tokens.

digital currency essay

What Are Smart Contracts?

A smart contract is a computer program designed to execute an agreed-upon set of actions. The concept was first introduced in the mid-1990s by Nick Szabo, who proposed vending machines as a primitive example: A vending machine is a mechanism that dispenses a product in exchange for a listed amount of coins (or bills); anyone with a sufficient amount of money can participate in this exchange. See Nick Szabo’s “ Smart Contracts ” (1994) and “ The Idea of Smart Contracts ” (1997). The key idea is that contractual terms, once agreed upon, are not renegotiable and are therefore automatically executed in the future. In economic theory, so-called Arrow-Debreu securities have the same property. Smart contracts allow interested parties to engage in secure financial transactions without the participation of third parties. As we explain below, their application goes beyond conventional financial transactions.

Ethereum is a blockchain with smart contract capability that was released in 2015. In this case, smart contracts are a type of account, with their own balance and the capability to interact with the network. Rather than being controlled by a user, smart contracts run as programmed, with their code and data residing at a specific address on the Ethereum blockchain. Other platforms may implement smart contracts in different ways. For example, Hyperledger allows for confidential transactions, whereas Ethereum, a public network, does not. Bitcoin is also able to handle a variety of smart contracts.

Like cryptocurrencies, smart contracts overcome security and transparency concerns in transactions between untrusted parties, without the need for a trusted third party. In fact, smart contracts aim to do away with intermediaries such as brokers, custodians and clearinghouses.

Consider a collateralized loan as an example. In traditional finance, a borrower seeks a bank to lend funds or a broker to find potential lenders. The parties then agree on the terms of the loan: interest rate, maturity, type and value of collateral, etc. The borrower’s collateral is placed in escrow. If the borrower fulfills the terms of the contract, the collateral is released and full ownership rights are returned. If the borrower defaults, the collateral is used to fulfill the contract (e.g., repay the remaining principal, interest and penalties). There are many parties involved in this transaction: financial intermediaries, appraisers, loan servicers, asset custodians, and others.

In a smart contract, the entire agreement is specified as part of the computer program and is stored on a blockchain. The program contains the terms of the loan, as well as the specific actions it will take based on compliance (e.g., the transfer of collateral ownership in the event of default). Since the blockchain handles the faithful execution of the contract, there is no need to involve any parties beyond the borrower and lender.

Asset Tokenization

The example above illustrates an important wrinkle: It may not be possible for all the elements and actions of a contract to be handled by the blockchain—particularly when it comes to collateral. If collateral is not available as an asset in the native protocol (i.e., the specific blockchain where the smart contracts exist), then, as in traditional finance, the contract necessitates a third party to provide escrow services. Naturally, this exposes the contract to counterparty risk. One solution to this problem is asset tokenization.

Asset tokenization consists of converting the ownership of an asset into digital tokens, each representing a portion of the property. If the asset exists in physical form (e.g., a house), then tokenization allows the asset to exist in a blockchain and be used for various purposes (e.g., as collateral). An important issue is how to enforce property rights stored in the blockchain for assets that exist in the physical world. This is an ongoing challenge for DeFi and one that may never be fully resolved.

Tokens also have a variety of nonfinancial applications. For example, they may grant owners voting rights to an organization. This allows for the decentralized control of institutions within a blockchain, as we describe below. Another popular application is the creation of nonfungible tokens (NFTs), which provide ownership of a digital image created and “signed” by an artist. Although the image could in principle be replicated countless times, there is only one version that is verifiably authentic. The NFT serves as a certificate of authenticity in the same way that artists’ signatures ensure paintings are originals and not copies. The advantage of an NFT is the security provided by the blockchain—signatures can be forged, whereas the authenticity of the NFT is validated by a decentralized communal consensus algorithm.

Decentralized Autonomous Organization

Smart contracts could transform the way we organize and control institutions. Applications may range from investment funds to corporations and perhaps even the provision of public goods and services.

A decentralized autonomous organization, or DAO, is an organization represented by a computer code, with rules and transactions maintained on a blockchain. Therefore, DAOs are governed by smart contracts. A popular example is MakerDAO, the issuer of the stablecoin Dai, whose stakeholders use tokens to help govern decisions over protocol changes.

The concept of governance refers to the rules that balance the interests of different stakeholders of an institution. For example, a corporation’s stakeholders may include shareholders, managers, creditors, customers, employees, the government and the general public, among others. The board of directors typically plays the critical role in corporate governance. One of the main issues corporate governance is designed to mitigate is agency problems: when managers do not act in the best interest of shareholders. But governance extends beyond regulating internal matters and may, for example, manage the role of a corporation inside a community or relative to the environment.

DAOs may be created for ongoing projects, such as a DeFi entity, or for specific and limited purposes, such as public works. Because they offer an alternative governance model by encoding rules in a smart contract, they replace the traditional top-down structure with a decentralized consensus-based model. Two prominent examples—the decentralized exchange Uniswap and the borrowing and lending platform Aave—started out in the traditional way, by having their respective development teams in charge of day-to-day operations and development decisions. They eventually issued their own tokens, which distributed governance to the wider community. With varying details, holders of governance tokens may submit development proposals and vote on them.

Centralized and Decentralized Exchanges

Currently, the most popular way in which cryptoassets are traded is through a centralized exchange (CEX), which works like a traditional bank or a broker: A client opens an account by providing personal identifiable information and depositing funds. With an account, the client can trade cryptoassets at listed prices in the exchange. The client does not own these assets, however, as the exchange acts as a custodian. Hence, clients’ trades are recorded on the exchange’s database rather than on a blockchain. Binance and Coinbase are CEXs that offer accessibility to users. However, since they stand between users and blockchains, they need to overcome the same trust and security issues as traditional intermediaries.

Decentralized exchanges (DEXs), on the other hand, rely on smart contracts to enable trading among individuals on a P2P basis, without intermediaries. Traders using DEXs keep custody of their funds and interact directly with smart contracts on a blockchain.

One way to implement a DEX is to apply the methods from traditional finance and rely on order books. These order books consist of lists of buy and sell orders for a specific security that display the amounts being offered or bid on at each price point. CEXs also work in this way. The difference with DEXs is that the list and transactions are handled by smart contracts. Order books can be “on-chain” or “off-chain,” depending on whether the entire operation is handled on the blockchain. In the case of off-chain order books, typically only the final transaction is settled on the blockchain.

Order-book DEXs may suffer from slow execution and a lack of liquidity. That is, buyers and sellers may not find adequate counterparties, and individual transactions may affect prices too much. DEX aggregators alleviate this problem by collecting the liquidity of various DEXs, which increases the depth of both sides of the market and minimizes slippage (i.e., the difference between the intended and executed price of an order).

An automated market maker (AMM) is another way to solve the liquidity problem in DEXs. Market makers are also derived from traditional finance, where they play a central role in ensuring adequate liquidity in securities markets. AMMs create liquidity pools by rewarding users who “deposit” assets in the smart contract, which then can be used for trades. When a trader proposes an exchange of two assets, the AMM provides an instant quote based on the relative availability (i.e., liquidity) of each asset. When the liquidity pools are sufficiently large, trades are easy to fulfill and slippage is minimized. Automated market makers are currently the dominant form of DEXs, because they resolve the liquidity problem better than alternative mechanisms and thus provide speedier and cheaper transactions.

What Are Stablecoins?

As we described earlier, cryptocurrencies are subject to extreme exchange rate volatility, which makes them highly unsuitable as payment instruments. A stablecoin is a cryptocurrency that ties its value to an asset outside of its control, such as the U.S. dollar. Some stablecoins stabilize their value by pegging to the U.S. dollar, backed with non-U.S. dollar assets; Dai, for example, pegs its value to a senior tranche of other cryptoassets. See Dankrad Feist’s “ On Supply and Demand for Stablecoins ,” 2021. To accomplish this, the stablecoin must effectively convince its liability holders that its liabilities can be redeemed on demand (or on short notice) for U.S. dollars at par (or at some other fixed exchange rate). The purpose of this structure is to render stablecoin liabilities more attractive as payment instruments. Pegging to the U.S. dollar is attractive to people living in the U.S. because the U.S. dollar is the unit of account. Those outside the U.S. may be attracted to the product because the U.S. dollar is the world’s reserve currency. This structure serves to increase demand for the stablecoin. But why would someone want to make U.S. dollar payments using a stablecoin instead of a regular bank account?

The answer ultimately rests on which product offers its clients the services they desire at a price they find attractive. A stablecoin is likely to be attractive at the wholesale level, where firms would be able to make USD payments at each point in an international supply chain without the need for conventional banking arrangements. Stablecoins market themselves as leveraging blockchain technology to deliver safer and more efficient account management and payment processing services. These efficiency gains can then be passed along to customers in the form of lower fees. A more cynical view ascribes these purported lower costs to regulatory arbitrage (i.e., sidestepping certain costs by relocating the transaction outside of the regulatory environment), rather than technological improvements in database management.

A Primer on Stablecoins

Stablecoins are cryptocurrencies that tie their value to an outside asset. In this short video, St. Louis Fed economist Fernando Martin takes a deep dive into stablecoins and how they have characteristics that are similar to money market mutual funds.

digital currency essay

Financial Stability Concerns

U.S. dollar-based stablecoins are similar to money market funds that peg the price of their liabilities to the U.S. dollar. They also look very much like banks without deposit insurance . As the financial crisis of 2007-09 showed, even money market funds are subject to runs when the quality of their assets is questioned. Unless a U.S. dollar-based stablecoin is backed fully by U.S. dollar reserves (it needs an account at the Federal Reserve for this) or by U.S. dollar bills (the maximum denomination is $100, so this seems unlikely), it is potentially prone to a bank run. If a stablecoin cannot dispose of its assets at fair or normal prices, it may fail to raise the U.S. dollars it needs to meet its par redemption promise in the face of a wave of redemptions. In such an event, the stablecoin would turn out to be not so stable.

