Explainer - What are cryptocurrencies like bitcoin?
Cryptocurrencies - also known as digital currencies or virtual currencies - are a form of digital money. They allow payments to be made electronically and function in a similar way to standard currencies that use physical cash. However, unlike standard currencies that can be exchanged physically using notes and coins, cryptocurrencies are only exchanged electronically using lines of computer code. Examples of well-known cryptocurrencies are bitcoin and ethereum, but a wide range of others also exist.
How are cryptocurrencies different from standard money?
Most "paper currencies," such as the euro, have legal tender status. This means the currency is the country’s officially recognised currency, and must be accepted as payment of a debt.
Cryptocurrencies on the other hand, do not have legal tender status. This means there is no legal obligation for them to be accepted.
Another big difference between cryptocurrencies and paper currencies is how they are structured. Official currencies are centralised and guaranteed by a central bank that controls their supply. So for example, the European Central Bank guarantees the euro and controls its supply in the euro area. Cryptocurrencies meanwhile are unregulated and decentralised. This means that no central bank guarantees them or controls their supply.
Who controls cryptocurrencies?
Cryptocurrencies are controlled using a technology known as “blockchain” or “distributed ledger technology”. A good way to understand distributed ledger technology is to think of it like one big public file – or ledger – that is shared and stored across a huge network of computers. This file contains all the transactions made using the cryptocurrency. Because it is publicly shared and its contents validated by so many different people, it makes it virtually impossible for anyone to include a fraudulent transaction on it.
Is bitcoin a currency?
A common question relating to bitcoin (and other cryptocurrencies) is whether it is a currency and if it can function as money. A well-functioning currency has the following three functions:
- Store of value
- Unit of account
- Medium of exchange.
Bitcoin struggles to meet these criteria for the following reasons:
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Store of value
To be a store of value, a currency should be stable over time. Due to large price fluctuations, this is not the case for bitcoin.
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Unit of account
A unit of account means that the money should allow us to easily form an understanding of the value of goods and services, and allow us to compare them to each other. The volatility of bitcoin makes it difficult to perceive it as a unit of account.
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Medium of exchange
A medium of exchange means money should facilitate buyers and sellers to make transactions. In some ways, bitcoin fulfils this condition – as buyers and sellers can use it for some transactions. However, limitations such as slow transaction speeds, high transaction costs, as well as bitcoin’s unstable value make it difficult for it to properly function as a medium of exchange.
In general, bitcoin, and cryptocurrencies are more like very high-risk, speculative assets than a standard currency.
Could a central bank issue a digital currency?
As part of the Eurosystem, the Central Bank is investigating the potential issuance of a central bank digital currency (CBDC) – a digital euro.
Any digital euro would be complementary to physical euro banknotes and coins rather than a substitute for them.
It would be fundamentally different from a cryptocurrency like bitcoin because it would be backed by the European Central Bank.
As such, people using a digital euro could have the same level of confidence as with cash, since they would be both backed by a central bank.
For more information and the latest updates on the possible creation of a digital euro see: A Digital Euro.
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