Recent technological advances have unlocked the possibility of a completely digital form of money known as a virtual currency. Proponents claim it promises fast and inexpensive storage and transactions over large distances, sometimes automatically. It’s also less vulnerable to mass theft due to a central administrator being the victim of a cyberattack.
However, it presents unique challenges for financial institutions, such as volatile valuation, fake currency scams, and instances of money laundering that are difficult to track or reverse. So what is a virtual currency, how does it work, and how should financial institutions prepare themselves to handle this new type of digital-only money?
We’ll explain all of this in the following article. First, we'll cover virtual currency’s meaning, including how it differs from the related terms of digital currency and cryptocurrency.
What is Virtual Currency?
A virtual currency is a type of unregulated digital currency, which means it isn’t issued or controlled by a central bank. Instead, it’s typically issued by a private group and exchanged via software and networks run by that group. It has no intrinsic value, so its price is often highly speculative.
Digital Currency vs. Virtual Currency
Digital currency is a blanket term that refers to any electronic form of money. So the main difference between digital and virtual currency is that digital currencies can also include electronic representations of fiat currencies, such as dollars or euros. As such, they can sometimes be converted to physical versions of those currencies at ATMs or other exchanges.
A virtual currency, meanwhile, is a specific type of digital currency that is entirely electronic and has no equivalent in the physical world. It sometimes does not exist outside of the virtual currency platform or network on which it is used.
Virtual Currency vs. Cryptocurrency
Is virtual currency the same as cryptocurrency? Not quite. A cryptocurrency is a specific type of virtual currency that often exists on a blockchain network. It is so named because it uses cryptographic technology to both secure and validate transactions between users.
What are the Pros and Cons of Virtual Currency?
Virtual currency's purpose is to improve current models of financial value-tracking and record-keeping. Because it’s entirely electronic, it can do this in some ways: it’s lightweight, able to bypass geographic boundaries, and can be managed automatically in some cases. But because virtual currencies are mostly unregulated for the time being, there are concerns about their valuation, security, and legal status.
Here are some of the main advantages of virtual currency:
- Low production and storage costs: Virtual currencies are completely electronic, so they cost much less to manufacture and store than physical money.
- Fast and convenient transactions: Virtual currencies are used entirely over the internet so that they can be exchanged quickly anywhere in the world, regardless of geographic or political boundaries.
- Lack of middlemen: Decentralized virtual currencies don’t have to be managed, or have their transactions facilitated, by intermediaries. This increases transaction speeds while reducing costs and avoids a crisis if the central administrator is compromised.
- Ability for automated transactions: The electronic nature of virtual currencies allows them to be programmed to execute transactions automatically when certain conditions are met, without a human needing to intervene manually.
There are downsides to virtual currencies, however. These include:
- Not entirely free of logistics costs: Virtual currencies still have some cost-inducing infrastructure associated with them. These include digital wallets and cryptocurrency custody services.
- Speculative pricing: Virtual currencies often do not have their values tied to fiat currencies or physical commodities, and are often not otherwise regulated by centralized authorities. This makes them vulnerable to dramatic price fluctuations, and even scams where fake currencies are traded with no actual network infrastructure to use them on.
- Prime targets for hackers: Coupled with their volatile valuation system, the fact that virtual currencies are digital-only makes them attractive targets for cybercriminals. This is especially true when prices are high or expected to rise.
- Lack of legal recourse: Because virtual currencies are by and large not regulated by financial oversight institutions, investors have few legal protections against crimes committed involving virtual currencies. These include thefts, scams, and money laundering.
- Slow acceptance as legal tender: Virtual currencies can sometimes be exchanged for one another. However, the lack of comprehensive and uniform regulations surrounding them has caused division among nations as to whether they represent objects of actual value that can be exchanged for fiat currencies or physical commodities.
Types of Virtual Currency
When it comes to forms of virtual currency, there are four major categories: closed, open, centralized, and decentralized. We will explain the differences between these groups below.