If the adverse consequences of a stablecoin run were limited to the owners of stablecoins, then standard consumer protection legislation would be sufficient. But regulators also are concerned about the possibility of systemic risk. Consider, for example, the commercial paper market, where firms regularly borrow money on a short-term basis to fund operating expenses. Then consider a stablecoin (or any money market fund) with large holdings of commercial paper. A stablecoin run in this case may compel a fire sale of commercial paper to raise the funds needed to meet the wave of redemptions. This fire sale would likely have adverse economic consequences for firms that make regular use of the commercial paper market: As commercial paper prices decline, the value of commercial paper as collateral falls, and firms may find it more difficult to borrow the funds they normally access with ease. If the fire sale spills over into other securities markets, credit conditions may tighten significantly and lead to the usual woes experienced in an economic recession (missed payments, worker layoffs, etc.). These events are sufficiently difficult for a central bank to handle when the entities involved are domestic money market funds. The problem is compounded if the stablecoin is an unregulated “offshore” DAO. Will offshore stablecoins that are “too big to fail” be able to take advantage of the implicit insurance provided by central bank lender-of-last-resort operations? If so, this would be an example of how the private benefits of DeFi arise from regulatory arbitrage and not from an inherent technological advantage. This possibility presents a significant challenge for national and international regulators.

On the other hand, it may be possible for stablecoins to be rendered “run-proof” by employing smart contracts to design more resilient financial structures. For example, real-time communal monitoring of balance sheet positions is a possibility—a feature that could shine light on what are traditionally opaque financial structures. The opacity of financial structures is not necessary to explain bank runs. For example, the canonical model of bank runs assumes the existence of transparent balance sheets. See Douglas Diamond and Philip Dybvig’s “ Bank Runs, Deposit Insurance, and Liquidity ,” The Journal of Political Economy , 1983. Furthermore, because redemption policies can potentially manifest themselves as computer code, their design can be made more elaborate (state-contingent) and credible (contractual terms that can be credibly executed and not reversed). These features can potentially render stablecoins run-proof in a manner that is not possible with conventional banking arrangements. 

Regulators and Stablecoins

The regulatory concerns with stablecoins are similar to age-old concerns with the banking industry. Banks are in the business of creating money and do so by issuing deposit liabilities that promise a fixed (par) exchange rate against U.S. dollar bills and dollar credits held in Federal Reserve accounts. Lower-yielding liabilities are used to acquire higher-yielding assets. Because commercial banks normally hold only a very small fraction of their assets in the form of reserves, they are called fractional reserve banks. Since the introduction of federal deposit insurance, retail-level bank runs have been practically nonexistent. Banks also have access to the Federal Reserve’s emergency lending facilities. These privileges are matched by a set of regulatory constraints on bank balance sheets (both assets and liabilities) and other business practices.

Some stablecoin issuers would undoubtedly like to base their business models on those of banks or prime institutional money market funds. The motivation is clear: Issuing low-cost liabilities to finance high-yielding assets can be a profitable business. (Until, of course, something goes wrong. Then, regulators and policymakers face blame for permitting such structures to exist in the first place.) This business model naturally involves non-negligible risk and could make for a potentially unstable stablecoin. As stablecoins with these properties interact with off-chain financial activity, they introduce risks that may spill over to other markets and, therefore, prompt some form of regulation.

Other stablecoin issuers are likely to focus on delivering payment services, which can be accomplished by holding only safe assets. These stablecoins would be more akin to government money market funds. Stablecoins that submit to government regulations may be permitted to hold only the safest of securities (e.g., U.S. Treasury securities). If they could, they might even hold only interest-bearing reserves, thereby becoming “narrow banks.” The business model in these cases would be based on generating profits through transaction-processing fees and/or net interest margins enhanced by what stablecoin users would hope to be a wafer-thin capital requirement.

  • The Makeup of a Central Bank Digital Currency

The Board of Governors of the Federal Reserve System, in its recent paper “ Money and Payments: The U.S. Dollar in the Age of Digital Transformation ,” defines a central bank digital currency (CBDC) as a “digital liability of the Federal Reserve that is widely available to the general public.” This essentially means allowing the general public to open personal bank accounts at the central bank. How might a CBDC work?

Today, only financial institutions defined as depository institutions by the Federal Reserve Act and a select number of other agencies (including the federal government) are permitted to have accounts at the Federal Reserve. These accounts are called reserve accounts. The money balances that depository institutions hold in their reserve accounts are called bank reserves. The money account held by the federal government at the Federal Reserve is called the Treasury General Account. In a sense, a CBDC already exists, but only at the wholesale level and only for a small group of agencies. The question is whether to make it more broadly accessible and, if so, how.

What Is a Central Bank Digital Currency?

Economist David Andolfatto notes that there is more than one model for a central bank digital currency. In this short video, he explains how those models vary and highlights one big difference between a CBDC and traditional bank deposits: how they are insured.

digital currency essay

As explained above, the general public already has access to a digital currency in the form of digital deposit liabilities issued by depository institutions. Most households and businesses have checking accounts with private banks. The general public also has access to a central bank liability in the form of physical currency (cash). While banks are obligated to redeem their deposit liabilities for cash on demand, deposits are not legally central bank or government liabilities. To put it another way, CBDC is (or would presumably be made) legal tender, while bank deposits represent claims to legal tender.

Federal Deposit Insurance

Bank accounts in the United States are presently insured up to $250,000 by the Federal Deposit Insurance Corp. From a political-economic point of view, bank deposits at the retail level are a de facto government liability. Moreover, given the role of the Federal Reserve as lender of last resort, one could make a case that large-value bank deposits are also a de facto government liability. To the extent this is so, the legal status of CBDC versus bank money may not be important as far as the ultimate safety of money accounts is concerned.

The Question of Counterparty Risk

Safety is only one of the many concerns surrounding money and payments. There is also the question of how counterparty risk may affect access to funds. For example, even if money in a bank account is insured, access to those funds may be delayed if a bank is suddenly subject to financial stress. This type of risk may be one reason corporate cash managers often turn to the repo market, where deposits are typically collateralized with Treasury securities that can be readily liquidated in the event deposited cash is not returned on time. If there is no restriction on the size of CBDC accounts, the product would effectively provide fully insured money accounts for corporations with no counterparty risk. Such a product, if operated effectively, could very well disintermediate (i.e., eliminate) parts of the money market.

Potential for Efficiency Gains

There is also the question of how a CBDC might improve the overall efficiency of the payments system. This is a difficult question to answer. Proponents often compare a well-designed CBDC with the payments system as it exists today in the United States, which has not caught up to developments in other jurisdictions, including in many developing economies. The U.S. payments system, however, is evolving rapidly to a point that may make CBDC a less attractive proposition. For example, The Clearing House now offers a 24/7 real-time payment services platform . The Federal Reserve’s FedNow platform will provide a similar service.

There may be no single best way to organize a payments system. A payments system is all about processing payment requests and debiting/crediting money accounts. Conceptually, bookkeeping is very simple, even if the actual implementation and operation of a payments system are immensely challenging endeavors. Any arrangement would need mechanisms that guard against fraud. Messaging must be made fast and secure. Institutions (or DAOs) must be trusted to manage the ledgers containing money accounts and related information. Property rights over data ownership would need to be specified and enforced. Some have advocated strongly for a CBDC (e.g., John Crawford et al. in “ FedAccounts: Digital Dollars ,” 2021). Others seem less enthusiastic (e.g., Larry White in “ Should the U.S. Government Create a Token-Based Digital Dollar? ” 2020; George Selgin in “ Central Bank Digital Currency as a Potential Source of Financial Instability ,” 2021; and Christopher Waller in “ CBDC: A Solution in Search of a Problem? ” 2021). In principle, a private, public or private-public arrangement could be made to work well.

What Are the Potential Benefits of a CBDC?

Payments systems have evolved over the years, and a central bank digital currency could be the next step in that evolution. In this short video, economist David Andolfatto examines how a CBDC may increase the efficiency of payments systems. He does so also within the context of The Clearing House’s 24/7 real-time payment services platform.

digital currency essay

Like most central banks, the Federal Reserve is designed to facilitate payments at the wholesale level. It performs a vital function and overall performs it well. Traditionally, servicing the needs of a large and demanding retail sector in the United States is left to the private sector. A CBDC could be designed to respect this division of labor in one of two ways:

  • Permit free entry into the business of “narrow banking.” This would entail granting Fed master accounts to qualified firms with the requirement that they hold only reserves (and possibly U.S. Treasury bills) as assets. In this arrangement, digital currency remains a private liability (though fully backed by reserves).
  • Grant households and firms direct access to CBDC and delegate the responsibility of processing payments at the retail level to private firms. This latter arrangement is the one described in the Federal Reserve Board’s aforementioned report on CBDC. (See box below.)

Central Bank Digital Currency: Read and Comment on the Fed’s Paper

The Federal Reserve Board’s discussion paper (PDF) , released in January 2022, examines the pros and cons of a potential U.S. CBDC. While the Fed has made no decisions on whether to pursue or implement a CBDC, it has been exploring the potential benefits and risks from a variety of angles. As part of this process, the Board is seeking public feedback on whether and how a CBDC could improve an already safe and efficient U.S. domestic payments system. The comment period is open until May 20, 2022.

