virtual currency schemes
OctOBer 2012
VIRTUAL CURRENCY SCHEMES
OCTOBER 2012
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EXECUTIVE SUMMARY 5
1 INTRODUCTION 9
1.1 Preliminary remarks and motivation
9
1.2 A short historical review of money
9
1.3 Money in the virtual world
10
2 VIRTUAL CURRENCY SCHEMES 13
2.1 Denitionandcategorisation
13
2.2 Virtual currency schemes and electronic money
16
2.3 Paymentarrangementsinvirtualcurrencyschemes
17
2.4 Reasonsforimplementingvirtualcurrencyschemes
18
3 CASE STUDIES 21
3.1 The Bitcoin scheme
21
3.1.1 Basic features
21
3.1.2 Technical description of a Bitcoin transaction
23
3.1.3 Monetary aspects
24
3.1.4Securityincidentsandnegativepress
25
3.2 The Second Life scheme
28
3.2.1 Basic features
28
3.2.2 Second Life economy
28
3.2.3 Monetary aspects
29
3.2.4 Issues with Second Life
30
4 THE RELEVANCE OF VIRTUAL CURRENCY SCHEMES FOR CENTRAL BANKS 33
4.1 Risks to price stability
33
4.2 Riskstonancialstability
37
4.3 Risks to payment system stability
40
4.4 Lackofregulation
42
4.5 Reputational risk
45
5 CONCLUSION 47
ANNEX: REFERENCES AND FURTHER INFORMATION ON VIRTUAL CURRENCY SCHEMES 49
CONTENTS
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Virtual currency schemes
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EXECUTIVE SUMMARY
Virtualcommunitieshaveproliferatedinrecentyears–aphenomenontriggeredbytechnological
developments and by the increased use of the internet. In some cases, these communities have
created and circulated their own currency for exchanging the goods and services they offer,
and thereby provide a medium of exchange and a unit of account for that particular virtual
community.
This paper aims to provide some clarity on virtual currencies and tries to address the issue in a
structured approach. It is important to take into account that these currencies both resemble money
and necessarily come with their own dedicated retail payment systems; these two aspects are
covered by the term “virtual currency scheme”. Virtual currency schemes are relevant in several
areasofthenancialsystemandarethereforeofinteresttocentralbanks.This,amongotherthings,
explainstheECB’sinterestincarryingoutananalysis,especiallyinviewofitsroleasacatalystfor
paymentsystemsanditsoversightrole.
This report begins by dening and classifying virtual currency schemes based on observed
characteristics;thesemight change in future,whichcould affect the currentdenition.A virtual
currency can be dened 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 specic virtual
community.Dependingontheirinteractionwithtraditional,“real”moneyandtherealeconomy,
virtualcurrencyschemescanbeclassiedintothreetypes:Type1,whichisusedtorefertoclosed
virtualcurrencyschemes,basicallyusedinanonlinegame;Type2virtualcurrencyschemeshave
aunidirectionalow(usuallyaninow),i.e.thereisaconversionrateforpurchasingthevirtual
currency, which can subsequently be used to buy virtual goods and services, but exceptionally
alsotobuyrealgoodsandservices;andType3virtualcurrencyschemeshavebidirectionalows,
i.e.thevirtualcurrencyinthisrespectactslikeanyotherconvertiblecurrency,withtwoexchange
rates(buyandsell),whichcansubsequentlybeusedtobuyvirtualgoodsandservices,butalsoto
purchaserealgoodsandservices.
Virtual currency schemes differ from electronic money schemes insofar as the currency being
usedastheunitofaccounthasnophysicalcounterpartwithlegaltenderstatus.Theabsenceofa
distinctlegalframeworkleadstootherimportantdifferencesaswell.Firstly,traditionalnancial
actors, including central banks, are not involved. The issuer of the currency and scheme owner
is usually a non-nancial private company. This implies that typical nancial sector regulation
andsupervisionarrangementsarenotapplicable.Secondly,thelinkbetweenvirtualcurrencyand
traditionalcurrency(i.e.currencywithalegaltenderstatus)isnotregulatedbylaw,whichmight
beproblematicorcostlywhenredeemingfunds,ifthisisevenpermitted.Lastly,thefactthatthe
currency is denominated differently (i.e. not euro, US dollar, etc.) means that complete control
ofthevirtualcurrencyisgiventoitsissuer,whogovernstheschemeandmanagesthesupplyof
money at will.
There are several business reasons behind the establishment of virtual currency schemes. They may
provideanancialincentiveforvirtualcommunityuserstocontinuetoparticipate,orcreatelock-in
effects.Moreover,schemesareabletogeneraterevenuefortheirowners,forinstanceoatrevenue.
In addition, a virtual currency scheme, by allowing the virtual community owner to control its
basicelements(e.g.thecreationofmoneyand/orhowtoallocatefunds),providesahighlevelof
exibilityregardingthebusinessmodelandbusinessstrategyforthevirtualcommunity.Finally,
specicallyforType3schemes,avirtualcurrencyschememayalsobeimplementedinorderto
compete with traditional currencies, such as the euro or the US dollar.
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TherstcasestudyinthisreportrelatestoBitcoin,avirtualcurrencyschemebasedonapeer-to-
peernetwork.Itdoesnothaveacentralauthorityinchargeofmoneysupply,noracentralclearing
house,norarenancialinstitutionsinvolvedinthetransactions,sinceusersperformallthesetasks
themselves.Bitcoinscanbespentonbothvirtualandrealgoodsandservices.Itsexchangeratewith
respecttoothercurrenciesisdeterminedbysupplyand demand and several exchange platforms
exist. The scheme has been surrounded by some controversy, not least because of its potential to
becomeanalternativecurrencyfordrugdealingandmoneylaunderingasaresultofitshighdegree
of anonymity.
The second case study in this report is Second Life’s virtual currency scheme, in which Linden
Dollars are used. This scheme can only be used within this virtual community for the purchase
ofvirtualgoodsandservices.LindenLabmanagestheschemeandactsasissuerandtransaction
processor and ensures a stable exchange rate against the US dollar. However, the Second Life
schemehasbeensubjecttodebate,andithasbeensuggestedthatthiscurrencyismorethansimply
moneyforonlinegaming.
Thereafter, a preliminary assessment is presented of the relevance of virtual currency schemes
forcentralbanks,payingattentionmostlytoschemeswhicharemoreopenandlinkedtothereal
economy(i.e.Type3schemes).Theassessmentcoversthestabilityofprices,ofthenancialsystem
andofthepaymentsystem,lookingalsoattheregulatoryperspective.Italsoaddressesreputational
risk concerns. It can be concluded that, in the current situation, virtual currency schemes:
do not pose a risk to price stability, provided that money creation continues to stay at a low −
level;
tend to be inherently unstable, but cannot jeopardise nancial stability, owing to their −
limited connection with the real economy, their low volume traded and a lack of wide user
acceptance;
are currently not regulated and not closely supervised or overseen by any public authority, −
eventhoughparticipationintheseschemesexposesuserstocredit,liquidity,operationaland
legalrisks;
couldrepresentachallengeforpublicauthorities,giventhelegaluncertaintysurroundingthese −
schemes, as they can be used by criminals, fraudsters and money launderers to perform their
illegalactivities;
could have a negative impact on the reputation of central banks, assuming the use of such −
systemsgrowsconsiderablyandintheeventthatanincidentattractspresscoverage,sincethe
publicmayperceivetheincidentasbeingcaused,inpart,byacentralbanknotdoingitsjob
properly;
do indeed fall within central banks’ responsibility as a result of characteristics shared with −
paymentsystems,whichgiverisetotheneedforatleastanexaminationofdevelopmentsand
the provision of an initial assessment.
This report is a rst attempt to provide the basis for a discussion on virtual currency schemes.
Althoughtheseschemescanhavepositiveaspectsintermsofnancialinnovationandtheprovision
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EXECUTIVE SUMMARY
of additional payment alternatives to consumers, it is clear that they also entail risks. Owing to
the small size of virtual currency schemes, these risks do not affect anyone other than users of
theschemes.Thisassessmentcouldchangeifusageincreasessignicantly,forexampleifitwere
boosted by innovations which are currently being developed or offered. As a consequence, it is
recommendedthatdevelopmentsareregularlyexaminedinordertoreassesstherisks.
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1 INTRODUCTION
1.1 PRELIMINARY REMARKS AND MOTIVATION
This report seeks to provide clarity on the topic of virtual currencies and tries to address the issue in
astructuredapproach.Suchanapproachhasbeenabsent,atleasttosomeextent,fromtheexisting
literature. Moreover, there have previously been no references to this topic in the publications of
centralbanks,internationalorganisationsorpublicauthorities.Asaconsequence,thisreportlargely
reliesoninformationanddatagatheredfrommaterialpublishedontheinternet(seetheAnnexfor
referencesandfurtherreading),whosereliability,however,cannotbefullyguaranteed.Thisplaces
serious limitations on the present study.
Virtual currencies resemble money and necessarily come with their own dedicated retail payment
systems; these two aspects are covered by the term “virtual currency scheme”. Virtual currency
schemesarerelevantinseveralareasofthenancialsystemandarethereforeofinteresttocentral
banks.Virtualcurrencyschemeshavebeensubjecttoincreasedpresscoverage,evenbeingfeatured
in respectable media publications. The ECB has been contacted a number of times in recent months
by academics, journalists and concerned citizens, who want to know its view or want to warn the
institution about potential problems with virtual currency schemes. In this context, it was considered
advisabletostriveforacommonunderstandingand,thereafter,toformulateacoordinatedresponse.
ThisexplainstheECB’sinterestincarryingoutamoredetailedanalysis,especiallyinviewofits
roleasacatalystforpaymentsystemsanditsoversightrole.Thepresentreportistheresultofthis
analysis.Itisarstattempttoprovidethebasisforadiscussiononvirtualcurrencyschemes.
This report is structured into four parts. After a brief review of the history of money in this chapter,
Chapter 2 denes and classies virtual currency schemes. It also shows how their payment
arrangementswork andaddresses the various business reasonsfor implementingthese schemes.
Chapter 3 focuses on two prominent virtual currency schemes, namely Bitcoin and Second Life’s
Linden Dollars, and describes their basic features, technical elements and monetary aspects.
It also addresses the latest issues and security incidents in which these schemes have been involved.
Chapter4offersanassessmentofhowcentralbankscouldbeaffectedbytheseschemes,taking
into account different aspects, i.e. price stability, nancial stability, the smooth operation of
paymentsystems,theregulatoryperspectiveandreputationalrisk.Thereportnishesbyoffering
conclusions and proposals for future action.
1.2 A SHORT HISTORICAL REVIEW OF MONEY
Itisdifculttoestablishthepreciseoriginsofmonetarysocieties.Itseemsthatpaymentsusing
someformofmoneywerebeingmadeasearlyas2200BC.Nevertheless,theformatofmoneyhas
changedconsiderablysincethen.Earlymoneywasusuallycommoditymoney,thatis,anobject
whichhadintrinsicvalue(e.g.cattle,seeds,etc.,andlater,goldandsilver,forinstance).
Around the eighteenthcentury, “commodity-backed”money startedto beused, whichconsisted
of items representing the underlying commodity (e.g. gold certicates). These pieces of paper
werenotintrinsicallyvaluable,buttheycouldbeexchangedforaxedquantityoftheunderlying
commodity.Themainadvantagesofthissystemweretheportabilityofthemoneyandthatlarger
amounts of money could be transferred.
Modern economies are typically based on “at” money, which is similar to commodity-backed
moneyinitsappearance,butradicallydifferentinconcept,asitcannolongerberedeemedfora
commodity.Fiat money is any legaltender designated andissued bya central authority.People
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arewillingtoacceptitinexchangeforgoodsandservicessimplybecausetheytrustthiscentral
authority.Trustisthereforeacrucialelementofanyatmoneysystem.
Regardlessoftheformofmoney,itistraditionallyassociatedwiththreedifferentfunctions:
Medium of exchange• : money is used as an intermediary in trade to avoid the inconveniences
of a barter system, i.e. the need for a coincidence of wants between the two parties involved in
the transaction.
Unit of account• : money acts as a standard numerical unit for the measurement of value and
costsofgoods,services,assetsandliabilities.
Store of value• : money can be saved and retrieved in the future.
Money is a social institution: a tool created and marked by society’s evolution, which has exhibited
agreatcapacitytoevolveandadapttothecharacterofthetimes.Itisnotsurprisingthatmoneyhas
beenaffectedbyrecenttechnologicaldevelopmentsandespeciallybythe widespread use of the
internet.
1.3 MONEY IN THE VIRTUAL WORLD
Sinceitsestablishmentinthe1980sandfollowingthecreationoftheWorldWideWebinthemid-
1990s,accesstoanduseoftheinternethasgrowndramatically.AccordingtoInternetWorldStats,
1
the number of internet users in the world was 361 million at the end of 2000, whereas by the end
http://www.internetworldstats.co1 m
Chart 1 Internet penetration and growth by region (December 2011)
(percentage)
Internet penetration (% population) Internet penetration growth (2000-2011)
1 Africa
2 Asia
3 Europe
4 Middle East
5 North America
6 Latin America/Caribbean
7 Oceania/Australia
8 World total
21 3 4 65 7 8
100
90
80
70
60
50
40
30
20
10
0
100
90
80
70
60
50
40
30
20
10
0
3,200
2,800
2,400
2,000
1,600
1,200
800
400
0
3,200
2,800
2,400
2,000
1,600
1,200
800
400
0
21 3 4 5 6 7 8
1 Africa
2 Asia
3 Europe
4 Middle East
5 North America
6 Latin America/Caribbean
7 Oceania/Australia
8 World total
Source:InternetWorldStats.
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11
I INTRODUCTION
11
of 2011 this gure had reached 2,267 million,
orapproximately33%oftheglobalpopulation.
Theimpacthasbeensosignicantthatitcould
reasonablybeconsideredastructuralchangein
socialbehaviour,affectingthewaypeoplelive,
interactwitheachother,gatherinformationand,
of course, the way they pay.
In connection with the high penetration of the
internet, there has also been a proliferation of
virtual communities in recent years. A virtual
community is to be understood as a place within
cyberspacewhereindividualsinteract and followmutualinterestsor goals. Social networkingis
probablythemostomnipresenttypeofvirtualcommunity(e.g.Facebook,MySpace,Twitter),but
thereareotherprominentcommunities,suchasthosethatshareknowledge(e.g.Wikipedia),those
thatcreateavirtualworld(e.g.SecondLife)orthosethataimtocreateanonlineenvironmentfor
gambling(e.g.OnlineVegasCasino).
Insomecases,thesevirtualcommunitieshavecreatedandcirculatedtheirowndigitalcurrencyfor
exchanging the goods and services they offer, thereby creating a new form of digital money
(see Table 1). Theexistence of competing currencies isnot new, as local, unregulated currency
communitiesexistedlongbeforethedigitalage.
2
These schemes can have positive aspects if they
contribute to nancial innovation and provide additional payment alternatives to consumers.
