Virtual Currency: Definition, Types, Advantages & Disadvantages

A virtual currency is a digital representation of value only available in electronic form. It is stored and transacted through designated software, mobile, or computer applications. Transactions involving virtual currencies occur through secure, dedicated networks or over the Internet. They are issued by private parties or groups of developers and are mostly unregulated.

Virtual currencies are a subset of digital currencies and include other types of digital currencies, such as cryptocurrencies and tokens issued by private organizations. The advantages of virtual currencies include faster transaction speeds and ease of use. The disadvantages of virtual currencies are that they can be hacked and do not provide much legal recourse to investors because they are not regulated.

Understanding Virtual Currencies 

Virtual currencies are a form of digital currency. They are issued by private parties, such as a group of developers or organizations, and are intended only for online use—they do not have a physical incarnation like paper money. Thus, they are different from digital representations of central bank-issued currency, also known as central bank digital currency (CBDC). 

The term virtual currency came into existence in 2012, when the European Central Bank (ECB) defined it to classify types of "digital money in an unregulated environment, issued and controlled by its developers and used as a payment method among members of a specific virtual community." The Internal Revenue Service (IRS) in the United States describes virtual currencies as "digital representations of value that function as a unit of account, a store of value, and a medium of exchange."  

Both definitions, though broad enough to encompass multiple attributes of virtual currencies, may not be entirely correct today.

The universe of currencies that may be considered virtual has expanded considerably since 2012 to include various forms of money that do not adhere to the ECB's definition of the term. For example, certain cryptocurrencies, which are considered a form of virtual currency, like Ripple's XRP, are not strictly controlled or used by a virtual community.

Virtual currencies have also failed to take off as a payment method or medium of exchange in mainstream society. They have restricted usage, sometimes in gaming communities and other times as a speculative investment asset. Whether they have emerged as a store of value, like gold, also remains questionable.

There's also the question about regulation. Though virtual currencies remain unregulated in the vast majority of financial jurisdictions, that situation is slowly beginning to change. Bitcoin, the cryptocurrency with the biggest market capitalization, is legal tender in El Salvador.

In the United States, home to the world’s most sophisticated financial markets, virtual currencies are unregulated. But regulation is seriously being considered by authorities. The trading watchdog Securities and Exchange Commission (SEC) wants to bring cryptocurrency exchanges under its supervision. Regulation for stablecoins, another form of virtual currency, is also in the cards. The IRS taxes trades that involve certain types of virtual currencies, such as cryptocurrencies.

Types of Virtual Currencies 

Depending on their operating network, virtual currencies are classified as follows: 

Closed virtual currency

A closed virtual currency, as the name suggests, operates in a controlled and private ecosystem. It cannot be converted into another virtual currency or into a real-world fiat currency. Examples of closed virtual currencies are currencies in gaming systems. Though such currencies can be used in their respective environments (in this case games), they cannot be converted into real-world cash. Another example of closed virtual currencies is airline miles. They are issued by private parties, can only purchase additional miles, and cannot be converted into their associated monetary value.  

Open virtual currency 

Open virtual currencies are also known as convertible virtual currencies because they can be converted to other forms of money. They operate in open ecosystems and can be converted into another currency either within the platform or outside it. Examples of open virtual currencies are stablecoins and cryptocurrencies. Bitcoin and Ethereum, the two biggest cryptocurrencies by market capitalization, can be converted into other cryptocurrencies or certain fiat currencies. This conversion process is considered a trade transaction by the IRS and is taxed. 

Though most open virtual currencies have a decentralized setup, certain cryptocurrencies like Ripple's XRP are centralized in design, meaning a central agency is responsible for their production and distribution. 