The ability to write history is a tremendous power. Who should be entrusted with such power? And how should privileges be restricted to ensure honesty, accuracy and (where needed) privacy?

All sorts of individual and group histories play an important role in coordinating economic activity, including credit histories, work histories, performance histories, educational attainment histories and regulatory compliance histories. In this report, we have focused primarily on payment histories in the context of cryptocurrency—including the fact that histories can be fabricated, and that individuals and organizations may be tempted to misrepresent their own histories for private gain at the expense of the broader community. Even relatively well-functioning societies must devote considerable resources to reconciling conflicting claims of past behavior, given the absence of reliable databases that contain those histories. The U.S. Chamber of Commerce Institute for Legal Reform found the cost of litigation in the United States amounted to $429 billion, or 2.3% of U.S. gross domestic product, in 2016. Over 40% of this cost was used to pay legal, insurance and administrative costs. These costs constitute a lower bound, as most disputes are reconciled outside the legal system.

Much of our everyday economic activity occurs outside any formal record-keeping, and societies have relied on informal communal record-keeping to incentivize individual and organizational behavior. Paper and electronic receipts issued for most commercial exchanges are more formal but are often incomplete and easily fabricated. More important records—for physical property, bank accounts, financial assets, licenses, certificates of education, etc.—are managed by trusted authorities.

These traditional forms of record-keeping are likely to be challenged by blockchain technology, which provides a very different model of information management and communication. Competitive pressures compel organizations and institutional arrangements to evolve in response to technological advances in data storage and communications. Consider, for example, how the telegraph, telephone, computer and internet have transformed the way people interact and organize themselves. Advances in blockchain technology are likely to generate even more dramatic changes, though what these may be remains highly uncertain.

  • For an accessible introduction to the technology, see Fabian Schär and Aleksander Berentsen’s “ Bitcoin, Blockchain, and Cryptoassets: A Comprehensive Introduction ,” MIT Press, 2020.
  • See Narayana Kocherlakota’s “ The Technological Role of Fiat Money ,” Federal Reserve Bank of Minneapolis, Quarterly Review , 1998.
  • Relatively minor patches to the code to fix bugs or otherwise improve performance have been implemented. But certain key parameters, like the one that governs the cap on the supply of bitcoin, are likely impervious to change.
  • Beyond viewing the balances, one can also view the transaction histories of every monetary unit in the account (i.e., its movement from account to account over time since it was created).
  • It is important to note that many cryptocurrency users hold their funds via third parties to whom they relinquish control of their private keys. If an intermediary is hacked and burgled, one’s cryptocurrency holdings may be stolen. This has nothing to do with security flaws in the cryptocurrency itself—but with the security flaws of the intermediary.
  • See David Andolfatto and Andrew Spewak’s “ Whither the Price of Bitcoin? ” Federal Reserve Bank of St. Louis, Economic Synopses , 2019.
  • Legal tender is an object that creditors cannot legally refuse as payment for debt. While deposits are claims to legal tender (they can be converted into cash on demand), they also constitute claims against all bank assets in the event of bankruptcy.
  • For a more extensive review, see Fabian Schär’s “ Decentralized Finance: On Blockchain- and Smart Contract-Based Financial Markets ,” Federal Reserve Bank of St. Louis, Review , 2021; also see an analysis by Sara Feenan et al. in “ Decentralized Financial Market Infrastructures: Evolution from Intermediated Structures to Decentralized Structures for Financial Agreements ,” The Journal of FinTech , 2021.
  • See Nick Szabo’s “ Smart Contracts ” (1994) and “ The Idea of Smart Contracts ” (1997). The key idea is that contractual terms, once agreed upon, are not renegotiable and are therefore automatically executed in the future. In economic theory, so-called Arrow-Debreu securities have the same property.
  • For example, Hyperledger allows for confidential transactions, whereas Ethereum, a public network, does not. Bitcoin is also able to handle a variety of smart contracts.
  • Some stablecoins stabilize their value by pegging to the U.S. dollar, backed with non-U.S. dollar assets; Dai, for example, pegs its value to a senior tranche of other cryptoassets. See Dankrad Feist’s “ On Supply and Demand for Stablecoins ,” 2021.
  • The opacity of financial structures is not necessary to explain bank runs. For example, the canonical model of bank runs assumes the existence of transparent balance sheets. See Douglas Diamond and Philip Dybvig’s “ Bank Runs, Deposit Insurance, and Liquidity ,” The Journal of Political Economy , 1983.
  • The U.S. Chamber of Commerce Institute for Legal Reform found the cost of litigation in the United States amounted to $429 billion, or 2.3% of U.S. gross domestic product, in 2016. Over 40% of this cost was used to pay legal, insurance and administrative costs. These costs constitute a lower bound, as most disputes are reconciled outside the legal system.

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Cashless: Is Digital Currency the Future of Finance?

If the U.S. wants to future-proof banking, then a digital dollar could be a solution.

April 17, 2024

digital currency essay

Finance experts like Darrell Duffie see digital currency as an inevitability. “It’s hard to imagine that 100 years from now, people will be reaching into their pockets and pulling out grubby bits of paper,” he says.

As the Adams Distinguished Professor of Management and Professor of Finance at Stanford Graduate School of Business, Duffie ’s research centers on banking, financial market infrastructure, and fintech payments. And with digitization already transforming the way money moves around the world, Duffie is particularly interested in how digital currency, whether developed privately or issued by governments, promises to revolutionize finance even further. In this episode of If/Then: Business, Leadership, Society , he explores how it could even expand economic opportunity for people left out of the current financial system.

Duffie’s research has tracked countries’ development and rollout of central bank digital currencies (CBDCs). In contrast to cryptocurrencies like Bitcoin, a CBDC is backed by a central bank and is essentially a digital version of a country’s fiat currency. “Virtually all countries are exploring a central bank digital currency for potential use,” he says, and some, like China and the Bahamas, have already implemented them. This shift, Duffie believes, could offer significant benefits over the current financial system by sidestepping the high fees and inefficient timelines associated with moving money, particularly across borders.

Duffie notes that a well-designed CBDC could also address the issue of financial inclusion. “Millions of Americans do not have a bank account. They’re off the grid in terms of payments,” he says. “Maybe this technology would allow many underprivileged Americans to get access to the payment system.”

Despite the political challenges of transitioning away from traditional currencies, Duffie believes digital currencies are on the horizon. The challenge, he says, is striking the right regulatory balance between fostering innovation and mitigating risks. As this episode of If/Then explores, if the U.S. wants to future-proof banking, then a digital dollar could be a solution.

Senior Editor, Stanford GSB

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If/Then is a podcast from Stanford Graduate School of Business that examines research findings that can help us navigate the complex issues we face in business, leadership, and society. Each episode features an interview with a Stanford GSB faculty member.

Full Transcript

Note: Transcripts are generated by machine and lightly edited by humans. They may contain errors.

Kevin Cool: If the U.S. wants to future-proof banking, then a digital dollar could be the solution.

Dawn Sands: You travel to the states, you hear your friends or family members talking about various wallets. These Venmos, these cash apps that they use and transfer money, and you’re like, oh, okay. And then you hear a sand dollar and you’re like, okay, now The Bahamas is catching up.

Kevin Cool: Dawn Sands owns a restaurant in Nassau called NRG Nutrition ready to go in 2020. She was one of the first businesses to start using the country’s new digital currency. That’s a way of paying for transactions electronically, a little like Bitcoin, but backed by the country’s central bank in The Bahamas. It’s called the sand dollar.

Dawn Sands: I did not operate in the cryptocurrency space whatsoever. In the beginning. I was very confused about that. I was more trying to understand the technology behind it. It was a blockchain for me, the sand dollar, it just took a shape and form in my brain. Just the way I hold my credit card. I’ll hold my phone as a wallet and my money is boxed by the Central Bank.

Kevin Cool: Dawn has a good reason to want an alternative to conventional banking.

Dawn Sands: I don’t know if it’s the same where you’re from, but in The Bahamas, banking is a challenge from opening. An account can take you days, and when I say days, you can sit at the bank for literally six to eight hours and then get an account number days from there. My money sits in the bank and my bank is always being hacked. Yeah, my bank account was just hacked the other day. It got hit $4,000 and I’m still waiting to be paid.

Kevin Cool: Her frustrations with banks make her excited about the sand dollars benefits.

Dawn Sands: For example, if you’re going to allow me to receive a sand dollar, I don’t have to pay a fee. Literally, there’s a bank over here that charges $5 for every a hundred I think it is that you deposit. If I can use more than I can deposit less of the bank, I guess that’s what the future is going to look like. If we continue on the path.

Kevin Cool: The United States isn’t getting its own digital currency anytime soon, but its proponents say it will come with many consumer benefits. If it does, it’s already a reality in 11 countries, including China and 130 countries are exploring it. What do these developments mean for the future of banking and finance? Will the U.S. dollar keep its status as the world’s standard if it lags behind on a digital currency? This is if then a podcast from Stanford Graduate School of Business where we examine research findings that can help us navigate the complex issues facing us in business, leadership, and society. I’m Kevin. Cool. Senior editor at the GSB. Today we speak with finance professor Daryl Duffy.

Darrell Duffie: It’s hard to imagine that a hundred years from now, people will be reaching into their pockets and pulling out grubby bits of paper.

Kevin Cool: The focus this episode, if the U.S. wants to future-proof banking than a digital dollar, could be the solution. What do we mean, first of all by a digital currency? How do we differentiate that, say from Bitcoin?

