- Cryptocurrencies and stablecoins have boomed in 2021, sucking in investors.
- The world’s central banks are increasingly looking to create their own digital currencies.
- Insider cuts out the jargon and explains the key differences and what they’re used for.
- See more stories on Insider’s business page.
Cryptocurrencies and stablecoins have boomed in 2021. And central banks around the world are increasingly keen on their own digital currencies. But how do they all work and what are they used for?
Cryptocurrencies are basically digital currencies that aren’t controlled or issued by a centralized authority, such as commercial or central banks.
These coins are sent back and forth on enormous peer-to-peer networks – essentially groups of computers that share data.
The innovation of cryptocurrencies is that the “ledger” that keeps track of transactions – known as the blockchain – is overseen and verified by network users known as “miners.” Miners collectively do the work of a central authority, checking people aren’t trying to spend coins twice, and earning newly created bitcoin in return.
“What we aim to do with the blockchain is to make this ‘trustless’ so that nobody has overall control of it,” says Ben Edgington, a software developer for the ethereum network. “It’s fully democratic [and] it’s fully accessible.”
Bitcoiners say it’s ‘digital gold’
When bitcoin was launched by the anonymous person or group Satoshi Nakamoto in 2008, many thought it could be used for payments. In reality, it’s way too volatile.
Now, many bitcoiners say its scarcity – only 21 million coins can be mined – means it will hold its value and protect investors against inflation. Others say it’s purely speculative.
Other cryptocurrencies have different uses. The ethereum network, for example, can be used to build applications like collectible “non-fungible tokens.“
Cryptocurrencies are highly risky
In bitcoin and other networks that follow its model, miners verify transactions by using large amounts of computing power to solve complex math problems. Bitcoin’s mining system uses as much electricity annually as medium-sized countries. Other cryptocurrencies are less energy intensive.
Cryptocurrencies are largely unregulated and are some of the riskiest investments out there. Bitcoin has plunged around 50% since its April record high of close to $US65,000 ($AU88,065).
Wild volatility has been a huge deterrent for some investors as it can make crypto harder to use. That’s where stablecoins come in. Stablecoins maintain a “stable” value with a peg to other assets, like the dollar.
Traders love stablecoins
Interest in stablecoins has shot up too. They’re central to cryptocurrency trading, by allowing investors to easily move in and out of more volatile assets like bitcoin.
Stablecoins are also commonly used in the world of decentralized finance – a booming ecosystem that lets people create financial products without the need for central authorities.
Regulators are worried
But they’re facing heavy scrutiny. In May, the Federal Reserve’s Lael Brainard raised concerns stablecoins could default and destabilize the financial system. New York also banned Tether trading after an investigation found it had overstated its US dollar backing.
As with the rest of the cryptocurrency world, a lack of regulation means investors have almost no protection if their stablecoin suddenly collapses.
Central bank digital currencies
Countries are trying to find ways to make it easier to spend and send money – and keep control of payment systems that are increasingly private (think PayPal or Visa). A digital currency issued by central banks directly to consumers could be the answer.
Right now, private banks and payment companies are the most important players in the everyday use of money. But a central bank digital currency (or CBDC) would be a digital version of banknotes and coins, letting people hold and make payments in central bank money.
CBDCs could make payments safer
CBDCs could speed up transactions for individuals and big institutions, Chris Giancarlo, founder of non-profit Digital Dollar Project, told Insider. The DDP plans to test CBDCs in real-world situations.
“If you can send a photograph to Japan in a second, why can’t you send money in a second?” he said.
Central bankers also think CBDCs can make the financial system safer. Although unlikely, even a big global payment system could feasibly collapse.
Some bankers are concerned
One concern is privacy. Some governments may design CBDCs so transactions are anonymized, like cash, but others won’t. Privacy questions have arisen over China’s trial digital yuan.
“With a CBDC, the government would have direct access to all your spending patterns,” Bobby Ong, co-founder of data firm CoinGecko, says.
Some bankers are worried CBDCs could remove them from key parts of the financial system. CBDCs could reduce the demand for commercial bank accounts and cut banks out of the business of verifying transactions, although central banks are working on the details.