Sunday, April 7, 2013

Virtual Currency Schemes – Why they don’t (yet) affect the real economy

Bitcoin bubble grows and grows”, the Financial Times has written a few days ago about the virtual currency created in 2009 for a peer-to-peer network. Should we care? In a recent research paper, the ECB has examined precisely this question.

Definition and Typology

A currency is called virtual if it is created by and applicable within a virtual community to exchange virtual or real goods and services and to serve as a unit of account. Its characteristics are:

  • It is virtual money.
  • It is digital money.
  • It is not regulated by official Government agencies but only created and controlled by its developers
  • Traditional financial actors such as central banks are not involved.

Depending on their interaction with the real world, the ECB differentiates 3 types of virtual currencies:

Opportunities and Threats

From a commercial perspective, issuing virtual currency can first of all lock-in customers by providing a financial incentive to keep on participating in the virtual community. Second, as the developer controls the creation of virtual currency, a virtual currency program enhances the issuer’s business model flexibility and his strategic control over the business. Finally, a virtually currency can simply generate revenue.
Beyond, virtual currencies can contribute to financial innovation and provide additional payment alternatives to consumers.

On the other hand, virtual currencies also cause risks such as

  • lack of regulation and legal uncertainty;
  • counterparty and fraud risk;
  • alternative currency for drug dealing;
  • money laundering instrument;
  • price instability;
  • instability of the financial system and, especially, payment systems;
  • reputation risk for central banks;
  • undermining consumer protection laws.
    In addition, a type 3 virtual currency system might be interpreted as a Ponzi scheme in a sense that you always need additional investors to reconvert your virtual currency to real currency.

Appreciation of threats

In a nutshell, the ECB currently estimates the dangers as not substantial, given the small size of virtual currency schemes, compared to regulated currency schemes:

For the time being, [virtual currency schemes] do not jeopardize financial stability, given their limited connection to the real economy, the low volumes traded and the lack of wide user acceptance. However, developments should be carefully monitored as the situation could change substantially in the future.”

To illustrate ECB's position, the value of USD in circulation is currently more than 6,000 times the USD value of issued Bitcoins.

As a matter of fact, in the ECB’s view, type 1 virtual currency schemes are irrelevant as they are entirely disconnected from the real economy.

As regards type 2 schemes, they might have a negative impact if

  • they substantially modify the quantity of money;
  • they influence the velocity of money (how often a unit of currency is spent over a specific period of time) or the use of cash;
  • they can perturb the measurement of monetary aggregates;
  • there is an interaction between the virtual currency and the real economy.

Now, I feel comfortable again. Let the bitcoin bubble burst...