Virtual Currency Schemes - Essay Example

? VIRTUAL CURRENCY SCHEMES By Virtual Currency Schemes In recent years, virtual communities have grown rapidly due to the technological development in the real world. These communities for that matter have circulated and created their own currency for exchanging of their services and goods (European Central Bank, 2012). In definition, a virtual currency is a type of digital money that is unregulated, controlled, and issued by its developers; it is then introduced to the users and calls for acceptance among the members of the relevant virtual community (European Central Bank, 2012). These currencies resemble real money and do come with their discrete, but open retail payment system; leading to the term virtual currency scheme. There are different types of virtual currency schemes; Type 1 (closed virtual currency scheme), it is used in online games; Type 2 (unidirectional flow), this is usually an inflow, this means that they have a conversion rate for buying the virtual currency that aid not only in purchasing the virtual goods and services, but also the real goods and services; Type 3 (bidirectional flow), this gives the currency the ability to behave like any other convertible currency, that is, possess the buying and selling exchange rate, and therefore, it can be used to buy both the virtual and real goods and services. Issues Surrounding Virtual Currency Schemes (Bitcoin and Linden Dollar) The Bitcoin is a virtual currency scheme that is based on the technology of BitTorrent of sharing files over the Internet (European Central Bank, 2012). This technology is based on peer-to-peer network. Its operation is global and has the ability to conduct both real and virtual transaction of goods and services. The exchange rate of Bitcoins which is not nailed to any real-world currency is determined by demand and supply in the market (King, 2012). Due to all these, the currency is decentralized, meaning that it has no central clearing house; it is anonymous and controlled by the partners involved, this means that there is no institution or financial house involved in the transaction (European Central Bank, 2012). By anonymous, it means that accounts are not registered, so the Bitcoins are transferred directly from one machine to another. The transactions are enabled by free and open-source software that is downloaded and installed in a machine; thereby, purchased Bitcoins are stored in the machine in a digital wallet. This turns to be the basic threat to this system, users can easily lose their money if they do not implement and secure their machines with back-ups and antivirus measures. Although the insecurity factor is a big concern, users still prefer to use this technology because of its fast and cheap transactions with no bank account fees involved (European Central Bank, 2012). Because this system has no rules, its economic foundation has been interfered with governments and other agencies through criticism of the current fiat money system. Users of Bitcoin generally share common ideas which help to maintain Bitcoin within operation range, these include; the scheme is inspired and promoted by former gold standards, users also think that it is a starting point to end the central bank monopoly in the issuance of money, lastly the user criticize the fractional-reserve banking system. All these ideas have led to a number of issues; first, the economists criticize the Bitcoin and argue that Bitcoins are bits stored in a computer; therefore, they have no intrinsic value like gold. The other reason is that this technology fails to satisfy the Misean Regression Theorem (European Central Bank, 2012). Another issue about the Bitcoins is that the system is complex and not easily understandable, creating questionable doubts on the system, considering that the transactions are sent through a network minus an intermediary to maintain and validate the connection. This can lead to double spending or coin forge even with tough measures like time stamp and mining are deployed to validate the transactions. The monetary aspect is also an issue when dealing with Bitcoin. As stated before, this system has no involvement with monetary authorities; therefore, money is introduced or created in the system through the mining process (King, 2012). Unlike in the monetary policy where the central bank control the supply of money, in Bitcoin supply of money depends on the interested users performing a transaction or activity. Although many users claim that the system is supposed to avoid inflation, the system is accused of resulting to a deflationary spiral, and in reality, the extent to which this could be a problem is indefinite and unclear (European Central Bank, 2012). The fact that this currency is not a currency area or country, it is, therefore, open to merchants that sell the goods and services. It is also anticipated that deflation would give rise to situations where merchants adapt and decide prices of their goods in Bitcoins. This system is also posing a lot of threat to the social, security, and well-being of users. Due to information asymmetry, it can be used in money laundering, drug dealing, and tax evasion due to