However,itisclearthattheycanalsoposerisksfortheirusers,especiallyinviewofthecurrent
lackofregulation.
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full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.
See 2 http://en.wikipedia.org/wiki/Local_currency
Table 1 A money matrix
Legal
status
Unregulated
– Certain types of
local currencies
– Virtual currency
Regulated
– Banknotes and
coins
– E-money
– Commercial bank
money (deposits)
Physical Digital
Money format
Source: ECB.
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2 VIRTUAL CURRENCY SCHEMES
2.1 DEFINITION AND CATEGORISATION
Againstthe backgroundprovided inthe previouschapter andbased onobserved characteristics,
itispossibletoprovidethefollowingdenitionofvirtualcurrency:“avirtualcurrencyisatype
ofunregulated,digitalmoney,whichisissuedandusuallycontrolledbyitsdevelopers,andused
andacceptedamongthemembersofaspecicvirtualcommunity”.Thisdenitionmayneedtobe
adaptedinfutureiffundamentalcharacteristicschange.
There are typically two ways to obtain virtual currencies. In many virtual currency schemes, the
fastest way is to purchase it using “real” money at a conversion rate that has been previously
established;
1
the virtual currency itself usually has no commodity-backed value.
2
Secondly, users
can often increase their stock by engagingin specic activities, for instance by responding to a
promotionoradvertisementorbycompletinganonlinesurvey.
There are many different virtual currency schemes and it is not easy to classify them. One
possibility is to focus on their interactions with real money and the real economy. This occurs
throughtwo channels: a) the monetaryow via currency exchanges; andb) the realow inthe
senseofthepossibilitytopurchaserealgoodsandservices.Takingthisasabasis,threetypescan
bedistinguished:
1) Closed virtual currency schemes. These schemes have almost no link to the real economy and
aresometimescalled“in-gameonly”schemes.
3
Users usually pay a subscription fee and then
earn virtual money based on their online performance. The virtual currency can only be spent
bypurchasingvirtualgoodsandservicesofferedwithinthevirtualcommunityand,atleastin
theory, it cannot be traded outside the virtual community.
Forthetimebeing,thereseemstobenovirtualcurrencyexchangesystemfortransferringandexchangingmoneybetweenthedifferent1
virtualcommunities.Thissituationcouldchangeifinitiatives,suchas“CurrencyConnect”(http://www.currencyconnect.com/) succeed.
Theremaybeexceptions.Forinstance,e-gold(2 http://www.e-gold.com/) is a virtual currency scheme, which was founded in 1996 and
isoperatedbyGold&SilverReserveInc.tradingase-goldLtd.Thiscurrencyis100%backedbyphysicalgold(orsilver,platinumand
palladium)heldinlocationsaroundtheworld,suchasLondonorZurich.Usersopeningane-goldaccountareactuallybuyingaquantity
ofgold. Thevalue of theaccount is linkedto theprice of gold.The system,which also allowsthe transfer ofmoney toother users,
operateswithsomecompaniesactingasmarketmakers,buyingandsellingthisvirtualcurrency(i.e.theunderlyingmetal)againstother
currencies.TheUSauthoritieshaveaccusedthisschemeofviolatinganti-moneylaunderingregulations.In2008thecompany’sfounder
andtwoseniordirectorsagreedtopleadguiltytovariouschargesrelatedtomoneylaunderingandtheoperationofanunlicensedmoney
transferbusiness.In2009thecompanycontactedtheUSGovernmentinordertoreconvertitsactivity.Thedialogueculminatedinthe
development of a Value Access Plan acceptable to both the company and the Government. Once this plan is implemented, the expectation
isthatuserswillagainhaveaccesstothevalueintheiraccounts.
Strauss (2010).3
Example: World of Warcraft (WoW) Gold is a virtual currency used in this well-known
online role-playing game designed by Blizzard Entertainment. Players have different options
(with different subscription fees) for opening an account and starting to play. WoW Gold is
neededasameansofexchangeinthegame,forinstanceinorderforplayerstoequipthemselves
wellenoughtoreachhigherlevels.PlayershaveseveralopportunitiestoearnWoWGoldwithin
thegame.BuyingandsellingWoWGoldintherealworldisstrictlyforbiddenundertheterms
and conditions established by Blizzard Entertainment.
1
1 However, there seems to be a black market for buying and selling WoW Gold outside the virtual currency scheme. If Blizzard
Entertainmentdiscoversanyillegalexchange,itcansuspendorbanaplayer’saccount.
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2) Virtual currency schemes with unidirectional ow. The virtual currency can be purchased
directly using real currency at a specic exchange rate, but it cannot be exchanged back to
theoriginalcurrency.Theconversionconditionsareestablishedbytheschemeowner.Type2
schemesallowthecurrencytobeusedtopurchasevirtualgoodsandservices,butsomemay
alsoallowtheircurrenciestobeusedtopurchaserealgoodsandservices.
3) Virtual currency schemes with bidirectional ow. Users can buy and sell virtual money
accordingtotheexchangerateswiththeircurrency.Thevirtualcurrencyissimilartoanyother
convertible currency with regard to its interoperability with the real world. These schemes
allowforthepurchaseofbothvirtualandrealgoodsandservices.
Example 1: Facebook Credits (FB), Facebook’s virtual currency was introduced in 2009 to
allowuserstobuyvirtualgoodsinanyapplicationontheFacebookplatform.Itwaspossible
tobuythiscurrencyusingacreditcard,PayPalaccountoravarietyofotherpaymentmethods.
A purchase made using any other currency than US dollars would undergo a conversion
into US dollars using a daily exchange rate, before beingexchanged for Facebook Credits
attherateofFB1=USD0.10.UserswereabletogainadditionalFacebookCreditsthrough
special promotions, for instance if they made online purchases. The terms on the website did
not provide for a conversion back to US dollars.
1
Surprisingly, in June 2012 the company
announced that it would “update the payments product” and that it would convert all prices
and balances that were quoted in Facebook Credits into local currency amounts starting
inJuly2012.
2
Example 2: The virtual currency scheme set up by Nintendo, called Nintendo Points, can be
redeemed in Nintendo’s shops and in their games. Consumers can purchase points online by
usingacreditcardorinretailstoresbypurchasingaNintendoPointsCard.ThePointscannotbe
converted back to real money.
1 See Liu (2010).
2 Seehttp://developers.facebook.com/blog/post/2012/06/19/introducing-subscriptions-and-local-currency-pricing/
Example: Linden Dollars (L$) is the virtual currency issued in Second Life, a virtual world
whereuserscreate“avatars”,i.e.digitalcharactersthatcanbecustomised.SecondLifehas
its own economy where users can buy and sell goods and services from and to each other.
In order to do so, they need Linden Dollars, which can be purchased with US dollars and
other currenciesaccording totheexchangeratesestablishedin the currencytradingmarket.
A credit card or PayPal account is needed. Users can sell their spare Linden Dollars in return
for US dollars.
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2 VIRTUAL CURRENCY
SCHEMES
15
Chart 2 Types of virtual currency scheme
Real economy money
Virtual money
Can be used for virtual
and real goods and
services
Type 3
Real economy money
Virtual money
Used only for virtual
goods and services
Type 1
Real economy money
Virtual money
Can be used for virtual
and real goods and
services
Type 2
Source: ECB.
Note: A subscription fee may be required for Type 1.
Box 1
FREQUENT-FLYER PROGRAMMES
Loyalty programmes in the form of vouchers, coupons and bonus points have long existed.
Airlines’points/airmilesprogrammesareoneoftheserewardsystemsimplementedtoincrease
frequentyers’loyaltytowardsthecompany.Everytimeacustomerbuysaightorpayswitha
creditcardlinkedtothefrequent-yerprogramme,theyreceiveadditionalairmilesthatcanbe
exchangedforfreeightsorforanupgradetobusinessclass.
AshighlightedbyTheEconomist(2005),theseprogrammeshavereachedoutstandingvalues,
evensurpassingthetotalamountofdollarnotesandcoinsincirculation(i.e.theM0supply).
Airlinecompaniesalsosellmilestocreditcardrms,generatingsubstantialadditionalrevenue
for airlines. In addition, these programmes form part of the airlines’ marketing and business
strategies.Byprovidingthefrequentyerwithairmilesforbuyingaightataparticulartime
or,onthecontrary,bymakingithardertospendairmiles(e.g.requestingmoreairmilesfora
freeightorrestrictingthenumberofseatsavailable),theairlinescaninuencetheircustomers’
demand.Inpractice,thismeansthattheairlinescanmanagethesupplyofairmilesaccordingto
theirownstrategy.
Based on the denition and concept of virtual currency schemes developed in this section,
frequent-yerprogrammescanbeviewedasaspecictypeofvirtualcurrencyscheme,which
exhibitsthefollowingfeatures:
Usersusuallyreceiveairmilesforbuyingaight,buttheycanalsoearntheminmanyother –
ways(e.g.bypayingwithalinkedcreditcard,byrespondingtoapromotion,etc.).Userscan
alsobuyairmileswithrealmoneyataspecicexchangerate.
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2.2 VIRTUAL CURRENCY SCHEMES AND ELECTRONIC MONEY
Virtualcurrency schemes canbe considered tobe a specictype of electronicmoney, basically
used for transactions in the online world. However, a clear distinction should be made between
virtual currency schemes and electronic money (see also Table 2).
According to the Electronic Money Directive (2009/110/EC), “electronic money” is monetary
value as represented by a claim on the issuer which is: stored electronically; issued on receipt of
funds of an amount not less in value than the monetary value issued; and accepted as a means of
paymentbyundertakingsotherthantheissuer.
Althoughsomeofthesecriteriaarealsometbyvirtualcurrencies,thereisoneimportantdifference.
In electronic money schemes the link between the electronic money and the traditional money
formatis preservedand has a legal foundation,as thestored funds are expressed in the sameunit
ofaccount(e.g.USdollars,euro,etc.).Invirtualcurrencyschemestheunitofaccountischanged
intoavirtualone(e.g.LindenDollars,Bitcoins).Thisisnotaminorissue,specicallyinType3
schemes.Firstly,theseschemesrelyonaspecicexchangeratethatmayuctuate,sincethevalue
of the virtual currency is usually based on its own demand and supply. Secondly, to some extent
the conversion blursthelink totraditional currency, which might beproblematic when retrieving
funds, if this is even permitted. Lastly, the fact that the currency is denominated differently
(i.e. not in euro, US dollar, etc.) and that the funds do not need to be redeemed at par value means that
completecontrolofthevirtualcurrencyislefttoitsissuer,whichisusuallyanon-nancialcompany.
Oncethemoneyisinthesystem,itcannotlegallyberedeemedintorealmoney.However,as –
is the case with other virtual currencies, there may also be a black market for air miles.
Air miles can be used to purchase real goods, i.e. ights. However, it seems that some –
schemesalsoallowairmilestobeusedwhenbuyingotherrealgoodsandservices,butthis
practiceseemstobemarginalatthisstage.
Taking all these elements into account, it is possible to classify the airlines’ frequent-yer
programmesascharacteristicoftheType2virtualcurrencyschemes.
Table 2 Differences between electronic money schemes and virtual currency schemes
Electronic money schemes Virtual currency schemes
Money format
Digital Digital
Unit of account
Traditional currency (euro, US dollars, pounds, etc.)
withlegaltenderstatus
Invented currency (Linden Dollars,
Bitcoins,etc.)withoutlegaltenderstatus
Acceptance
Byundertakingsotherthantheissuer Usuallywithinaspecicvirtualcommunity
Legal status
Regulated Unregulated
Issuer
Legallyestablishedelectronicmoneyinstitution Non-nancialprivatecompany
Supply of money
Fixed Notxed(dependsonissuer’sdecisions)
Possibility of redeeming funds
Guaranteed (and at par value) Notguaranteed
Supervision
Yes No
Type(s) of risk
Mainly operational Legal,credit,liquidityandoperational
Source: ECB.
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17
Moreover, electronic money schemes are regulated and electronic money institutions that
issue means of payment in the form of electronic money are subject to prudential supervisory
requirements. This is not the case for virtual currency schemes.
Consequently, the risks faced by each type of money are different. Electronic money is primarily
subject to the operational risk associated with potential disruptions to the system on which the
electronic money is stored. Virtual currencies are not only affected by credit, liquidity and
operationalriskwithoutanykindofunderlyinglegalframework,theseschemesarealsosubjectto
legaluncertaintyandfraudrisk,asaresultoftheirlackofregulationandpublicoversight.
The denition of virtual currency schemes used in this report excludes an entity like PayPal, the
internet-basedpaymentsystem.Althoughavirtualaccountiscreated,novirtualcurrencyisissuedin
the PayPal environment. A PayPal account is funded via credit transfer from a bank account or by a
creditcardpayment,i.e.itoperateswithinthebankingsystem.Besides,itsEuropeansubsidiaryisbased
inLuxembourgandhasbeenoperatingwithanEUbankinglicencesince2007.Asaconsequence,
PayPalissupervisedbytheCommissiondeSurveillanceduSecteurFinancierofLuxembourgandthe
electronicmoneyschemeisoverseenbytheBanquecentraleduLuxembourg.
2.3 PAYMENT ARRANGEMENTS IN VIRTUAL CURRENCY SCHEMES
Justlikeintherealeconomy,inavirtualeconomythereareawiderangeofeconomicactorswho
engageintransactionsthathavetobesettled.Thesetransactionshavetwosettlementcomponents:a)
thedeliveryof(usuallyvirtual,butpotentiallyalsoreal)goodsandservices;andb)thetransferof
funds.
A“paymentsystem”canbedenedasasetofinstruments,procedures,andrulesforthetransferof
fundsamongsystemparticipants.Itistypicallybasedonanagreementbetweentheparticipantin
thesystemandthesystemoperator,andthetransferoffundsisconductedusinganagreedtechnical
infrastructure.
4
In essence, virtual currency schemes work much like retail payment systems, except
forthefactthatnancialintermediariesarenotusuallyinvolvedinthepaymentprocess.Virtual
currency schemes demonstrate three main elements or processes of a retail payment system:
5
Apaymentinstrumentisusedasthemeansofauthorisingandsubmittingthepayment.a)
Processingandclearinginvolvesapaymentinstructionbeingexchangedbetweenthecreditorb)
and the debtor concerned.
Debits and credits are settled in the user’s account. c)
Althoughtherearedifferentmodelsthatmayleadtoimportantvariations,thefollowingspecic
featurescantypicallybeobservedforpaymentarrangementswithinvirtualcurrencyschemes:
Agents involved – :Virtualcurrenciesareheld outside the traditional banking channels.Anon-
nancialinstitutionplaysthecrucialroleandtherearenootherinstitutionsprovidingpayment
accountsorpayment services, ororganisationsthat operate payment,clearingand settlement
services. In this regard, virtual currency schemes work like traditional three-party schemes
BIS(2001),p.14,andECBGlossaryofTermsRelatedtoPayment,ClearingandSettlementSystems.4
Kokkola (ed.) (2010), p. 25.5
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1818
with a scheme-owned processor. The accounts to be debited and credited are held within this
organisation,whichisthevirtualcommunityoperator.Virtualcurrencypaymentsaretherefore
handled “in house” and can be classied as a specic type of “on-us” transaction, that is,
a transfer of a claim on the virtual currency issuer.