Darrell Duffie: So Bitcoin, because it’s expensive and takes time to use for making payments, it’s not really a very good form of money for making payments, and most importantly, if I promise to pay you for whatever, a cup of coffee or a new car, the money that I send may be worth less than what we agreed by the time it gets to you, because Bitcoin is moving around a lot.

Kevin Cool: It’s a lot of volatility. Yeah.

Darrell Duffie: Price volatility is very high. It’s not that reliable. We, for many years will probably continue to just use our bank accounts for those things, but people are now talking about going to a new world of central bank digital currency or what’s sometimes called a digital dollar. What does that mean? First of all, it means that instead of paying money out of your own bank account at wherever you bank Chase or Wells Fargo, you’ll be paying money out of your account with the Fed, the Federal Reserve Bank. That basically is the central bank for the United States.

Kevin Cool: Let me just clarify. When you say you would be paying from your account, I don’t have an account with the Federal Reserve right now. How would that work?

Darrell Duffie: Well, you don’t have an account at the Federal Reserve now because we don’t have digital dollars right now. The only actors in our economy that have accounts at the Federal Reserve are large financial institutions. Now, we’re not going to knock on the door of the Federal Reserve Bank of San Francisco and ask them for an account. They’re going to delegate that operational side to a commercial bank or to another payment service provider like PayPal or somebody else. So we’ll call Wells Fargo or PayPal and say, would you provide us with some digital dollars that you’ll hold on our behalf at the Fed?

Kevin Cool: What advantage would there be to having a digital dollar rather than just having my bank account at Wells Fargo where I have dollars that I can access digitally?

Darrell Duffie: Well, the question you asked has been the central question under debate for the last five years or so in the us, but there are advantages and disadvantages. Let’s run through a few of them. The Fed doesn’t go bankrupt as opposed to some banks.

Kevin Cool: I certainly hope not.

Darrell Duffie: Well, Silicon Valley Bank went bankrupt, and if you had your account at Silicon Valley Bank rather than at the Fed, you might’ve lost money. Another reason might be that the digital dollar be built on a blockchain like Bitcoin that would allow you to buy things automatically and not fear that you wouldn’t get what you bought. For example, if you were to buy Euros with your digital dollars, doing it on a blockchain means that code software can guarantee that you will receive your Euros if your dollars are taken, as opposed to the current world in which your dollars go somewhere and maybe the Euros that you bought don’t come back to you. Currently, banks are not providing a service that guarantees those payments.

Kevin Cool: What are the impediments? Is it a philosophical policy difference that would be getting in the way here, or what would be the impediments for the United States to do this right away or in the short term?

Darrell Duffie: I think there are two major impediments. Both are partly political. One of them is the concern about privacy. There’s a suspicion by some that if your money is held on account at the Fed rather than your commercial bank, that you will lose privacy over your payments. It’ll be a so-called Big brother situation in which the government could it’s suggested spy on your payments and take advantage of that information to your detriment

Kevin Cool: Because the government has visibility now into essentially all of your transactions, right?

Darrell Duffie: Well, today, they’re not supposed to get access to your transactions unless you’re doing something suspicious, and in that case, your bank is supposed to report you. Last year there were 4 million of those suspicious activity reports or SARS sent to the government by banks. Now, a small fraction of those were actually illegal payments, but the government already has access whenever there’s some potential for a suspicious payment. It’s suggested that by some, not me actually, that if there were a digital dollar, the situation would be much worse because instead of asking banks to send that information, the government supposedly would have direct access to it. There’s a misconception there. First, it’s not necessary that that technology provides information to the government that it couldn’t already get, and secondly, the way that U.S. politics work, the Fed would almost certainly need to guarantee that it couldn’t access all of your payment information or give it to the government, which is a different proposition. So there is a reason to be concerned about privacy, but that’s one of the reasons that Central Bank digital currencies in some countries are going to be delayed until people are confident.

Kevin Cool: So would you say this is inevitable at some point, or not necessarily?

Darrell Duffie: It’s hard to imagine that a hundred years from now people will be reaching into their pockets and pulling out grubby bits of paper.

Kevin Cool: Well, I hope pennies at least are gone by then. Don’t give me to start it on pennies.

Darrell Duffie: I imagine eventually we’ll be using digital dollars and not using paper money to the extent that we use any government currency.

Kevin Cool: Why don’t you just give us sort of a lay of the land in terms of what countries are doing this, how far along are they and so on.

Darrell Duffie: Virtually all countries are exploring a central bank digital currency for potential use. Some of them have gotten to the point where they’ve actually developed or in the course of developing the technology, which is not easy. Some of them have gotten further to the point of piloting a central bank digital currency, and some very few have actually released a central bank digital currency for general use. Like Bahamas is one example, but Bahamas is a small country, and even in Bahamas, a small fraction of money is held in the form of their digital currency, which is called the sand dollar

Kevin Cool: Appropriately.

Darrell Duffie: The largest country that’s well along the way with a central bank digital currency is China. In around 2020, China began piloting a major piloting of its central bank digital currency. It’s only a fraction of 1% of the total amount of money issued by the central bank. Most of it is in paper form. People in China already had access to a really whizzbang electronic payment systems, the two most popular of which are called Alipay and WeChat Pay, which are private sector payment systems put up by two of their largest tech companies. It would be as though Amazon or Google or Facebook or Microsoft were to make available digital payment accounts to everyone and allow you to pay into and out of those accounts. You can imagine that would be quite a powerful option in the United States as well. But in China, those two payment systems account for more than 90% of urban payments.

Kevin Cool: Now, the dollar historically has been essentially the reserve standard for global business. Is the fact that the Chinese government is pursuing this, an effort to encroach on the dollar as that standard.

Darrell Duffie: That’s the central question of a report that I worked on as part of a large committee of experts a few years ago. China’s new central bank digital currency does not threaten the dominance of the U.S. dollar as you described it. It remains and will remain for decades. The go-to currency for international finance, whether it’s central banks holding dollars in their foreign exchange reserves or it’s banks making cross-border payments to each other or invoicing for goods and services or in the foreign exchange market, trading one currency for another, the dollar is by far and away dominant and will remain dominant for decades.

Kevin Cool: For decades. You are listening to if then a podcast from Stanford Graduate School of Business will continue our conversation after the break. The broader experience with cryptocurrency is quite volatile, obviously. I mean, we just saw the whole implosion with FTX and there’ve been other bad actors in this space. What have we learned about cryptocurrency at this point, about its effects on society, its potential advantages in the future? What are we supposed to think about cryptocurrency right now?

Darrell Duffie: It’s very early stages, Kevin. It’s kind of like the Wild West or the beginning of era where the potential is great, but it’s a bit unruly. The U.S. government is lagging relative to other countries and setting out the rules for cryptocurrencies and digital assets more generally. And until those rules are laid down pretty clearly, you can expect a very bumpy ride. In terms of adherence to the law or what is the law, the questions about what is the law that is, you can expect lots of litigation, you can expect some collapses like the ones that we’ve seen, and FTX was only the most spectacular example, but there have been many others. What we should be thinking about is what are the applications of this new technology that could help Americans or people generally, and how can those be safeguarded? How can we avoid losing those opportunities either by failing to regulate or by overregulating?

It’s a balance, but consider the opportunities. Like I mentioned earlier, if you can make payments on a blockchain, you can assure the safety of payments. You can arrange for payments automatically without fear. If the software is reliable, you could potentially provide payments much more broadly in the economy. That issue is called financial inclusion. The United States suffers from millions of Americans who do not have a bank account. They’re off the grid in terms of payments. Maybe this technology would allow many underprivileged Americans to get access to the payment system. Right now, if you’re, let’s say making a remittance, you’re taking a huge loss off the top where the remittance company will hack off whatever, six, 8% to send your money to your family and wherever it is, Philippines, Mexico,

Kevin Cool: Because you don’t have a bank account,

Darrell Duffie: Because you don’t have a bank account or because you’re afraid of your bank, or maybe you don’t want somebody to know that you’re making a payment. So I mentioned there’s a balance. You want the government to be able to stop illegal payments. You want the government to protect you from payment service providers that would take advantage of you. You want the government to be making sure that your money is safe and your payments will go safely to their destination, and at the same time, you don’t want the government to get unduly involved in your private affairs. U.S. government is grappling with these issues right now. There have been a number of acts floated in Congress draft bills that have not yet passed. Europe has moved ahead with its regulatory framework for this. So has the United Kingdom, Hong Kong, Singapore, a number of other countries around the world are moving ahead to provide a path for entrepreneurs to develop these technologies safely and in the knowledge that their capital will not get wiped out by an unexpected change in regulation or the explosion of a piece of infrastructure because it wasn’t properly regulated and the ability to make cross-border payments, which I don’t know if you’ve tried it lately, Kevin, but for me, it’s a nightmare trying to get or make a cross-border payment of one currency for another these days.

A very expensive, very slow, very mistake prone. The technologies we’re discussing could address that and doesn’t need to be a digital dollar in the sense of a government money. It could be some bright entrepreneur that finds a way to do it in the private sector. Now, digital dollar is another approach, and we’ll see whether that turns out to be the winning approach

Kevin Cool: For all the attention they’ve gotten. As an alternative to government backed money, Bitcoin and other cryptocurrencies are not a useful way to buy and sell goods and services, but the blockchain technology behind them has opened the door for a digital currency that’s more versatile and more secure than traditional money. As Daryl Duffy says, the days of pulling out grubby bits of paper to pay for something are numbered when or if the United States introduces a digital dollar, its possibility could bring about the innovation the banking system needs. If that doesn’t happen, the rest of the world may race ahead.

