Digital currencies: what are they and why do we need them?

If you consider how we use it, most of the money today could already be classified as ‘digital money’, so what do we actually mean when we talk about digital currencies – and where can they provide the most value for companies, investors, and the markets more broadly?

Despite the breadth of potential applications, we see a couple of particularly relevant use cases where digital currencies could improve current processes through both increased safety and efficiency measures. This is particularly prevalent when using these digital assets as a means of payment, form of exchange and, looking ahead, for Repo and Foreign Exchange (FX) transactions. 

Understanding the current digital currency landscape

Digital currencies can be categorised based on specific features such as the issuing body, the backing asset (if any) and the redeemability or fungibility of the currency. It is these characteristics that can help you assess their suitability depending on intended use.


Cryptocurrencies are private, unbacked digital currencies that are based on cryptographic algorithms. This means that they have no underlying asset stabilising their value, which can sometimes lead to volatility. Due to the possible change in value of cryptocurrencies, they are often used as an investment opportunity as opposed to a means of payment.


Stablecoins are private digital currencies that are backed by an underlying asset with the goal of stabilising their value.

There are three main categories of stablecoins: FIAT-backed, commodities-backed, and algorithmic. 


FIAT-backed stablecoins are backed 1 for 1 with a traditional currency, such as Circle’s USDC stablecoin which is at parity with the US dollar. Commodities-backed stablecoins, such as the AABB Gold token, are backed by material goods such as gold, art, or any physical object of value. Due to the nature of the backing asset, these are considered to be less liquid when it comes to redemption.


Finally, algorithmic stablecoins are backed by a series of protocols that stabilise the currency. Depending on the set up of the digital currency, the algorithms could link the coin to a basket of other stablecoins or be purely cryptographically generated. Similar to commodities stablecoins, these are considered less easily exchanged back to traditional money.

Central Bank Digital Currency (CBDC)

Think of a CBDC as a digital representation of cash as we know it. There are currently only four in existence, all of which are still in different implementation stages and not fully integrated into their respective payment systems.

Given the growing popularity of digital currencies and the possible efficiencies they can bring, central banks have been increasingly exploring both wholesale and retail CBDCs, with nearly 90 countries worldwide actively considering their feasibility according to research from The Atlantic Council.


CBDCs represent a tool that could then be used by the private sector to drive the development of innovative products, further contributing to the advancement and resiliency of the economy. Examples of this could include leveraging the programmability features of the tokens to automate certain tasks, such as dividend or coupon payments.


The implementation of the CBDC will ultimately dictate how it will be used. As CBDCs are currently being developed in siloes according to each jurisdiction’s economic needs, they will not necessarily be interoperable. Customisable characteristics can extend as far as holding limits, interest levels, and data privacy.


CBDCs could also differ operationally, with central banks having the option to run the infrastructure themselves, or simply to provide the medium of exchange for the private sector, thereby serving as a smooth transition channel that has the ability to reduce opacity and complexity in the market. This intermediated approach would protect fiat currencies by avoiding the kind of fragmentation that could otherwise undermine payments system and prevent central banks from implementing policies for monetary and financial stability.


In the UK, the Bank of England is currently consulting with industry on the potential creation of a CBDC. But it has made it clear that any potential CBDC would not replace cash. Similarly in Europe and in the US, there is a sense among regulators and the wider industry that cash will (and should) remain in use as long as there is demand for it, and that – for retail use – a CBDC would be an alternative to complement the current payment landscape.


In wholesale markets, emphasis has been placed on alternative payment solutions, such as the Real Time Gross Settlement (RTGS) renewal system in the UK, which is due to launch in 2024. Although not based on Distributed Ledger Technology (DLT), it would have the ability to settle atomically through synchronisation, and be interoperable with private and public networks. If this proceeds as planned, it could effectively act as a wholesale CBDC, albeit not built on a DLT infrastructure. Similarly, the US has just launched their real time settlement system, FedNow, which is the Federal Reserve’s priority ahead of a wholesale CBDC consideration. The EU focus on a retail CBDC is likely a consequence of Target 2, the European Central Bank’s RTGS platform, which shares many of the same features found in similar US and UK schemes. 

