Digital currency is a term that refers to any currency, money, or money-like asset that is primarily managed, stored, or exchanged digitally. There are various types of digital currencies, including cryptocurrency, virtual currency, and central bank digital currency.
Digital currencies tend to exhibit properties similar to traditional currencies, but do not exist within a physical form. Have you been wondering what is digital currency backed by? When it comes to cryptocurrencies, most cryptocurrencies derive their value on factors based on the algorithms of their blockchain networks and their demand and supply.
Central Bank Digital Currencies (CBDC) is a type of digital currency that is backed by underlying assets to derive their value. This post will focus on CBDCs and tell you everything you need to know about these digital currencies that are supported by the government.
What Is A Central Bank Digital Currency?
The term Central Bank Digital Currency refers to the virtual form of a fiat currency. A CBDC is effectively a digital token of a country’s official currency. It means that CBDCs are issued and regulated by a country’s central bank or any other central monetary authority in the country. It means that these digital currencies are backed by the issuing country’s full faith and credit.
CBDCs have the ability to encourage more financial inclusivity in an economy by bringing unbanked individuals into the financial system, and they can simplify implementing monetary and fiscal policy. However, CBDCs are a centralized form of digital currency, and that means they cannot be considered the same as cryptocurrencies, which do not have any central authority regulating them.
How Do CBDCs Work?
Fiat currency is the term that refers to the traditional currency issued by a country. It is available in the form of coins and currency notes, and it is considered a legal tender that can be used to transact for various purposes, including the purchase of goods and services. A CBDC is effectively the virtual form of that fiat currency. It means that a CBDC is backed by the faith of the issuing government, much like the country’s fiat currency.
CBDCs represent fiat currency and the goal of using them is to provide the convenience of digital currency with the security of the regulated and reserve-backed circulation of the traditional banking system used in a country. These currencies are designed to operate as a unit of account, store of value, and medium of exchange for day-to-day transactions.
CBDCs are under various stages of development in countries worldwide. As of October 2021, there were 83 countries that have been involved with developing CBDCs. Many countries have their own reasons for the need to develop CBDCs.
The US wanted to develop CBDCs in its financial systems to add the efficiency of digital payments systems that can improve its domestic payments systems. Sweden has been developing an electronic version of the krona (its fiat currency) to address the issue of a decline in use of cash in the country. India has been on a bid to develop a CBDC to address an entirely different issue. A significant portion of people living in India is unbanked. Setting up the necessary infrastructure to help them enter the financial ecosystem through fiat currency will be costly. Establishing a CBDC would allow India to effectively include its unbanked citizens in its financial ecosystem.
CBDCs vs. Cryptocurrencies
The very basis behind CBDCs would not exist without cryptocurrencies. Cryptocurrencies are decentralized digital currencies that rely on cryptography to maintain a digital ledger of transactions that is impossible to duplicate, operating on blockchain technology. The underlying blockchain technology enables seamless and direct transfers between cryptocurrency users, simplifying the implementation of monetary policy in an economy – all without the need of a central authority regulating the flow of funds.
Bitcoin is the first cryptocurrency in the world and it was introduced in 2009, setting the framework for other cryptocurrencies to follow in the years since it has been around. Cryptocurrencies typically do not have anything backing them. Unfortunately, the lack of a central authority regulating the flow of funds and deriving the value of cryptocurrencies makes them extremely volatile to fluctuations.
Stablecoins
A stablecoin is a class of cryptocurrencies that attempt to do away with the volatility typically associated with cryptocurrencies. These stablecoins are backed by a reserve asset. This new asset class is gaining popularity worldwide as it can potentially bring together the best of fiat currencies and cryptocurrencies together.
There are various forms of stablecoins that are backed by a range of reserve assets. Let’s take a quick look at the types of stablecoins to help you understand them better.
Fiat-Collateralized Stablecoins
Fiat-collateralized stablecoins are backed by a 1:1 ratio to traditional fiat currency. The fiat collateral backing the fiat-collateralized stablecoins remain in reserve with a central authority in proportion to the stablecoin in circulation on the blockchain network.
Commodity-Backed Stablecoins
Commodity-backed stablecoins are backed by physical assets that are used as collateral for them. There are several stablecoins that use an underlying commodity to derive value. Tether Gold is a popular commodity-backed stablecoin that relies on collateralizing gold back to its value. Commodity-backed stablecoins can also use other physical assets as collateral, including other precious metals, real estate, and oil.
Algorithm-Based Stablecoins
Algorithmic stablecoins do not have any asset backing them. These assets rely on introducing stability through specialized algorithms and smart contracts integrated into the blockchain network to manage the supply of tokens.
Crypto-Collateralized Stablecoins
Crypto-collateralized stablecoins are stablecoins that follow a crypto collateral structure. These stablecoins are backed by another cryptocurrency as collateral. It means that these stablecoins are also free of control from a central authority. However, these stablecoins are not inherently stable due to the volatile nature of the underlying asset used as collateral for them.
Wrapping It Up
Did you find this post explaining what digital currencies are backed by helpful? Keep following The Crypto World for more informative posts about digital currencies and the broader cryptocurrency industry.