If/Then is produced by Jesse Baker and Eric Nuzum of Magnificent Noise for Stanford Graduate School of Business. Our show is produced by Jim Colgan and Julia Natt. Mixing and sound design by Kristin Mueller. From Stanford GSB: Jenny Luna, Sorel Husbands Denholtz, and Elizabeth Wyleczuk-Stern. If you enjoyed this conversation, we’d appreciate you sharing this with others who might be interested and hope you’ll try some of the other episodes in this series. For more on our professors and their research or to discover more podcasts coming out of Stanford GSB visit our website at Find more on our YouTube channel. You can follow us on social media @StanfordGSB. I’m Kevin Cool.

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What Is a Digital Currency?

Understanding digital currencies.

  • Characteristics
  • Disadvantages

The Bottom Line

  • Cryptocurrency
  • Strategy & Education

Digital Currency Types, Characteristics, Pros & Cons, Future Uses

digital currency essay

Amilcar has 10 years of FinTech, blockchain, and crypto startup experience and advises financial institutions, governments, regulators, and startups.

digital currency essay

Katrina Ávila Munichiello is an experienced editor, writer, fact-checker, and proofreader with more than fourteen years of experience working with print and online publications.

digital currency essay

Investopedia / Paige McLaughlin

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.

Key Takeaways

  • Digital currencies are currencies that are only accessible with computers or mobile phones because they only exist in electronic form.
  • Typical digital currencies do not require intermediaries and are often the cheapest method for trading currencies.
  • All cryptocurrencies are digital currencies, but not all digital currencies are cryptocurrencies.
  • Some of the advantages of digital currencies are that they enable seamless transfer of value and can make transaction costs cheaper.
  • Some of the disadvantages of digital currencies are that they can volatile to trade and are susceptible to hacks.

Digital currencies do not have physical attributes and are available only in digital form. Transactions involving digital currencies are made using computers or electronic wallets connected to the internet or designated networks. In contrast, physical currencies, such as banknotes and minted coins, are tangible, meaning they have definite physical attributes and characteristics. Transactions involving such currencies are made possible only when their holders have physical possession of these currencies.

Digital currencies have utility similar to physical currencies. They 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.

Digital currencies also enable instant transactions that can be seamlessly executed across borders. For instance, it is possible for a person located in the United States to make payments in digital currency to a counterparty residing in Singapore, provided they are both connected to the same network.

Characteristics of Digital Currencies

As mentioned earlier, digital currencies only exist in digital form. They do not have a physical equivalent. Digital currencies can be centralized or decentralized. Fiat currency , which exists in physical form, is a centralized system of production and distribution by a central bank and government agencies. Prominent cryptocurrencies , such as Bitcoin and Ethereum , are examples of decentralized digital currency systems.

Digital currencies can transfer value. Using digital currencies requires a mental shift in the existing framework for currencies, where they are associated with sale and purchase transactions for goods and services.

Digital currencies, however, extend the concept. For example, a gaming network token can extend the life of a player or provide them with extra superpowers. This is not a purchase or sale transaction but, instead, represents a transfer of value.

Types of 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 are digital currencies that use cryptography to secure and verify transactions in a network. Cryptography is also used to manage and control the creation of such currencies. Bitcoin and Ethereum are examples of cryptocurrencies. Depending on the jurisdiction, cryptocurrencies may or may not be regulated.

Cryptocurrencies are considered virtual currencies because they are unregulated and exist only in digital form.

Virtual Currencies

Virtual currencies are unregulated digital currencies controlled by developers or a founding organization consisting of various stakeholders involved in the process. Virtual currencies can also be algorithmically controlled by a defined network protocol. An example of a virtual currency is a gaming network token whose economics is defined and controlled by developers.

Central Bank Digital Currencies

Central bank digital currencies (CBDCs) are regulated digital currencies issued by the central bank of a country. A CBDC can be a supplement or a replacement to traditional fiat currency . 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.

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 .

The introduction of a U.S. CBDC presents a number of difficulties. For instance, for Congress to authorized the issuance of a CBDC, there must be robust privacy and security infrastructures put in place. The government must also weight the possible impacts on monetary policy and the operational management of the switch from conventional money to a CBDC.

Advantages of Digital Currencies

The advantages of digital currencies are as follows:

Fast Transfer and Transaction Times

Because digital currencies generally exist within the same network and accomplish transfers without intermediaries, the amount of time required for transfers involving digital currencies is extremely fast.

As payments in digital currencies are made directly between the transacting parties without the need for any intermediaries, the transactions are usually instantaneous and low-cost. This fares better compared to traditional payment methods that involve banks or clearinghouses . Digital-currency-based electronic transactions also bring in the necessary record keeping and transparency in dealings.

No Physical Manufacturing Required

Many requirements for physical currencies, such as the establishment of physical manufacturing facilities, are absent for digital currencies. Such currencies are also immune to physical defects or soiling that are present in physical currency.

Monetary and Fiscal Policy Implementation

Under the current currency regime, the Fed works through a series of intermediaries—banks and financial institutions—to circulate money into an economy. CBDCs can help circumvent this mechanism and enable a government agency to disburse payments directly to citizens. They also simplify the production and distribution methods by obviating the need for physical manufacturing and transportation of currency notes from one location to another.

Cheaper Transaction Costs

Digital currencies enable direct interactions within a network. For example, a customer can pay a shopkeeper directly as long as they are situated in the same network. Even costs involving digital currency transactions between different networks are relatively cheaper as compared to those with physical or fiat currencies. By cutting out middlemen that seek economic rent from processing the transaction, digital currencies can make the overall cost of a transaction cheaper.


Digital currencies may be decentralized. This means they are not controlled by any government or financial institution. Digital currencies that are decentralized make them more resistant to government interference, censorship, and manipulation. Decentralization means true control over the digital currency is spread over a broader range of owners or users.

Due to the fact that transactions with digital currencies are not linked to personal data, users are given a high level of privacy and anonymity. They are therefore very helpful for those who want to protect the confidentiality of their financial dealings.

Accessible Around the World

Anyone with an internet connection can utilize digital currencies from anywhere in the globe. These services are therefore particularly helpful for people who do not have access to conventional banking institutions. In addition, many of these banking services only need access to an internet connection; for geographical areas that are not as developed with a strong financial infrastructure, digital currencies may be a stronger option.

Disadvantages of Digital Currencies

The disadvantages of digital currencies are as follows:

Storage and Infrastructure Issues

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 smartphones and services related to their provisioning. Online wallets with robust security are also necessary to store digital currencies.

Hacking Potential

Their digital provenance makes digital currencies susceptible to hacking. Hackers can steal digital currencies from online wallets or change the protocol for digital currencies, making them unusable. As the numerous cases of hacks in cryptocurrencies have proved, securing digital systems and currencies is a work-in-progress.

Volatile Value

Digital currencies used for trading can have wild price swings. For example, the decentralized nature of cryptocurrencies has resulted in a profusion of thinly capitalized digital currencies whose prices are prone to sudden changes based on investor whims.

Other digital currencies have followed a similar price trajectory during their initial days. For example, Linden dollars used in the online game Second Life had a similarly volatile price trajectory in its early days.

Limited Acceptance

Digital currencies are still not commonly used as a means of payment by retailers and other enterprises. Because of this, using them for routine transactions may be challenging. Though digital currencies have gained gained in popularity, there are still limited functionalities in everyday transactions in many places.


On a digital currency network, transactions are irreversible. This means that once a transaction has been completed, it cannot be undone. In circumstances where a mistake or fraud has taken place, this may be a disadvantage.

This is also a tremendous disadvantage for those new to the digital currency space, as there is a substantial learning curve. Because there is no central oversight area for many digital currencies, new users can't simply go to their local branch to receive help for many digital currencies.

Pros and Cons of Digital Currencies

Faster transaction times.

Do not require physical manufacturing.

Lower transaction costs.

Make it easier to implement monetary and fiscal policy.

Offers greater privacy than other forms of currency.

Can be difficult to store and use.

Can be hacked.

Can have volatile prices that result in lost value.

May not allow for irrevocability of transactions.

Still has limited acceptability.

Central Bank Digital Currencies Around the World

Some major central banks around the world have begun looking issuing their own digital currencies. Some of the larger, more notable examples include the countries below.

  • China: Since 2020, the People's Bank of China (PBOC) has been testing the digital yuan , also known as e-CNY, in a number of Chinese localities. Millions of Chinese citizens currently utilize the digital yuan, which is intended to be used for retail transactions.
  • Sweden: Also since 2020, Sweden's Riksbank has been testing the e-krona digital currency. The e-krona is being created to complement Sweden's diminishing use of currency and to give the general public access to a safe and effective payment system.
  • EU: A digital euro that may be issued by the European Central Bank (ECB) and used for retail transactions within the Eurozone is being investigated.
  • England: The Bank of England is looking into the prospect of launching the "Britcoin" cryptocurrency . The UK's payment system would be backed by a digital currency, which could also reduce the nation's dependence on cash.
  • Canada: The Bank of Canada has been conducting research and consultations on the idea of creating a CBDC.

Future of Digital Currencies

Cryptocurrencies like bitcoin have exploded in value, but they are largely used for speculation or to buy other speculative assets. Although there have been some signs of merchant adoption in countries like El Salvador, the high volatility and complexity of these currencies make them impractical for most daily applications.