Tokenised commercial bank money

More recently, the private sector has been considering the potential of a digital currency backed by tokenised deposits. This is in line with deposit-taking institutions’ current way of doing business, meaning that they already have the regulatory provisions in place. One example of this is JP Morgan’s coin, which is used internally within its Onyx platform to engage with digital assets more broadly.


Tokenised deposits are likely to materialise prior to the implementation of a CBDC given the speed of development in the private sector in addition to the complementary existing lending capabilities. 


Financial institutions would be well placed to provide an alternative solution to CBDC, as they are already heavily regulated and trusted by market players. A commercial bank-backed digital currency would allow institutions to build the internal capabilities and infrastructure needed to accommodate digital currencies more broadly, paving the way towards a digital asset ecosystem.


In the UK, the government is transparent about wanting to collaborate with the private sector to test the technology and guide the shape of the digital pound should it proceed. The Treasury has said it would expect a wholesale stablecoin to materialise before a wholesale CBDC as the private sector is further along and isn’t constrained by public policy. Furthermore, Andrew Bailey, Governor of the Bank of England recently encouraged the development of tokenised commercial bank money during his speech at the Institute of International Finance (IIF), stating that:


“I think it would be preferable not to disturb the existence of both inside and outside money and the broad balance between them. But, this requires a number of things to happen and questions to be answered. It requires banks to be more active in thinking about digital commercial bank money and not leave it to CBDC.”


This speech reinforces the need for public (inside money) – private (outside money) collaboration.

Digital currencies could facilitate innovation across financial markets

We see the digital currencies having the most impact in the wholesale environment, acting as a means of payment and exchange.


On a primary level, the tokenisation of assets is going to require a digital currency in order to exchange the money for the asset, token for token, with the programmability for each being locked in a smart contract that would allow for Delivery vs Payment (DvP) and Payment vs Payment (PvP) settlement. 


Instant settlement could also impact the reserve levels needed for any transaction, thereby freeing up funds and liquidity.


Benefits will become more prevalent in the long term, as the reduction of manual steps and the maximisation of collateral management can lead to cost savings over the streamlined settlement process.

Repo Markets

Digital currencies and assets could be of particular interest for repo transactions, being able to improve operational and settlement efficiency through automation, whilst also reducing the risk of errors. 


The use of smart contracts and instant settlement could revolutionise the exchange of repo, by enabling the loans to span over the course of hours instead of overnight, with the interest charged by the minute instead of the hour.


This increased flexibility could lead to the development of a variety of products that can be more closely customised to customers’ specific needs in order to promote improved collateral management and liquidity.

Foreign Exchange

The FX market intermediary networks have remained largely unchanged since 1977, when the SWIFT network was first launched. This is now a trusted network, but today’s digital age leaves room for improvement, particularly when it comes to the opaque manual processes and the average T + 2 settlement period – which creates settlement and liquidity risk.


The ability to settle token for token through PvP would help address these risks. The programmability of the smart contracts means that the trades can be settled instantly, with the transfer of ownership occurring at the same time. The immutable nature of DLT allows for the ownership change to be irreversible, allowing settlement finality.


Atomic settlement also disrupts the traditional roles and responsibilities within the market, as there is room for partial disintermediation due to the simplification of transactions. This could lead to an overall reduction in cost long term, as the complex network of intermediaries can be streamlined.

The road ahead

Understanding the different types of digital currencies is the first step towards appreciating their different uses and therefore using them according to your goals. We see a lot of promise in the development of tokenised commercial bank money as this can serve to provide the needed confidence in digital currencies as CBDCs are developed further, ultimately complementing them to achieve new efficiencies in the market.

Get in touch

We are working closely with industry partners and customers to ensure the currency, capital markets, and payments systems we rely on can respond to the demands of businesses – and new business models. Get in touch to learn more about how we can partner for a more digital future. Speak with your NatWest representative and follow us on social media to learn more about the implications of these exciting financial innovations for your financial strategy.

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