Today, there are more than seven hundred digital currencies in existence. Entering the marketplace is undertaken by so many due to the low cost of entry and the profit opportunity. In 2014, the European Banking Authority defined virtual currency as “a digital representation of value that is neither issued by a central bank nor a public authority, nor necessarily attached to a fiat currency, but is accepted by natural or legal persons as a means of payment and can be transferred, stored, or traded electronically.” The first and most widely known instance of such digital, virtual, or cryptocurrency is Bitcoin.

Bitcoin Background

Bitcoin, a peer-to-peer digital currency or cryptocurrency, operates without the involvement of traditional financial institutions, and it provides a direct digital alternative to physical currencies. Bitcoin transactions take place online directly between the buyer and seller, with each transaction having a unique encryption. Transactions are recorded on a decentralized public ledger available for network users to verify valid transactions. Special users on the network (“miners”) oversee this verification process. After verifying a block of transactions, miners are paid with twenty-five newly generated Bitcoins and the transactions are processed and approved; this is how the total number of Bitcoins grows. The number in circulation as of January 2015 was approximately 13.7 million, with the maximum set at 21 million. As of April 2015, their total value was $3 to $4 billion.

Governments worldwide generally do not yet see it and other digital currencies as a destabilizing “threat,” and some scholars have argued that it may best be seen as a speculative investment. Bitcoin has certainly had its ups and downs: As of April 1, 2015, its value stood at $242 per Bitcoin, after a January 14 low of $177 and a March 11 high of $296. The currency has also had a long run of troubles with hackers and fraud, most spectacularly in 2014 when the exchange Mt. Gox declared bankruptcy after Bitcoins worth $460 million at the time were apparently stolen. Bitcoin’s decentralized model and degree of anonymity have also raised concerns over its use in illegal money transfers, fueling potential illicit commerce across the “dark Web” and on sites such as Silk Road.

The organization Bitcoin.org, meanwhile, touts the currency’s potential for opening up a “whole new platform for innovation”:

Advantages and Disadvantages

A 2015 Congressional Research Service (CRS) report, “Bitcoin: Questions, Answers and Analysis of Legal Issues, explores the following technical, functional, and legal issues associated with Bitcoin—and, by extension, all virtual currencies.

Bitcoin advantages:

• Lower transaction costs: Because Bitcoin operates without a third-party intermediary, merchants are able to avoid the fees traditionally charged by payment systems such as credit cards.
• The possibility of increased privacy: Bitcoin provides a heightened degree of privacy for purchases and transactions, though by the system’s nature, a complete list of all transactions is forever recorded to each user’s encrypted identity.
• Protection from inflation: Since Bitcoin’s circulation is not linked to currency or government regulation, it is not subject to standard inflation. However, it more than makes up for this in volatility.

Bitcoin disadvantages:

• Severe price volatility: The value of a Bitcoin is determined by supply and demand and, as a result, can fluctuate rapidly. The value was as high as $1,100 in December 2013, then hit a low of $177 in January 2015. This extreme fluctuation is more characteristic of a commodity than a currency.
• Not legal tender: Debtors are not required to accept it, and without any formal backing other than the computer program to which it is linked, Bitcoin can be seen as an “unattractive vehicle” for holding and accumulating wealth.
• Uncertain security against theft and fraud: While the counterfeiting of Bitcoins is allegedly impossible, the system has at times found itself vulnerable to large security breaches and cyberattacks. Most recently, Bitstamp, a large European Bitcoin exchange, lost 19,000 Bitcoins (valued at about $5 million) in a digital security breach. This follows the massive problems with Mt. Gox in 2014 and the collapse of other exchanges in 2011.
• Vulnerability of Bitcoin “wallets”: Purchased or mined Bitcoins are stored in a digital wallet on the user’s computer or mobile device, and digital keys can be lost, damaged, or stolen. Paper or offline storage is an option, but it’s not always practiced.

Federal banking regulators have yet to issue guidance or regulations governing how banks are to deal with Bitcoins. In a February 2014 statement, Federal Reserve chair Janet Yellen said: “Bitcoin is a payment innovation that’s taking place outside the banking industry. . . . There’s no intersection at all, in any way, between Bitcoin and banks that the Federal Reserve has the ability to supervise and regulate.” Some state financial authorities have taken steps to devise regulations, with New York’s Department of Financial Services (NYDFS) in the lead.

The responsibility to oversee digital currency falls upon Congress. As of now, Congressional actions remain in the exploratory phase. The tax code lacks clarity on how such currency should be treated: Is it digital currency, property, barter, or foreign currency? Early concerns have focused more on tackling consumer-protection issues than tax ambiguities, and as a result, the Consumer Financial Protection Bureau has become involved regarding questions related to Bitcoin.

The following video explains further some of the gray areas in which this virtual currency is operating.

Whether it’s Bitcoin or another cryptocurrency, the fact that more than seven hundred of these unregulated digital currencies have emerged in just the last two years is just one more indication that consumers may be breaking off their longstanding love affair with traditional cash.