Cryptocurrencies, digital currencies – changes in financial systems, or a whole new world?

Cryptocurrencies, digital currencies, electronic money… are the talk of the world.  A common question these days is what cryptocurrencies are and how they work.  This question now has a more recent addition – what are digital currencies?  Is digital currency a synonym for cryptocurrency?  If not, what is the difference?  If you are a fintech enthusiast, you may think that this is a great time to be alive.  But if you are not, it is perfectly ok to be confused, even a bit scared by the changes happening this fast.  The only thing we can do is to keep up with the changes.

Cryptocurrencies

According to the Digital Assets Act (the “Act”), cryptocurrencies are digital records of value that one can buy, sell, exchange or transfer, and that can also be used as a means of exchange or for investment purposes.  The term was coined based on the cryptography used to secure transactions, in the form of blockchain technology. The technology is based on lists of records called blocks.  Using cryptography, blocks are linked in the chains.  All data blocks are connected in such a way that there is no possibility to change the content of one block without changing the content of all previous blocks.  Therefore, it is difficult, almost impossible to change the data in a blockchain.

What is specific when it comes to cryptocurrencies?

Cryptocurrencies are decentralized.  They are not issued by central banks, nor do they guarantee for them.  Satoshi Nakamoto, the mysterious inventor of the world’s most popular cryptocurrency – Bitcoin, describes it as a “peer-to-peer electronic cash system“.  Their value depends on supply and demand in the market.  As many factors may affect this balance, cryptocurrencies are a very risky and potentially highly lucrative investment, a clear representation of one of the basic principles of economics – the risk-return tradeoff.

We must remember that cryptocurrencies are not “money, at least not according to the Act.  They are a means of exchange, and as such may be exchanged for goods, services, or money.

The growing interest expressed for these currencies leads to the need for their faster regulation.  However, the complexity of the matter and that this is completely new territory in the world of finance makes it more difficult for regulation to keep up.  By adopting the Act, Serbia became one of the first countries in the region to introduce a legal framework for cryptocurrencies (and digital tokens). But there is still a long journey ahead until their full regulation.

Central Bank Digital Currencies (CBDC)

Digital currencies issued by central banks, so-called digital fiat currencies, are the response to the expansion of the use of cryptocurrencies.  States could not remain blind to the growing importance of digital assets in global financial flows.  Concerns about the traditional financial and banking systems have led central banks around the world to start working on their versions of digital currencies.

These currencies are virtual records of existing fiat currencies.  They represent the complete equivalents of currencies such as the euro, dollar, dinar, etc.  This means that 1 euro in digital currency represents the same value of 1 euro in fiat currency.  Meanwhile, the value of cryptocurrencies depends exclusively on supply and demand.

These currencies will be centralized, issued and regulated by monetary authorities of countries. Furthermore, while cryptocurrencies are based on the principle of anonymity, digital currencies will enable central banks to monitor transactions more closely.  As fiat currencies, they will be covered by national foreign currency reserves which means they will be considered as money.  In simple terms, we could say that these are “regulated cryptocurrencies”.

The main advantage when it comes to digital currencies is their form which will allow transactions to be completed within seconds, regardless of whether parties involved in a transaction are in the same country or not (an interesting question raised is on the legal regulation that will be applied in such cases).  Also, it is likely that transactions will be fulfilled through the infrastructure of central banks as they are the ones issuing them.  So, the cost per transaction will be significantly lower, as commercial banks would not be an intermediary.

The People`s Bank of China has led the way in creating a digital currency by launching a digital yuan pilot program.  The European Central Bank followed suit, by releasing a report on its digital euro.  Many other countries are working on pilot programs as well.  The goal is for digital currencies to provide another alternative to traditional currencies, combining the best of both worlds – the benefits of digital cryptocurrency, but also the regulation and coverage provided by the familiar banking system.

However, numerous questions remain unanswered.  For example, there is no consensus on the technology that will be used.  It is possible that blockchain will be used as the only base technology, but other ideas are arising on this topic.  For instance, the digital yuan is not based on blockchain technology.  The form digital currencies will take remains to be seen – could we expect bank accounts within central banks, will digital currencies have the form of tokens stored in phones or could we expect a third option?  Also, there is the question of the role of commercial banks, as their current way of doing business remains open to discussion.

While digital currencies remain at the level of a topic for research, we are witnessing significant changes in the in the world.  The years to come will unequivocally lead to the creation of completely new business models compared to the ones we know now.  These developments urge businesses to stay informed and to develop a model which suits their needs best.