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International Currency Markets

Digital Currency

Development of Digital Currency

Digital currency, including electronic, virtual, and cryptocurrencies, is a relatively new form of currency being used in global economies.

Currency has evolved from bartering an actual asset to exchanging physical tokens that represent some value but have little to do with any underlying asset. Electronic trade is another step in the evolution of this still-changing system.

Digital currency can be broken into three categories: electronic, virtual, and cryptocurrencies. In electronic currency, the most common mechanisms are credit and debit cards. Credit cards provide predetermined credit limits to consumers. Debit card transactions are simple—they mimic writing a check; transacted funds are registered at a financial institution and, under central agreement, are electronically moved from one institution to another.

Virtual currencies have developed as a result of the social nature of the Internet. This form of currency most closely resembles barter, in that there is an agreement of value within the community. Unlike other forms of currency exchange, virtual currency has no legal tender. In other words, it cannot be exchanged for country-issued currency. Simple forms of virtual currency are coupon exchanges.

The last category of digital currency, and the one with the most current news coverage, is cryptocurrency. Cryptocurrency is a form of electronic currency that is not issued by a central bank. The best-known and most-traded cryptocurrency is Bitcoin. Cryptocurrency uses a peer-to-peer network to create a blockchain. A blockchain is a final digital ledger for a cryptocurrency transaction after the transaction has been verified and blocked. A typical cryptocurrency transaction starts with the request for a transaction. This can be a contract or an agreement to transfer cryptocurrency from one account to another. The transaction enters a peer-to-peer network called a node that validates the authenticity of the request using established algorithms. After it is verified, the transaction is clustered into a group of transactions called a block. The block is then added to a larger component, the blockchain, which records the transaction. The transaction is unalterable at this stage, as it is considered completed.

In place of selling stocks, cryptocurrency and initial coin offerings have become a new source of capital development. For example, Cogs Inc. can create its own cryptocurrency and offer it to investors. This currency is leveraged against physical assets such as a building or cash. It then creates a form of open credit for Cogs Inc. to use to expand a product line or purchase more physical assets.

How a Cryptocurrency Transaction Works

A cryptocurrency transaction begins with a request, which is verified using specialized algorithms. The transaction is placed into a blockchain that cannot be altered.

Advantages and Disadvantages of Cryptocurrencies

Cryptocurrency may be easy to use and offers considerable privacy, but it faces many challenges, from its newness and lack of centralization to being accepted as a modern currency.

The advantages of cryptocurrency revolve around its ease of use, privacy, and monetary control. Digital currency is immediate and requires little physical trade evidence, a goal that has existed since the beginning of trade. As a decentralized currency transaction, it is available to anyone who can get online and make a trade. The fees tend to be low, and the transactions are immediate. Because it is computer generated and electronic, there is no face-to-face interaction, so digital currency offers considerable privacy to users.

Studies have shown that reliance on cryptography is also an advantage. The cryptography of Bitcoin, for example, is some of the most secure in the world, surpassing that of credit card companies. Part of this is because digital currency does not allow for charge-backs, which are a major source of fraud in the credit card industry. A charge-back uses the ability to reverse a charge at the last minute. The cryptography of Bitcoin is so effective that major global banks are trying to purchase the system for their transactions.

The disadvantage of cryptocurrency is its relative novelty in the currency world. At its introduction in 2009, Bitcoin had no backing from real assets, no regulatory guarantees, and sometimes even little regulatory oversight. Many people have found the idea and use of cryptocurrency to be confusing, and they have been uncertain how to convert digital currency into physical assets. Because it is a decentralized system, other than a normal search engine investigation, there are few sources one can access to ask questions. Customer service is exclusive to specialty trade organizations, and because cryptocurrency is not widely understood, it is not broadly used. This makes cryptocurrency very much a speculative niche market.

The lack of centralization leads to one of the greatest disadvantages for cryptocurrency. There is no simple button to reset your password. Cryptocurrencies such as Bitcoin have a digital wallet that resides on your computer. As an analogy, it is a vault that includes all of a person's money. If the computer is lost without a backup or the password is forgotten, there is no system in place to retrieve the digital wallet. A hard drive crash could result in the loss of millions of dollars in cryptocurrency.

Digital Currency Risks

Using digital currency comes with its own risks, such as nonrecognition, significant volatility, and compliance risk.

The disadvantages of digital currency can lead to unique risks. The most significant risk for cryptocurrencies is the fact that they are not recognized as currencies by leading economies of the world. For example, China has banned the trading of Bitcoin and its use as a payment system. The primary reason for the ban is that there is no regulation from the government and no way to verify any underlying assets. Likewise, in the United States, the Securities and Exchange Commission (SEC) has declared that Bitcoin is a commodity, not a currency. Currencies have the backing of a country, whereas commodities are assets defined by companies. Another cited concern for electronic trade, especially for cryptocurrency, is the technological risk. For security, cryptocurrency relies on sophisticated cryptography in tandem with its peer network blocks. The fear is that this security system may be breached, giving access to perpetrators of fraud. To date, the system seems secure, with large banking institutions adopting the technology. However, computer hackers may be tempted to break into the system. Because this form of currency is virtual, a data breach would be analogous to a bomb in Fort Knox. Millions of dollars would be destroyed, with no way to backtrack the transactions.

Because it is still seen as speculative in nature, cryptocurrency has significant volatility risk. One of the reasons that it is not widely used is that large corporations do not know how to respond to the swings in volatility. The key problem for corporations, banks, and governments is how Bitcoin is valuated. Some market analysts believe Bitcoin is approaching the limits of its "bubble" and that investors may choose to back away from the asset. This is linked to exchange risk. The volatility can affect the rates of exchange for the contracts that are being transacted.

Also because of its newness, there are compliance risks associated with digital currency. This form of currency is susceptible to fraud with respect to money laundering. The currency is difficult to track and is not always attached to a physical asset. There are no well-defined rules for the accounting of digital currency in financial statements, and the currency has no well-established exchange rates for conversion to home country currency.