Virtual Currency: Definition, Types, Advantages & Disadvantages

What Is a Virtual Currency?

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

Virtual currencies are a subset of digital currencies, such as cryptocurrencies and tokens, issued by private organizations. Virtual currencies can allow for faster transaction speeds, ease of use, and broad access. However, virtual currencies can be hacked through software used to access them and are not regulated, so there is generally no legal recourse for users if they are victims of an attack.

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 officially issued digital currency, also called central bank digital currency (CBDC).

Regulation

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, 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.

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) has brought U.S.-based cryptocurrency exchanges under its supervision and continues to scrutinize all crypto-related products. Regulation for stablecoins, another form of virtual currency, is also in the works.

How Virtual Currencies are Used

Originally released as payment methods, virtual currencies have somewhat failed to take off as a medium of exchange in mainstream society. Most commonly, they are purchased and sold by investors and traders on cryptocurrency exchanges to profit from volatile price fluctuations.

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.

Types of Virtual Currencies 

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

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 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 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, 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: 

• The technology rails of virtual currencies can 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 cryptocurrency theft by hackers.
  
• Virtual currencies can be subject to 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. 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 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. Most 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 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.

 The comments, opinions, and analyses expressed on Investopedia are for informational purposes only. Read our warranty and liability disclaimer for more info. As of the date this article was written, the author does not own cryptocurrency.