What is Virtual Currency?
Virtual currency is a type of unregulated digital currency. It is not issued or controlled by a central bank. Examples of virtual currencies include Bitcoin, Litecoin, and XRP. Digital currencies are stored in and transacted through designated software, applications, and networks in digital form.
Virtual currencies are typically issued by private issuers and used among specific virtual communities. The security of the software and networks that virtual currencies stand on is a critical concern.
The traditional regulated currencies are backed by sovereign debts (fiat currency) or hard assets such as gold. In contrast, virtual currencies are not backed with no intrinsic value. The value of a virtual currency is mainly driven by the sentiment of traders. As a result of its unregulated nature, a virtual currency can experience extensive price fluctuations.
- Virtual currency is a type of unregulated digital currency that is not issued or controlled by a central bank. Examples include Bitcoin, Litecoin, and XRP.
- Virtual currency can be either centralized or decentralized. A decentralized virtual currency does not have a central administrator.
- The decentralization of virtual currency relies on blockchain networks, which is cryptography-based. The cryptography-based virtual currency is known as cryptocurrency.
Types of Virtual Currency
In terms of legal status, there are two major types of virtual currencies – centralized and decentralized.
A centralized virtual currency has a central administrator or repository. The central administrator of a virtual currency is typically the issuer of that currency. The role is similar to a central bank in a regulated currency system. XRP is an example of centralized virtual currency.
Conversely, a decentralized currency does not have a third-party central administrator or repository. Instead, a distributed system will authenticate the transactions of a decentralized virtual currency.
Many decentralized currencies are based on blockchain networks such as Bitcoin, Litecoin, and Ethereum. A blockchain network links a list of records, which is known as blocks, with cryptography. When a transaction is requested, the request is broadcasted in the network consisting of many computers (nodes).
After the transaction is verified by the network, a permanent and unchangeable block that contains the transaction information is added to the existing blockchain. The transaction is completed and recorded accordingly.
Compared with a centralized virtual currency system, the decentralized peer-to-peer network avoids a central administrator, and thus avoids a centralized security failure. Also, due to the absence of intermediaries, decentralization allows for more transparency between parties and lower transaction costs.
However, the lack of a central authority leads to regulatory concerns. Money laundering and other illegal transactions can take advantage of the decentralized setup.
Advantages of Virtual Currencies
The major advantage of virtual currencies is convenience. Payments with virtual currencies are fast and easy due to its network-based nature. The use of virtual currencies is especially convenient in international transactions.
Additionally, decentralization also avoids intermediaries. It lowers transaction costs and avoids the security failure of the central administrator.
Disadvantages of Virtual Currencies
1. Lacks comprehensive regulation
The regulations over virtual currencies are not comprehensive or systematic enough, hindering their worldwide acceptance. Lacking the supervision from a central administrator, decentralized virtual currencies provide opportunities for illegal transactions and money laundering.
2. Highly volatile
Out of the charge of a central bank, the value of a virtual currency is highly volatile. Therefore, it is a less favorable tool to store value or medium of exchange. For example, Bitcoin peaked at the end of 2017 at nearly $20,000 per unit. It later dropped to around $3,000 per unit within one year.
3. Potential security issues
Virtual currencies also raise security concerns. Despite improving encryption techniques, the loss or leakage of authentication information is still possible and can cause great losses to virtual currency owners.
Digital Currency, Virtual Currency, and Cryptocurrency
Digital currency is a broad concept, referring to all the monetary assets that are in digital form. Virtual currency is a subset of digital currency, and cryptocurrency is a subset of virtual currency.
Digital currency can be either regulated or unregulated. A regulated digital currency is issued by a country’s central bank and can be denominated to a sovereign currency. The regulated type of digital currency is thus subject to a country’s monetary policy.
Virtual currency is a type of unregulated digital currency. It is issued and controlled by a private issuer instead of a central bank. Therefore, it is not subject to any monetary policy. A virtual currency can be either centralized or decentralized. Some virtual currencies contain cryptography, and some do not.
Cryptocurrency refers to a type of virtual currency that implements cryptography technology to secure and authenticate currency transactions. Cryptocurrencies depend on blockchain networks. Hence, cryptocurrencies are decentralized virtual currencies.
CFI is the official provider of the global Commercial Banking & Credit Analyst (CBCA)™ certification program, designed to help anyone become a world-class financial analyst. To keep advancing your career, the additional CFI resources below will be useful: