A recent financial phenomena which is seemingly gaining increasing traction is the emergence of virtual or digital currencies, the most well-known and well-developed of which is Bitcoin.  Digital or virtual currency is essentially electronic money that is not produced or endorsed by any government or central bank.  Instead it is created, usually through computer programs and peer to peer networking and used to purchase whatever individuals are willing to exchange for it.  Virtual currencies have been around since as early as 1999, however as opposed to virtual money, which has historically been used in virtual economies primarily in the online gaming world, virtual currencies can be used in transactions with real goods and services.  The popularity of virtual currencies took off in the post-GFC world as central banks adopted looser monetary policy and stimulus measures involving the printing of traditional currency.  Proponents of virtual currencies have sought to position themselves as an alternative that would not be diluted through over issuance or used to inflate away the increasing pool of sovereign debt amongst global economies.

By far the most liquid and fastest growing virtual currency is Bitcoin, currently there are approximately $USD 9.2 billion worth of Bitcoins in “circulation”.  Founded in 2009 by Satoshi Nakamoto, Bitcoin is a cryptocurrency where users can create Bitcoins by solving a complex array of computer equations producing a “proof of work” of the processing time used which equates to an amount of Bitcoins.  This process of producing Bitcoins is termed “Bitcoin mining”.  These Bitcoins are then be held in virtual wallets and can be used to purchase goods and services from merchants prepared to accept Bitcoins or traded for traditional currency on a number of trading platforms that provide a market for converting the virtual currency.

There are a number of big issues that will determine whether virtual currencies are a passing post-GFC fad or a credible emerging alternative to fiat currencies.  Firstly, while there is increasing liquidity behind the various trading platforms dealing in Bitcoins, this transparency also highlights the massive volatility in the price at which Bitcoins can be converted in US dollars.  In the space of just 12 months the value of Bitcoins in USD has gone from $US 12 to $USD1200 back to $USD300 and then to around $USD1000.  This heightened volatility only adds to the perception that virtual currencies will go the way of tulips and quickly fade as a financial instrument.

The second challenge for virtual currencies to becoming an integral part of the financial landscape is to get merchants and service providers to accept them as payment for goods and services.  There has been some success in this area, particularly in the US.  Increasingly a greater number of businesses are accepting Bitcoins as payment.  For example recently Ebay added Bitcoin to its payments system and social gaming giant Zynga, with 240 million active users began accepting Bitcoins for payment.   This lead to a sharp rally in the USD price for Bitcoins as traders saw it becoming more widely spread.  However, while merchants are stating they are accepting Bitcoins, in actuality in the majority of cases they are transferring them to other currencies through intermediary trading platforms before accepting payment.  So effectively the merchants are still not prepared to accept much risk in accumulating revenues in Bitcoins, so it is not quite that mainstream yet.

However by far the biggest challenge for Bitcoin and other virtual currencies is in how they are going to be treated by governments and central banks.  Recent rulings in the US would appear to indicate that Bitcoin is certainly an asset that can be regulated and form parts of settlement akin to traditional securities and that it meets the definition of an investment contract.  More recently a court in Finland, where the monetary system closely reflects the German system the court ruled that Bitcoin does not meet the definition of a currency as there is no issuer but is more comparable to a commodity.  In another blow to the fledgling currency China has recently banned lenders from dealing and handling the virtual currency.

As it stands it would appear that Bitcoins and other virtual currencies still have a way to go to become completely mainstream as a means of exchange.  The penetration as a means of payment, whilst growing is still tightly limited to intermediaries and seems to be more about the marketing opportunity for the merchants rather than a desire to have an alternative to traditional currency.  Governments and central banks, whilst wanting to maintain regulation of transaction involving virtual currencies appear to be in favour of limiting its expansion into the monetary system.  The purveyors of alternative currencies will need to find a solution to this lack of regulatory enthusiasm if they are to maintain the momentum and ensure that virtual currencies are not just the latest financial instrument fad, but a serious alternative to fiat currency.