Type of transactions: – From a conceptual perspective, payments can be classied as retail
payments, i.e. a large number of payments with small values. The payment instrument is
typically a virtual credit transfer.
Type of settlement: – Payments are usually settled on a gross basis. Each payment instruction
ispassedonandsettledindividuallyacrosstheaccountsofthepayerandthepayee,resulting
inadebitandcreditentryforeverysinglepaymentinstructionsettled.Asageneralrule,the
settlementisinrealtime,i.e.onacontinuousbasisthroughoutanentireday.
2.4 REASONS FOR IMPLEMENTING VIRTUAL CURRENCY SCHEMES
Thereareseveralreasonsforavirtualcommunitytoissueitsownvirtualcurrency.Byimplementing
avirtualcurrencyschemefocusedontheonlineworld(basicallyforvirtualgoodsandservices)
acompanycangenerateadditionalrevenue.Theuseofvirtualcurrenciescanhelpmotivateusers
bysimplifyingtransactionsandbypreventingthemfromhavingtoentertheirpersonalpayment
details every time they want to make a purchase. It can also help lock users in if, for instance,
itispossibletoearnvirtualmoneybylogginginperiodically.Ifusersareaskedtolloutasurvey
or to answer other questions in order to earn extra virtual money, users reveal their preferences,
therebyprovidingvaluableinformationforcommercialuse.Virtualcurrenciescanalsobeusedas
animportanttoolforapplicationdevelopersandadvertiserswhendesigningastrategytoreapthe
benetsofthevirtualgoodsmarket.
Atthisstage,itisverydifculttocomeupwithareliablegureforthesizeofthevirtualgoods
market.
6
On the one hand, there is no universal criterion of what the virtual goods market
encompasses.Ontheotherhand,innovationsinthiseldaregrowingandspreadingsignicantly
and,therefore, it is nearlyimpossible to gathertheinformation necessary toprovidea complete
picture of the virtual communities and virtual currency schemes that exist. Nevertheless, there are a
fewestimatescirculatingontheinternet.Theseshowthemodestmagnitudethatthismarket,which
isparticularlyconcentratedinAsiaandtheUnitedStates,mayhavereached(seeChart3).Although
mostoftheseestimatesarenotmadeonascienticbasis,theyallindicatethatthesizeofthevirtual
goodsmarketisfarfromreachingitspotentialandthatitwillgrowinthefuture.
Traditionalpayment serviceproviders donot want to get left behind either. VISA, for instance,
recently acquired PlaySpan Inc. for USD 190 million, with additional considerations for performance
milestones. PlaySpan is a privately held company, whose payments platform handles transactions
for digital goods in online games, digital media and social networks around the world.
7
Avirtualgoodorresourcecanbedenedas“anyvirtual-worldobject/servicethatincreases[…]satisfaction,desirabilityorusefulness,6
for example, website goodwill, e-books, music les, game equipments, rights to access web, or e-payment services a site provides”
(Guo,ChowandGong,2009,p.85).Therefore,anillustrationofaowersenttosomeoneelseinasocialnetworkorbetterequipmentfor
acharacterwhichisneededtoreachhigherlevelsinanonlinegamearetwoexamplesofvirtualgoodsthataresoldinvirtualcommunities.
However,inourview,thereshouldbeacleardifferentiationbetweengoodsthatareusedonlyinthevirtualenvironmentandthosewhich
areusedintherealworld(e.g.musiclesorelectronicbooks).
See the company’s press release (7 http://corporate.visa.com/media-center/press-releases/press1099.jsp).
19
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SCHEMES
19
In September 2011, American Express paid USD 30 million for Sometrics, a four-year-old company
thathelps video game makersestablish virtual currenciesandvirtual currency commercewithin
theirgames.
8
Apparently, the company plans to build a virtual currency platform in other industries,
takingadvantageofitsmerchantrelationships.
Anadditionalreasonforimplementingavirtualcurrencyschemeisthepossibility,inType2and
3schemes,toobtainnewrevenuefromtheoatthatresultsfromthetimedifferencebetweenthe
moment at which money is transferred into the system and the moment at which it is taken out
fromthesystemagain(either–inType3only–viaacurrencyexchangeor–forbothtypes–
followingthepurchaseofgoodsandservicesfromthirdparties).Inaddition,schemeownersmay
alsomakeabreakageprotfrommoneywhichisnotspentorexchangedback afteritsowners
stopbeingactiveusers.
Ingeneral, the motivationfor setting upType 3 schemesmay differ fromthe incentives forthe
otherschemes;ofparticularinterestaretheschemesdesignedtocompeteagainstrealcurrencies
asamediumofexchange.Forthetimebeing,themostprominentcaseisBitcoinwhich,according
to its creators and supporters, should overcome the limitations of traditional currencies that result
fromthemonopolisticsupplyandmanagementbycentralbanks.
See Button (2011).8
Chart 3 Estimates for the size of the virtual goods market
(USD billions)
GDP in selected countries, 2011
estimated size of the US market for virtual goods
in 2011
0
1
2
3
4
5
6
7
8
9
10
0
1
2
3
4
5
6
7
8
9
10
1 2 3 4 5 6 7 8
1 Guinea-Bissau
2 Belize
3 Liberia
4 San Marino
5 Central African Republic
6 Guyana
7 Sierra Leone
8 Malta
Source Estimated size
C.Hudson(2008)
SoftTech VC and Bionic
Panda Games
USD 200 million in 2008
C. C. Miller and B. Stone (2009)
New York Times
USD 1 billion in the United
States in 2008;
USD 5 billion worldwide
B. Parr (2009)
Mashable
USD 1 billion in the US market;
USD 7 billion in the Asian
market
A. Shukla (2008)
Offerpal Media
USD 2 billion in the United
States in 2008
J.SmithandC.Hudson(2010)
Inside Network
USD 1.6 billion in the United
States in 2010; will reach
USD 2.1 billion overall in 2011
M. Shiels (2009)
BBC News
USD 5 billion in the United
Statesinveyears;inAsiathis
gurehasalreadybeenreached
Sources:IMFWorldEconomicOutlookdatabaseandSmithandHudson(2010)estimate.
21
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ThischapterfocusesontwoprominentType3virtualcurrencyschemes;therstisBitcoinandthe
second is the scheme established by Linden Lab for Second Life, namely Linden Dollars.
3.1 THE BITCOIN SCHEME
3.1.1 BASIC FEATURES
Bitcoin is probably the most successful – and probably most controversial – virtual currency scheme
todate.DesignedandimplementedbytheJapaneseprogrammerSatoshiNakamotoin2009,
1
the
schemeisbasedonapeer-to-peernetworksimilartoBitTorrent,thefamousprotocolforsharing
les,suchaslms,gamesandmusic,overtheinternet.Itoperatesatagloballevelandcanbeused
asacurrencyforallkindsoftransactions(forbothvirtualandrealgoodsandservices),thereby
competingwithofcialcurrenciesliketheeuroorUSdollar.Theschememaintainsadatabasethat
lists product and service providers which currently accept Bitcoins.
2
These products and services
rangefrominternetservicesandonlineproductstomaterialgoods(e.g.clothingandaccessories,
electronics,books,etc.)andprofessionalortravel/tourismservices.Bitcoinsaredivisibletoeight
decimal places enabling their use in any kind of transaction, regardless of the value.
Although
Bitcoin is a virtual currency scheme, it has certain innovations that make its use more similar to
conventional money (see Box 3 in Chapter 4).
Bitcoinsarenotpeggedtoanyreal-worldcurrency.Theexchangerateisdeterminedbysupplyand
demandinthemarket.ThereareseveralexchangeplatformsforbuyingBitcoinsthatoperateinreal
time.
3
Mt.GoxisthemostwidelyusedcurrencyexchangeplatformandallowsuserstotradeUS
dollars for Bitcoins and vice versa. As previously stated, Bitcoin is based on a decentralised, peer-
to-peer(P2P)network,i.e.itdoesnothaveacentralclearinghouse,norarethereanynancialor
other institutions involved in the transactions. Bitcoin users perform these tasks themselves. In the
samevein,thereisnocentralauthorityinchargeofthemoneysupply.Aswillbeexplainedlater,
themoneysupplyisdeterminedbyaspecictypeof“mining”activity.Itdependsontheamount
of resources (electricity and CPU time) that “miners” devote to solving specic mathematical
problems.
InordertostartusingBitcoins,usersneedtodownloadthefreeandopen-sourcesoftware.Purchased
Bitcoinsarethereafterstoredinadigitalwalletontheuser’scomputer.Consequently,usersface
theriskoflosingtheirmoneyiftheydon’timplementadequateantivirusandback-upmeasures.
Users have several incentives to use Bitcoins. Firstly, transactions are anonymous, as accounts are
notregisteredandBitcoinsaresentdirectlyfromonecomputertoanother.
4
Also, users have the
possibilityofgeneratingmultipleBitcoinaddressestodifferentiateorisolatetransactions.Secondly,
transactions are carried out faster and more cheaply than with traditional means of payment.
Transactionsfees,ifany,areverylowandnobankaccountfeeischarged.
However,thisisnothis/herrealname.SeetheentryontheBitcoinwiki(1 https://en.bitcoin.it/wiki/Satoshi_Nakamoto). The content of this
chapter partially relies on the information provided by Bitcoin (http://www.bitcoin.org/) and the Bitcoin community (https://en.bitcoin.it/
wiki/FAQ).TheoriginalpaperbyNakamoto(2009)isalsoused.
See 2 https://en.bitcoin.it/wiki/Trade
TheseareMt.Gox,TradeHill(closeddownin2012),Bitomat,Britcoin,Intersango,ExchangeBitcoin.com,CampBX,Bitcoin7,VirtEx,3
VirWox or WM-Center. For smaller amounts, the options are limited due to bank transfer fees, conversion fees and restrictions on
transactionsize.OptionsincludeBitcoinMarket,BitMarket.eu,Bitcoiny.cz,Bit/BTCChina,Bitfunnel,#bitcoin-otc,BitcoinExchange
Services, Lilion Transfer, Nanaimo Gold, Bitcoin Morpheus, Bitcoin Argentina, Bitcoin.com.es, Bahtcoin, Bitcoin Brasil, BitPiggy,
GetBitcoin, Bitcoin 4 Cash, Bitcoin2Cash, bitcoin.local, YouTipIt and Ubitex.
However,itseemsthatallBitcointransactionsarerecordedandcan,undercertaincircumstances(e.g.lawenforcement),betraced.4
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Box 2
ECONOMIC FOUNDATIONS OF BITCOIN
The theoretical roots of Bitcoin can be found in the Austrian school of economics and its
criticism of the current at money system and interventions undertaken by governments and
otheragencies,which,intheirview,resultinexacerbatedbusinesscyclesandmassiveination.
One of the topics upon which the Austrian School of economics, led by Eugen von
Böhm-Bawerk, Ludwig von Mises and Friedrich A. Hayek, has focused is business cycles.
1
In short, according to the Austrian theory, business cycles are the inevitable consequence of
monetary interventions in the market, whereby an excessive expansion of bank credit causes an
increaseinthesupplyofmoneythroughthemoneycreationprocessinafractional-reservebanking
system,whichinturn leads toarticiallylowinterestrates.
2
In this situation, the entrepreneurs,
guidedbydistortedinterestratesignals,embarkonoverlyambitiousinvestmentprojectsthatdo
not match consumers’ preferences at thattime relating to intertemporal consumption (i.e. their
decisionsregardingnear-termandfutureconsumption).Soonerorlater,thiswidespreadimbalance
cannolongerbesustainedandleadstoarecession,duringwhichrmsneedtoliquidateanyfailed
investment projects and readapt (restructure) their production structures in line with consumers’
intertemporal preferences. As a result, many Austrian School economists call for this process to be
abandonedbyabolishingthefractional-reservebankingsystemandreturningtomoneybasedon
thegoldstandard,whichcannotbeeasilymanipulatedbyanyauthority.
Another related area in which Austrian economists have been very active is monetary theory.
OneoftheforemostnamesinthiseldisFriedrichA.Hayek.Hewrotesomeveryinuential
publications, such as Denationalisation of Money(1976),inwhichhepositsthatgovernments
should not have a monopoly over the issuance of money. He instead suggests that private
banksshouldbeallowedtoissuenon-interest-bearingcerticatesbasedontheirownregistered
trademarks. These certicates (i.e. currencies) should be open to competition and would be
tradedatvariableexchangerates.Anycurrenciesabletoguaranteeastablepurchasingpower
would eliminate other less stable currencies from the market.
3
The result of this process of
competitionandprotmaximisationwouldbeahighlyefcientmonetarysystemwhereonly
stable currencies would coexist.
ThefollowingideasaregenerallysharedbyBitcoinanditssupporters:
TheyseeBitcoinas a goodstartingpointto end the monopolycentralbankshave in the –
issuance of money.
They strongly criticise the current fractional-reserve banking system whereby banks can –
extend their credit supply above their actual reserves and, simultaneously, depositors can
withdraw their funds in their current accounts at any time.
Theschemeisinspiredbytheformergoldstandard. –
1 A description of the Austrian Business Cycle Theory can be found, for instance, in Rothbard (2009).
2 Fractional-reservebankingisaformofbankingwherecreditinstitutionsmaintainreserves(incashandcoinorindepositsatthecentral
bank) that are only a fraction of their customers’ deposits. Funds deposited into a bank are mostly lent out, and banks keep only a fraction
(calledthereserveratio)ofthequantityofdepositsasreserves.Modernbankingsystemsarebasedonfractional-reservebanking.
3 AninterestingspeechonthisissuecanbefoundinIssing(1999).
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3.1.2 TECHNICAL DESCRIPTION OF A BITCOIN TRANSACTION
The technical aspects of this system are complex and not easy to understand without a sound technical
background. Therefore, a comprehensive explanation of the underlying technical mechanism of
Bitcoin lies outside the scope of this report. This section aims simply to provide a basic description
ofthefunctioningofthisvirtualcurrencyscheme.Accordingtothefounder,Nakamoto(2009),an
electroniccoincanbedenedasachainofdigitalsignatures.Eachownerofthecurrency(P
i
) has a
pairofkeys,onepublicandoneprivate.Thesekeysaresavedlocallyinaleand,consequently,a
lossordeletionofthelewouldmeanthatallBitcoinsassociatedwithitarelostaswell.
5
AsimpliedillustrationofachainoftransactionsfromonenodetoanothercanbefoundinChart4.
The virtual coin shown in the picture is the same one, but at different points in time. To initiate the
transaction, the future owner P
1
hastorstsendhispublickeytotheoriginalownerP
0
. This owner
transferstheBitcoinsbydigitallysigningahash
6
of the previous transaction and the public key of
thefutureowner.EverysingleBitcoincarriestheentirehistoryofthetransactionsithasundergone,
and any transfer from one owner to another becomes part of the code. The Bitcoin is stored in such
a way that the new owner is the only person allowed to spend it.