Many companies have tried to reduce volatility by introducing stablecoins , whose value is fixed to the price of fiat currency. This is usually done by depositing an equivalent amount of fiat, which can be used to redeem the tokens. However, stablecoin issuers such as Tether have used these deposits on more speculative investments, raising concerns that they are vulnerable to a market crash.

Another possible application is in central bank digital currencies , which could be issued by a country's bank or monetary authority. These would be used and stored in online wallets, similar to cryptocurrencies, but allowing the central bank to issue and freeze tokens at will. Several countries, such as China, have proposed digital versions of their currencies.

Can You Invest in Central Bank Digital Currencies?

CBDCs are unlikely to be useful for speculative investments since they will likely be pegged to the value of an underlying currency. However, it will still be possible to invest in those currencies through the forex markets .

How Do You Buy China's Digital Yuan?

The digital yuan, or e-CNY, is only available to Chinese citizens living in 23 major cities. Users can buy digital yuan by downloading an app and connecting it to their bank accounts.

How Do You Make a Digital Currency?

Most digital currencies are created by issuing them on Ethereum or another blockchain capable of running smart contracts . The issuer must first decide how many tokens to issue, and any special rules that limit transactions or ownership. Once these choices are coded into the smart contract, the issuer pays a small amount of cryptocurrency to pay for the computational cost of issuing the tokens.

Digital currencies are assets that are only used for electronic transactions. They do not have any physical form, although they can be exchanged for regular money or other assets. Although the most popular digital currencies are cryptocurrencies like bitcoin, many national governments are considering issuing their own centralized digital currencies.

State University of New York, Oswego. " The Basics about Cryptocurrency ."

European Central Bank. " Virtual Currency Schemes ." Page 5.

Bank of England. " Central Bank Digital Currency: Opportunities, Challenges and Design ."

European Central Bank. " Virtual Currency Schemes – a Further Analysis ." Page 6.

Sveriges Riksbank. " E-krona ."

European Central Bank. " Digital Euro ."

Bank of England. " The Digital Pound ."

Bank of Canada. " Central Bank Digital Currency ."

digital currency essay

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106 Cryptocurrency Essay Topic Ideas & Examples

🏆 best cryptocurrency topic ideas & essay examples, 🎓 good research topics about cryptocurrency, ⭐ simple & easy cryptocurrency essay titles, ❓ cryptocurrency research questions.

  • Bitcoin: Advantages and Disadvantages The law of supply and demand applies to the cryptocurrency sector since it relies on the rate of interest charged in the market.
  • Aspects of Bitcoin Transaction Threats Thus, it is imperative that the wallets are encrypted and have an offline backup to ensure the information can be accessed even after a DDoS attack. This can be addressed by improving the Bitcoin protocols […]
  • PayPal’s Big Bitcoin News PayPal is one of the latest financial companies to embrace Bitcoin as a currency in its services, a step that has potential benefits to the institution and its clients.
  • Aspects of Bitcoin and Cryptocurrency Bitcoin is a digital currency that is much different from any other past form of money that has existed in the past.
  • Cryptocurrency and Its Impact on the Banking Industry Advanced coding is used to store and transfer cryptocurrency data between the wallet and a public ledger, and encryption is used to confirm transactions.
  • Diffusion of Innovation as Exemplified by Bitcoin This paper will give an example of a company officially registered as “Satoshi Nakamoto,” which created and implemented one of the first and most popular cryptocurrencies – Bitcoin.
  • Cryptocurrency Adoption in Africa A cryptocurrency is a type of virtual money that employs encryption to authenticate the ownership of a unit of financial value.
  • Cryptocurrency Crimes in Financial Markets One of the most relevant, and important news in recent times is the trend of cryptocurrency crimes in financial markets. In this case, it is necessary to improve security systems concerning the management, control, storage, […]
  • Bitcoin Technology: Ethical Considerations and Summing Up Moral principles that govern a person’s behavior or the conduct of an activity Standards of right and wrong that exist in society and guide the individual in terms of rights and responsibilities, justice, virtue, […]
  • Ethical Implications of the Use of Bitcoin The emergence of cryptocurrency has been a significant breakthrough for global economic policy and practice, and Bitcoin is expected to continue to evolve. In particular, increased states are recognizing Bitcoin and creating legal regulations for […]
  • The Cryptocurrency Concept Analysis The basis of cryptocurrency operations is essential codes that allow the private exchange of business. The anonymity of banks and other government organizations poses a big threat to the operation of cryptocurrencies.
  • Bitcoin: The Key Characteristics In theory, this should increase the cybersecurity of the use of such money, and this presentation will detail the characteristics of Bitcoin as one of the most important cryptocurrencies of our time.
  • Money Laundering Through Cryptocurrencies This study will try to critique the approaches used by countries to address the aspect of money laundering activities and the risks posed by digital currencies.
  • Analysis of Solana Cryptocurrency An investment in Solana is a safer choice among cryptocurrencies, yet it has the potential to multiply one’s savings. Solana has the potential to overcome these barriers and turn into a globally accepted currency.
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IvyPanda. (2024, March 2). 106 Cryptocurrency Essay Topic Ideas & Examples.

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Essay on Digital Currency

Students are often asked to write an essay on Digital Currency in their schools and colleges. And if you’re also looking for the same, we have created 100-word, 250-word, and 500-word essays on the topic.

Let’s take a look…

100 Words Essay on Digital Currency

What is digital currency.

Digital currency is money that exists only in the digital world. It’s not physical like coins or notes. Instead, it’s stored on computers. It’s a type of currency that you can use to buy things online. Bitcoin is a famous example of digital currency.

How Does Digital Currency Work?

Digital currency works through technology called blockchain. This is a type of computer system that keeps track of all digital money transactions. It’s like a digital ledger. This system ensures that the digital currency is safe and can’t be copied or faked.

Types of Digital Currency

There are many types of digital currencies. Bitcoin is the most well-known. Others include Ethereum, Ripple, and Litecoin. Each one works in slightly different ways, but they all use blockchain technology.

Advantages of Digital Currency

Digital currency has many advantages. For example, it can be sent anywhere in the world quickly and cheaply. Also, it’s secure because of the blockchain technology. It’s also easy to carry around because it’s not physical.

Disadvantages of Digital Currency

There are also disadvantages to digital currency. For example, its value can change quickly, which can be risky. Also, if you lose access to your digital wallet, you could lose all your digital money. Plus, not all places accept digital currency.

Also check:

  • Advantages and Disadvantages of Digital Currency

250 Words Essay on Digital Currency

Digital currency is money that is available only in digital form. It is not like the physical money that we can touch or see, such as coins and notes. It exists only on computers and the internet. Examples of digital currencies are Bitcoin, Ethereum, and Ripple.

Digital currency works using technology called blockchain. Think of blockchain as a digital notebook. This notebook keeps a record of all transactions made with digital currencies. This record is public and can’t be changed, making digital currency safe and secure.

The Use of Digital Currency

Digital currency can be used to buy goods and services online. Some online stores and even some physical stores accept digital currencies like Bitcoin. People also use digital currencies for investment. They buy these currencies when their prices are low and sell them when their prices go up.

The Future of Digital Currency

Digital currency is becoming more popular. More people are learning about it and starting to use it. Some experts believe that digital currencies could replace traditional money in the future. This means we might not use coins and notes anymore and only use digital money.

In conclusion, digital currency is a new form of money that exists only on the internet. It is safe, secure, and easy to use. As more people start using it, it could change the way we use money in the future.

500 Words Essay on Digital Currency

Digital currency is like money but in electronic form. It’s not something you can touch or feel, but you can use it to buy things online. It’s like the money you see in your bank account when you check it on your phone or computer.

There are many types of digital currencies. Some of them are called cryptocurrencies, like Bitcoin and Ethereum. These are special because they use a technology called blockchain to keep them safe and secure. Other types of digital currencies are created by governments, and these are often called Central Bank Digital Currencies (CBDCs).

Just like when you use paper money to buy something, digital currencies are used to pay for goods and services. But instead of handing over cash, you send the digital currency from your digital wallet to someone else’s. This can be done using a computer or a smartphone.

Why Do People Use Digital Currency?

People use digital currencies for many reasons. Some like it because it’s quick and easy to send money around the world. Others like it because it can be more secure than traditional money. And some people like it because they hope the value of the digital currency will go up and they can make money.

Are There Risks with Digital Currency?

Yes, there are risks with using digital currency. One risk is that the value of the digital currency can go up and down a lot. This means if you own some, you might lose money. Another risk is that if you lose access to your digital wallet, you could lose all your digital currency. Also, because it’s still pretty new, the rules around using digital currency can change quickly.

In conclusion, digital currency is a new kind of money that exists only in electronic form. It’s used by people all over the world for many different reasons. But like all things, it comes with both benefits and risks. It’s important to understand these before you start using digital currency.

That’s it! I hope the essay helped you.

If you’re looking for more, here are essays on other interesting topics:

  • Essay on Digital Education
  • Essay on Digital Citizenship
  • Essay on Digital Addiction

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Dikshu C. Kukreja

RBI’s Digital Currency and its Significance

RBI’s Digital Currency and its Significance

  • Feb 15, 2022, 12:20

What is a Digital Currency?

The term ‘digital currency’ refers to money exclusively available in digital or electronic form. It is also known as cyber cash, digital money, electronic money, or electronic currency. Electronic wallets or computers connected to the internet or specified networks conduct digital currency transactions. Typically, digital currencies do not require intermediaries and it is frequently the most cost-effective way to trade currencies. Not all digital currencies are cryptocurrencies, and not all cryptocurrencies are digital currencies. Digital currencies have the ability to transfer value seamlessly and reduce transaction costs. India’s official digital currency is in the works and would be launched by 2022–23, according to the Reserve Bank of India (RBI).

