SuWhat are digital currencies?

The advent of Bitcoin as the first widely used cryptocurrency brought unimaginable consequences upon the traditional financial markets and led to a complete overhaul of the concept of money. Nowadays, you can pay for goods and services with tokens issued by companies that previously collected millions in funding; it is almost like anyone can create their own currency and generate a following large enough to bring it into circulation. 

Naturally, this is perceived as a very high risk by authorities, which do not want to see a single entity gaining that much control (see the current circumstances of Libra, for example) and also do not want a rival currency to rise that might threaten the country’s legal tender – after all, the latter does not only act as a medium of exchange but also as a tool to regulate monetary policies.

It is therefore important to have an understanding of what digital currencies are, what the authorities’ stance might be and if there are any important variations.

The FATF classifies digital currency as a digital representation – as opposed to a physical representation in the form of banknotes and coins – of a virtual currency (non-fiat) or e-money (fiat). In the most general sense, it is money that can be used for the purchase of goods and services and for the transfer or exchange from one currency into the other. It does not adhere to geographical or political borders and allows for instantaneous transactions. 

What are digital currencies?

 

Therefore, virtual currencies constitute a subset of digital currencies. But what other characteristics do virtual currencies have?

First and foremost, they are not considered equivalent to money by central banks. This is a very important point and should be kept in mind when dealing with this type of currency. Hence, they cannot be considered legal tender and are not issued by central banks, credit institutions or by e-money institutions. However, virtual currencies can act as a medium of exchange, and/or a unit of account and/or a store of value, as stated by the FATF. Some of them might have a very restricted use, in the sense that they can only be exchanged within a specific platform or purpose (e.g. gaming coins). Virtual currencies can be further distinguished according to their convertibility – in fact, if the virtual currency is convertible, then it will have an equivalent value in real currency and can be exchanged back-and-forth. If it is non-convertible, it is intended to be specific to a particular virtual domain or platform only and cannot be exchanged for fiat currency.

Since we have already mentioned that authorities perceive it as a high risk if single entities outside of governments start issuing their own currencies, which ultimately might end up in direct competition with a country’s legal tender, we need to go one step further and also explain the difference between centralized and decentralized virtual currencies.

Centralized virtual currencies have a single point of control – this can be a company or a single person that is responsible for the issuing of the currency, for establishing the rules for its use, maintaining the central payment ledger and also, having the power to influence the circulation to their will. 

An interesting example of how these definitions can translate into a country’s legislation, is the local Virtual Financial Assets Act and how it defines a Virtual Token: “[…] a VT as a form of digital medium recordation whose utility, value or application is restricted solely to the acquisition of goods or services, either solely within the DLT platform in relation to which it was issued or within a limited network of DLT platforms.” It can therefore be understood as a non-convertible virtual currency according to our previous statements.

What are cryptocurrencies?

 

As for decentralized virtual currencies, these are distributed, open source, math and p2p-based. All of these attributes seem familiar – and they are, as they constitute the underpinning of what are known as cryptocurrencies. 

Considering all of the above, cryptocurrencies can be described as math-based, decentralized and convertible virtual currencies that are protected by cryptography. Cryptography helps secure transactions, verify their authenticity and control the currency’s inflation rate. Due to their decentralized nature, cryptocurrencies run on a distributed ledger technology (DLT), or blockchain. Bitcoin is the best and most popular example – it was also the first. 

Digital vs virtual vs cryptocurrency

By now, it should have become apparent how the three currency types relate to each other. Digital currency is the umbrella term, including every form of digital money there is – be it regulated or unregulated. Virtual currencies constitute a subset of digital currencies and can be further distinguished into the convertible/non-convertible and centralized/decentralized type. They are not considered legal tender and most often are restricted in use – for example, as a medium of exchange on one specific platform only. As for cryptocurrencies, these are virtual currencies with specific characteristics. Subjectively, decentralization, cryptography and distribution seem to be their most important features since they translate into no single point of control, security of transactions and preferably, independent actors (nodes) maintaining the network.  

One could consider the relationship between these currencies less of a rivalry and more of an evolution from the type of money we knew, even in its digital form in our bank accounts, to the current state of affairs where Bitcoin and cryptocurrencies are slowly but surely making their way into commerce and people’s everyday lives. Acceptance from central banks is still low; however, it seems that the idea of issuing their own cryptocurrency has started to grow on at least some governments. Thus, at some point in time, cryptocurrencies might actually be considered legal tender. 

Julia Krieger

Julia Krieger

Julia holds a Master’s Degree in Management Information Systems and a Bachelor’s Degree in International Business Studies from the University of Paderborn, Germany. Her strong interest in capital markets, investments, and innovation led her away from traditional finance and towards the blockchain industry. As an Analyst, she had the opportunity to work on numerous projects in the space and put her extensive knowledge of economics and technologies to use.