What is cryptocurrency?
A cryptocurrency is a medium of exchange – anything widely accepted as payment for goods and services – secured by a blockchain-based ledger – a data store that keeps track of transactions. Blockchain technology allows users to make transactions on the ledger without reliance upon a trusted third party to maintain the ledger. Cryptocurrencies use decentralised control as opposed to centralised digital currencies and central banking systems.
The Bitcoin
The first cryptocurrency was Bitcoin. It was created by Satoshi Nakamoto and released in 2009. Since then, people have made thousands of cryptocurrencies across many different blockchains.
Bitcoin aims to challenge the power institutions in our society like banks and governments have over financial instruments and to give it to the people using money. Many times, it has been compared to gold or the internet. Like gold, Bitcoins would always be scarce – only 21 million of them would ever be released – and hard to counterfeit. Also, the Bitcoin network wasn’t run by any central authority. Similar to how the internet was created, Bitcoin is built and sustained by all the people who hooked their computers onto the public blockchain (which anyone in the world could do).
In the beginning, Bitcoin:
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was seen as a digital payment method that doesn’t require users to hand over identifying information each time they use it;
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equalled universal money that doesn’t have to be exchanged at every border;
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promised the fairness of a currency that even the poorest people in the world can keep in a digital account without paying hefty fees, rather than relying on cash;
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promised the convenience of a payment system that makes it possible for online services to change small amounts of money, skirting the current limits imposed by the 20/ 30 cent minimum charge for a credit card transaction.
Nevertheless, because of its volatility, Bitcoin has been viewed as not such a reliable store of value (despite its built-in scarcity) and because of its restricted use as a medium of exchange, it remained primarily a tool for speculations. Also, the low transaction throughput (approx. seven transactions per second) of its blockchain makes it not an effective retail payment network, but merely a settlement system for large amounts. The innovation of the growing Lightning layer could fill in the retail payment needs, but time will tell.
Crypto wallets
To understand how Bitcoin works, some compare it with sending emails: the user doesn’t understand exactly the computer science behind how it works, but the act of sending and receiving an email is a universal practice. Email addresses can be shared with anybody but only the password holder can access received messages. Bitcoin works similarly. You can share your Bitcoin address with anyone sending you money, but only you, with your password called a private key, can spend it. To understand how peers send and receive Bitcoin, it is important to understand the relationship between keys and addresses. Addresses that are used to receive Bitcoin are generated from numbers called private keys. This means that possession of Bitcoin itself is the possession of a number. Private keys are 256-character binary strings like this: 110010001….
These numbers can be stored in a smartphone application called a wallet, on dedicated memory devices called a hard wallet, simply written down on a piece of paper, or any other way you can store a number. The private key generates an address that is used to receive Bitcoin, but the address cannot be reversed or engineered to reveal the private key behind it, thanks to encryption technology. Bitcoin addresses look something like this:
1ExAmpLe0FaBiTco1NAdDr3sSV5tsGaMF6hd
That’s it: private keys (send) and addresses (receive). Bitcoin can be sent around the network after it’s mined without a central router to authorise or censor the transactions. Any peer in the network with Bitcoin software can send, receive, and survey transactions, but no single peer can prevent them from happening. People using a smartphone wallet do not need the full Bitcoin software to transact in Bitcoin. Wallets allow self-custody of Bitcoin private keys but rely on third-party nodes to relay transactions to the network if not used in tandem with a Bitcoin node.
Stablecoins
One of cryptocurrency’s key drawbacks is that it is volatile (the prices are unpredictable and tend to fluctuate wildly), despite the decentralisation or intermediary-free transactions offered by Bitcoin. To compensate for this instability another important category of cryptocurrency has been created – the stablecoins. These are somewhat resistant to volatility, so users won’t see significant price changes.
Stablecoins’ prices are tied to a reserve asset like the USD or gold. For example, BUSD, USD Coin (USDC), and Tether (USDT) are all backed on a 1:1 basis with the USD. One BUSD or USDC or USDT is the same as one USD. However, there are also ‘non-collateralised’ stablecoins called algorithmic stablecoins.
The waves created by cryptocurrencies and stablecoins suggests that users are demanding more out of the traditional ways of payment, they want cheaper, faster, borderless transactions, and governments and central bankers are starting to pay attention.
Central bank digital currencies (CBDCs)
Central bank digital currencies (CBDCs) are digital versions of currency issued by central banks as a means of preserving and expanding existing monetary policy levers. CBDCs are the electronic version of the cash used by households and businesses to store value and make payments. Many central banks across the world exploring CBDC projects. According to the Boston Consulting Group CBDC tracker, there are now two live retail CBDCs in the world – in The Bahamas (Sand Dollar) and Jamaica (JAM-Dex). Also, there are 13 pilots, 18 proofs of concepts, and 72 central banks that have communicated publicly about their CBDC work.
