Digital currency: does virtual cash have real risks?

Digital currency is shaking up transactions on the internet – but for many, it remains mysterious. Matt Packer explains how it works

Like any sprawling foreign nation, the online landscape has produced currencies that are unique to its economic requirements, and very different to the ones that visitors may be used to.

As Europe desperately swerves around financial obstacles to keep the Euro afloat, and Greece anxiously contemplates a return to the Drachma, the internet is single-mindedly pursuing a range of alternative financial models.

And while they have the advantage of being unencumbered by many of the inconveniences that have put a squeeze on conventional currencies, they still have a number of drawbacks of their own. Not least that lots of people don’t know much about them.

With that in mind, it’s time to make some introductions:

Bitcoin (BTC)

Created by software guru Satoshi Nakamoto – about whom very little is known – Bitcoin gave digital currency a boost thanks to his trailblazing innovation: a desktop application comprising an encrypted peer-to-peer system and a digital-signature tool.

Together, they ensured that virtual money could not be duplicated, and that transactions could be carried out in private. At least, that’s the theory (see ‘Problems’, below).

Nakamoto’s application, the Bitcoin client, was made available in January 2009. At the same time, Nakamoto triggered the Bitcoin currency issue, consisting of 21 million coins. Imagine Nakamoto as a kind of Mervyn King character, pumping currency into the market at a capped level.

Those 21m coins are the playground for Bitcoin traders, who build up their savings by ‘mining’ the currency from other users via networks of micro trades.

Bitcoin holdings are pictured on users’ desktop clients in the form of blocks in a chain, with the largest holdings rising to the top. It is this image – and accompanying notion of an inverted pyramid – that has led critics to label Bitcoin as a Ponzi scheme.

So, what do people spend Bitcoin on? Well, a Fortune article of last year pointed out that a New York meze grill had starting accepting the currency for lunches. There are also specialist online retailers who accept Bitcoin for a host of different products. In short, the answer is that people spend the currency on anything and everything – as long as the seller has the necessary software for processing the payments.

Ven

Rare among digital currencies in that it is actually linked to the conventional money market, Ven was first released as an experimental digital currency on Facebook in 2007.

Unlike Bitcoin, which can be traded for any product, Ven now has a very specific purpose as the currency of choice for environmental social network Hub Culture. Members of that network use Ven to buy and sell distribution for pieces of content about carbon reduction and other environmental issues.

In September last year, Hub Culture struck a deal for Ven to be listed and priced on the Thomson Reuters finance network. The value of the currency is determined by a ‘basket’ of indicators, including environment-specific factors such as carbon futures. Its special Thomson Reuters instrument code is <.VEN>.

Flattr

Every penny counts, but standard online cash-handling systems such as Paypal tend to have minimum-spending rules with high thresholds to ensure they’re not clogged up with millions of tiny transactions. But Flattr turns that on its head. Essentially, it takes chunks of inspiration from Bitcoin and Ven, enabling people to make micro-payments to artists who are producing eye-catching web content.

The idea behind Flattr is that, by actively encouraging tiny payments (often of pennies at a time) via a system specifically designed to handle that traffic, more people will want to donate, generating healthy sums through a higher number of little increments. Once artists have been ‘flattrd’, they can use the donations to purchase resources for improving their work.

Donors pay monthly sums into their Flattr accounts, then share that money among all the causes they want to ‘flattr’.

Virtual weaponry

Yes, even broadswords and axes made out of pixels can be exchanged and bartered for – if you happen to be a player on the world’s favourite time-wastage aid, World of Warcraft.

Benefits

Transactions on digital currencies are not plagued with the charges, fees or ponderous clearing times that tend to make customers furious with the ‘real-world’ banking system.

Anyone can obtain an account for a digital currency, regardless of national jurisdiction or domestic regulatory background. No pre-existing, conventional bank account or financial reference is required in order to sign up – you can start right away.

Problems

Digital currencies are underwritten by private companies rather than governments, so critics argue that one set of problems has been pretty much exchanged for another.

Aside from administrative matters, though, the biggest concern is that digital currencies are as vulnerable to cyberattacks as any other electronic infrastructure. Bitcoin, for example, has endured several hacks – including one in June last year on the specialist MtGox trading platform that siphoned off $9m of the virtual currency.

It is also fair to say that the unregulated atmosphere in which these currencies thrive could pose future risks – especially considering how low regulation has affected conventional finance.

Matt Packer is Online Editor at Think Publishing.

The death of cash will be covered in more detail in the September/October 2012 issue of Accounting Technician, AAT’s membership magazine.

Matt Packer is a freelancer journalist who has contributed to Accounting Technician magazine, 20 magazine and the CMI website.