Demystifying digital currencies and tokenisation

This is the first in a series of blogs exploring the evolving landscape of digital currencies, their impact on the financial sector, and the implications for banks and other financial institutions.

What Are digital currencies?

Digital currencies are monetary units that exist primarily in electronic form, unlike traditional fiat currencies which have both physical and electronic representations. This is the key difference between existing fiat currency and digital currencies. So, while a large proportion on fiat currency is today held as electronic money, a small proportion is still held in physical form as cash and notes.

Digital currencies can be broadly categorised into two types:

Decentralised digital currencies: Decentralised currency refers to methods of transferring wealth or ownership of any other commodity without needing a third party (e.g. banks). Examples include unregulated cryptocurrencies like Bitcoin, virtual currencies and Stablecoins.

• Unregulated Cryptocurrencies use blockchain technology to secure transactions and control the creation of new units. They operate independently of central banks and are known for their volatility and potential for high returns that drives speculation.
• Virtual currencies are unregulated digital currencies often used within specific virtual communities or platforms, such as online games. They are controlled by their developers or founding organisations.
• Stablecoins are a type of digital currency to maintain a stable value by pegging to a reserve asset, like a fiat currency (e.g. USD) or a commodity. Examples include Tether (USDT). However, a lack in transparency in the reserves backing such a currency means there is a degree of mistrust in their perceived stability.

Centralised digital currencies: A centralised currency, on the other hand is one that is regulated by an institution like central bank for a country. A prime example is Central Bank Digital Currencies (CBDCs) which are digital versions of fiat currencies issued and regulated by central banks. They aim to combine the reliability of traditional currencies with the benefits of digital transactions. Transactions using CBDCs are settled directly on the central bank ledger, although the CBDC’s themselves could be distributed to and held in custody by commercial banks or authorised fintech’s for retail customers. The Bahamas, Jamaica, and Nigeria have already introduced CBDCs, while China has been testing its digital yuan (e-CNY) in several localities, with millions of citizens already using it for retail transactions.

Why are digital currencies getting more traction now?

To understand this, we need to look at the two broad areas where they will be used.

From a commercial perspective, digital currencies can improve the speed of cross-border payments including foreign exchange (FX) settlement. They would also help corporates, financial institutions and in some cases even individuals manage their liquidity better because of faster settlement of transactions. Both established organisations (e.g., SWIFT, Visa, MasterCard) and Fintech’s (e.g., Wise, Revolut) have been driving this agenda without the use of digital currencies for some time now and digital currencies are an addition to the available options. In some countries e.g. Nigeria introducing eNaira, central banks have had to introduce CBDCs to avoid other decentralised digital currencies from disrupting the financial system. However, multiple factors, which are beyond the scope of this blog, determine if such a CBDC can succeed and remove the need for central bank currency in physical form and overcome popularity of other private digital currencies.

On the other hand, from a retail perspective, CBDCs have the benefit of boosting financial inclusion, by allowing people who do have bank accounts access to digital money backed by the central bank. In many developing countries, this can aid in direct and timely financial to those in need. At the same time, retail use of CBDCs, must balance the concerns of individuals compared to the relative anonymity offered by cash. While a retail CBDC will certainly provide a degree of anonymity, central banks can choose to implement identity requirements to use the network, meaning less anonymity for the users. Furthermore, most central banks plan to implement a cap on the amount of retail CBDCs that an individual can hold, to avoid large scale withdrawals from money held today in commercial banks to be held as retail CBDCs. If not, planned correctly this will adversely affect existing financial system (loans, mortgages, saving instruments etc.). We will have a look at the different use-cases for both wholesale and retail CBDCs in the next blog in the series but first let’s have a look at tokenisation.

What is tokenisation and the importance of CBDCs for realising the benefits from tokenisation.

Tokenisation is the conversion of any asset into a digital representation – a token. Distributed Ledger Technology (DLT) and blockchains are used to protect integrity and verify transactions performed using a token, as with cryptocurrency.

Despite recent waves of digitisation, a large proportion of assets are recorded in different ledgers that remain separate from messaging networks. This means that financial intermediaries must record transactions on siloed ledgers and then message each other to reconcile their books and finalise settlement. For example, electronic money is recorded in the accounts of different entities held in banks, which must use different messaging platforms (e.g. SWIFT) for the settlement of transactions in a coordinated manner.

This need for coordination across ledgers and networks between entities creates inefficiencies that increase costs and risks, lengthens settlement times, and in general adds overhead to financial services. Even where some of these financial assets (e.g. stocks, bonds etc.) are tokenised as digital assets, at present, conversions between digital assets and traditional fiat currencies can be cumbersome and expensive. For reasons mentioned above, both cryptocurrencies and stablecoins cannot completely substitute the stability and trust of a fiat currency.

That is where CBDCs could play a role as they are tokenised stores of value backed by central banks. CBDC’s could act as foundation for the tokenisation of financial assets that would cut costs by automating greater portions of the value chain in managing such assets and boosting competition.

What Next?

In the next blog we will look at the characteristics of DLT, do a deep dive into CBDCs, and usage of smart contracts. In the third and possibly final blog in this series will talk about what this means for central and commercial banks and the interoperability between existing payment settlement systems and those using CBDCs/other forms of digital currencies.