Central Bank Digital Currency

A Central Bank Digital Currency (CBDC) is a digital form of a legal tender issued by the central bank. It is equivalent to fiat cash and may be exchanged one-to-one but in a different form. A sovereign currency in electronic form will appear on the central bank’s balance sheet as a liability (currency in circulation). It should be possible to exchange CBDCs for cash. Central banks worldwide are promoting digital currencies for various reasons including to popularise usage of electronic money and thwart the emergence of private digital assets such as cryptocurrencies. According to a poll by the Bank for International Settlements (BIS) in 2021, 86% of central banks were actively researching possibilities for CBDCs, 60% were experimenting with the technology and 14% were conducting trial projects. More than 91 countries, representing over 90% of the world’s GDP, have their own centralised digital currency in works. India is in the development stage of its digital currency.

India’s own official digital currency is expected to emerge in early 2023 and will be similar to any of the already available private company-operated electronic wallets, with the exception that it will be a sovereign-backed facility. Ms. Nirmala Sitharaman, Minister of Finance and Corporate Affairs, mentioned in her 2022–23 budget speech that a central bank-backed 'digital rupee' would be launched soon. The RBI has made public its proposal to adopt digital currency in stages. Mr. T. Rabi Sankar, Deputy Governor of RBI, stated in December that the wholesale component of the CBDC had made significant progress, while the retail component would take longer. The digital rupee will be based on blockchain technology, which will reduce the cost of currency maintenance and allow the government to manufacture fewer notes. The currency will be digital; its lifespan is extended because digital forms cannot be destroyed or lost.

Difference between a CBDC and Digital Asset

Significance of Digital Currency

  • A safer form of money: CBDCs, such as paper currency, are direct liabilities of the central bank, making them a safer form of digital money. This can be compared to a situation in which every person has a checking account with the central bank.
  • End to paper cash: The central bank will be the custodian of everyone’s cash and the clearer of all transactions, and there will be no need for conversion of paper money into digital money because a CBDC unit is a direct central bank liability that is precisely equivalent to paper money rather than merely convertible into it, rendering paper cash obsolete. People will no longer require cash outlets and will have fewer options for depositing cash and other valuables.
  • Easier policy implementation and regulation: In a CBDC environment, all transactions can theoretically be monitored using data analytics and AI to quickly identify banks that are failing or participating in questionable transactions. It becomes much easier for authorities to identify the parties to a transaction in a CBDC world where digital bank codes are visible to the clearing institution, which largely simplifies the detection of criminal activity and eliminates black markets that deal primarily in physical money.
  • Increased diversity: CBDC transactions do not require a bank account, which is crucial in developing countries where a third of the population lacks access to traditional finance but has mobile internet access. With an Aadhar number and a smartphone, an unbanked Indian customer can easily transact using a mobile app. This means that governments in the industrialised world will quickly incorporate those who had previously been excluded from the financial system.
  • Cost of currency management: Based on the market estimate, the cost of each Rs 100 (US$ 1.33) note in its four-year life cycle is 15–17% on each tender of Rs 15–17 (US$ 0.2–0.23). The cycle comprises a series of new notes being printed, and soiled notes being returned to the RBI via commercial banks. The cost reductions from a digital currency might be significant, given that bigger denomination notes are being phased out and people start switching to digital rupee instead of paper-based currency.
  • Overcoming international differences: CBDCs could help payment systems become more real-time and cost-effectively globalised. An Indian importer can pay an American exporter in digital dollars in real-time without an intermediary. This transaction would be complete, just like handing over cash in dollars, and it would not even require the US Federal Reserve system to be open for settlement. Currency settlements would no longer be affected by time zone differences.

A Step Towards a Cashless Economy

Faced with diminishing paper currency usage, central banks try to popularise a more acceptable electronic form of currency. They are attempting to accommodate the public’s need for digital currencies, as evidenced by the growing use of private virtual currencies, while also avoiding the more harmful repercussions of such private currencies. CBDCs can offer users advantages such as liquidity, scalability, acceptance, transaction convenience, anonymity, and speedier settlement. With the government’s support infrastructure, CBDC adoption will improve and make it easier for individuals to utilise, much as UPI made it easier to use digital currency.

In the real world, the digital rupee can be used for programmable payments for subsidies and by financial institutions for faster lending and payments. There can be a pragmatic shift to a cashless economy in the near future. This might encourage the government's push for cashless payments and positively impact the banking sector . As the digital rupee grows, it may improve things such as cross-border remittances. An environment for interoperability may be built, and lead to a cashless economy.

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Essay on RBI Digital Currency

Essay on RBI Digital Currency, Essay on Digital Currency

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Essay on RBI Digital Currency 100 words

Digital currency is a currency that can only be received in digital or electronic form, not in its physical form. There are a few other names for it, including cyber-cash, digital money, electronic currency, and electronic money. They can be obtained through the use of computers or mobile phones. Purchases conducted with digital currency do not need to involve any other parties. However, each and every currency is entirely made up of digital cash. However, not all digital currencies may be defined as cryptocurrencies.

Essay on RBI Digital Currency 200 words

Digital currencies are virtual. Only computers, cell phones, and electronic wallets can be used to do business. It can also be used to buy goods and pay for services, just like any other central bank. The digital currency was mostly used for instant payments. When it was linked to devices and networks that supported it, it could be used to make payments across borders without any problems.

Since digital currencies are paid directly from one person to another without the need for a middleman, transfers are usually quick and cheap. When people do business together, it’s important to keep records and be clear about what’s going on. In 1983, David Chaum put forward the idea of digital money in a research paper. In 1989, he started Digicash, an electronic cash company, so that the ideas from his research could be used in the real world.

In 1996, e-gold was first used. In 1998, Paypal entered the scene. Bitcoin came out in 2009. It is a type of digital currency based on the blockchain that doesn’t have a base station and doesn’t hold any physical assets in reserve.

Essay on RBI Digital Currency

Essay on RBI Digital Currency 300 words

The Many Benefits of Using Digital Currency

Reduced fees for transferring money and the ability to pay at any time are also benefits. Collecting funds in a manner that is more effective than traditional financial institutions. Customers from other countries will have an easier time conducting business with you.

Protection against fraud, for example, You are not required to reveal any of your personal information when participating in crypto exchanges. The use of digital currency leads to a decrease in the costs related to producing cash. Anyone, at any time and location, can simply receive or transmit money transfers.

The Disadvantages of Using Digital Currency

It is necessary to have a strong technical system for digital currency. Insufficient Internet connections in many parts of the country, a lack of tech-minded users. A lack of electronic devices and other gadgets, such as mobile phones, laptops, and other such items, is common among poor people. Causes a reduction in the total number of banking industry positions.

Currency in digital form in India

Suppose a central bank is responsible for regulating digital currency. It is recognised as the digital currency issued by central banks (CBDC). CBDCs , on the other hand, are digital currencies that hold the same value as currencies issued by the central banks of respective nations. This is in contrast to crypto-currencies, which are issued without the support of a central bank and are exchanged on exchanges.

At the end of the day, the methods of conducting business could be made useless by the introduction of digital currencies. To put it another way, the challenges that virtual currencies must overcome before they can be considered “mainstream” are not limited to financial in nature but also include mental concerns.

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Essay on RBI Digital Currency 500 words

What is digital money?

Digital currency is money that can only be found in digital or electronic form. It is also called cybercash, digital money, electronic money, and electronic currency. Digital currency transactions are done on computers that are connected to the internet or other networks. Most of the time, digital currencies don’t need a middleman, and trading them is often the cheapest way to do so. 

Not all digital currencies are cryptocurrencies, and not all cryptocurrencies are digital currencies. Digital currencies can make it easy to send and receive money and lower the cost of transactions. The Reserve Bank of India says that India’s official digital currency is in the works and will be ready by 2022 or 2023. (RBI).

Central Bank Digital Currency

A Central Bank Digital Currency (CBDC) is a digital version of money that the central bank has made legal currency. It’s the same as central bank money and can be traded for it one-to-one but in a different way. A government-issued electronic currency will show up as a responsibility on the central bank’s balance sheet. CBDCs should be able to be traded for cash. 

Central banks all over the world are promoting digital currencies for a number of reasons, such as to make electronic money more popular and to stop the rise of private digital assets like cryptocurrencies. In 2021, the Bank for International Settlements (BIS) did a survey and found that 86% of central banks were looking into the options of CBDCs, 60% were trying out the technology, and 14% were running trial projects. 

More than 91 countries, which together make up more than 90% of the world’s GDP, are working on their own central control of digital currency. The digital currency of India is still in the process of being made.

How important is digital currency?  

A safer form of money: CBDCs, like paper money, are directly supported by the central bank, which makes them a safer form of digital money. This is like a situation where everyone has a checking account at the central bank.

End to paper cash: The central bank will hold everyone’s cash and settle all transfers. There will be no need to change paper money into digital money because a CBDC unit is a direct central bank claim that is essentially equal to paper money, not just convertible into it. This makes paper cash useless. People won’t need cash outlets anymore, and there will be fewer places to put cash and other valuables.

A Step Towards a Cashless Economy

In the real world, the digital rupee can be used to make customisable payments for grants and by financial institutions to speed up lending and payments. There could be a practical move away from cash in the near future. This could help the government move toward cashless payments and be good for the banking industry. As the digital rupee grows, it could help with things like sending money across borders. Connectivity could be set up, which could lead to a cashless economy.