The work and conversation around CBDCs have been sparked initially by Libra’s development (now a defunct project), and by the payment’s digitalisation boosted by COVID – at that time, the general knowledge was that the COVID-19 virus might live on banknotes and coins. Also, during the pandemic, governments embarked on a direct financial handout to the public (‘helicopter money’), which (on future occasions) may be done more smoothly and targeted with CBDCs, because of their scale and (foreseen) programmability. At a macro level, the ongoing geopolitical currency wars have also led national central banks to consider the use of CBDC in international transactions and investments to bypass the US banking system SWIFT and reduce their dependence on the USD. Furthermore, CBDC could be an important adoption element in the evolution of the world reserve currency. And finally, the innovation brought about using cryptocurrencies and concepts such as DeFi is forcing financial institutions to modernise their infrastructure and adapt to a new way of conducting payments.
If we think about the implementation model, there are two types of CBDCs:
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A retail CBDC refers to a digitised form of M0 money, coexisting alongside cash and issued by a central bank as a direct liability for general purpose, domestic circulation;
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A wholesale CBDC refers to financial institutions that carry reserve deposits with a central bank.
According to PwC research, wholesale efforts are more prevalent in advanced economies that have more developed interbank systems and capital markets. In contrast, retail CBDC projects are more common in emerging economies with financial inclusion expected as an outcome.
Regarding their underlying format, these can be:
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Account-based CBDC – the ownership of the CBDC is linked to an identity whereby a transaction is an update of payer and payee balance;
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token-based CBDC – the ownership of the CBDC is linked to proof. Using cryptography, it is possible to verify digital signatures to execute and verify the transfer. Thus, a transaction is a change of ownership of a specific unit of account or token.
Another way of categorising CBDCs is according to their distribution models:
Direct Model – all parties involved in the transaction will hold an account at the central bank. Payments will be transferred from one account to the other and all claims will be backed by the central bank. The central bank will issue the currency and manage a permission system to clear transactions. In addition, Know Your Customer (KYC) and anti-money laundering (AML) compliance requirements will be met by the central bank.
Indirect Model – the central bank will pass the digital currency token to the commercial bank or a non-bank financial institution (e.g. fintech), which will then distribute the currency and also handle KYC and AML requirements. The claim for the currency will be on the commercial bank or non-bank financial institution and not the central bank. This type of CBDC is also referred to as ‘synthetic CBDC’ by the IMF.
The Hybrid Model – many central banks are working on a hybrid model, whereby the central bank distributes CBDC to a regulated intermediary such as a commercial bank or fintech, which handles the transaction and the KYC and AML requirements. However, importantly, the claim remains on the central bank.
In terms of perceived benefits, on one hand, CBDCs would enable governments and central banks to reduce the costs of managing and transferring cash and would boost financial inclusion for all segments of society due to having safe money accounts at the central banks. Plus, CBDCs make it easy for a central bank to keep track of every unit of the currency, supporting the fight against tax evasion and financial crime. Furthermore, the ‘programmable money’ potential of CBDCs holds considerable appeal for policymakers. Government support payments could be more efficiently and promptly distributed – with their use limited to defined categories of goods. Expiration dates could also be set on currency, either to encourage consumption or discourage consumption.
On the other hand, crypto enthusiasts oppose CBDCs development as these might violate data privacy and could become a means of control by a central or national authority. Other risks involve banks run if consumers pull too much money out of banks at once and purchase CBDCs, effectively replacing commercial bank money with central bank money, reducing the liquidity of the commercial bank sector.
In our next instalment, we will delve more into NFTs and tokens, DeFi and DeFi protocols, and the metaverse. If you feel like recapping blockchains, check out Part 1.
This editorial was initially published in our Crypto Payments and Web 3.0 For Banks, Merchants, and PSPs Report. The first edition of our report aims to provide a go-to payment resource of crypto terms and concepts for those interested to understand the basics of crypto payments and their long-term impact. Furthermore, it shares practical examples of cryptocurrency-enabled ecommerce and banking services and presents the latest developments in the regulatory landscape. Also, it reveals what are the most innovative companies in this space, that are building the crypto rails.
Feel free to download your copy here.
About Mirela Ciobanu
Mirela Ciobanu is a Lead Editor of the Banking and Fintech domain at The Paypers. She is actively involved in drafting industry reports, carrying out interviews, and writing about the digital assets industry, the regtech space, digital identity, fraud prevention, and payment innovation. Mirela is passionate about finding the latest news on crypto, blockchain, DeFi, and fincrime investigations and is an advocate of the need to keep our online data/presence protected.
As a writer, she aims to always get the best obtainable version of the truth. She can be reached at mirelac@thepaypers.com or via LinkedIn.
This news is republished from another source. You can check the original article here