Allsignedtransactionsarethensenttothenetwork,whichmeansthatalltransactionsarepublic
transactions,althoughnoinformationisgivenregardingtheinvolvedparties.Thekeyissuetobe
addressed by the system is the avoidance of double spending, i.e. how to prevent a coin being
copiedorforged,especiallyconsideringthereisnointermediaryvalidatingthetransactions.The
solution implemented is based on the concept of a “time stamp”, which is an online mechanism
Userscanalsousespecicwebservicestostoretheirmoney.Theseservicesallowpeopletoaccesstheirmoneyfromeverywhere,but5
alsoentailrisksasusersareoutsourcingthemanagementoftheirmoneytoanunknownthirdparty.
Ahash,orhashvalue,isthevaluereturnedbyanalgorithmthatmapslargedatasetstosmallerdatasetsofxedlength.6
AlthoughthetheoreticalrootsoftheschemecanbefoundintheAustrianSchoolofeconomics,
Bitcoinhasraisedseriousconcernsamongsomeoftoday’sAustrianeconomists.Theircriticism
covers two general aspects:
4
a) Bitcoins have no intrinsic value like gold; they are mere bits
storedinacomputer;andb)thesystemfailstosatisfythe“MiseanRegressionTheorem”,which
explainsthatmoneybecomesacceptednotbecauseofagovernmentdecreeorsocialconvention,
butbecauseithasitsrootsinacommodityexpressingacertainpurchasingpower.
4 As described in Matonis (2011).
Chart 4 A chain of Bitcoin transactions
• P
0
signature
• Hash
0
containing all
previous
transactions
• P
1
signature
• Hash
1
containing all
previous
transactions
• P
2
signature
• Hash
2
containing all
previous
transactions
Bitcoin x
t=0
Bitcoin x
t=1
Bitcoin x
t=2
+ P
0
private key
+ P
1
public key
+ P
1
private key
+ P
2
public key
Transaction 1 Transaction 2
Source: ECB.
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usedtoensurethataseriesofdatahaveexistedandhavenotbeenalteredsinceaspecicpointin
time,inordertogetintothehash.Eachtimestampincludestheprevioustimestampinitshash,
formingachainofownership.Bybroadcastingthenewtransactions,thenetworkcanverifythem.
The systems that validate the transactions are called “miners” – essentially these are extremely fast
computers in the Bitcoin network which are able to perform complex mathematical calculations
that aim to verify the validity of transactions. The people who use their systems to undertake this
miningactivitydosoonavoluntarybasis,buttheyarerewardedwith50newlycreatedBitcoins
everytimetheirsystemndsasolution.
“Mining”isthereforetheprocessofvalidatingtransactionsbyusingcomputingpowertondvalid
blocks (i.e. to solve complicated mathematical problems) and is the only way to create new money
in the Bitcoin scheme.
7
AccordingtoNakamoto(2009),miningisalsoaveryreliableprocedureforthesecurityandsafety
ofthesystemasitprovidestheincentivetoacthonestly:“ifagreedyattackerisabletoassemble
moreCPUpowerthanallthehonestnodes,hewouldhavetochoosebetweenusingittodefraud
peoplebystealingbackhispayments,orbyusingittogeneratenewcoins.Heoughttonditmore
protabletoplaybytherules,suchrulesthatfavourhimwithmorenewcoinsthaneveryoneelse
combined,thantounderminethesystemandthevalidityofhisownwealth”.However,aswillbe
explainedlater,fraudstersmaystillhavenon-nancialincentivestocompromisethesystem.
3.1.3 MONETARY ASPECTS
The Bitcoin scheme is designed as a
decentralised system where no central monetary
authority is involved. Bitcoins can be bought
on different platforms. However, new money
is created and introduced into the system only
viatheabove-mentionedminingactivity,i.e.by
rewardingthe“miners”whoperformthecrucial
role of validating all transactions made, with
new Bitcoins.
Therefore, the supply of money does not depend
on the monetary policy of any virtual central
bank, but rather evolves based on interested
usersperformingaspecicactivity.According
to Bitcoin, the scheme has been technically
designedin such away that themoney supply
will develop at a predictable pace (see Chart 5).
The algorithms to be solved (i.e. the new
blocks to be discovered) in order to receive
newly created Bitcoins become more and
more complex (more computing resources are
AsstatedontheBitcoinwebsite,fromatechnicalpointofview,miningisthecalculationofahashofablockheader,whichincludes,7
amongotherthings,areferencetothepreviousblock,ahashofasetoftransactionsandanonce(a32-bit/4-byteeldwhosevalueisset
sothatthehashoftheblockwillcontainarunofzeros).Ifthehashvalueisfoundtobelessthanthecurrenttarget(whichisinversely
proportionaltothedifculty),anew block is formed andtheminergets50newlygeneratedBitcoins.If the hash is notlessthanthe
currenttarget,anewnonceistried,andanewhashiscalculated.Thisisdonemillionsoftimespersecondbyeachminer.
Chart 5 Total Bitcoins over time
0
2
4
6
8
10
12
14
16
18
20
22
0
2
4
6
8
10
12
14
16
18
20
22
2009 2015 2021 2027 2033 2039 2045 2051
Total Bitcoins (in millions)
Source: Bitcoin.
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needed). As explained on its website,
8
the rate of block creation is approximately constant over
time:sixperhour,oneeverytenminutes.However,thenumberofBitcoinsgeneratedperblockis
settodecreasegeometrically,witha50%reductioneveryfouryears.Theresultisthatthenumber
of Bitcoins in existence will reach 21 million in around 2040. From this point onwards, miners are
expectedtonancethemselvesviatransactionfees.Infact,thiskindoffeecanalreadybecharged
byaminerwhencreatingablock.
The fact that the supply of money is clearly determined implies that, in theory, the issuance of money
cannotbealteredbyanycentralauthorityorparticipantwantingto“print”extramoney.According
to Bitcoin supporters, the system is supposed to avoid ination, as well as the business cycles
originatingfromextensivemoneycreation.However,thesystemhasbeenaccusedofleadingtoa
deationaryspiral.ThetotalsupplyofBitcoinsisexpectedtogrowgeometricallyuntilitreaches
anitelimitof21million.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deationary spiral.Theextentto
which this could be a problem in reality is not clear. Two remarks should be made. Firstly, as
highlightedbytheEconomist(2011a),thedeationhypothesisentailsanassumptionwhichisnot
realisticatthisstage,i.e.thatmanymorepeoplewillwanttoreceiveBitcoinsinreturnforgoodsor
inexchangeforpapermoney.However,Bitcoinisstillquiteimmatureandilliquid(the6.5million
Bitcoins are shared by 10,000 users) which is a clear disincentive for its use. Secondly, Bitcoin
isnotthecurrencyofacountryorcurrencyareaandisthereforenotdirectlylinkedtothegoods
and services produced in a specic economy, but linked to the goods and services provided by
merchantswhoacceptBitcoins.Thesemerchantsmayalsoacceptanothercurrency(e.g.USdollars)
andtherefore,thefactthatdeationisanticipatedcouldgiverisetoasituationwheremerchants
adaptthepricesoftheirgoodsandservicesinBitcoins.
3.1.4 SECURITY INCIDENTS AND NEGATIVE PRESS
From time to time, Bitcoin is surrounded by controversy. Sometimes it is linked to its potential for
becomingasuitablemonetaryalternativefordrugdealingandmoneylaundering,asaresultofthe
highdegreeofanonymity.
9
On other occasions, users have claimed to have suffered a substantial
theftofBitcoinsthroughaTrojanthatgainedaccesstotheircomputer.
10
The Electronic Frontier
Foundation,whichisanorganisationthatseekstodefendfreedominthedigitalworld,decidednot
toacceptdonationsinBitcoinsanymore.Amongthereasonsgiven,theyconsideredthat“Bitcoin
raises untested legal concerns related to securities law, the Stamp Payment Act, tax evasion,
consumerprotectionandmoneylaundering,amongothers”.
11
However, practically identical problems can also occur when using cash, thus Bitcoin can be
considered to be another variety of cash, i.e. digital cash. Cash can be used for drug dealing and
moneylaunderingtoo;cashcanalsobestolen,notfromadigitalwallet,butfromaphysicalone;and
cash can also be used for tax evasion purposes. The question is not so much related to the format of
moneyassuch(physicalordigital),butrathertotheusepeoplemakeofit.Nevertheless,iftheuseof
digitalmoneyinitselfcomplicatesinvestigationsandlawenforcement,specialrequirementsmaybe
needed. Therefore, the real dimension of all these controversies still needs to be further analysed.
See 8 https://en.bitcoin.it/wiki/Controlled_ination
See,forinstance,http://gawker.com/5805928/the-underground-website-where-you-can-buy-any-drug-imaginable9
Oneuserclaimstohavelost25,000BitcoinsworthUSD500,000.Seehttp://forum.bitcoin.org/index.php?topic=16457.010
AnnouncedbyCindyCohn,LegalDirectorfortheFoundation.Seehttp://www.eff.org/deeplinks/2011/06/eff-and-bitcoin11
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Bitcoin has also featured in the news, in particular following a cyberattack perpetrated on
20 June 2011, which managed to knock the value of the currency down from USD 17.50 to
USD 0.01 within minutes. Apparently, around 400,000 Bitcoins (worth almost USD 9 million)
wereinvolved.AccordingtocurrencyexchangeMt.Gox,oneaccountwithalotofBitcoinswas
compromisedandwhoeverstoleit(usingaHongKongbasedIPtologin)rstsoldalltheBitcoins
inthere,onlytobuythembackagainimmediatelyafterwards,withtheintentionofwithdrawingthe
coins. The USD 1,000/day withdrawal limit was active for this account and the hacker was only able
toexchangeUSD1,000worthofBitcoins.Apartfromthis,nootheraccountswerecompromised,
andnothingwaslost.
12
Chart6showstheevolutionofBitcoin’sexchangerateontheMt.Goxexchangeplatformduring
the hours of the incident, and is also the expression of how an immature and illiquid currency can
almostcompletelydisappearwithinminutes,causingpanictothousandsofusers.
Inaddition,theperpetratorhackedintotheMt.Goxdatabase,gainingaccesstousernames,e-mail
addressesandhashedpasswordsforthousandsofusers.Mt.Goxreactedbyclosingthesystemfor
a few days and by promisingthat the transactions carried out by the hacker wouldbe reversed.
Bitcoin defenders claim that the Bitcoin system did not fail. The problem was related to a particular
tradingplatform–Mt.Gox–whichdidnothavestrongenoughsecuritymeasures.
In a more recent case (May 2012), the exchange platform Bitcoinica lost 18,547 Bitcoins from
its deposits following a cyberattack, in which sensitive customer data might also have been
obtained.
13
SeeMt.Goxpressreleasehttps://mtgox.com/press_release_20110630.html12
Seehttp://www.nextra.com/News/Fullstory.aspx?newsitemid=2371313
Chart 6 Mt.Gox exchange rate on 20 June 2011
20
15
10
5
0
-5
20
15
10
5
0
-5
20 00 04 08 12 16 20 00 04 08 12 16 20
x-axis: time (UTC)
y-axis: price ($/BTC)
Source: Mt.Gox.
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Another recurrent issue is whether Bitcoin works likea Ponzi scheme or not. Users gointo the
systemby buying Bitcoins againstreal currencies, butcanonly leave andretrievetheir funds if
other users want to buy their Bitcoins, i.e. if new participants want to join the system. For many
people, this is characteristic of a Ponzi scheme. The US Securities and Exchange Commission
denesaPonzischemeinthefollowingterms:
APonzischemeisaninvestmentfraudthatinvolvesthepaymentofpurportedreturnstoexisting
investors from funds contributed by new investors. Ponzi scheme organizers often solicit new
investorsbypromisingtoinvestfundsinopportunitiesclaimedtogeneratehighreturnswithlittle
ornorisk.InmanyPonzischemes,thefraudstersfocusonattractingnewmoneytomakepromised
paymentstoearlier-stage investors and tousefor personal expenses, insteadofengaging in any
legitimateinvestmentactivity.
14
On the one hand, the Bitcoin scheme is a decentralised system where – at least in theory – there
isnocentralorganiserthatcanunderminethesystemanddisappearwithitsfunds.Bitcoinusers
buyandsellthecurrencyamongthemselveswithoutanykindofintermediationandtherefore,it
seemsthatnobodybenetsfromthesystem,apartfromthosewhobenetfromtheexchangerate
evolution (just as in any other currency trade) or those who are hard-working “miners” and are
thereforerewardedfortheircontributiontothesecurityandcondenceinthesystemasawhole.
Moreover,theschemedoesnotpromisehighreturnstoanybody.AlthoughsomeBitcoinusersmay
trytoprotfromexchangerateuctuations,Bitcoinsarenotintendedtobeaninvestmentvehicle,
just a medium of exchange. On the contrary, Gavin Andresen, Lead Developer of the Bitcoin
virtual currency project, does not hesitate to say that “Bitcoin is an experiment. Treat it like you
wouldtreatapromisinginternetstart-upcompany:maybeitwillchangetheworld,butrealisethat
investingyourmoneyortimeinnewideasisalwaysrisky”.
15
In addition, Bitcoin supporters claim
that it is an open-source system whose code is available to any interested party.
However,itisalsotruethatthesystemdemonstratesaclearcaseofinformationasymmetry.Itis
complex and therefore not easy for all potential users to understand. At the same time, however,
userscaneasilydownloadtheapplicationandstartusingiteveniftheydonotactuallyknowhow
thesystemworksandwhichriskstheyareactuallytaking.Thisfact,inacontextwherethereisclear
legaluncertaintyandlackofcloseoversight,leadstoahigh-risksituation.Therefore,althoughthe
currentknowledgebasedoesnotmakeiteasytoassesswhetherornottheBitcoinsystemactually
workslikeapyramidorPonzischeme,itcanjustiablybestatedthatBitcoinisahigh-risksystem
foritsusersfromanancialperspective,andthatitcouldcollapseifpeopletrytogetoutofthe
system and are not able to do so because of its illiquidity. The fact that the founder of Bitcoin uses
apseudonym–SatoshiNakamoto–andissurroundedbymysterydoesnothingtohelppromote
transparency and credibility in the scheme.
Alltheseissuesraiseseriousconcernsregardingthelegalstatusandsecurityofthesystem,aswell
asthenalityandirrevocabilityofthetransactions,inasystemwhichisnotsubjecttoanykindof
publicoversight.InJune2011twoUSsenators,CharlesSchumerandJoeManchin,wrotetothe
Attorney General and to the Administrator of the Drug Enforcement Administration expressing
theirworriesaboutBitcoinanditsuseforillegalpurposes.MrAndresenwasalsoaskedtogivea
presentation to the CIA about this virtual currency scheme.
16
Further action from other authorities
can reasonably be expected in the near future.
