What Is a Virtual Currency?

What makes up a virtual currency?

A virtual currency is completely digital. Unlike other digital currencies, which are simply electronic representations of a currency, virtual currencies can only be used electronically.

For example, a U.S. dollar could be represented by a $1 balance shown in your bank account. That's a digital currency. But if you withdraw that $1 from your bank account, you'll receive a green piece of paper with George Washington's face on it. That's no longer a digital currency.

If you try to withdraw your airline miles from your frequent flyer account, the airline is going to think you're crazy. That's because it's a form of virtual currency. There's no physical representation of it.

There's no central bank backing a virtual currency like there is for the U.S. dollar. In fact, in the case of cryptocurrency, there's no central authority at all. The currencies are distributed by private parties or networks. Furthermore, virtual currencies have limited regulation around the world.

Some virtual currencies have restricted use cases. For example, virtual gold collected in World of Warcraft doesn't have much use outside of the game. Others, however, such as Bitcoin (BTC -0.34%), can be transacted freely for any type of good or service you can think of.

Types of virtual currencies

Closed

A closed virtual currency exists only in a private economy like that of a massively multiplayer online game. There's no exchange of outside currency for the closed virtual currency or vice versa. As such, they can only be used to pay for things within the environment where they were earned.

Note that some closed virtual currencies may be bought and sold on the gray market, but that essentially requires two transactions: one where the virtual currency is transferred to another party in exchange for nothing, and another in the real-world economy where fiat currency is transferred for nothing.

Virtual currencies with currency flow in one direction

Some virtual currencies allow you to buy them using fiat currency, but you cannot exchange them back once you purchase them. Examples of these include in-game currencies, loyalty programs such as frequent flyer miles, vouchers or coupons, and gift cards. 

You may be able to earn these virtual currencies within their own economies, but you can also purchase them with fiat currency. Once you've acquired one of these virtual currencies, they're only good within the private economy in which they were created. For example, you probably can't use your frequent flyer miles to pay for a new computer.

Pros of virtual currency

• Faster transactions. Virtual currencies are designed to clear transactions almost instantly. There's no need to wait for a clearing house or cross-border remittance service to ensure the money ends up where it's going. Even a slow cryptocurrency transaction is confirmed within an hour, whereas it typically takes days to settle other digital currency payments.
• Lower-cost transactions. The cost of transacting in virtual currency can be free, which saves businesses and consumers money. In the case of sending money internationally, using cryptocurrency is often less expensive than traditional services.
• No manufacturing or storage costs. Since virtual currency is strictly electronic, there's no cost to produce a physical representation of the currency as there is with most central bank-backed currency.
• Improved cash flow for businesses. Businesses can sell their virtual currency to increase cash flow without having to provide any goods or services in return. For example, airlines sold frequent flyer miles to credit card companies in 2020 to bolster cash flow during a time when travel plummeted.
• Eliminate intermediaries. Cryptocurrencies provide a decentralized monetary system that allows two transacting parties to directly connect instead of relying on a bank or third party as an intermediary. This may be preferred in some instances.

Cons of virtual currency

• A target for hackers. As virtual currencies rise in popularity, hackers can find significant amounts of value stored on computers. Cryptocurrency exchanges have been targeted, as have travel loyalty programs. If a hacker gets access to virtual currency, it can be tough to get back.
• Unregulated and unprotected. Virtual currency isn't subject to regulations, which means consumers have little recourse if transactions go awry. This makes virtual currencies a breeding ground for scams.
• Hidden costs. While the transaction costs of virtual currencies are typically very low, there are hidden costs to some virtual currencies. For example, the Bitcoin network consumes a massive amount of energy. If you keep your cryptocurrency on an exchange, it may have custody costs.
• Easily traced. Since virtual currency can only be used electronically, there's always a paper trail showing the transactions made. That's true even with cryptocurrency, which is anonymous but still traceable. Using paper money allows for truly anonymous and untraceable transactions.
• Subject to price swings and devaluation. Virtual currency doesn't always hold its value stable to your preferred fiat currency. Cryptocurrency is known to be extremely volatile. Meanwhile, travel loyalty programs periodically decrease the value of their points and miles to adjust for inflation or to reduce their outstanding liability.

The future of virtual currencies

Virtual currencies are still developing. Cryptocurrency, in particular, is a nascent industry with the potential for blockchain technology to fuel a lot more business and financial applications. Businesses may adopt more virtual currencies to foster greater customer loyalty, and central banks are exploring the potential for cashless virtual currencies.

As consumers begin to show greater trust in virtual currencies, we should see broader applications going forward.