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Digital currency is currency that is only used in digital form without any physical form to back it up, such as coins or bills. It’s also referred to as electronic currency, digital money, electronic money, and e-money, among other names. The cryptocurrency Bitcoin is the most well-known and widely used digital currency.

Digital money has existed as long as the internet has, but it has taken many years for it to be widely used and trusted. Part of the reason that digital currency has gained traction in recent years is because of the blockchain technology first used by Bitcoin, which allows for more security and transparency.

Prior to the creation of cryptocurrencies, PayPal brought the idea of quick and easy person-to-person transactions to the masses. The money used by banks and central governments is also digital money, since it often gets transferred electronically rather than physically. However, banks are required by law to hold a certain amount of money in physical cash.

While the terms “money” and “currency” are often used interchangeably, they are not the same thing. Money is a more intangible concept of value and numbers, whereas currency is what is physically (or digitally) exchanged. For example, a check or savings account is money, and coins or paper bills are currency.

How Does Digital Currency Work?

Digital currency can be used in the same way as physical currency to pay for goods and services.

Although money has been transacted digitally for many years via online bank accounts, wire transfers, and credit cards, digital currency is a newer market tool that is changing the way the world transacts. With digital currency, every action—from its creation and storage to sending and receiving it—is done electronically through phones, credit cards, and online exchanges.

Digital currency has been growing in popularity in recent years, in part thanks to its increased transparency and quick transactions. Additionally, without the need for intermediaries, transactions are generally faster and lower cost than going through a bank. As more and more companies and countries are adopting it, this increasingly widespread use has contributed to the spread of globalization, since it’s easier to send money and trade internationally than ever before.

Pros and Cons of Digital Currency

These are some of the pros and cons to using digital currency.

Pros:

•  Increased transparency
•  Quick transactions
•  Convenience

Cons:

•  Still some risk of fraud, data theft, scams, and criminal use
•  May be volatile
•  Lack of regulations can cause issues

Types of Digital Currency

There is more than one type of digital currency. While cryptocurrency may be the first thing that comes to mind, there are also central bank digital currencies. Below we’ll outline how each works, and how they differ from each other.

Cryptocurrencies as Digital Currency

Cryptocurrencies are a type of digital currency that is secured by cryptography, which adds an extra layer of security and anonymity to transactions—and tackles the problem of “double spend” (the possibility of spending the same unit of digital currency twice). Cryptocurrencies aren’t controlled or created by a central authority, are held in digital wallets, and are sent from peer to peer on decentralized exchanges, using a blockchain ledger that keeps track of all transactions. Examples of popular cryptocurrency types include Bitcoin, Ethereum, Litecoin, and Ripple.

Recommended: Understanding The Different Types of Cryptocurrency

One reason cryptocurrencies were created was as a response to the way current fiat currencies operate. Rather than being created and issued by a company or government, cryptocurrencies are mined using decentralized computational methods and algorithms. Certain cryptocurrencies, such as Bitcoin, have a predetermined amount of ‘coins’ that will ever be available in the market.

Cryptocurrencies aren’t tethered to a physical asset or otherwise backed by anything, so their value is based solely on supply and demand. This has historically made them fairly volatile as their use and demand changes, but they may not remain volatile as they become more widely used.

It’s worth noting that cryptocurrency is subject to different types of crypto regulations than central-bank-backed digital currency.

Central Bank Digital Currencies

Some digital currency is issued by a central bank and has the same regulations as physical currencies. These are called Central Bank Digital Currencies, or CBDC. These are not widely used yet, but more and more governments are working towards issuing digital forms of their fiat currencies.

Central banks have been motivated to update their technology and practices to outpace the growth of cryptocurrencies in the market. Countries and regions such as China and Europe are racing to lead the way into this new era of digital currencies, partly to avoid the rise of unregulated cryptocurrencies. China is already in the process of testing the digital yuan and other countries will be doing similar tests soon.

