Digital Currencies and the Future of Money: A Comprehensive Guide

In the absence of money, goods were exchanged for one another as far back as 600 B.C. Money evolved over time as people became more civilised in their personal lives.

Digital currency attempted and failed to gain traction in the 1990s, but things changed in the 2000s, allowing it to grow in popularity and widespread use. In fact, modern economies rely heavily on digital currencies like cryptocurrency and virtual currencies.

Cryptocurrencies have evolved from digital novelty to trillion-dollar technology with the potential to disrupt the global financial system in a matter of years. Bitcoin and hundreds of other cryptocurrencies are becoming increasingly popular as investments, and they are being used to purchase everything from software to real estate to illegal drugs.

Problems with digital money:

• Identification: how do you identify your counter party?
• Genuineness of transaction: the issue of double-spending.
• Record keeping and audit trial: who or how will one keep the records of these transactions?

Satoshi Nakamoto is the pseudonym used by the cryptocurrency Bitcoin's anonymous creator(s).Even though the name Satoshi Nakamoto is frequently associated with Bitcoin, the actual person who bears the name has never been verified.

He published a whitepaper : "Bitcoin: A Peer-to-Peer Electronic Cash System."

He said in his paper that, "Commerce on the Internet has come to rely almost exclusively on financial institutions serving as trusted third parties to process electronic payments."

Hence, to avoid the involvement of a third party, he tried to solve these problems in two ways:

• Public key cryptography
• Distributed ledger technology and blockchain

Public-key cryptography

Public-key cryptography, also known as asymmetric cryptography, is an encryption method that employs two keys that are mathematically related but not identical—a public key and a private key. Each key has a different function, in contrast to symmetric key algorithms that use the same key for both encryption and decryption. Encryption is performed using the public key, and decryption is performed using the private key. The computation of the private key based on the public key is computationally impossible. As a result, public keys can be freely shared, providing users with a simple and convenient method for encrypting content and verifying digital signatures, while private keys can be kept private, ensuring that only the holders of the private keys can decrypt content and create digital signatures.

Because public keys must be shared but are too large to memorise, they are stored on digital certificates for secure transport and sharing. Because private keys are not shared, they are simply stored in the software or operating system that you use, or on hardware (e.g., USB token, hardware security module) that contains drivers that enable them to be used with your software or operating system.

For a better understanding, please see the image below.

The other is Distributed Ledger Technology (DLT) and Blockchain

DLT is a novel and rapidly evolving method of recording and sharing data across multiple data stores (or ledgers). Transactions and data can be recorded, shared, and synchronised across a distributed network of different networks using this technology.

A 'blockchain' is a type of database used in some distributed ledgers that stores and transmits data in packages known as' blocks' that are linked together in a digital 'chain.' Blockchains use cryptographic and algorithmic methods to immutably record and synchronise data across a network. A graphical representation of how blockchain works is shown in the figure.

A blockchain is a linked list that employs hash pointers rather than standard pointers.

How is it tamperproof?

"Though there are a number of cryptocurrencies, bitcoin is the mother of all."

An Introduction to Bitcoin

Like all money, Bitcoin is a new type of digital currency that can be stored, exchanged, and used to make payments. The key to what makes Bitcoin unique is that it is an opt-in currency controlled by the 'consensus' or will of its users. It is made up of a growing network of people who mutually agree to the Bitcoin protocol's rules. They use decentralised infrastructure to conduct peer-to-peer transactions and store value independently of any government, corporation, or financial institution. There is no need to seek permission to use Bitcoin, and there is no danger of being disconnected from the system.

Despite the fact that the bitcoin market is volatile and unpredictable, the rise in bitcoin's value has pleased investors and drawn them into the mining process.

The rapid rise and value of bitcoin have enticed investors and traders, and businesses and government agencies have undoubtedly begun to accept bitcoin as a medium of exchange. Still, there are some obstacles that the bitcoin community must overcome, and they are as follows:

Bitcoin's Legal Status Around the World:

The main issue with determining whether bitcoins should be treated as currency, securities, commodities, or something entirely different is determining their legal status. While bitcoins are commonly referred to as "currencies" because they share many characteristics with them, the legal definition of a currency requires it to be issued, used, and accepted by a country, which bitcoin does not. Another issue with bitcoins is that not every country has legalised their use. The disparity in the legalisation of bitcoin in various countries is a major issue.

