If you’ve ever used an in-game currency like Second life‘s Linden or bought a plane ticket with loyalty miles, you used virtual currency. Virtual currency is a type of digital currency that only exists in electronic form and includes many types of currencies, including cryptocurrency.

Virtual currency can offer several advantages over fiat currency for businesses and individuals, and it exists in a variety of industries including gaming, travel, and finance.

What is virtual currency?

A virtual currency is completely digital. Unlike other digital currencies, which are simply electronic representations of a currency, virtual currencies can only be used electronically.

For example, a US dollar can be represented by a balance of $ 1 displayed in your bank account. It is a digital currency. But if you withdraw that $ 1 from your bank account, you will receive a piece of green paper with George Washington’s face on it. It is no longer a digital currency.

If you try to withdraw your airline miles from your frequent flyer account, the airline will think you are crazy. This is because it is a form of virtual currency. There is no physical representation of it.

There is no central bank backing a virtual currency like the US dollar is. In fact, in the case of cryptocurrency, there is no central authority. Currencies are distributed by private parties or networks. In addition, virtual currencies have limited regulation around the world.

Some virtual currencies have restricted use cases. For example, virtual gold collected in World of warcraft doesn’t have much use outside of gaming. Others, however, like Bitcoin (CRYPTO: BTC), can be traded freely for any kind of good or service you can think of.

Types of virtual currencies

Firm

A closed virtual currency only exists in a private economy like that of a massively multiplayer online game. There is no exchange of foreign currency against closed virtual currency or vice versa. As such, they can only be used to pay for things in the environment where they were earned.

Note that some closed virtual currencies can be bought and sold in the gray market, but this essentially requires two transactions: one where the virtual currency is transferred to another party in exchange for nothing, and another in the real world economy where fiat currency is transferred for nothing.

Virtual currencies with currency flow in one direction

Some virtual currencies allow you to buy them in fiat currency, but you cannot exchange them after you buy them. Examples of these include in-game currencies, loyalty programs such as frequent flyer miles, vouchers or coupons, and gift cards.

You might be able to earn these virtual currencies within their own savings, but you can also buy them with fiat currency. Once you have acquired one of these virtual currencies, they are only valid in the private economy in which they were created. For example, you probably can’t use your frequent flyer miles to pay for a new computer.

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Convertible

Convertible virtual currencies, as the name suggests, can be converted into other digital currencies. Cryptocurrencies, for example, are mostly convertible. You can convert Bitcoin to any other cryptocurrency or exchange it for fiat currency on any cryptocurrency exchange.

Other convertible virtual currencies include Second life‘s Linden, which players can exchange for fiat currency through the LindeX exchange on the game developer’s platform. Credit card transferable points programs can also be considered convertible virtual currencies. Most credit card companies offer the option of redeeming points for US dollar statement credit, or you can transfer them to certain frequent flyer or hotel loyalty programs.

Virtual currency, digital currency and cryptocurrency

Virtual currency, digital currency, and cryptocurrency are closely related terms. One way to think of them is like Russian nesting dolls. All cryptocurrencies are inside the virtual currency doll, and all virtual currency dolls are inside the digital currency doll.

In other words, all cryptocurrencies are virtual currencies, but not all virtual currencies are cryptocurrencies. Likewise, all virtual currencies are digital currencies, but not all digital currencies are virtual currencies.

Examples of virtual currencies that are not cryptocurrencies include in-game currencies and loyalty miles. Examples of digital currencies that are not virtual currencies include U.S. dollars represented by my bank statement or other fiat currency not held in physical form.

Benefits of virtual currency

• Faster transactions. Virtual currencies are designed to clear transactions almost instantly. You don’t have to wait for a clearinghouse or cross-border transfer service to make sure the money gets where it’s going. Even a slow cryptocurrency transaction is confirmed within an hour, whereas it typically takes days to settle other digital currency payments.
• Lower cost operations. The cost of virtual currency transactions can be free, saving businesses and consumers money. In the case of sending money internationally, the use of cryptocurrency is often cheaper than traditional services.
• No manufacturing or storage costs. Since virtual currency is strictly electronic, there is no cost to produce a physical representation of money as is the case with most currencies backed by central banks.
• Improved cash flow for businesses. Businesses can sell their virtual currency to increase their cash flow without having to provide any goods or services in return. For example, airlines sold frequent flyer miles to credit card companies in 2020 to boost cash flow at a time when travel was plummeting.
• Cut out the middlemen. Cryptocurrencies provide a decentralized monetary system that allows two parties to the transaction to connect directly instead of relying on a bank or third party as an intermediary. This may be preferable in some cases.

Disadvantages of virtual currency

• A target for hackers. As virtual currencies gain in popularity, hackers can find significant amounts of value stored on computers. Cryptocurrency exchanges have been targeted, as have traveler loyalty programs. If a hacker has access to virtual currency, it can be difficult to go back.
• Unregulated and unprotected. Virtual currency is not subject to regulations, which means consumers have little recourse if transactions go wrong. This makes virtual currencies fertile ground for scams.
• Hidden costs. While the transaction costs of virtual currencies are generally very low, there are hidden costs for some virtual currencies. For example, the Bitcoin network consumes a lot of energy. If you keep your cryptocurrency on an exchange, it may incur custody fees.
• Easily traceable. Since virtual currency can only be used electronically, there is always a paper trail showing the transactions made. This is true even with cryptocurrency, which is anonymous but still traceable. The use of paper money allows for truly anonymous and untraceable transactions.
• Subject to price fluctuations and devaluation. Virtual currency does not always keep its value stable against your preferred fiat currency. Cryptocurrency is known to be extremely volatile. Meanwhile, travel loyalty programs periodically decrease the value of their points and miles to adjust for inflation or to reduce their unpaid liability.

The future of virtual currencies

Virtual currencies are still in development. Cryptocurrency, in particular, is an emerging industry with the potential for blockchain technology to power many more business and financial applications. Businesses can adopt more virtual currencies to increase customer loyalty, and central banks are exploring the potential of cashless virtual currencies.

As consumers begin to trust virtual currencies more, we should see broader applications develop.