CBDCs may use the same blockchain technology as cryptocurrencies or they may rely on different, centralized technologies. One benefit of CBDCs is that they may be more stable than cryptocurrencies, because they are backed by central banks. Additionally, if a digital currency is issued by a central authority, they may choose to create more of it over time.

The Bank for International Settlements (BIS) has a list of 14 characteristics that define CBDCs in order to ensure their financial stability and their interoperability with existing fiat currencies. Some of these characteristics include:

•  They can be used between different types of banking systems
•  They will be legal and supported by central banks
•  Their value and conversion rates will be the same as physical money
•  The cost of creation and distribution will be low
•  They will be resilient and safe, protecting against technology issues and cyberattacks

Investing in Digital Currency

Investing in digital currency like crypto is considered quite risky — in part because prices can fluctuate so wildly. For example, Bitcoin was valued at more than $14,000 per coin in 2017 before dropping to less than $3,500 per coin by the beginning of 2019.

On the flip side, some investors find it appealing to invest in digital assets and crypto because it is also one way to diversify a portfolio that might be largely made up of stocks and bonds. Cryptocurrency is one of many alternative investments that investors sometimes look to in diversifying. In fact, 2021 saw the launch of the first North American crypto exchange traded fund (ETF), in Canada.

The steps to investing in digital currency are relatively simple:

1. Make an account with a digital currency exchange. This is a platform that allows you to buy, sell, and exchange crypto, and gives you the unique addresses you need to make transactions. To open the account, you’ll create a username and password, and also verify personal data like your residential address or social security number.

2. Get a digital wallet. This is a way to securely store your crypto, and is key if you want to trade crypto and also use it to pay for goods and services. There are many free wallets available on the market, some of which are designed for specific platforms, like Windows desktop, iOS, or Android mobile. Note: Some bitcoin brokerages, like Coinbase , operate as both an exchange and a wallet.

3. Link your wallet to an external bank account. This is the account you’ll use to buy digital currency, or to withdraw it in the form of your home currency. You’ll typically need to provide your routing and account numbers, though some wallets can connect to your bank account (or PayPal account, or another source of funds) directly with your digital login credentials.

4. Transfer funds into your new account and start investing. Now you can use your digital currency for purchases or trades. (One thing to note: your wallet may take a portion of your purchase as a transaction fee.)

Digital Currency and Taxes

Anyone who’s interested in investing in digital currency should familiarize themselves with how to pay taxes on crypto. The IRS considers digital currency to be property, rather than monetary income. So in the same way that an individual who purchased or sold a property (like a vacation home) would keep track of the transaction, an individual who bought crypto like a stock or other asset will need to keep track of their crypto transactions—and report the value of their holdings (translated to U.S. dollars) on their tax filings.

There is one exception to the IRS’s cryptocurrency-as-property rule : If you receive crypto as a gift, you mine it, or you are paid in crypto for goods or services you’ve sold, that is in fact treated as income by the IRS, and taxed accordingly.

Typically, crypto exchanges keep track of an investor’s transaction history (in the same way a brokerage might with stocks). But it never hurts to keep your own records, as well.

The Takeaway

Digital currencies are becoming more popular and prevalent in the market, both due to the rise of cryptocurrencies and the shift towards government issued central bank currencies. These currencies reflect the way people are enacting transactions — virtually, rather than in person — and are also considered at the forefront of security and privacy technology.

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Crypto: Bitcoin and other cryptocurrencies aren’t endorsed or guaranteed by any government, are volatile, and involve a high degree of risk. Consumer protection and securities laws don’t regulate cryptocurrencies to the same degree as traditional brokerage and investment products. Research and knowledge are essential prerequisites before engaging with any cryptocurrency. US regulators, including FINRA , the SEC , and the CFPB , have issued public advisories concerning digital asset risk. Cryptocurrency purchases should not be made with funds drawn from financial products including student loans, personal loans, mortgage refinancing, savings, retirement funds or traditional investments. Limitations apply to trading certain crypto assets and may not be available to residents of all states.

Investment Risk: Diversification can help reduce some investment risk. It cannot guarantee profit, or fully protect in a down market.

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