Closed vs. Open Virtual Currency
A closed virtual currency is only meant to be used within the context of the network or application in which it’s found. It may be able to be purchased with fiat currencies or other virtual currencies, but it usually cannot be converted back into these other forms of money. An example is a currency used in an online game; it can be purchased with other types of money but has no value outside of being exchanged for assets in that game (or sometimes other related games).
In contrast, an open virtual currency is one that is given value outside of its origin software or network. As such, it can be exchanged for other virtual currencies, or even some fiat currencies in some instances. Examples include Bitcoin and Ether, two of the most popular cryptocurrencies.
Centralized vs. Decentralized Virtual Currency
Many types of virtual currency are decentralized. This means that they aren’t issued or administered by a single central authority. Instead, transactions involving them are broadcasted to the rest of the network, which then has to verify and record these transactions by majority consensus. The main advantage of this is that it avoids jeopardizing the system's integrity if a central administrator suffers a security breach.
However, because these decentralized transactions must be approved by a majority of users on a network, they are difficult to undo once recorded. This makes decentralized virtual currencies attractive to criminals looking to launder money or conduct other illegal transactions irreversibly. For this reason, some virtual currencies choose to have a centralized setup, so only a single party controls the clearing and tracking of any transactions.
Examples of Virtual Currency
The following virtual currency list demonstrates a few of the different types of virtual currencies that are in circulation today.
Type: Open | Decentralized
Bitcoin is perhaps the most well-known open virtual currency. As a cryptocurrency, it runs on a blockchain network, making it a type of decentralized virtual currency. Its inventor is still unknown, as they use the pseudonym of “Satoshi Nakamoto.”
Type: Open | Decentralized
Ether is another popular cryptocurrency, developed for use on the Ethereum blockchain developer platform. Ether’s original purpose was to cover the computing expenses of people keeping Ethereum running so others could use the system to build things like security programs, financial applications, games, and even other cryptocurrencies! However, ether is now a publicly-exchanged cryptocurrency that can be used as payment with certain merchants.
Type: Open | Centralized
Tether is a centralized cryptocurrency owned by iFinex Inc. It’s known as a “stablecoin” because it attempts to tie its value to fiat currencies. The most popular version is tied to the US dollar, and is traded under the code “USDT.”
Type: Open | Semi-Centralized
XRP is a cryptocurrency primarily used for facilitating international money exchanges, including settlements and remittances. There is debate as to whether it’s centralized or decentralized, as the company Ripple owns most of the supply, and only certain users on the Ripple blockchain are permitted to validate transactions.
Type: Closed | Centralized
Minecoins are a type of virtual currency used in the popular video game Minecraft. They can be purchased with fiat money, but cannot be converted back. They can be spent on additional content within the game – such as different character avatars, clothing items for avatars, and access to user-created maps – but have no value outside the game.
How to Perform Fraud Compliance for Virtual Currencies
The overall lack of centralized regulation on virtual currencies has made them popular for criminals wanting to run Ponzi schemes, finance terrorism, or conduct other illegal transactions anonymously and irreversibly. So it is likely that virtual currencies will come under increased regulation in the future, requiring compliance with anti-fraud and AML rules regarding them.
Here are a few general strategies:
- Know Your Customer: Customers should be thoroughly checked to verify not only that they are who they say they are, but also that their financial behavior lines up with their identity. This can help to evaluate their risk of fraud or money laundering, especially by tracing their transactions to determine if their sources of funds are legitimate.
- Screen for sanctioned countries and PEPs: Certain people present a higher risk for virtual currency fraud because of their occupations and/or administrative influence (i.e. “politically exposed persons”). People with financial activity originating in specific countries that are known for virtual currency schemes can also present higher risk profiles. Screen and monitor these individuals with extended due diligence and KYC. Also, be aware that sanctions lists change from time to time, so stay up to date.
- Monitor activity on and off the blockchain: Remember that open virtual currencies can be exchanged for each other, and sometimes also for fiat money. So it’s important to have anti-fraud software that can monitor for suspicious activity in both fiat exchanges and transactions into and out of cryptocurrency wallets.
- Have robust AML tools in place: The right AML technology solutions can simplify many of the above procedures by combining KYC, due diligence, the ability to file suspicious activity reports (SARs), and AI-powered behavioral analytics.