Electronic cash explained: What is virtual currency?

With the rise of fintech apps, online banking, and cryptocurrencies, managing money without handling physical cash has never been easier. Cashless transactions have become the norm in many nations and are expected to only grow. Some projections suggest global digital payments could surge to 2.8 trillion annually by 2028.

But as the world’s familiarity with virtual currencies grows, so do the complexities surrounding them, given each currency’s unique features and their legal differences. Anyone interested in the future of finance should understand what qualifies as a virtual currency and how it differs from related financial categories.

Below, we’ll tell you what you need to know. 

What is virtual currency? A few preliminary considerations  

While official definitions vary, regulators and economists largely agree that virtual currencies are digital-native assets representing transferable value. The U.S. Office of Foreign Assets Control (OFAC) classifies virtual currencies as mediums of exchange, units of account, or stores of value used on digital platforms. Similarly, the Commodity Futures Trading Commission (CFTC) acknowledges the digital nature of virtual currencies and outlines the same three primary use cases.

The Internal Revenue Service (IRS) shares these core definitions but emphasizes that virtual currencies differ from “real currencies” issued by national governments, like the U.S. dollar. For tax purposes, the IRS treats virtual currencies as property and specifies they must be easily “convertible” to real currencies.

Keep in mind that definitions and regulations can vary internationally and are continuously evolving. It’s important to check the latest legal codes in your jurisdiction to stay compliant with local laws on digital assets.

Digital currency vs. virtual currency and cryptocurrency: Explaining the differences

The distinctions between virtual currencies, digital currencies, and cryptocurrencies are arguably subtle, but understanding the unique traits of each term clarifies their differences. Though all three refer to forms of digital value, they represent distinct asset categories:

• Digital currency: This is the broadest term, encompassing any value stored in digital form. It includes everything from traditional payment platforms and digital banking apps to in-game currencies and decentralized crypto assets. Think of digital currency as the overarching category for any form of electronic value.
• Virtual currency: A subset of digital currency, virtual currencies are limited to specific online ecosystems and aren't recognized as official fiat currencies. While these digital currencies often function like traditional money as a medium of exchange or store of value, they lack a centralized issuer, such as a national government.
• Cryptocurrencies: A specialized type of virtual currency, cryptocurrencies are secured with cryptographic technology and operate on decentralized networks called blockchains. Their key feature is a peer-to-peer (P2P) structure that eliminates the need for intermediaries. The crypto space is diverse: Public blockchains like Bitcoin (BTC) and Ethereum (ETH) offer transparent ledgers, while private blockchains restrict access to selected users and validators.

Key features of virtual currency

To understand how virtual currencies function, it helps to examine their key characteristics. Recognizing these features helps distinguish when a digital asset qualifies as a virtual currency.

• Digital-only existence: Virtual currencies are exclusively available in electronic form. Though some represent synthetic versions of real-world items, they operate solely on digital networks and can't be physically exchanged.
• Value representation: While governments don’t back virtual currencies, they hold value relative to other currencies. People use them for various purposes, from purchasing in-game items and real-world goods to making investments, and they have recognized exchange rates.
• Common use cases: Regulators generally categorize virtual currencies as mediums of exchange, stores of value, or units of account. Although broader applications exist, most virtual currencies fit at least one of these classifications. 
• Convertibility: Even if a virtual currency can't be swapped directly for fiat money, it can usually be exchanged within its ecosystem or on trading platforms. Users might not withdraw these currencies as cash, but they can convert them into other assets, such as buying items in a game.
• Ease of transfer: Virtual currencies facilitate faster, more convenient transfers than physical cash. As long as users have compatible accounts, digital currencies can be sent almost instantly across borders. 

Two types of virtual money: Closed vs. open currencies

Economists often break down virtual currencies into two main subgroups based on their transferability: closed and open. Closed virtual currencies are typically confined to specific platforms or ecosystems, whereas open virtual currencies provide broader usability and easier conversion into other assets, including fiat currencies.

Closed virtual currency 

Also known as "closed-loop virtual currencies," these assets function only within their specific digital ecosystems. A common example is in-game currency, like Linden Dollars in Second Life (more on that in a bit), or loyalty rewards such as credit card points and frequent flier miles. These currencies cannot be exchanged for fiat money on open markets but can be redeemed for goods or services available within their respective platforms.

Open virtual currency 

Conversely, open virtual currencies are easily exchangeable for fiat currencies or other assets. Platforms that support these currencies allow traders to convert them based on transparent market values. Cryptocurrencies like Bitcoin are prime examples of open virtual currencies, as they have recognized market prices and can be traded on various exchanges.

Examples of virtual currencies 

Virtual currencies are fundamentally digital representations of value, but what they signify can differ widely. As advancements in areas like fintech, gaming, and blockchain continue, the range of virtual currencies keeps expanding.

In-game currencies 

Along with Second Life, video games like Fortnite and World of Warcraft feature proprietary virtual currencies for in-game purchases and experiences. Players earn these currencies through gameplay challenges or buy them with fiat money, such as U.S. dollars. These are typically closed-loop systems, meaning they are only exchangeable within the game environment. However, some web3-based games, like Axie Infinity, have introduced cryptocurrencies as rewards, giving players more control over their digital assets.

Stablecoins

Stablecoins are cryptocurrencies designed to maintain a fixed value, often tied to assets like the U.S. dollar. For example, USD Coin (USDC) and Tether (USDT) have reserves to uphold their value by holding equivalent amounts of fiat currency and other assets. Other stablecoins rely on algorithms to manage supply and demand, stabilizing their price without traditional reserves. These digital currencies enable stable peer-to-peer transactions that reduce exposure to volatile cryptocurrencies like Bitcoin and Ethereum.

Central Bank Digital Currencies (CBDCs)

CBDCs function similarly to stablecoins, maintaining a 1:1 value with fiat currencies. The main distinction is that central banks issue and regulate CBDCs, granting them the same legal status as physical money. Governments recognize CBDCs as legal tender despite their existence on blockchain networks. Countries like the Bahamas, Jamaica, and Nigeria have already implemented CBDCs, while others, such as Russia, China, and Australia, are exploring them through research and pilot programs.

Non-fungible tokens (NFTs) 

First introduced in 2014 with the artwork Quantum, NFTs are unique digital assets built on blockchains like Ethereum and Solana. Unlike fungible tokens, NFTs represent distinct digital assets and cannot be exchanged on a 1:1 basis. They cover a wide range of media, from digital art and virtual items in video games to property rights and event tickets. Popularized by projects like CryptoPunks, NFTs are traded using various methods, including popular marketplaces like OpenSea, directly from creators via their websites or social media, and through dynamic auctions on platforms like Sotheby’s Metaverse.

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Disclaimer: This post is informational only and is not intended as tax advice. For tax advice, please consult a tax professional.