1. Definitions

In 2012, the European Central Bank defined virtual currency as "a type of unregulated, digital money, which is issued and usually controlled by its developers, and used and accepted among the members of a specific virtual community".^[1]:13

In 2013, Financial Crimes Enforcement Network (FinCEN), a bureau of the US Treasury, in contrast to its regulations defining currency as "the coin and paper money of the United States or of any other country that [i] is designated as legal tender and that [ii] circulates and [iii] is customarily used and accepted as a medium of exchange in the country of issuance", also called "real currency" by FinCEN, defined virtual currency as "a medium of exchange that operates like a currency in some environments, but does not have all the attributes of real currency". In particular, virtual currency does not have legal tender status in any jurisdiction.^[2]

In 2014, the European Banking Authority defined virtual currency as "a digital representation of value that is neither issued by a central bank or a public authority, nor necessarily attached to a fiat currency, but is accepted by natural or legal persons as a means of payment and can be transferred, stored or traded electronically".^[3]

2. History of the Term

In a 2013 congressional hearing on virtual currencies, Ben Bernanke said they "have been viewed as a form of 'electronic money' or area of payment system technology that has been evolving over the past 20 years", referencing a 1995 congressional hearing on the Future of Money before the Committee on Banking and Financial Services.^[4] The Internet currency Flooz was created in 1999.^[5] The term "virtual currency" appears to have been coined around 2009, paralleling the development of digital currencies and social gaming.^[6]

Although the correct classification is "digital currency", the U.S. government prefers and has uniformly adopted the term "virtual currency". The U.S. Treasury's FinCEN was first, followed by the FBI in 2012,^[7] the General Accounting Office in 2013,^[8] as well as the government agencies testifying at the November 2013 U.S. Senate hearing on bitcoin, including the Department of Homeland Security, the Securities and Exchange Commission, the Office of the Attorney General.^[9]

3. Limits on Being Currency

Attributes of a real currency, as defined in 2011 in the Code of Federal Regulations, such as real paper money and real coins are simply that they act as legal tender and circulate "customarily".^[10]

The IRS decided in March 2014, to treat bitcoin and other virtual currencies as property for tax purposes, not as currency.^[11][12] Some have suggested that this makes bitcoins not fungible—that is one bitcoin is not identical to another bitcoin, unlike one gallon of crude oil being identical to another gallon of crude oil—making bitcoin unworkable as a currency.^[13] Others have stated that a measure like accounting on average cost basis would restore fungibility to the currency.^[13]

4. Categorization by Currency Flow

4.1. Closed Virtual Currencies

Virtual currencies have been called "closed" or "fictional currency" when they have no official connection to the real economy, for example, currencies in massively multiplayer online role-playing games such as World of Warcraft. While there may be a grey market for exchanging such currencies or other virtual assets for real-world assets, this is usually forbidden by the games' terms of service.

4.2. Virtual Currencies with Currency Flow into One Direction

This type of currency has been known for a long time in the form of customer incentive programs or loyalty programs. The first known coupon in history is probably from the US, attributed to Asa Candler, inventor of Coca-Cola and the free drink coupons in 1887, followed by C. W. Post's one-cent-off coupon in breakfast cereal boxes in 1895, both to drive sales. The business issuing the coupon functions as a central authority.^[14] Coupons remained unchanged for 100 years until new technology enabling credit cards became more common in the 1980s, and credit card rewards were invented. The latest incarnation drives the increase of internet commerce, online services, development of online communities and games. Here virtual or game currency can be bought, but not exchanged back into real money. The virtual currency is akin to a coupon. Examples are frequent flyer programs by various airlines, Microsoft Points, Nintendo Points, Facebook Credits and Amazon Coin.

4.3. Convertible Virtual Currencies

A virtual currency that can be bought with and sold back for legal tender is called a convertible currency. It can be decentralized, as for example bitcoin.

5. Centralized Versus Decentralized Virtual Currencies

FinCEN defined centralized virtual currencies in 2013 as virtual currencies that have a "centralized repository", similar to a central bank, and a "central administrator".

A decentralized currency was defined by the US Department of Treasury as a "currency (1) that has no central repository and no single administrator, and (2) that persons may obtain by their own computing or manufacturing effort".^[2] Rather than relying on confidence in a central authority, it depends instead on a distributed system of trust.^[15]

6. The Money Matrix

Digital currency is a particular form of currency that is electronically transferred and stored, i.e., distinct from physical currency, such as coins or banknotes. According to the European Central Bank, virtual currencies are "generally digital", although their enduring precursor, the coupon, for example, is physical.^[1]

A cryptocurrency is a digital currency using cryptography to secure transactions and to control the creation of new currency units.^[16] Since not all virtual currencies use cryptography, not all virtual currencies are cryptocurrencies. Cryptocurrencies are generally not legal tender. Ecuador is the first country attempting a government run digital currency -no cryptocurrency; during the introductory phase from Christmas Eve 2014 until mid February 2015 people can open accounts and change passwords. At the end of February 2015 transactions of electronic money will be possible.^[17][18]

7. Regulation

Virtual currencies pose challenges for central banks, financial regulators, departments or ministries of finance, as well as fiscal authorities and statistical authorities. Gareth Murphy, Central Bank of Ireland, described the regulatory challenges posed by virtual currencies as relating to:^[21]

• Economic statistics
• Monetary and exchange rate policy
• Tax leakage
• Payment systems and settlement infrastructure
• Consumer protection
• Anti-money laundering
• Impact of financial regulation on financial service providers

7.1. US Treasury Guidance

On 20 March 2013, the Financial Crimes Enforcement Network issued a guidance to clarify how the US Bank Secrecy Act applied to persons creating, exchanging and transmitting virtual currencies.^[2]

7.2. Securities and Exchange Commission Guidance

In May 2014 the U.S. Securities and Exchange Commission (SEC) "warned about the hazards of bitcoin and other virtual currencies".^[22]

7.3. New York State Regulation

In July 2014, the New York State Department of Financial Services proposed the most comprehensive regulation of virtual currencies to date commonly referred to as a BitLicense.^[23] Unlike the US federal regulators it has gathered input from bitcoin supporters and the financial industry through public hearings and a comment period until October 21, 2014 to customize the rules. The proposal, per NY DFS press release "… sought to strike an appropriate balance that helps protect consumers and root out illegal activity".^[24] It has been criticized by smaller companies to favor established institutions, and Chinese bitcoin exchanges have complained that the rules are "overly broad in its application outside the United States".^[25]