The basics of digital currencies

Managing Principal
Banking, Finance & Regulatory
15 August 2023

As the digital revolution takes hold on global economies, we are inching ever-closer to a cashless society. But what is digital currency? How does it work? And what does it mean for the Australian financial system?

Finance and the digital revolution

Long gone are the days when digital currency was reserved to the fringes of the global financial landscape. With the trend of the past decade towards electronic transactions dramatically accelerated by the pandemic, it’s no secret that the use of cash is in sharp decline across the world.

From the USA to China and Europe, the story is the same – banks now spend far more time processing digital transactions than handling cash in-branch. The Reserve Bank of Australia estimates that cash payments have halved since 2019, accounting for only 8 percent of transactions last year. 

Whichever way you look, we seem to be headed closer and closer towards a cashless society. And as the tides turn digital, it’s not just the cryptocurrency ecosystem which is disrupting the status quo. As the allure of alternative money systems continues to gain traction, governments across the globe are also looking at ways to get in on the action. 

Until now, blockchain assets have remained a largely unregulated gap in the financial services industry. However, as we approach a second wave of digital currency, Australia is joining a chorus of world leaders in undertaking a radical rethink of the state’s relationship with digital assets – with significant consequences for the way we think about finance at home and abroad.

As all records on the blockchain are recorded and decentralised, transactions are traceable and capable of being verified, albeit largely anonymously. Despite this element of anonymity, cryptocurrencies can be restrained by a Court order if the acquisition is suspected to have arisen in connection with criminal offences. Although, the decentralised structure of the network(s) on which cryptocurrencies exist has made it difficult for central authorities to take control or restrain that property. Our article on whether cryptocurrency can be restrained under the Proceeds of Crime Act 2002 (Cth) and Confiscation Act 1997 (Vic) discusses these points in greater detail. 

Understanding digital currency

The concept of digital currency has come a long way since the emergence of bitcoin (the earliest form of cryptocurrency) back in 2009. As the appeal of a more inclusive, simplified approach to finance has taken hold, thousands of digital currencies have entered the game. From Ethereum to XRP,  an increasingly diverse portfolio of crypto assets has become available to investors.

In simple terms, cryptocurrency relies on blockchain technology to facilitate secure transactions and verify new units. Whilst each has its own characteristics, they share one important factor – all are privately issued and decentralised, and are completely independent of government regulated banks. 

As  a result, one of the main drawbacks of cryptocurrencies is their volatility. Because they are not tied to national currencies, their value can fluctuate wildly in response to movements in financial markets. To make things even riskier, there are no state bailouts in place in the event of a collapse. 

The inherent instability of traditional cryptocurrency has led to the development of the next evolution of digital currency – stablecoin. Still privately issued, stablecoin aims to achieve greater security through anchoring the currency to an externally consistent currency or financial instrument, such as the pound, US dollar, or euro. However, because stablecoin remains a decentralised form of currency, it is therefore still not subject to any central regulation.

Central Bank Digital Currency (CBDC) - What is it?

Central Bank Digital Currency (CBDC) is the most recent evolution of digital currency. Issued exclusively by a country’s central bank, the value of a CBDC is tied to that of the country’s fiat currency (state-issued currency such as banknotes). A CBDC can be “wholesale” (targeted at financial institutions) or “retail” (targeted at the general public).

The concept of CBDCs originally began in China with the development of the Digital Currency Electronic Payment (DCEP) system. However, governments around the world are now beginning to follow suit, exploring the prospect of establishing their own state-backed digital currency systems.

Traditionally, the role of a central bank is to support state financial services. As such, national banks have traditionally issued and maintained stable currency through financial planning, intervention, and monetary policy. In Australia, national currency is controlled by the Australian Reserve Bank. However, with the proliferation of privately issued digital currencies, that role looks set to evolve.

As alternative digital currencies gain momentum against the decline of traditional fiat currencies, there is a growing sense that governments risk ‘losing control’ of financial systems altogether. This goes a long way towards explaining why so many are now contemplating CBDCs as a way to re-establish stable domestic governance through centrally issued digital currency.

It’s easy to see the theoretical benefits of CBDCs. Bringing digital currency back under the wing of the state makes it far simpler to monitor, control and regulate, and clears the pathway for implementation of regulatory frameworks and fiscal policy. For consumers, the promise is of access to a cheap, secure, and stable currency without the risk associated with private cryptocurrencies. 

Australia’s position and the token mapping process

Australia is no exception to the global shift towards digital currency. The Australian Reserve Bank is currently looking into the prospect of establishing its own CBDC. On 2 February 2023, the Australian government also became one of the first in the world to undertake a comprehensive “under the hood” stocktake of the cryptocurrency landscape in its first ever consultation on token mapping. 

What is token mapping? In short, the term describes the process of classifying the various different types of cryptocurrency tokens in order to understand how the ecosystem interacts with the existing financial services regulatory framework. The idea is to use the results to inform the development of a fit for purpose regulatory regime – including the issue of any Australian CBDC.

With the consultation now complete, full legislation regulating the cryptocurrency landscape is anticipated sometime in 2024. For now, we know that the framework will take a “principles based” and tech-agnostic approach, mapping the different types of tokens based on their purpose and function. 

With a focus on striking a balance between protection for consumers and encouraging innovation, it is hoped that whatever framework emerges will be equipped for the challenges that lie ahead. 

Looking forward

There is no doubt that digital currency is set to shape the future of our financial landscape. However, with CBDCs still in their nascency, and so far only implemented by a handful of countries worldwide, it remains to be seen whether the concept will truly allow governments the opportunity to capitalise on the advantages of digital currency – without sacrificing the stability of traditional fiat currency.

As is the case with any major systemic upheaval, major question marks remain over what the impact of such a fundamental change to our financial structures would have on business, households, and economies. The accompanying regulatory challenge is significant, and it is likely that world leaders will be watching as the Australian government continues to navigate this – as yet – uncharted territory.

The information provided in this article does not, and is not intended to, constitute legal advice; instead, all information is for general informational purposes only.

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