Seehttp://www.sec.gov/answers/ponzi.htm14
Seehttp://gavinthink.blogspot.com/2011/06/that-which-does-not-kill-us-makes-us.html15
AccordingtoFinextra(http://www.nextra.com/news/fullstory.aspx?newsitemid=22644)andChapman(2011).16
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3.2 THE SECOND LIFE SCHEME
3.2.1 BASIC FEATURES
Second Life is a virtual community created by
Linden Lab (Linden Research, Inc.), a privately
held company based in San Francisco. The
company, whose CEO is Philip Rosedale, has
developed a ‘massively multiplayer online
role-playing game’, which was launched in
June 2003. It is based on a three-dimensional
modellingtoolthatallowsuserstobuildvirtual
objects.
The main idea behind Second Life is to create an
opportunityforpeople to change allthethings
about their life that they dislike. This virtual
world mirrors the real world, and its users –
called residents – interact with each other and
perform their daily tasks and activities just as
they do in real life (e.g. meeting friends, playing, writing or organising a party). They can also
engageinabusinessprojectorbuyahouse,acarorayacht.Inthisvirtualworld,usersdonothave
to face any kind of restriction.
Users need to install software on their computers and open a free Second Life account to make use
of the virtual world. A premium membership option (USD 9.95 per month, USD 22.50 quarterly,
or USD 72 per year), which extends access to an increased level of technical support, is also
available.Chart7showsthattheaveragenumberofusersloggingineachmonthisquitestable
atjustaboveonemillionpermonth.Thenumberofusersregisteredon28November2011was
morethan26million.Oncetheyhavesubscribed,usersbecomeresidentsandtheycanstartusing
thisonlineworldbycreatingavatars–theresidents’digitalrepresentation–whichmaytakeany
formtheychoose(human,animal,vegetable,mineral,oracombinationthereof)oreventheirown
imageinreallife.Aresidentaccountcanonlyhaveoneavataratatime.Nevertheless,residentsare
freetochangetheformoftheiravatarsatanytime.Residentscanearnmoneyindifferentways.
Theycansellwhatevertheyareabletocreate;theycanalsoprotfromtheirpreviousinvestments
(e.g.buyingahouseandthensellingitatahigherprice),buttheycanalsowinprizesinevents.
Inaddition,premiumaccountsreceiveaweeklyautomaticgrantof300LindenDollarspaidintothe
member’s avatar account.
3.2.2 SECOND LIFE ECONOMY
IntheSecondLifeeconomy,peoplecreateitems,suchasclothes,gamesorspacecraft,andthen
sell them within the community. Most of the money earned comes from the virtual equivalent of
landspeculation,aspeopleleaseislandsorerectbuildingsandthenrentthemouttoothersata
premium.
17
The economy within Second Life works in a similar way to any other economy in the
world, but exhibits three specic features. Firstly, it is a self-sufcient economy, i.e. a closed
economy where no activity is conducted with the outside; secondly, it is only focused on virtual
goods and services; and thirdly, it is generated and takes place entirely within Linden Lab’s
infrastructure. Everything else is quite similar to a normal economy. Second Life has its own
The Economist (2006).17
Chart 7 Average number of users logging
in each month
(thousands)
800
900
1,000
1,100
800
900
1,000
1,100
2010 2011
Source: Reports on Second Life Economy.
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economic agents (buyers, sellers and even an
online-community regulator) interacting in its
economic system and conducting commerce;
the factors of production are the same as in a
real economy (labour, capital and land); and the
price system is the mechanism in charge of
resource allocation. As a consequence, Second
Life’soutputcanbemeasuredand,accordingto
one estimate, the value of transactions increased
by 94% on a year-on-year basis in 2009.
Residents exchange goods and services worth
around USD 600 million each year and the
SecondLifeeconomyisestimatedtobebigger
in terms of GDP than 19 countries, including
Samoa.
18
AlthoughSecond Lifeseems tohave
the largest output among the virtual
communities, it is obvious that it is still far from
reachingasignicantvolume.SecondLifehas
itsownnancialsystemandexchangemarket.
In 2006 this virtual community also started
issuing itsownvirtualcurrency,called Linden
Dollars(L$).TheLindenDollarisavirtualcurrencythathastobepurchased(e.g.bycreditcard
orPayPal)beforebeingusedtobuyvirtualgoodsandservicesinsidetheSecondLifecommunity.
Inprinciple,real-worldgoodsandservicescannotbepurchasedwithLindenDollars.
This currency can be bought through Linden Lab’s currency brokerage, the LindeX Currency
Exchange,orotherthird-partycurrencyexchanges.Itcanalsobeconvertedbackintorealmoney.
AscanbeseeninChart8,theexchange rate has been quitestable,ataroundL$260=USD1.
ThisisbecauseLindenLabtriestokeepvolatilitylowbyinjectingnewLindenDollarsasdemand
increases.Therefore,itcanbesaidthattheLindenDollaris,tosomeextent,peggedtotheUSdollar.
AccordingtotheSecondLifeEconomyinQ42010report,thetotalLindeXvolumetradedin2010
wasnearlyUSD119million,2.8%higherthanin2009.
AlthoughSecondLife’seconomyexistsonline,companiessellingvirtualgoodsandservicescan
makerealprots.Moreover,asreportedbyElliot(2008),somecompaniesarealsostartingtouse
theonlineworldformerchandisingtheirproducts.Companies,suchasCisco,Reuters,Dell,Sun
Microsystems,Adidas,StarwoodHotelsandToyotahavemadeuseoftheSecondLifeenvironment
for marketing and brand-building purposes. In addition, some universities (e.g. Chicago Law
School,theUniversityofIdaho and New York University)andpoliticians(e.g.HillaryClinton)
have a presence in Second Life.
3.2.3 MONETARY ASPECTS
Second Life also has its own monetary policy, based on the supply of Linden Dollars by Linden
Lab.AsexplainedbyPengandSun(2009),thetotalamountofthisvirtualcurrencyincirculation
dependsonthreeelements:a)thenetsellingamountofLindenDollarstradedbyLindenLabon
LindeXwithusers,whichissimilartotheopenmarketoperationsconductedbycentralbanksin
the real world; b) Linden Lab’s revenue in Linden Dollars from island sales and land rental to
Fleming(2010).18
Chart 8 Average exchange rate
(Linden Dollar/US dollar)
240
245
250
255
260
265
270
275
280
240
245
250
255
260
265
270
275
280
2009 2010 2011
Source: Reports on Second Life Economy.
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residents; and c) the Linden Dollar grant paid
by Linden Lab to premium members. Only in
therstandlastcasesisnewmoneycreated.In
its terms of service, the company clearly states
that “Linden Dollars are available for purchase
or distribution at Linden Lab’s discretion, and
are not redeemable for monetary value from
Linden Lab”. Furthermore, “Linden Lab has
the right to manage, regulate, control, and/
or modify the license rights underlying such
LindenDollars(…)”.Inpractice,itcanbesaid
thatLindenLabactsastheissuingbankinthe
Second Life environment. It can change the
quantity of money in circulation as it wants and
decide how to allocate these resources.
Chart 9 shows the evolution of the supply of
Linden Dollars and, in order to provide an
overview of the dimension of this virtual money
supply, it is compared with the supply of US
dollars. So far money supply is negligible and
cannotthereforeinuenceanystate’seconomy.
LindenLab’smoney issuing policywithinthe virtual communityhasnot escaped criticism.For
example, Beller (2007) suggests that they may be creating an endogenous shock since Linden
LabnancesitsdecitbycreatingnewLindenDollars.AdecitinSecondLifeoccurswhenthe
weeklyLindenDollargrantsthatLindenLabpaystopremiumaccountholdersexceeditsrevenue
from land rentals and other administrative services it provides to residents. Every time Linden Lab
runsadecit,thesupplyofmoneyinstantlyincreasesbyanequivalentamount.Asaconsequence,
tonanceitsdecit,LindenLabis“printing”LindenDollars,ratherthanborrowingthemfromthe
market,i.e.itisnotincreasingitsstockofpublicdebt,insteadcreatingnewmoneywhichisnot
supported by real money.
Thismoneycreationprocess,whicharticiallyinatesthemoneysupply,couldbecreatingaboom
withinSecondLife’seconomythatcouldleadtoarecessionifLindenLabisforcedtotightenits
moneysupply.Inthissituation,alossofcondenceandasuddendeprecationoftheLindenDollar
would be expected, causing all users that are involved in the virtual community to suffer some
losses.Inanycase,itisimportanttohighlightthatthiswouldonlyhaveanegativeimpactwithin
the virtual community and for its users. Its effects would not spread to the real economy.
3.2.4 ISSUES WITH SECOND LIFE
SecondLifeisfocused on thevirtualworld,butthis does notmeanthateverythingis virtual in
this community. There are real economic transactions behind Second Life and there are also real
issuesandproblemsthatarise.WithinSecondLife,LindenLabistheonlyauthorityandregulator.
To some extent they also oversee the system, but without the involvement of any public authority.
It is not even clear if any authority even needs to be involved. In fact, in the current situation, any
potentialissuewithinthisvirtualmarketplacecanperhapsberegardedinthecontextofconsumer
protectionrights.
Chart 9 Supply of Linden Dollars
and US dollars
(in US dollar millions)
Linden dollars (left-hand scale)
US dollars (right-hand scale)
2009 2010 2011
32
30
28
26
24
22
20
10,000,000
9,500,000
9,000,000
8,5000,000
8,000,000
7,500,000
7,000,000
Sources: Second Life and Federal Reserve.
Notes: The US money stock is measured by M2 (not seasonally
adjusted).Theguresrefertothelastmonthofeveryquarter.
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3 CASE STUDIES
31
SecondLifegoesbeyondaregularonlinegame.Fromaneconomicandnancialpointof view,
Second Life exhibits specic features that link this virtual world with the real world. Firstly,
as stressed above, some companies are starting to use the online world for merchandising their
products.Also,virtualbusinesseshavebeensetupandobtainrealprotsinSecondLife.Secondly,
itseemsthatsomeresidentshavebeenabletoearnsignicantamountsofrealmoneywiththeir
nancialtransactions,butintheprocesshaveassumedhighlevelsofrisk.Inthepast,someSecond
Life banks started offering very high interest rates on deposits, which motivatedmany users to
changerealmoneytobuyLindenDollarsanddeposittheminthesebanks.Suchahighyieldina
non-regulatedenvironmentraisedsome concerns withregardtothepossibilitythatSecondLife,
or some users of Second Life, might actually be working like Ponzi schemes.
19
One case even
appearstoconrmthis:GinkoFinancial,abankthatusedtopayveryhighinterestratestodepositors
(theycouldostensiblyreachupto69.7%peryear),wentbankruptinAugust2007,causinglosses
of around USD 750,000 to some Second Life residents. After the collapse, Linden Lab introduced a
ruleprohibitingusersfromofferinginterestoranydirectreturnoninvestment(whetherinLinden
Dollars or any other currency) from any object, such as an ATM, located in Second Life, without
proofofanapplicablegovernmentregistrationstatementornancialinstitutioncharter.
20
Second Life’s real estate market has also developed quite quickly, basically fuelled by land
speculation.In2006,BusinessweekmagazinehighlightedthecaseofAnsheChung,aresidentwhose
realnameisAilinGraef.Apparently,thiswoman(wholivesinFrankfurt)hasbecometherstonline
guretoachieveanetworthofmorethanonemillionUSdollars;thishasbeenachievedfromprots
entirely earned inside Second Life. This fortune is especially remarkable because she developed it
over a period of two and a half years from her initial investment of USD 9.95, the amount required to
open a premium account.
21
Herbusinessisbasedonthepurchaseofvirtuallandandtheconstruction
of resorts (houses, mansions, beaches, etc.) that she sells or rents on to other residents.
In its role as unique authority and regulator, Linden Lab can control every single aspect within
the community which, in turn, could have real economic consequences for its users. It could, for
instance, make new rules, implement a new tax or eliminate a particular business without any kind
oflimitation,whichgivesthiscompanynearcompleteaccesstothefundscirculatingintheSecond
Lifeenvironment.Forthetimebeing,LindenLabhasusedthispowertobanspecicbusinesses
fromSecondLife,forinstanceinternetgamblingcompanies(inJuly2007),butitcouldbeusedat
any time for other purposes.
This is just one area in which uncertainty exists about Second Life, partially as a result of a lack
of proper legal basis and oversight, but there are other situations in which this legal risk might
materialise:
AlthoughSecondLifehasdevelopedDigitalRightsManagementtechnology,therehavebeen –
someclaimsrelatedtotheinfringementofintellectualpropertyrights.Moreover,anumberof
payingusershaveledaclass-actionlawsuitagainstthecompanyanditsfounder.Apparently,
thetermsofvirtualpropertyownershipwerechanged,andresidentswereforcedtoagreeto
newtermsofservicethaterodedtheirownershiprightstovirtualpropertyandgoods.
22
ForacriticalassessmentofSecondLife,seeHarrison(2007a,b).19
Formoreinformationonthisparticularcase,seehttp://alphavilleherald.com/2007/08/ginko-nancial-2.htmlFormoreinformationonthe20
LindenLabOfcialPolicyregardingin-worldbanks,seehttp://wiki.secondlife.com/wiki/Linden_Lab_Ofcial:New_Policy_Regarding_
Inworld_Banks
SeeBusinessweek(2006)andhttp://www.anshechung.com/include/press/press_release251106.html21
Seehttp://news.cnet.com/8301-13577_3-20004004-36.html22
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32
According to Second Life’s terms of service, Linden Lab is not required to pay any –
compensation if Linden Dollars are lost from the database. They are completely exonerated
from any operational disruption that could happen in Second Life. As the system is not properly
overseen,itisdifculttoassesswhethertheoperationalriskandbusinesscontinuitymeasures
inplaceareenoughtomitigateallpotentialrisks.
In the same vein, Linden Lab is not liable for its users’ actions, and is released from any claims –
relating to other users. Its liability is also limited in the event of security incidents. Linden
Lab is trying to gather information on all incidents reported and is implementing different
policiestoavoidthem.However,althoughthereseemstobeadecreasingtrend,incidentshave
continued to be reported in recent years.
Special attention also needs to be paid to counterparty risk and fraud risk. Users are not protected
againsteither,butbotharerealrisksthatexistinthisvirtualenvironment.Usersgenerallydonot
knowthereliabilityofthecounterpartywithwhichtheyaredoingbusiness.Inthiscontext,thelack
ofregulationandinformationrequiredtoopenanaccountmightcreatetheadequateconditionsfor
criminals, terrorists, fraudsters and money launderers.
23
Theextenttowhichanymoneyowscan
be traced back to a particular user is unknown.
Tosumup,everycriminalactwhichtakesplaceintherealworldmightalsobereproducedand
adapted to Second Life and probably also to other virtual communities; but the likelihood is even
strongerasaresultofthelackofproperregulationandoversightandowingtothehighdegreeof
anonymity that exists in these online worlds.
