A Real “Virtual Currency” Emerges: Could BitCoins Threaten “Real” Currencies?

I’ve talked fairly often on this blog about the trade of virtual goods and virtual currencies in virtual worlds such as Second Life or Facebook.  While novel, neither of these elements are legally what they claim to be.  With respect to virtual currencies like Facebook Credits or Linden Dollars, they are limited license rights to access particular aspects of the online service.  They are confined to being used within the platform for which they were created and cannot be exchanged for cash.  Regardless of how successful they are within their particular platform, the currencies’ limitations make them academically interesting, but economically dull. Enter the BitCoin.  This revolutionary peer-to-peer virtual currency is everything it claims to be.  Created to be a private, secure alternative to cash, checks and credit cards, BitCoins are traded over a network of P2P clients with no central server.  BitCoins are purely bits of data transmitted from one person’s computer to another’s.  There are no physical representations–no coins, no bills, no tokens of any kind.  All you need is software and an internet connection.  You can trade them freely for goods or services as long as your counterpart accepts them. The economics of BitCoins are fascinating from a macroeconomics perspective.  At the start, there is a fixed, pre-determined rate of inflation–meaning that new Bitcoins are added to the pool at a known rate.  One way that more Bitcoins are added to the economy is mining.  People can “mine” Bitcoins by running a variety of programs that use a computer’s central processor or graphics processor to solve small math puzzles for a chance to “win” a Bitcoin.  As the site describes it, it’s like a lottery that happens millions of times per second, with a microscopic chance of winning.  It’s rather technical, but the point is that there are a few different ways to obtain the currency aside from purchasing them outright with traditional money. The negative aspects of Bitcoins are fairly evident from the outset.  A secure and totally private currency opens all sorts of doors for criminals and other less-than-ethical people to exploit.  While the creators claim there are plenty of legitimate uses for Bitcoin, the most obvious is money laundering and black market trades.  Of course, this is limited by the ability to exchange Bitcoins for real money.  As of now, the vast majority of people accepting and trading Bitcoins are highly sophisticated Internet entrepreneurs, such as web designers and site hosts.

The potential for utilizing Bitcoins in illegal activities is more than just academic speculation.  According to a report by NPR’s Planet Money podcast, Bitcoins are a commonly used currency for transactions between credit card thieves because they are instant and secure.  It makes sense, when you think about it, because thieves are likely to have trust issues, especially when they are transacting over the Internet where cash is unavailable.  Unlike early concerns about virtual world currencies being used for money laundering and other black market activities, there are too many ways that those transactions can be traced for smart criminals to favor them over Bitcoins.  Additionally, the places where Bitcoins can be spent is increasing by the day, making them an easier and less risky substitute currency than Lindens, Facebook Credits or the old standby, WoW Gold.

The legal status of Bitcoins is curious.  There are plenty of legitimate uses for them, as the proponents are eager to point out.  You can even use them to pay for an immigration lawyer.  But their design is so perfectly suited to money laundering and tax evasion, it’s a wonder that world governments aren’t clamoring for a way to regulate trade in them.

Others are concerned that it is an all-but-declared Ponzi scheme, where new users who buy in pay for earlier users to cash out after making significant returns on investment.  I don’t see it necessarily being a Ponzi scheme, since it isn’t designed as an investment vehicle.  The creator isn’t promising unbelievable returns, rather, until the amount of Bitcoins maxes out in 20 years, there is actually a downward pressure on their value because new coins are being added to the economy through mining.

The more immediate issue will be how to account for transactions to the IRS and state Departments of Revenue.  Will it be like other virtual currencies, where nothing is taxed until the currency is cashed out for US Dollars or will people be required to report the barter value of transactions?  Also, depending on the state, merchants must charge sales or use taxes.  Even though the temptation to hide the money will be great since there will be no record of the transaction by a third party like a bank, it’s no different than getting paid in cash.  It’s still the duty of the merchant to collect and remit sales tax.

I am currently fascinated with this technology, and already I’ve heard about competitors emerging.  What the future holds for these true virtual currencies is anyone’s guess.  If it catches on, we may see that they replace the expensive and complicated systems for credit cards and certainly for checks.  Technologies like cell phone payments and near field communication may help move Bitcoins into the mainstream even faster.  What other uses can you envision for a purely electronic currency?