Virtual currencies like bitcoin are digital units that can be created by solving complex cryptographic equations by everyone in the possession of a computer that has sufficient power. This is called mining. Of the over 200 virtual currencies that seem to be in existence today, bitcoin is by far the best known and most frequently used. The underlying system claims to protect the privacy of the payer and the payee because transactions are linked to a string of alphanumeric characters (the bitcoin address) rather than to an individual person. The system also enables users to make worldwide payments quickly and at low costs without using an intermediary such as a bank. In this way, bitcoin can induce payment services providers to continue improving their payment services for cross-currency transactions where processing time and costs are concerned.
Nevertheless, virtual currencies such as bitcoin are unlikely to replace the current financial system and money as we know it. Although media attention seems to suggest otherwise, the use of these currencies is as yet at a very low level. During the past year, some 65,000 daily bitcoin transactions were performed worldwide, of which less than 1,000 per day in the Netherlands. By comparison, we make over 16 million euro payments a day in the Netherlands. The relatively low number of bitcoin transactions is hardly surprising, in view of their considerable disadvantages. Virtual currencies are not fully able to take up all the functions that money has, and market players in virtual currency systems provide only weak security guarantees. In addition, users run considerable risks when buying, spending, or receiving virtual currencies.
Medium of exchange, store of value, and unit of account?
Although virtual currencies were designed to function as money, to date they have not been able to fully fulfil the three functions of money: medium of exchange, store of value, and unit of account. Currently, bitcoin's viability as a medium of exchange is limited, its store of value role is even smaller, and it is virtually inadequate as a unit of account. As bitcoin scores low on security and user-friendliness in comparison with other payment instruments and virtual currencies are still hardly accepted, bitcoin is unsuitable for wide use as a medium of exchange. Bitcoin's value is determined in the marketplace and it is highly susceptible to speculation. To give an example, the price in early November 2013 of such a USD 200 per bitcoin shot up to some USD 1,200 in early December, owing to growing interest in bitcoin in China, but fell back to some USD 700 within in a few days following negative comments about virtual currencies from China’s central bank. Its volatility is such that prices would fluctuate from day to day if expressed in bitcoin. This poses risks to users (who may easily lose large amounts of money), and caps the use of bitcoin as a unit of account and as store of value. Consequently, virtual currencies like bitcoin are at present no viable alternative for the euro and other currencies.
Episodes like the theft of 650,000 bitcoins from Mt. Gox and its subsequent file for bankruptcy show that virtual currency systems are definitely still falling short where security is concerned. Due to its decentralised set-up, there is no central party in the virtual currency world that has the responsibility to hold market players to account when they fail to comply with conditions for use, security demands, or legal frameworks. There is also no alternative in the virtual currency system for the –government-guaranteed – deposit guarantee system, which covers consumer balances up to EUR 100,000 if something were to go wrong with the financial institution keeping their accounts. In addition, virtual currency systems have no compensation policies in place indemnifying consumers who fall victim to cybercrime. Balances are lost forever following theft or the demise of a wallet provider.
Other user risks
In addition to the said volatility and security problems, virtual currency systems carry a number of inherent user risks. These include ICT risks as the reliability of the software used is not guaranteed by certification. The software supporting a virtual currency system may be faulty, meaning that the integrity of transactions cannot be guaranteed. These are uncertainties that stand in the way of large-scale and professional use. The development of transaction fees is also uncertain. These have so far been low as new bitcoins are still being created with the publication of transactions, but when the vast majority of the maximum number of 21 million bitcoins will have been created around 2030, transaction processing costs will have to be recovered from transaction fees. The current low fees are then unlikely to be maintained. As virtual currencies fall outside the scope of the Dutch Financial Supervision Act, De Nederlandsche Bank (DNB) has as yet no authority over virtual currencies or the institutions trading in them. There is also no security in respect of funds received, i.e. no guarantee that balances will be returned following bankruptcy, and outstanding payments will be executed. No-one monitors whether virtual currency-institutions have sound and responsible business operations.
In short, virtual currencies fulfil only a very small part of the role of money, market players do not guarantee the security of their customer accounts, and the system entails all sorts of risks for its users. Consequently, virtual currencies like bitcoin do not seem to be a viable alternative for traditional currency at present.