Elliot (2008).23
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As shown in the previous chapters, virtual currency schemes have become relevant in several areas
thattraditionallyfallwithinthescopeofthenancialsystemandespeciallysoinrelationtothe
tasks of central banks. Consequently, it seems appropriate to consider the extent to which they
mightaffectacentralbank’stasksintheareasofpaymentsystems,regulation,nancialstability,
monetary policy and price stability.
1
Aclosedvirtualcurrencyscheme(Type1)whichfocusesonaspecicvirtualcommunity(e.g.an
onlinegame) is notrelevant from acentral bank’s perspective.This kind ofscheme is asimple
adaptationoftraditionalgamestosuittheonlineworldand,therefore,canbequicklydisregarded
in this context. For schemes that are more open and/or linked to the real economy (Types 2 and 3)
thesituationisdifferent,especiallyifbilateralexchangeratesareinvolved,creatingtheopportunity
forspeculativebehaviour,and/orifthevirtualcurrencycanbeusedtobuyrealgoodsandservices,
therebycompetingwithtraditionalcurrencies.
This chapter focuses on the potential impact that virtual currency schemes may have in relation
tothefollowingcentralbanktasks:a)pricestability,b)nancialstability,andc)paymentsystem
stability. A nal section is also included that examines the potential for central banks to face
reputationalrisksarisingfromsecurityincidentsinvolvingvirtualcurrencyschemes.
It is important to stress that this chapter is not intendedto be a fully-edged analysis; ratherit
isarstattemptat providing a basisfordiscussiononthis issue. Largely, thisisaresultof the
uncertainty surrounding virtual currency schemes and the lack of reliable information and data.
Fromtheanalysisoftheexistinginformationitisalreadypossibletodrawaninitialconclusion:
itisverycomplicatedtoobtainaclearoverviewofthesituationregardingvirtualcurrencyschemes
atthisstage.Almostalloftheinformation that can be found isontheinternet,writteninblogs
oronwebpages where personalbiascannotbeexcluded(see,forinstance, thereferenceslisted
intheAnnex).Withtheexceptionofafewarticlesfromrespectablemediasourcesoreconomics
journals, it is almost impossible to nd any comprehensive papers on this issue, since no
internationalorganisationshavepublishedstatements.Asimilarproblemexistswithregardtothe
quantitative information and statistics that would be needed in order to assess the speed at which
thesevirtualcurrencyschemesaregrowingandthepointatwhichtheycouldbecomearealthreat.
The quantitative information that is available is not extensive and is usually provided by the
respective scheme owner.
4.1 RISKS TO PRICE STABILITY
Thewaysinwhichinnovationstopaymentsystemsmighthave an impact on price stability and
monetary policy has been extensively discussed in the context of electronic money.
2
The most
importantchallengesidentiedwere(i)thepreservationoftheunitofaccount,(ii)theriskstothe
effectiveness of monetary policy and its implementation, and (iii) the possible distortions to the
informationcontentofmonetaryaggregates.Conceptually,virtualcurrencyschemescouldhavean
impact on price stability and monetary policy if they affect the demand for the central bank’s
Theissuanceofnewformsofdigitalmoneyandtheirimpactoncentralbanks’roleshasbeenintensivelydebatedsincetheearlyyearsof1
the European Monetary Institute (see, for instance, EMI, 1994). More recently, these issues have also been discussed in the context of the
Electronic Money Directive.
See, for instance, ECB (1998).2
4 THE RELEVANCE OF VIRTUAL CURRENCY
SCHEMES FOR CENTRAL BANKS
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liabilities and interfere in the control of the supply of money through open market operations.
Overall, these schemes could affect price stability if:
they substantially modify the quantity of money;a)
theyhaveanimpactonthevelocityofmoney,theuseofcash,and/orinuencethemeasurementb)
ofmonetaryaggregates;
there is an interaction between the virtual currencies and the real economy. c)
Regardingtherstaspect–theimpactonthequantityofmoney–itisdifculttoassess,owing
tothelackofreliableinformation,theextenttowhichvirtualcurrencyschemesarecreatingnew
money.However,inprinciple,mostoftheseschemesworkonaprepaidbasis,i.e.theissuanceof
virtualcurrencytakesplacewhenrealmoneyisexchangedand,inthesamevein,virtualcurrencyis
absorbed(withdrawnfromcirculation)whenexchangedbacktorealmoney.Consequently,thenet
effect should, in theory, be limited.
The supply of money in the most prominent schemes seems to be quite stable and does not reach
signicantgures,atleastnotyet(seesections3.1.3and3.2.3).However,twocommentsshould
be made:
It is assumed that the money supply will remain more or less stable over time; however, there is –
actuallynowayofensuringthis.
The impact of the money supply on a real currency has to be assessed in terms of the latter, –
i.e.therecouldbeacertainimpactasaresultoftheexchangerate,evenifthemoneysupply
remains stable. In the case of Linden Dollars, this is not a serious issue, as – for the time
being–LindenLabusesseveralinstrumentstokeeptheexchangerateinSecondLiferelatively
stable.However,in theeventofhighexchangerate volatilitythispicturecouldchangequite
substantially. Bitcoin is a clear example of this.
3
The second aspect to consider is how virtual currencies could have an impact on the velocity of
money,theuseofcash,and/orinuencethemeasurementofmonetaryaggregates. The velocity of
moneyisameasureofhowoftenaunitofcurrencyisspenttopurchasegoodsandservicesproduced
in the economy.
4
A textbook assumption is to consider that the velocity of money is constant in the
shortterm,asitreliesontheinstitutionalandtechnologicalfeaturesoftheeconomyandtheseare
assumednottochangeintheshortrun.However,itisnotclearatthisstagehowthetechnological
innovationspresentedbyvirtualcurrencyschemesmightaffectthevelocityofmoney.Asthisisa
network industry, it will largely depend on the number of active virtual currency scheme users
(consumers willing to pay with these virtual currencies and merchants willing to accept their
payments).
ThenumberofBitcoinsincirculationasof26July2011was6,905,450.TakingthemarketexchangerateforBitcoinson1April20113
(USD0.785),thismeansthatthemoneysupplywasaroundUSD5.4million.If,however,theexchangerateof8June2011(USD30.99)
isused,thenthetotalamountofBitcoinsincirculationwouldbearoundUSD214million.On3May2012,theexchangeratewasaround
USD5.099.WitharoundeightmillionBitcoinsincirculation,thevalueofthiscurrencywasaroundUSD41million.
Intheclassicalequationofexchange,thevelocityofmoney(4 V)isrepresentedinthefollowingterms:V = P x Y / M, where P x Y is the
nominal GDP and M is the money supply.
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35
In an extreme case, virtual currencies could have a substitution effect on central bank money if they
becomewidelyaccepted.Theincreaseintheuseofvirtualmoneymightleadtoadecreaseinthe
useof“real”money,therebyalsoreducingthecashneededtoconductthetransactionsgenerated
bynominalincome.Inthisregard,awidespreadsubstitutionofcentralbankmoneybyprivately-
issuedvirtualcurrencycouldsignicantlyreducethesizeofcentralbanks’balancesheets,andthus
alsotheirabilitytoinuencetheshort-terminterestrates.Centralbankswouldneedtolookattheir
existingtoolstodealwiththisrisk(forinstance,tryingtoimposeminimumreserverequirements
on virtual currency schemes).
Thesubstitutioneffectwouldalsomakeitmoredifculttomeasuremonetaryaggregatesand,as
a consequence, would affect the relationship betweenthe monetary aggregates as measured and
ination,whichisusedtogaugeriskstopricestabilityinthemediumtolongerterm.
Lastly, on this second aspect, when virtual money is created outside the realm of the central bank
and virtual credit can be extended, this may have implications for the way interest rate decisions
bythecentralbankaretransmittedthroughtheeconomyandthecentralbank’scontrolovermoney
and credit developments could become less effective.
The third aspect to examine is the interaction between the virtual currencies and the real economy.
SecondLifeandBitcoinusersarespreadaroundtheglobeandthereforetheirimpactshouldalsobe
interpreted globally. However, if a virtual currency scheme was to be focused on one specic
country, it could indeed have an impact on the money supply of this country. This is what happened
in China with the Chinese virtual currency scheme Q-coin, introduced by the company Tencent,
oneoftheleadingtelecomoperatorsinthecountry.QQisaninstantmessagingserviceprovidedby
this company that also allows virtual payments to be made with Q-coins. This currency can be
purchased by credit card or by using the remaining balance on a prepaid telephone card. The
exchangerateisxedagainsttherenminbi.Originally,thiscurrencywasimplementedonlyforthe
purchaseofgoodsandservicesprovidedbyTencent.However,usersstartedusingitforpersonto
person(P2P)paymentsandsomemerchantsalsostartedacceptingQ-coinsasameansofpayment.
In addition, several online games rewarded users with points that could be exchanged against
Q-coinsandultimatelyalsoagainstyuanintheblackmarket.Thevirtualcurrencyhadevolvedinto
anillegalmoneyscheme.ChineseauthoritiessawtheamountofQ-coinstradedreachseveralbillion
yuaninoneyear,afterrisingaround20%annually.InJune2009,theChineseauthoritiesdecidedto
banthiscurrencyfortradinginrealgoodsinorderto“limititspossibleimpactontherealnancial
system”.
5
Theyalsoprovidedadenitionofavirtualcurrencyandstressedthattheywouldonly
allowedittobeusedforpurchasingthevirtualgoodsandservicesprovidedbyitsissuerandnotfor
realgoodsandservices.
Box 3 shows a few examples of innovations based on Bitcoin. Apart from fraud concerns, two
possible effects can be expected if these kinds of innovation proliferate and succeed. On the one
hand,theycouldhaveanimpactonthevelocityofmoneyexistingintheeconomy.Ontheother,
the interaction between virtual currencies and the real economy could also increase if widely used.
In both cases, there would be a need to monitor these innovations.
Ministry of Commerce, People’s Republic of China: (http://english.mofcom.gov.cn/aarticle/newsrelease/commonnews/200906/ 5
20090606364208.html).
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The economics literature has not yet addressed the effect of virtual currencies on real money and
monetarypolicy.OneexceptiontothisisapaperwrittenbyPengandSun(2009).Theseauthors
argue that virtual currency schemes act as a medium of exchange in the real goods trade and,
therefore,thatrealGDPisaffectedandshouldbetakenintoaccountwhenassessingtheeffectsof
virtualcurrencyschemesontherealmoneysupply.Accordingtotheauthors,theimpactofvirtual
currencies on the real money supply depends on two aspects:
the substitution effect of the virtual economy on the real economy. Based on a survey, they infer a)
that in China the total income of the real economy tends to decrease because of virtual economic
activities(e.g.peoplespendingalotoftimeinvirtualgamesspendlesstimeworkinginthereal
world),therebyalsoaffectingthevolumeofthemonetarybase.
Box 3
INNOVATION AND VIRTUAL CURRENCY SCHEMES – BITCOIN EXAMPLES
Innovationsintheretailpaymentmarketsareprogressingveryquickly,triggeredbytechnological
developments. Virtual currency schemes are no exception. In the context of Bitcoin, for
instance,anewpaymentinstrumentisbeingdevelopedcalledBitbills(http://bitbills.com/index.
html). Bitbills are prepaid cards for storing Bitcoins or for conducting point of sale payment
transactions in regular shops. There are several denominations (1, 5, 10 and 20 Bitcoins).
TheycanbeviewedasasubstituteforcashbasedontheBitcoinsystemwithoutrequiringan
internetconnection.EachBitbillcontainsaspecialsecurityhologramwhereaQRcodeisstored.
Thisencodesacryptographicsingle-useprivatekeylinkedtothemoneystoredonthecard.Users
caneitherexchangethecardsatfacevalue(forinstanceataretailer)orredeemthefundsand
spendthemintheBitcoinnetworkbycuttingthecardandextractingtheprivatekey.According
to the creator of this innovation, since their launch on 9 May 2011, the demand for Bitbills has
been substantial.
This is not, however, the only payment innovation linked to Bitcoin. Another example links
Bitcoins to payment cards from regular, international card schemes. For instance, Bitcoin 2
Credit Card (https://www.bitcoin2cc.com/) was a virtual credit card offered in exchange for
Bitcoins that could be used for purchases where a physical plastic card was not required, such
as for online and telephone purchases. Buyers of these cards received the necessary details to
perform a transaction (card number, expirydate and other relevant details). According to the
provider,thesecardsworkedwithPayPalandthebanksusedforhandlingthetransactionswere
locatedinCanadaandtheUnitedStates.AnotherwaytolinkBitcoinstoaregularpaymentcard
istoincreasethebalanceofanexistingpaymentcardbysellingBitcoins.Thisservice,called
Withdraw2Card,iscurrentlybeingofferedbyAurumXchange.CustomersselltheirBitcoinson
oneofthemajorexchangeplatformsandreceivearedeemablecouponwhichisusedtotransfer
the payment to the payment card (card number and expiry date are required). This part of the
serviceisbasedonanextensionoftheexistingcardschemeoptiontocreditacardintheevent
of a refund.
On 21 October 2011, another innovation related to Bitcoin was made public: the development
of a Bitcoin point of sale system (https://en.bitcoin.it/wiki/Casascius_Bitcoin_POS_system).
Its main function is to enable retailers to accept Bitcoins at the point of sale.
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thecrowding-outeffectofvirtualcurrenciesonrealcash.Asthevolumeofvirtualcurrenciesb)
increases, people hold less cash in real life. This causes a decrease in the cash/deposit ratio and,
consequently, an increase in the money multiplier.
6
Theauthorsargue thatastherealmoneysupply isaffectedbyvirtualcurrencyschemes,central
banks should incorporate virtual currencies into monetary statistics in order to monitor their
volume.
The challenge that virtualcurrency schemes might eventually pose for the conductof monetary
policy,intheevent that these schemesmanagetosubstantiallydiminishthe use ofcentralbank
sponsoredcurrencies(replacingitsrolesinprovidingliquidityandastoreofvalue),hasalsobeen
highlightedinarecentBISdocument.
7
Finally,itisimportanttosafeguardacurrency’sroleasaunitofaccount,associetyreapsbenets
fromawell-denedandstablemonetaryunitforitseconomictransactions,irrespectiveoftheissuer
or the format in which money is issued. Virtual currency schemes could lead to the emergence
of multiple units of account in the real economy. Virtual currency scheme owners could then be
temptedtoissueexcessiveamountsinordertoprotfromtheplacementofthesefunds.Achange
in views about the creditworthiness of these issuers (and the associated virtual exchange rate
variability)wouldthreatentounderminetheroleofmoneyinprovidingasingleunitofaccountas
acommonnancialdenominatorforthewholeeconomy.
4.2 RISKS TO FINANCIAL STABILITY
The ECB denes nancial stability as thecondition in which the nancial system – comprising
nancialintermediaries,marketsand market infrastructures –iscapableof withstanding shocks,
therebymitigatingthelikelihoodofdisruptionsinthenancialintermediationprocesswhichare
severeenoughtosignicantlyimpairtheallocationofsavingstoprotableinvestmentopportunities.
