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Blockchain Act. 04 Jan 2021

What are the differences between a digital currency and a cryptocurrency?

Central bank-backed digital currencies, such as the potential digital euro and digital yuan, may become a reality in the coming years. Unlike cryptocurrencies such as Bitcoin and Ethereum, these currencies promise less volatility and greater security. In addition, they will have the support of their respective monetary institutions, responsible for ensuring financial stability.

The European Central Bank (ECB) is studying and analyzing the creation of the digital euro, under the concept of a Central Bank Digital Currency. It would be a “digital form of central bank money that is different from balances in traditional reserve or settlement accounts” and that depends directly on the institution, according to the Bank for International Settlements (BIS), in the report ‘Central bank digital currencies: foundational principles and core features

The ECB is proceeding with caution and it is believed that the first studies and tests could be carried out in mid-2021. One possibility is putting into practice formulas based on blockchain technology, the same one used by cryptocurrencies such as bitcoin and ether. This would allow Europe to have tools that allow for greater transparency and monitoring of information, transactions and movements carried out, according to the BBVA Research report ‘Digital currencies issued by central banks: features, options, pros and cons.’

Centrally issued currencies backed by central banks

Unlike these two cryptocurrencies, which also have DLT (distributed ledger technology), officially backed digital currencies will be issued centrally and will be backed by their central banks. “One of the differences between a digital euro and a Bitcoin is the way they are issued. While the operations, in the case of the euro, are centralized and the only one that can issue it is the ECB, in the case of a Bitcoin it is totally different,” says Alberto Muñoz Cabanes, Professor at the Department of Applied Economics and Statistics at the National Distance Education University (UNED).

Referring to cryptocurrency mining by users. It’s a distributed process radically different from the issuance of currency by a central bank, since states can issue it without a limit; while, for example, the monetary mass of Bitcoin is predefined and will not exceed 21,000,000.

However, with cryptocurrencies something else occurs. To begin with, since they are created by the users themselves, only after the creation of the blocks and their verification do new coins enter circulation. From there, its value is set by the market. “From an economic point of view, the native cryptocurrencies of decentralized and non-permissive networks, such as Bitcoin or Ethereum, are not anchored to the value of a legal tender, but rather are subject to the price set by supply and demand. Furthermore, it must be borne in mind that they are not backed by a legal entity that responds in the event of technical problems,” explains Natalia Español, an economist at BBVA.

“One of the differences between a digital euro and a Bitcoin is the way they are issued", says Alberto Muñoz Cabanes, Professor at UNED

Another of the main differences is that a digital currency backed by a central bank would have low volatility, compared to that exhibited by cryptocurrencies today. This is due, according to Professor Muñoz Cabanes, to the fact that while central banks ensure financial stability through monetary policies, in relation to the value of other currencies, Bitcoin is a volatile currency because it acts in an immature market, not backed and full of expectations. Although the economist points out that this may change the more the use of cryptocurrencies becomes popular.

Cryptocurrencies backed by corporations

It is also worth mentioning that digital currency projects not backed by central banks, but by corporations are subject to regulation, such as Libra, now Diem, the cryptocurrency project backed by Facebook. “There are other types of solutions that seek to combine the innovative functionalities found in cryptocurrency networks with greater guarantees for users,” says Español.

These types of currencies are backed by an asset reserve of the institution that issues them and can be less risky than cryptocurrencies as a means of payment. “However, we must bear in mind that, given the novelty of these proposals, the authorities are currently analyzing them and, where appropriate, adapting financial regulation to accommodate these types of solutions,” explains the BBVA economist.

Español also stresses that “these types of solutions, when they have a global reach and a large number of users, pose significant challenges to financial stability due to their systemic importance.”

Characteristics of digital currencies

In order to issue a digital currency backed by central banks, called by the acronym CBDC, the Bank for International Settlements (BIS) lists up to 14 characteristics that make this type of currency a platform that aligns with the financial stability objectives that govern international monetary institutions. The highlights of CBDCs, according to the BIS, are:

  • The conversion and the value will be the same as with physical money and volatility will be avoided
  • They will be accepted and available for all types of online and offline transactions 24/7
  • Its cost will be low and almost zero in the moments of creation and final distribution of the money
  • They will be a safe and resilient system at all times against possible cyberattacks, system failures or disruptions
  • They will be operable between different banking systems
  • They will be robust and legal currencies thanks to the support of a central bank

In search of primacy in digital currencies

The race for the leadership of digital currencies has already started and both Europe and China want to take the lead and prevent unregulated cryptocurrencies from being the main player in the world of digital payments. “These digital currencies respond to the interest on the part of central banks to stay updated to guarantee the fulfillment of their objectives and functions. Many central banks are investigating the impact of a CBDC issuance on the financial system, while others have opted for its issuance and are in the development phase. Such is the case of the Chinese central bank, whose digital currency DCEP is in the testing phase,” says Español.

The People’s Bank of China, the equivalent of the ECB in Europe, has been running tests of its digital currency since April with the help of four banks in the country. Given the strength that the two Asian technology giants, WeChat and Alipay have acquired in the digital payments environment, China wants to take control from now on, seeing how well these means of payment have worked in the country. Their aim is to have the digital yuan be fully operational by 2022. In the longer term, the Chinese government plans for its digital currency to replace its physical currency across the country.

At an international level, the Asian giant is looking towards a hypothetical scenario in which its digital yuan would become the world´s preferred currency. “The fact of being the first to launch your digital currency allows you to eliminate internal problems, such as ´black money,´ while increasing your fiscal efficiency, since tax payments would be immediate. It would also allow the speeding up of trade, because payments are instantaneous,” explains Muñoz, who underlines the importance that a currency of this type could have on international transactions. The convenience of this type of digital payment could act as a stimulus for rapid adoption by those involved.

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