Advantages of Virtual Currencies 

The advantages of virtual currencies are as follows: 

• Virtual currencies do not have expensive manufacturing and physical storage costs.
• The technology rails of virtual currencies increase transaction speeds and eliminate geographical boundaries.
• Decentralized virtual currencies can eliminate intermediaries during monetary transactions and establish a direct connection between two transacting parties.
• Virtual currencies can be programmed to complete automated transactions. For example, smart contracts on Ethereum's blockchain can hold and release money in escrow accounts without human intervention.
• Virtual currencies are digital repositories of value and can assign value to disparate sets of objects, from gaming tokens to artwork.
  

Disadvantages of Virtual Currencies 

The disadvantages of virtual currencies are as follows:

• Virtual currencies are attractive targets for hackers. There have been several cases of hacking blockchain networks for cryptocurrencies, a form of virtual currency.
• Though they do not have manufacturing or physical storage costs, virtual currencies have other associated expenses. For example, cryptocurrency users are required to store them in digital wallets. At trading exchanges, cryptocurrencies also have custody costs.
• Virtual currencies can be subject to scams. Several initial coin offerings (ICOs), which became popular in the aftermath of a runup in cryptocurrency prices, were actually scams in which private developers sold worthless tokens for hypothetical networks. The tokens could not be converted into other currencies.
• Unregulated virtual currencies do not offer legal recourses to investors because they are issued by private entities and, for the most part, are not regulated by financial authorities.
• Virtual currencies traded on exchanges, such as cryptocurrencies, can be subject to highly volatile price swings.

Differences Between Digital Currencies, Virtual Currencies, and Cryptocurrencies

Even though they sound alike and function in a similar manner, digital, virtual, and cryptocurrencies are in fact different. Listed below are the main points of difference between the three types of currencies:

• All virtual currencies and cryptocurrencies are digital currencies. Not all digital currencies, however, belong to those two categories. For example, CBDCs are not virtual currencies or cryptocurrencies.
• Digital currencies can be regulated or unregulated. One example of a regulated digital currency is CBDC. Examples of unregulated digital currencies are Bitcoin and Ethereum. The overwhelming majority of virtual currencies are unregulated, while cryptocurrencies are not regulated in any jurisdiction.
• Not all digital currencies are cryptographically secured. Cryptocurrencies always use cryptography to secure their networks, while virtual currencies may or may not use cryptography to secure their networks.

The Bottom Line 

Virtual currencies are digital representations of value that can exist only in electronic form. Their transactions occur on online networks or the Internet. Examples of virtual currencies include tokens and cryptocurrencies. Virtual currencies are a novel form of currency and, as such, are mostly unregulated. But that situation is changing, and an increasing number of government agencies and countries are considering the implications of introducing virtual currencies into their economies.  

FAQs for Virtual Currencies

What are virtual currencies? 

Virtual currencies are digital representations of value whose transactions are conducted only through electronic networks or the Internet. They do not have a physical incarnation. 

What are the different types of virtual currencies?

Depending on the type of network they operate in, virtual currencies can be divided into open and closed virtual currencies. The former function in an open ecosystem and can be converted into other virtual currencies or fiat currencies, while the use and issue of the latter are restricted to the closed ecosystem.

What is the difference between virtual, digital, and cryptocurrencies? 

All virtual currencies and cryptocurrencies are digital currencies. But the opposite is not true—not all digital currencies are virtual currencies or cryptocurrencies. For example, CBDCs are digital currencies, but they are neither virtual currencies, which are unregulated, nor cryptocurrencies, which are decentralized networks.

What are the advantages of virtual currencies? 

Virtual currencies do not require manufacturing or physical storage costs. They also speed up transactions by eliminating intermediaries from the process and eliminate geographical boundaries. Virtual currencies can also be programmed for certain transactions, such as the release of escrow funds.

What are the disadvantages of virtual currencies?  

The digital makeup of virtual currencies makes them attractive targets for hackers. Virtual currencies also have associated costs, such as digital wallets and custody, for their storage and maintenance. As the ICO boom-and-bust cycle showed, the virtual currency ecosystem is also susceptible to scams.