The safeguarding of nancial stability requires an identication of the main sources of risk and
vulnerability,suchasinefcienciesintheallocationofnancialresourcesfromsaverstoinvestors
andthemispricingormismanagementofnancialrisks.
In the context of virtual currency schemes, as they work outside the banking system, the main
(and also, unlikely) source of potential nancial instability would be the link between virtual
PengandSun(2009)alsoexaminewhattheycallthe“behavioureffectofissuers”.Thiseffecthastheoppositeimpactonthemultiplier,6
comparedwith the crowding-outeffect.However, the authorsconcludethat the crowding-outeffectis greater and,therefore,that the
money multiplier increases.
See BIS (2012).7
CONCLUSIONS ON PRICE STABILITY
Whilesubjecttoalackofreliableinformation,wecanconcludethatvirtualcurrencyschemes
donotposeariskforpricestabilityatthisstage,providedthattheissuanceofmoneycontinues
tobeasstableasitseemstobeatpresent.Intheshorttomediumterm,nosignicantimpactcan
beexpectedonthevelocityofmoney.However,itisprobablyworthmonitoringtheinteraction
between virtual currencies and the real world.
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currencies and the real economy, i.e. the exchange rates and the exchange markets.
8
Obviously,
Type1and2schemesarenotaffectedbythis,meaningspecialattentionshouldbepaidtoType3
schemes, where two exchange rates (buy and sell) are involved. The value of Type 3 virtual
currenciesisdeterminedbythedemandandsupplyofmoneyintheforeignexchangemarket.The
big difference from real money is that there is no country or currency area behind the virtual
currencyschemeandthereforetheexchangerateisnotaffectedasseriouslybythestrengthofthe
(virtual) economy, its trade imbalances or its productivity. The price of the virtual currency and its
volatilitydependonvemainfactors:
The supply of money and other issuer actions1) , such as the decision to intervene in the market
inordertomaintainaxedorsemi-xedexchangerate.Typically,theexchangerateissetina
bid/askspread,although,forinstance,LindenLabalsoimplementsitsowntypeof“monetary
policy”measurestostabiliseit.LindenLabcanprintandsellLindenDollarsagainstrealmoney,
therebyactingasavirtualissuingbankandbenetingfromaformofincomefromseigniorage.
The dimension of the network. Virtual currency schemes exhibit network externalities, i.e. the 2)
value of the currency will also depend on how many users and merchants use and accept it.
Therefore,itcanbeexpectedthat,asthesizeofthenetwork(consumersandmerchants)grows,
thecurrency’svaluewillincreaseaccordingly. Moreover, virtual currency schemes withlow
tradingvolumesareexpectedtosuffermorevolatilityintheirexchangerates,astheexchange
transaction of only a few users could alter the value of the currency.
Institutional conditions governing the virtual community. The virtual communities that have3)
clearandtransparentpoliciesandstate-of-the-artsecuritymeasuresaremorelikelytogenerate
condenceandhavestrongercurrencies.
The virtual currency issuer’s reputation for meeting its commitments. Since virtual currency4)
payments are not settled in central bank money or commercial bank money, nor is there any
lenderoflastresort,acrucialelementaffectingthevirtualexchangerateisthetrustgainedby
the virtual currency issuer.
Speculationsregardingthefuturevalueofthecurrencyandhistoryofcyberattackssufferedin5)
the virtual community.
Type 3 virtual currency schemes may tend to be inherently unstable for several reasons, such as
thescheme’slackofmaturity,alackofcondenceonthepartofusersofanincipientsystem,low
volumestraded,lackoflegalcertainty,speculationandcyberattacks,etc.
One example of this instability is Bitcoin. Its value in terms of US dollars has increased
dramatically. On 1 April 2011, one Bitcoins was worth USD 0.785. The closing price on
8June2011wasUSD30.99,butitwentdowntoUSD0.10on20June2011,followingasecurity
incident(seesection3.1.4).On13December2011,theclosingpricewasUSD3.24(seeChart11).
Consideringtheshorttimeframeduringwhichthecurrencyappreciated,andthefactthatitappears
nosignicantchangeshadtakenplaceasfarasthefactorslistedabovewereconcerned,theexchange
rate evolution should probably be attributed entirely to speculation. Therefore, this evolution
resemblesabubble,especiallyifitisconsideredthatbetweenthesystembeingestablishedin2009
Asecondsourceofnancialinstabilitycouldariseiftheseschemesjeopardisethesmoothfunctioningofpaymentsystems.Thisissueis8
discussed in the next section.
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4 THE RELEVANCE OF
V I R T U A L C U R R E N CY
SCHEMES FOR
CENTRAL BANKS
39
and April 2011, the exchange rate was quite
stable at less than USD 1. Similar speculative
situations can also be expected in the future.
For the time being, the low volume traded in
these virtual currency schemes and the fact that
there is no substantial connection with the real
economy (relatively few users who are spread
across the world) means that the stability of the
nancial system cannot be negatively affected
byanyoftheseschemes.However,thesituation
could change in the future if these schemes
become an alternative to traditional currencies,
therebyintroducinginstabilityinthesystemas
a result of their substantial volatility, even with
the potential to distort the relative prices of
goodsandservices.Hereagain,thetrueimpact
ofvirtualcurrencyschemeswilllargelydepend
on the number of active users, as well as the
numberofmerchantswillingtoacceptthevirtualcurrencyforrealtransactions.Inaddition,thefact
thatthesecurrencieshaveonlyexchangevalueandnousevaluemayalsoposeaproblem.Users
ofthesystemactuallyexchangerealcurrencyforcomputingbits.Thereisnormallynoassetwith
intrinsicvalueunderlyingthevirtualcurrency,noristhereanycentralbankbackingthecurrency
andactingaslenderoflastresort.Atthesametime,thesemarketsareilliquidandrelyonothers
wantingtojointhescheme.Asaconsequence,usersfaceasubstantialliquidityriskandcouldend
upowningbitsthatnoonewantstobuy.
Itseemsthat,atthemoment,theseschemesdonotallowborrowingorlending.Butthismaychange
in the future. There is even speculation on how Bitcoin could evolve.
9
Banks could, for instance, act
asadepositoryforthewalletlesthatcontainusers’Bitcoins;theseuserswouldthenrelyonthe
banks’technicalandsecurityknowledge.Thebankscouldthenpayinteresttothosewhoholdthe
virtualcurrencywiththem.AlternativelytheBitcoinsystemcouldevenstartworkingasafractional-
reserve system, extending credit over and above its actual reserves; however, the scheme’s
supporters are clearly opposed to this. These developments, if they came to pass, could indeed have
acertainimpactonnancialstabilityinthefuture.
See,forinstance,http://www.webisteme.com/blog/?p=1929
Chart 10 Bitcoin exchange rate in Mt.Gox
0.0
2.5
5.0
7.5
10.0
12.5
15.0
17.5
20.0
22.5
25.0
27.5
30.0
32.5
0.0
2.5
5.0
7.5
10.0
12.5
15.0
17.5
20.0
22.5
25.0
27.5
30.0
32.5
Jan. Apr. July Oct. Jan. Apr. July Oct.
2011 2012
Source: Bitcoin charts (http://bitcoincharts.com/charts/)
CONCLUSIONS ON FINANCIAL STABILITY
Virtual currency schemes may be inherently unstable. Nevertheless, for the time being they
do not jeopardise nancial 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.
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4.3 RISKS TO PAYMENT SYSTEM STABILITY
As stressed earlier, in general, a payment made within a virtual currency scheme is handled
“in-house”andcanthereforebeclassiedasaspecictypeof“on-us”transaction.Paymentsare
usuallylowvaluepaymentsandaresettledonagrossandreal-timebasis.Thesettlementinstitution
(i.e.theissuer)isanon-regulatedinstitution.Asignicantconcentrationofpaymentactivitiesand
associatedexposureswithinthissingleinstitutioncouldensueifvaluesprocessedinthesevirtual
currencyschemesweretogrowsignicantlyinthefuture.
Virtualcurrencypaymentarrangementshaveevolvedinto“real”paymentsystemswithinthespecic
virtual community. As a consequence, they face the typical risks linked to payment systems:
Credit risk. Users are exposed to credit risk in relation to any funds held on the virtual accounts, –
as it cannot be guaranteed that the settlement institution is able to fully meet its nancial
obligationswhenthesearedueoratanytimeinthefuture.
Liquidity risk. Users are also exposed to liquidity risks if the settlement institution fails to meet –
any commitments it has made to provide liquidity to the participants as and when expected.
Inthisregard,virtualcurrencyschemesareveryilliquidasaresultofthelowvolumestraded.
In the event of security incidents, the conversion of users’ funds into real money would probably
notoccurquicklywithoutasignicantmateriallossinvalue.
Operational risk. Both payer and payee need to have accounts with the settlement institution and –
are therefore reliant on the soundness of its operational and business continuity.
Legal risk. There are many legal uncertainties regarding virtual currency schemes. In virtual –
currencyschemes,thelackofaproperlegalframeworksubstantiallyexacerbatestheotherrisks.
Thenature,sizeanddurationoftheseexposuresdependverymuchonfactorssuchasthedesign
ofthesystemoritsdegreeofilliquidity.However,asaruleofthumb,itcanbeassumedthatthese
risksareverydifculttoavoidortocontrolinavirtualcurrencyscheme.
In these schemes, the settlement asset is the virtual currency, and therefore the nality and
irrevocability of payments cannot be ensured. Only central bank money can do so, because central
banks present no default risk and act as lender of last resort to the member of the system in order to
stop any possible chain reaction resulting from payment incidents or unforeseeable liquidity
shortages.
10
Virtual currencies cannot therefore be considered to be safe money, since the likelihood
oftheassetretainingitsvaluefortheholder,andhenceitsacceptabilitytoothersasameansof
payment cannot be ensured. It simply relies on the creditworthiness of the issuer of the
settlement asset. The level of safety is clearly below that of commercial bank money, as commercial
banks are subject to prudential requirements and are supervised in order to reduce the likelihood of
default,therebyimprovingthesafetyofclaimsontheseinstitutions.
This is a fundamental risk relating to virtual currency schemes, which do not involve any kind
of supervision of the settlement institution or oversight of the system, and therefore no one is
accountable for their acts. Nor is there any kind of investor/depositor protection scheme in place.
As a consequence, users bear all of these risks themselves.
OECD (2002), p. 66.10
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4 THE RELEVANCE OF
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SCHEMES FOR
CENTRAL BANKS
41
Centralbanks’oversightactivitiesaimtoachievesafeandefcientpaymentandsettlementsystems,
and contribute to nancial stability and the proper functioning of the economy as a whole.
The“CorePrinciples”areusuallyacceptedas a basic referenceforimplementingcentralbanks’
oversightactivities;evenfornon-systemicallyimportantpaymentsystems(seeBox4).
11
AsacknowledgedbytheECB(2003),thesystemshavingalesserimpactonthenancialinfrastructureandtherealeconomy(including11
virtualcurrencyschemes)donotnecessarilyhavetocomplywiththerelevantoversightstandards:“Suchsystemshavetocomplywiththe
relevantoversightstandards,asandifdenedforthem”.Sincetherearenooversightstandardsforvirtualcurrencyschemes,thisreport
usesasitsstartingpointthePrinciplesforSystemicallyImportantPaymentSystems.
Box 4
CORE PRINCIPLES FOR SYSTEMICALLY IMPORTANT PAYMENT SYSTEMS (BIS, 2001)
I. Thesystemshouldhaveawell-foundedlegalbasisunderallrelevantjurisdictions.
II. Thesystem’srulesandproceduresshouldenableparticipantstohaveaclearunderstanding
ofthesystem’simpactoneachofthenancialriskstheyincurthroughparticipationinit.
III. Thesystemshouldhaveclearlydenedproceduresforthemanagementofcreditrisksand
liquidity risks, which specify the respective responsibilities of the system operator and the
participantsandwhichprovideappropriateincentivestomanageandcontainthoserisks.
IV.
1
 Thesystemshouldprovidepromptnalsettlementonthedayofvalue,preferablyduring
the day and at a minimum at the end of the day.
V.
1
Asysteminwhich multilateralnettingtakesplaceshould,ataminimum,becapableof
ensuringthetimelycompletionofdailysettlementsintheeventofaninabilitytosettleby
theparticipantwiththelargestsinglesettlementobligation.
VI. Assets used for settlement should preferably be a claim on the central bank; where other
assets are used, they should carry little or no credit risk.
VII. Thesystemshouldensureahighdegreeofsecurityandoperationalreliabilityandshould
havecontingencyarrangementsfortimelycompletionofdailyprocessing.
VIII. Thesystemshouldprovideameansofmakingpaymentswhichispracticalforitsusers
andefcientfortheeconomy.
IX. Thesystemshouldhaveobjectiveandpubliclydisclosedcriteriaforparticipation,which
permit fair and open access.
X. Thesystem’sgovernancearrangementsshouldbeeffective,accountableandtransparent.
1 Systems should seek to exceed the minima included in these two principles.
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It is quite clear that virtual currency schemes do not comply with most of the Core Principles, especially
inrelationtotheirlegalbasis(CPI);therulesandproceduresinplaceinordertoenableparticipants
tohaveaclearunderstandingoftheriskstheyaretaking(CPII);theproceduresforthemanagement
of credit and liquidity risks (CP III); the asset used for the settlement, i.e. the virtual currency (CP VI);
thedegreeofsecurityandoperationalreliability(CPVII);andthegovernancearrangements(CPX).
Thatbeingsaid,theCorePrinciplesalsoprovidethreecriteriainordertoassessthecriticalityofa
payment system: i) it is the only payment system in a country, or the principal system in terms of
theaggregatevalueofpayments;ii)ithandlesmainlypaymentsofhighindividualvalue;andiii)it
isusedforthesettlementofnancialmarkettransactionsorforthesettlementoftheotherpayment
systems.Fromaglobalperspective,noneofthesecriteriaaremetbyvirtualcurrencyschemes,and
therefore they cannot be considered systemically important payment systems. Consequently, it is
absolutely clear that they would not be capable of triggering disruptions or transmitting shocks
across the nancial system. However, they could cause a signicant environment of instability
withinthevirtualcommunityinwhichtheyoperate.Inthisregard,virtualcurrencyschemescan
indeedbe critical,but onlyfor theirusers withinthe virtualcommunity. Thisissue mightbe of
interestforotherauthorities(e.g.inthecontextofmarketconductregulationandsupervision).
4.4 LACK OF REGULATION
The instability of virtual currency schemes can be explained by one of the most critical aspects
mentionedearlier,i.e.thelackofaproperlegalbasisforvirtualcurrencyschemes.
12
Thelegalbasis
ofapaymentsystemconsistsofframeworklegislation,aswellasspeciclaws,regulations,and
agreementsgoverningbothpaymentsandtheoperationofthesystem.
