Virtual Currency: Definition, Types, Advantages & Disadvantages

What Is a Virtual Currency?

A virtual currency is a digital representation of value. It is stored and transacted through designated mobile or computer applications. Transactions involving virtual currencies occur through secure, dedicated networks or the internet. They are generally issued by private parties or groups of developers and are mostly unregulated.

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 do not have a physical form like paper money. They include cryptocurrencies and other tokens that hold value.

They differ from officially issued digital currencies called central bank digital currency (CBDC).

Regulatory Environment

As of June 2024, regulations covering virtual currencies, tokens, and assets are still emerging around the world. For example, in 2023, The European Union published a broad definition in its Markets In Crypto Assets (MiCA) regulation. "Crypto-assets are digital representations of value or of rights that have the potential to bring significant benefits to market participants, including retail holders of crypto-assets." According to this rule, a virtual currency may not fall under MiCA jurisdiction in the EU, but it might if it meets this very vague definition.

The Internal Revenue Service (IRS) in the United States describes virtual currencies as "digital representations of value, other than a representation of the U.S. dollar or a foreign currency ("real currency"), that function as a unit of account, a store of value, and a medium of exchange." It also taxes trades involving certain virtual currency types, such as cryptocurrencies.

The market watchdog, the Securities and Exchange Commission (SEC), has brought U.S.-based cryptocurrency exchanges under its supervision and continues to scrutinize all crypto-related products, services, and providers.

How Virtual Currencies Are Used

Virtual currencies have many forms, so there are endless ways that they can be used. Cryptocurrency is most commonly purchased and sold by investors and traders on cryptocurrency exchanges to profit from price fluctuations and increases.

However, they are also used in some countries by people who don't have access to other payment methods or financial services. In its 2023 Geography of Cryptocurrency Report, blockchain and crypto-assets analysis firm Chainalysis reported that cryptocurrency adoption is down from previous years; however, lower-middle-income countries are adopting these currencies at a much higher rate than others.

Many video games offer virtual currencies you can buy with real money and use to purchase items in-game. Most of these in-game currencies and tokens are not usable outside the game and cannot be transferred. However, there are blockchain-based games that use in-game currency which can be purchased with cryptocurrency. In this case, both currencies are virtual currencies because real-world value is being transferred.

Types of Virtual Currencies 

Depending on their operating network, virtual currencies are classified as either closed or open. 

Closed Virtual Currency

As the name suggests, a closed virtual currency operates in a controlled and private ecosystem. It cannot be converted into another virtual currency or 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 generally be converted into real-world cash.

Airline miles, while not typically thought of as currency, are closed virtual currencies. They are issued by private parties, can only be used to redeem specific items, and cannot be converted into an associated monetary value. 

Open Virtual Currency 

Open virtual currencies operate in open ecosystems and can be converted into another currency within or outside the platform. 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 can trigger taxes, depending on how long you hold your cryptocurrency and its market value when you purchased and sold it.

Though most open virtual currencies have a decentralized setup, some cryptocurrencies might be 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: 

• The technology behind virtual currencies can eliminate geographical boundaries.
• Decentralized virtual currencies can eliminate intermediaries during monetary transactions and establish a direct connection between two transacting parties.
• Some 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 cryptocurrency theft by hackers.
  
• Virtual currencies can be used in scams. Several initial coin offerings (ICOs), which became popular after a runup in cryptocurrency prices, were scams in which private developers sold worthless tokens for hypothetical networks.
• Unregulated virtual currencies do not offer legal recourses to investors or users because they are issued by private entities and, for the most part, are not regulated by financial authorities.
• Virtual currencies with market value 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:

• Digital currency is the group of currencies all virtual currencies, stablecoins, and CBDCs belong to.
• Virtual currencies generally encompass cryptocurrency, gaming tokens, or other types of tokens.
• Cryptocurrencies are virtual currencies that use cryptographic techniques.

The Bottom Line 

Virtual currencies are digital representations of value that can exist only electronically. 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.

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