The European Central Bank recently expressed concern about the lack of virtual currency regulation. Marcus Mac Dhonnagáin looks at the facts
Recently the European Central Bank (ECB) released a report titled Virtual Currency Schemes, expressing concern about the rise of online virtual currency systems. The report states that all real currencies are bound to a set of laws and regulations, as well as an understanding of the rights and obligations that different parties have when using them. Virtual currencies, however, do not have any of these in place.
The bank defined three currency systems: closed virtual currency schemes, virtual currency schemes with undirectional flow, and virtual currency schemes with bidirectional flow.
An example of a closed virtual currency scheme is gold in World of Warcraft. Gold is needed to purchase new gear by players in order to reach higher levels, and that buying and selling gold is strictly prohibited by Blizzard.
Virtual currency schemes with undirectional flow operate along the lines of systems such as Facebook Credits, which can be purchased with real money and used to purchase a virtual good, but cannot be converted back to money.
A virtual currency with a bidirectional flow allows users to buy and sell the virtual money with the exchange rate of their own currency.
Virtual currencies are used worldwide, making it difficult to exert any real control over them, because they could not be identified by any central jurisdiction and would therefore not be bound by any set of rules. Not only that, but no one is yet certain what kind of impact these virtual economies can have on a real economy, because they’re not valued when a nation’s production of wealth per capita is being estimated.
The report states, “In essence, virtual currencies act as a medium of exchange and as a unit of account within a particular virtual community. The question then arises as to whether they also fulfil the ‘store of value’ function in terms of being reliable and safe, or whether they pose a risk not only for their users but also the wider economy.”
The phrase ‘store of value’ refers to when a currency can be saved for future use. For instance, paper money is a currency that has a store of value, which reflects the state’s total wealth. Because of its store of value, currency can be saved or exchanged for goods and services.
If a virtual currency, therefore, were to grow in popularity but was not to be bound to a framework, it would be difficult to predict its worth in the future. This might not only be potentially damaging to people who use the currency, but it could have a wider implication for economies in general.
The bank concluded that any companies that use these systems should be turned into financial institutions, at the least to dissuade wrongdoers from taking advantage of them. “Registering these companies as financial institutions would at least reduce the incentive for terrorists, criminals and money launderers to make use of these virtual currency schemes for illegal purposes.”
Unfortunately, this may already be taking place. According to PCGamesN, it was reported on SteamRep that a group of users were abusing Team Fortress 2’s trading system. Allegedly, the users would buy Mann Co Supply Crate Keys with illegitimate credit cards. They would then exchange the Keys for Earbuds, Team Fortress 2’s most valuable item, at an inflated price (28,29, 30 Keys for each Earbud, as opposed to the normal 25 Keys). They would then sell their Earbuds for real money. The poster discovered this by noticing a large jump in the number of Earbuds being sold each day. By then interviewing different users who had exchanged the Earbuds, he discovered a group of different users who were making the dubious transactions. Though the post was speculative, it did show the potential abuse that could take place in a virtual currency system.
The ECB’s report also gives an example of a virtual currency scheme known as Bitcoin. Bitcoin is a virtual form of money created by Japanese programmer Satoshi Nakamoto (a pseudonym) in 2009. Bitcoins can be used throughout the world and, much like real currency, can be exchanged for real goods and services. Users can purchase Bitcoins from a number of different online sellers using real money. The exchange rate of the currency is determined by the supply and demand of the market itself and the money supply is determined by a process called ‘mining’. It’s designed so that it’s not under the control of a central authority.
In order to use Bitcoins, a user must download a free piece of software. They then can store their Bitcoins in their virtual wallet. The benefits of using Bitcoins are that the transactions are completely anonymous and there are very low to no bank fees involved. However, Bitcoins users must be cautious when using the system as their money can be taken if they do not have proper anti-virus protection.
The bank says that Bitcoin’s proponents state that the system avoids inflation that comes about when governments print extra money. The supporters also state that although the amount of Bitcoins created through its complex system increases, it will eventually reach a finite limit of 21 million. However, the ECB cast doubt on this claim.
The report says, “If, however, the number of Bitcoin users starts growing exponentially for any reason, and assuming that the velocity of money does not increase proportionally, a long-term appreciation of the currency can be expected or, in other words, a depreciation of the prices of the goods and services quoted in Bitcoins. People would have a great incentive to hold Bitcoins and delay their consumption, thereby exacerbating the deflationary spiral.”
The bank states that it is unclear that this scenario could arise, however. But Bitcoin has been dogged by a number of different controversies. The fact that the system is anonymous means that the Bitcoins could, in theory, be used for drug dealing and money laundering. Although traditional real cash alternatives exist for this sort of illegal activity, the fact that Bitcoins is a digital system could make it more difficult for law enforcement agencies to carry out investigations.
A hacking incident in 2011 also prompted Bitcoins to lose their worth in minutes, which the bank says shows how fragile the system can be to an attack. Bitcoin has also been accused of being a Ponzi scheme, and though the ECB doesn’t agree entirely with this assessment, in conjunction with the general lack of legal framework, and unpredictable monetary system, it does think that the system is a potential high risk for its users.
The ECB is right to be concerned about virtual currencies in general. They are becoming more popular and more recognized across the developed world. With this growth, however, they begin to become more integrated in actual economies. Closed virtual currency schemes and virtual currency schemes with undirectional flow aren’t as potentially damaging, but any virtual currency schemes with bidirectional flow can make a direct impact on a real economy.Real market currencies are bound by a set of rules and regulations that make their systems accountable. This ensures that any person, or party that uses them, has a sense of the legal framework that governs them, and what their rights are.
While control of the systems should remain in the hands of the developers who design them, stable rules and regulations will ensure that they’re being used fairly and properly, as well as making them less likely to be abused. This will ensure that they will become stable systems and make them safer for their users.
Follow Marcus on Twitter: @M_M_DH