Volatility:

Bitcoin has been at the centre of numerous scandalous events in recent years. As a result of the crackdown on the infamous Silk Road, Bitcoin has gained a bad reputation as a currency used to finance illegal transactions. Other events, such as the failure of Mt. Gox and data breaches, have also contributed to the negative perception of Bitcoin (Sagar, 2017). Bitcoin's high volatility raises serious concerns about its viability as a currency. Furthermore, because there is a close community dealing with bitcoins in comparison to traditional currency, any trivial matter or trade can affect the value of bitcoin. The block reward in circulation and merchants accepting Bitcoin as payment are both small.

Anonymity:

Because Bitcoin is public, everyone can see everything. As a result, it lacks true anonymity. Instead, it provides pseudonymity. Leaving aside the significant issues that dishonest users have with this, here are the reasons why pseudonymity is bad for honest users.

Some disclosure may be acceptable for individuals, but it is lethal for businesses. Every single one of their customers, sales, account balances, and other minor information would be made public. One of the most significant disadvantages of using Bitcoin is the lack of financial privacy.

Environmentally harmful:

To perform the work associated with crypto mining, Bitcoin and other proof-of-work cryptocurrencies require massive amounts of energy—more than entire countries use. The United States is the largest Bitcoin mining country, accounting for 37.84% of Bitcoin mining activity. As a by-product of Bitcoin mining, approximately 36 kilotons of electronic waste are generated each year, which is a significant issue.

As a result of the high volatility, cross-border transactions remain a barrier to the widespread adoption of crypto assets.

All of this resulted in the development of Stablecoins. As previously stated, stablecoins use blockchain technology to create cryptos that maintain their value against a pegged external asset class. Stablecoins are crypto assets that reduce volatility and enable hassle-free cross-border transactions.

"It's not the strongest species that survives, nor the most intelligent, but most responsive to change" - Charles Darwin

Central bank digital currencies

Without a doubt, Central Bank Digital Currencies (CBDCs) are gaining attention. There is increasing discussion concerning this new payment technology among regulators, bankers, policymakers, and members of the mainstream media. In fact, 85% of central banks worldwide are now either researching or testing CBDCs, according to the Bank for International Settlements. What is the reason for the widespread interest and what are the main lessons to be learned? In this research, we take a broad view of the essential characteristics of CBDCs and the primary scenarios that are likely to arise in the upcoming years, even though this is a complex topic and the CBDC story is still emerging.

What are some of the alleged advantages?

CBDCs are gaining popularity because they are said to have numerous benefits. Governments, for example, spend a lot of money managing and transferring cash, and this technology can help them save money. Furthermore, safe money accounts at central banks could increase financial inclusion for all segments of society by providing any legal resident or citizen with a free or low-cost basic bank account. Finally, CBDCs make it simple for a central bank to track the precise location of every unit of currency, making it easier to combat tax evasion and financial crime.

"With great advantages, comes the greater risk"

What is the downside?

CBDCs, like most technologies, have some risks associated with them. For example, if citizens withdraw too much money from banks at once and invest it in CBDCs, it may cause a bank run. The centralization of digital currencies through the government may also raise data privacy concerns. Finally, some current legal frameworks are insufficiently comprehensive or modernized to deal with new forms of money. CBDC issuance poses legal, financial, and reputational risks for central banks in the absence of robust legal systems.

The path ahead In the near future:

There will undoubtedly be more discussion and debate about CBDCs. Like with every new technical advancement, the advantages, and disadvantages, as well as the intended and unintentional effects, must be carefully addressed. However, it is clear that most policymakers are now very much aware of the potential advantages of CBDCs. Even though the CBDC tale is still in its infancy, some important characteristics are clearly noteworthy.

Conclusion:

Traditional digital and physical currencies will likely coexist alongside CBDCs, stablecoins, and cryptocurrencies in the future with a combination of account-based, token-based, decentralized, and all of the above.