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digital currency essay

Challenges of Digital Currency Development

T he development of technologies in the digital currency sector is subject to a multifaceted assessment. The issues of data collection, processing, and storage involving extensive databases of transaction details and their participants are seen as positive. However, there are heightened risks and suspicions concerning anti-money laundering measures. With the widespread legitimization of currencies, particularly digital currencies, these concerns have intensified for central banks, international financial institutions, and academic communities.

Ambiguities and Risks

The ambiguities associated with digital currencies—including their issuance methods, legal status, and the scope of their macroeconomic and monetary impact—hamper the assessment of risks linked to the illicit circulation of monetary proceeds. Moreover, by analyzing existing information on the methods and structures of shadow businesses overall, one can evaluate the preparedness of anti-money laundering systems to rapidly adapt to transformations in the digital currency space.

Characteristics of Digital Currency

Given that the definition of “digital currency” will continually evolve with technological advancements in the digital industry, it is crucial to consider the general characteristics of digital currencies to identify new threats to money laundering:

  • Value retention.
  • Capability for digital currency movements (sending, receiving, and transferring), along with storage and the ability to monitor balances.
  • Utilization for transactions with various objectives based on contracts.

Official Status and Money Laundering

The primary concern here is the circulation of digital currencies and systematic laundering. Thus, digital currencies need to acquire official status, which would entail characteristics such as:

  • Exclusive private issuance.
  • Denomination is in their own accounting unit, not in fiat currency.

Scientific Research and Legal Considerations

Scientific research in this field unequivocally identifies the transformation of fiat money into digital currency as direct money laundering. A report by the SWIFT organization emphasizes threats to the financial system from money laundering through transactions with digital currencies, cyberattacks on electronic monetary funds, and large-scale cyber thefts from bank accounts. They argue that these risks should be attributed to the characteristics of digital currencies acquired through criminal means and incorporated into the financial system. Until this factor is considered, digital currency will neither be recognized nor backed by fiat money, meaning it has no way to be deemed legal.

Jurisdiction and Legal Responsibility

Responsibility zones should be delineated by jurisdiction. Any thefts occurring in online spaces (in the networks of banking electronic systems), drug trafficking, and business involving illegal goods online, as well as payments to hackers in digital currency in exchange for lifting restrictions, imply criminal activity. This is what domestic law enforcement and national security services do. Meanwhile, the exchange of private digital currency ownership for other legitimate financial accounts can be considered the first stage of laundering illegal proceeds.

Anti-Money Laundering (AML) Measures

Here lies the line of legal responsibility for all banking organizations, which must prevent crime using digital currencies, taking into account key features of such monetary operations as anonymity, global distribution, and multilayeredness. Meanwhile, as employees in Anti-Money Laundering (AML) gain experience with digital currencies and the threats they pose, their competencies evolve.

Anonymity and Transparency

Digital currencies are known today for maintaining complete anonymity. Even with available data on any movement of digital currency, it is impossible to determine exactly who performed the operation. AML officials have identified a threat to the entire financial system, namely that “cryptocurrencies” are available for unlimited purchase by anonymous entities.

Although transaction data and its details are easily accessible (e.g., IP addresses of devices), internal agencies consider digital currencies “pseudo-anonymous,” considering that transactions with them are “more transparent than cash but more anonymous than other forms of online payments.”

Financial Industry Evolution

With the evolution of the financial industry and complex digital technologies, the scope of financial movements expands. Transfers, exchanges, and purchases, including international payments, all happen quickly and without significant expenses. This notably complicates the monitoring of digital currency operations, particularly in the realm of AML, which strives to limit the influx of “dirty” money. Many experts attribute this to the ambiguous behavior of digital assets.

Multilayered Nature of Digital Currency

The multilayered nature of digital currencies, facilitated by exchanges and transitions to third-party assets or conversion to other forms of virtual accounts and eventually into fiat money, however, should not be mistaken for money laundering. On the other hand, the exchange of digital currencies for fiat money conducted outside a legal and officially recognized system—for example, exchanging for cash without legal and official documentation—contains money laundering. Future cash integration processes into the lawful financial system for the purpose of laundering are executed through so-called “money mules.”

Money Mules and Laundering Schemes

A money mule is a person who participates, often unwittingly, in laundering money and receiving and transferring illegal funds between bank assets and/or countries. In traditional laundering schemes, the money mule acts as a front. Considering that money laundering, whether formed by traditional criminal methods or using digital currency systems, implies their soon integration into the legal financial system, this necessitates two main directions to mitigate threats involving financial organizations in laundering processes using digital currencies.

Financial Action Task Force (FATF) Recommendations

The risks of money laundering associated with the laundering of digital currencies of suspicious origin have active implementation in practice. To reduce risks associated with anonymity, the Financial Action Task Force (FATF) has introduced changes to more than 40 recommendations, requiring the identification of all clients who conduct operations with virtual assets, including digital currencies, and monitoring such operations.

Current Threats and Central Bank Involvement

Among the most current threats, the risks of money laundering are actively discussed by the IMF and FATF, which are involved in examining the situation. Existing options for the production and issuance of digital currencies by central banks are characterized by decentralized registries and distinctive structural features. Meanwhile, control systems and international communities actively maintain transparency in all stages of digital currency operations by central banks for money laundering transactions.

Reducing Money Laundering Risks with Central Bank Digital Currencies (CBDCs)

Considering the peculiarities of digital currency production technology, which should by default monitor transaction data, the use of central bank digital currencies will reduce the risks of money laundering . Moreover, the digitization at the stage of issuance and circulation of central bank digital currencies will reduce costs in the financial sector and aid in detecting criminal operations with digital transactions.

Regional Implementation of CBDCs

Undoubtedly, a positive aspect of central bank digital currencies in reducing money-laundering risks can be applied at the stage of creating a payment system for countries with a unifying nature of action. The consensus in the economic policy of participating countries, which calls for free trade, labor, services, and capital, necessitates the creation of a reliable payment system that will prevent external illegal challenges and provide a safe sanctioned space for economic activities. The main levers of favorable influence of central bank digital currencies in their implementation at the regional level can be preserved if the same principles are followed as in the issuance of central bank digital currencies.

Digital Payment Systems and Cybersecurity

It should be noted that digital payment systems are only an updated form of financial infrastructure. New technologies allow the formation of a settlement space that can ensure the reliability and safety of all operations conducted. At the same time, it has the ability to reflect attacks from shadow capital, thus not allowing it to penetrate the system of deferred settlement space. Thus, it can be judged that the main threats to cryptocurrency systems at all levels are cyberattacks , which in turn must be regulated and suppressed by law enforcement agencies and individual structures providing information security for financial organizations.

The development of technologies in the digital currency sector is subject to a multifaceted assessment. The issues of data collection, processing, and storage involving extensive databases of transaction details and their participants are seen as positive. However, there are heightened risks and suspicions concerning anti-money laundering measures. With the widespread legitimization of currencies, particularly digital […]


Essay On Digital Currency In India | Advantages & Disadvantages

Essay On Digital Currency

Essay On Digital Currency In India | Advantages & Disadvantages

Hello Friend, In this post “ Essay On Digital Currency In India | Advantages & Disadvantages “, we will read about “ Digital Currency and its advantages and Disadvantages as an Essay ” In Detail. So…

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Essay On Digital Currency In India

Introduction .

Digital Currency available in digital or electronic form and not in physical form. It is also known as electronic money, cyber-cash, electronic currency, or digital money . They are accessible with computers or cell phones. Digital currencies do not require an intermediary for a transaction. All digital currencies are not cryptocurrencies but all cryptocurrency is 100% digital currency .

What Are digital currencies?

Digital currencies are intangible. Transactions can be done only through computers, cell phones, or electronic wallets. Like any other fiat currency, it can also be used to purchase goods and pay for services.

Digital currency mainly worked for instantaneous transactions, When it linked to supported devices and networks, it can be seamlessly executed to make payments across borders.

As payments in digital currencies are made directly between the parties without the need for intermediaries the transactions are usually instantaneous and low cost. Transactions involving brings in necessary record-keeping and transparency in dealings.

David Chaum introduced the idea of digital cash through a research paper in 1983. In 1989, he founded Digicash an electronic cash company to commercialize the ideas in his research.

E-gold was introduced in 1996. In 1998 Paypal came into the picture. In 2009, bitcoin was launched which is a decentralized blockchain-based digital currency with no central server and no tangible assets held in reserve.

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Advantages Of Digital Currency

  • Lower transaction costs and ability to make payments any time.
  • Receiving funds more efficiently than by legacy financial institutions.
  • It is easier for international customers to do business with you.
  • Fraud protection, for e.g. In Cryptocurrency Trading, you don’t require to show your personal information.
  • The cost of making currency becomes decreased due to digital currency
  • Anyone can easily receive or send payment anywhere, anytime.

Disadvantages Of Digital Currency

  • For Digital Currency strong technical mechanism required.
  • lack of proper Internet connection across the country
  • Lack of skilled users
  • Lack of electronics, gadgets, such as mobile, laptop, etc. between poor’s person.
  • Reduces the number of jobs in the banking sector.

Digital Currency in India

If a digital currency is regulated by a central bank. it is known as central bank digital currency( CBDC ).

Unlike crypto-currencies which are issued without a central bank backing and are issued and traded on exchanges, a CBDC is a digital currency that holds the same value as fiat currencies issued by a country’s central bank.


At the end of the day, digital currencies have the potential to change the world of business as we know it.  In other words, the obstacles that digital currencies must overcome in order to become ‘mainstream’ are not just economic but mental, as well.

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