13
Virtual currency schemes
visiblylackaproperlegalframework,aswellasacleardenitionofrightsandobligationsforthe
differentparties.Keypaymentsystemconceptssuchasthenalityofthesettlementdonotseemto
beclearlyspecied.
Furthermore,theglobalscopethatmostof these virtual communitiesenjoynotonlyhindersthe
identicationofthejurisdictionunderwhichthesystem’srulesandproceduresshouldeventually
be interpreted, it also means the location of the participants and the scheme owner are hard to
establish.Asaconsequence,governmentsandcentralbankswouldfaceseriousdifcultiesifthey
tried to control or ban any virtual currency scheme, and it is not even clear to what extent they are
Thenon-existenceofaclearlegalbasisforvirtualcurrencyschemesisanillustrationoftheoverallexistinglackofunderstandingabout12
virtual economies and their impact on the real economy. For instance, it is not clear to what extent virtual production should be considered
whenestimatingtheproductionofwealthpercapita.Thecurrentnationalincomeandproductaccountsdonotassignanyvaluetoonline
assets(seeCastronova,2001).Moreover,tworelatedaspectsthatcouldbeconsideredarehowtotaxindividualincomeearnedthrough
virtualcurrencytransactionsandhowtodeneandprotectvirtualproperties(seeChu,2008andTheEconomist,2011b).
BIS (2001), p. 16.13
CONCLUSIONS ON PAYMENT SYSTEM STABILITY
Virtual currency schemes seem to work like retail payment systems within the virtual community
they operate. However, in contrast to traditional payment systems, they are not regulated or
closely overseen by any public authority. Participation in these schemes exposes their users to
credit, liquidity, operational and legal risks within the virtual communities; no systemic risk
outside these communities can be expected to materialise in the current situation.
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permitted to obtain information from them.
14
In the particular case of Bitcoin, which is a decentralised
peer-to-peer virtual currency scheme, there is not even a central point of access, i.e. there is no
server that could be shut down if the authorities deemed it necessary.
Onepossiblewaytoovercomethissituationandobtainsomequantitativeinformationonthemagnitudeofthefundsmovedthroughthese14
virtual currency schemes could be to focus on the link between the virtual economy and the real economy, i.e. the transfer of money from
thebankingenvironmenttothevirtualenvironment.Virtualaccountsneedtobefundedeitherviacredittransfer,paymentcardorPayPal
and therefore a possibility would be to request this information from credit institutions, card schemes and PayPal.
Box 5
BITCOIN AND THE EU LEGAL FRAMEWORK
Bitcoin’slegalframeworkisveryunclear.IntheEU,therearesomewhosuggestthatBitcoin
could fall under the Electronic Money Directive (2009/110/EC). This Directive uses three criteria
todeneelectronicmoney:(i)itshouldbestoredelectronically;(ii)issuedonreceiptoffunds
of an amount not less in value than the monetary value issued; and (iii) accepted as a means of
paymentbyundertakingsotherthantheissuer.
Can Bitcoin be considered an electronic money institution? Bitcoin probably complies with
the rst and the third criteria, but not with the second. Moreover, it is important to consider
theconversionintoanothercurrency,whichwasclearlynotenvisagedintheDirective.Infact,
Art. 11 explicitly says that “Member States shall ensure that, upon request by the electronic
money holder, electronic money issuers redeem, at any moment and at par value, the monetary
value of the electronic money held”. This cannot be ensured in a virtual currency scheme like
Bitcoin (or in any other Type 3 scheme). A last key aspect that should be taken into account is
the“mining”activity,whichleadstomoneycreationwithoutthereceiptoffunds.
1
Itisdifcult
to assess how this could be interpreted within the scope of the Directive.
AnotherEuropeanlawthatmighthavesomerelevancetovirtualcurrencyschemeslikeBitcoin
is the Payment Services Directive (2007/64/EC). This Directive lays down rules on the execution
of payment transactions where the funds are electronic money, yet it does not regulate the
issuanceofelectronicmoney,nordoesitamendtheprudentialregulationofelectronicmoney
institutionsasprovidedforintheElectronicMoneyDirective.Therefore,thenewcategoryof
payment service provider it introduces – payment institutions – should not be allowed to issue
electronic money. As a consequence, Bitcoin clearly falls outside the scope of the Payment
Services Directive.
Inthemeantime,someinitialattemptstodenethelegalstatusofBitcoinarealreadyhappening
in Europe. The French law courts are looking into theissue after local banks shut down the
currencyexchangefacilityforaccountshandlingthecurrency,onthepresumptionthatBitcoin
shouldconformtoelectronicmoneyregulations.
2
Finally,theissueofBitcoin’slegalframeworkhasbeenraisedintheEuropeanCommission’s
Payments Committee.
1 SeeJacobs(2011).
2 Finextra(http://www.nextra.com/news/fullstory.aspx?newsitemid=22921).
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Usually regulation lags behind technological developments by some years. This is alsothe case
invirtualcurrencyschemes(atleastintheircurrentform),whichwerealreadybeingestablished
asearlyasthelate1990s.Itwasonlyin2006thatanumberofUSgovernmentagenciesstarted
considering these schemes. The following year, some of these companies were charged with
operatingunlicensedmoneytransmittingbusinesses.Since then, a number ofotherlegalactions
have been taken and many of these schemes operating in the United Stateshave been closed.
15
Subsequently,China has also taken a stance against the use of virtual currency schemes for the
purchaseofrealgoodsandservices.Recently,inthecontextofasurveyoninnovationinpayment
systems carried out by the Reserve Bank of Australia (RBA), Microsoft asked the Australian
central bank to consider adjustments to the domestic payments market to help consumers conduct
transactions in virtual currencies.
16
Authoritiesneedtoconsiderwhethertheyintendtoformaliseoracknowledgeandregulatethese
schemes.Inthisregard,alikelysuggestioncouldsoonerorlaterinvolvevirtualcurrencyscheme
ownersregisteringasnancialinstitutionswiththeirlocalregulatingauthorities.Thisisasimilar
trajectorytotheonePayPalhasundergone,asitwasgrantedabankinglicenceinLuxembourgin
2007 after its service became popular.
17
This is not an easy step, but it looks like the only possible
way to strike a proper balance between money and payment innovations on the one hand, and
consumerprotectionandnancialstability,ontheother.
Registeringthesecompaniesasnancialinstitutionswouldatleastreducetheincentiveforterrorists,
criminalsandmoneylaundererstomakeuseofthesevirtualcurrencyschemesforillegalpurposes.
As explained, Type 3 schemes allow users to convert virtual currency into real currency and vice
versa,usingdifferentchannelsandaccounts.Villasenoretal.(2011)provideagoodoverviewof
howthesevirtualcurrencyschemesmightbeusedbycriminalsandmoneylaunderers.Anumberof
elementsfromthispaperareworthexamining.Ontheonehand,technology-facilitatedtransactions
canbedesignedtobeinvisibleortobevisiblebutanonymous.Ontheother,thesetransactionsare
verydifculttotraceback.Therearebasicallytwodifculties:
Technological hurdles: a movement of USD 900,000 conducted in 100 different electronic –
transfersofUSD9,000mightbeeasytospot,butthepowerofalarge,widely-dispersedonline
network that enables this money to be moved in 100,000 transactions with randomised amounts,
generallyintheUSD6toUSD15range,mightnotbesoeasytopinpoint.
Legalhurdles:avarietyofentitiesandintermediaries,eachlocatedinadifferentcountry,could –
be involved in the transaction, without any of them really having all the information on the
transaction.
Analaspectworthyoffurtherinvestigationistheextenttowhichtransactionscarriedoutinthese
virtual communities are or should be covered by consumer protection measures. Transactions within
virtualcommunitiescouldberegardedasaspecialkindofelectroniccommerce,astheylookquite
similartootheronlinetransactions.However,neitherDirective2011/83,onconsumerrights,nor
DGCMagazine(2010),p.28.15
See the feedback provided by Microsoft tothe Reserve Bank of Australia (http://www.rba.gov.au/payments-system/reforms/strategic-16
review-innovation/submissions/201106-strategic-review-innovation/microsoft.doc).
Korolov(2010).PriortothistheywerearegulatedelectronicmoneyinstitutionintheUK.17
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Directive 2000/31, on electronic commerce, seems to refer to the transactions performed in a virtual
community or with Bitcoin.
18
4.5 REPUTATIONAL RISK
The reputation of central banks is a key element determining the effectiveness of their various
policies, especially monetary policy. A reputation is hard to earn, but very easy to lose.
Since central banks are the institutions to which people look in order to establish how much trust
to place in money, they are very much concerned about their reputation. For the ECB, reputational
riskisdenedastheriskofdeteriorationofthereputation,credibilityorpublicimageoftheECB
towards different external stakeholders (e.g. general public, nancial sector, etc.). It is included
asithasaspecicimpactonoperationalrisk,whichisdenedastheriskofnegativenancial,
business or reputational impacts resulting from inadequate or failed internal governance and
business processes, people, systems or from external events. A reputational impact may occur
evenwhenbusinessobjectivesarebeingmet,i.e.evenifcentralbanksarenotresponsible.Virtual
currency schemes are able to have a reputational impact. They are about money and about payments
and therefore, for the general public, they clearly fall under the responsibility of central banks,
even though this might not be the case from a statutory and legal point of view. Therefore, the
possibility of a reputational impact in the event of a security incident should be taken into account.
Althoughtheimpactofafailureofavirtualcurrencyschemewouldbelimited,assumingtheydo
notsignicantlygrowinsize,thelikelihoodisconsiderableasaresultofthehighvolatilityand
instabilityofvirtualcurrencyschemesandthebroadmediacoveragetheyreceivefromtimetotime
(for instance, Bitcoin).
Directive2011/83/EU,onconsumerrights,alludesto“digitalcontent”anddenesitasdatawhichareproducedandsuppliedindigital18
form.Fromapurelyconceptualpointofview,therearefewdifferencesbetweenbuyinganimagetouseasascreensaveronamobile
phoneandbuyingclothesforanavatarinSecondLife.
CONCLUSIONS ON THE LACK OF REGULATION
Virtualcurrencyschemes,incontrasttotraditionalpaymentsystems,arenotregulated.Thelegal
uncertainty surrounding these schemes might constitute a challenge for public authorities, as
theseschemescanbeusedbycriminals,fraudstersandmoneylaundererstoperformtheirillegal
activities.
CONCLUSIONS ON REPUTATIONAL RISK
Iftheuseofvirtualcurrencyschemesgrowsconsiderably,incidentswhichattractpresscoverage
could have negative impacts on the reputations of central banks, if the public perceives the
incidentsasbeingcaused,inpart,bycentralbanksnotdoingtheirjobsproperly.Asaconsequence,
thisriskshouldbeconsideredwhenassessingtheoverallrisksituationofcentralbanks.
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5 CONCLUSION
Although in practical terms virtual currency schemes are only an evolution, from a conceptual
pointofviewtheydopresentsubstantialchangeswhencomparedtorealcurrenciesandpayment
systems.Firstly,conventionalactorslikenancialinstitutions,clearinghousesandcentralbanks
are absent from these schemes. Also, they proliferate more easily, against the background of
thehugegrowth in access toanduseof the internet andasa result of thetechnicalinnovations
behindtheseschemes.Moreover,theyarenotoftenboundtoaspeciccountryorcurrencyarea,
whichcomplicateslawmaking,regulatingandlawenforcing.
From the preliminary analysis in this report it can be concluded that, in the current situation, virtual
currency schemes:
do not pose a risk to price stability, provided that money creation continues to stay at a low –
level;
tend to be inherently unstable, but cannot jeopardise nancial stability owing to their –
limited connection with the real economy, their low volume traded and a lack of wide user
acceptance;
arecurrentlynotregulatedandarenotcloselysupervisedoroverseenbyanypublicauthority, –
eventhoughparticipationintheseschemesexposesuserstocredit,liquidity,operationaland
legalrisks;
couldrepresentachallengeforpublicauthorities,giventhelegaluncertaintysurroundingthese –
schemes, as they can be used by criminals, fraudsters and money launderers to perform their
illegalactivities;
couldhaveanegativeimpactonthereputationofcentralbanks,assumingtheuseofsuchsystems –
growsconsiderablyandintheeventthatanincidentattractspresscoverage,sincethepublicmay
perceivetheincidentasbeingcaused,inpart,byacentralbanknotdoingitsjobproperly;
do indeed fall within central banks’ responsibility as a result of characteristics shared with –
paymentsystems,whichgiverisetotheneedforatleastanexaminationofdevelopmentsand
the provision of an initial assessment.
Althoughtheseschemescanhavepositiveaspectsintermsofnancialinnovationandtheprovision
ofadditionalpaymentalternativesforconsumers,itisclearthattheyalsoentailrisks.Owingtothe
small size of virtual currency schemes, these risks do not affect anyone other than the users of the
schemes.However,itcanreasonablybeexpectedthatthegrowthofvirtualcurrencieswillmost
likelycontinue,triggeredbyseveralfactors:a)thegrowingaccesstoanduseoftheinternetand
the growing number of virtual community users, b) the increase of electronic commerce and in
particular digital goods, which is the ideal platform for virtual currency schemes; c) the higher
degreeof anonymity comparedto other electronicpayment instruments thatcan be achievedby
payingwithvirtualcurrencies;d)thelowertransactioncosts,comparedwithtraditionalpayment
systems;ande)themoredirectandfasterclearingandsettlementoftransactions,whichisneeded
and desired in virtual communities.
Given that the current assessment of risks is highly dependent on relatively small-sized virtual
currencyschemes,theassumptionthatvirtualcurrencyschemeswillcontinuetogrowmeansthata
periodical examination of the developments is needed in order to reassess the risks.
49
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ANNEX: REFERENCES AND FURTHER
INFORMATION ON VIRTUAL CURRENCY SCHEMES
Further information on the virtual currency schemes mentioned in this report can be found at the
followingwebsites:
WoWGold:• http://www.wowgoldeuro.com/
Facebook credits: • http://www.facebook.com/credits/
Linden Dollars: • http://wiki.secondlife.com/wiki/Linden_Dollar / http://wiki.secondlife.com/
wiki/Getting_Linden_Dollars_FAQ
Bitcoin: • http://www.bitcoin.org/ and https://en.bitcoin.it/wiki/FAQ
E-gold:• http://www.e-gold.com/ and http://www.e-gold.com/unsecure/contact.html
Tencent_QQ:• http://en.wikipedia.org/wiki/Tencent_QQ
Nintendo Points: • http://www.nintendo.co.uk/NOE/en_GB/systems/nintendo_points_1489.html
The Webpage “Virtual currency platforms” (http://www.virtualcurrencyplatforms.com/virtual-
currency-platforms/) provides some examples and information on Type 1 virtual currency
schemes.
*****
Inaddition,thefollowingreferenceshaveeitherbeencitedinthisreportorprovideaninteresting
overview of the topic.
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BBC (2009), “Sales of virtual goods boom in US”, available at http://news.bbc.co.uk/2/hi/
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50
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5050
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51
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ANNEX
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53
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ANNEX
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virtual currency schemes
novemBer 2012