its high degree of anonymity. Safety of the Bitcoins is not guaranteed in the system; Trojan, theft of Bitcoins, untested legal concerns, cyberattacks like hacking, fraud, and funds disappearing from the system are just but a few security issues in the system (King, 2012). The second life is mainly linked to the Linden Dollar. This is a virtual community that has created massively multiplayer online role-playing games (European Central Bank, 2012). The whole idea is based on a three-dimensional modeling tool that gives the users the ability to create virtual objects. The Second Life economy is similar to normal economies but with three additional features. These features include: self-sufficient economy which is a closed economy where no outsider is allowed to conduct activities, focuses only on virtual goods and services, and it is created and exercised within the Linden Lab’s environment and infrastructure. This economy also allows companies and merchants selling virtual goods to make real profits online. These features are exercised because Second Life has its own monetary policy that is based on Linden Lab’s supply of the Linden Dollars (European Central Bank, 2012). Virtual currency total amount in circulation in the market depends on Linden Lab’s revenue from land rental and island sales in Linden Dollars, the net selling amount of the currency (Linden Dollars) traded between users and LindeX, and the Linden Dollar Grant paid to premium members by Linden Lab (Rymaszewski, 2007). Although this system is generally an online virtual world, there are real economic transactions in the process that always lead to real problems and issues. There are high amount of risks in the process because all the processes and system are regulated and controlled by Linden Lab authorities; no public authority involved. Some crucial issues that face this system include infringement of intellectual property. Another issue is that the lab controls the monetary value of the Linden Dollar. Even though there is the involvement of companies in distribution and purchasing at Linden Lab system, the lab regulates controls, manages, and modifies the rights and license terms of the Linden Dollar (European Central Bank, 2012). Another important issue in the Linden Lab is that there is no definite compensation payment made by the company if the database loses any Linden Dollar; therefore, the operational risks are high as there is no enough measure to mitigate the potential risk. Another problem the users face in the system is the fact that Linden Lab is released from claims made relating to another user, they are not liable for the users’ actions (Rymaszewski, 2007). Other issues facing this system include fraud risks and counterparty risks, criminal and terrorist attraction, and money launderers. This means that most common criminal actions done in the real world can be exercised within the Second Life, and with a more likelihood (King, 2012). Engineering a Depreciation of the Linden Dollar The Linden Dollar being basically a closed virtual currency scheme and not related majorly to real economy, it is not regarded by central bank, and therefore irrelevant from a central bank’s perspective (European Central Bank, 2012). Consequently, the Linden Dollar can also be linked to an economy of its own terms, so some regulations and rules of the central bank might directly or indirectly affect the functionality of the Linden Dollar economy. In this context, an introduction of the virtual central bank is necessary to regulate the rights within the Second Life, and therefore, aid in depreciating the Linden Dollars that acts as a monopoly as far as virtual economy is concerned (King, 2012). First, as a governor of central bank, introduction of direct action and control of the monetary policy will be priority in the list. These are regulations that can help the central bank independently regulate, modify, and control the money supply and monetary value of the Linden Dollar in that market (Rymaszewski, 2007). Then the central bank will reduce the risk in price stability by balancing the demand and supply through open market operations. This will allow the central bank to modify the quantity of money, interaction between LindeX and the users as far as currency and money are involved, and take control of the velocity of money in the market; thereby regulating the interest rates as a long-term measure (European Central Bank, 2012). The central bank will also need to safeguard the financial stability which comprises of the markets, market infrastructures, and financial intermediaries. This means that the central bank will compel the Linden Lab to work within the banking system (Rymaszewski, 2007). This can be done by maintaining the following factors: the dimension of the network, supply of money, institutional conditions governing the Linden Dollar. Another measure is to maintain and regulate the payment system stability; this may be done by controlling the credit risk by guaranteeing user of a settlement after problem occurs, liquidity of assets, and the commitment of the Linden Lab to meet the participants’ expectation. The central bank should also ensure that the system is accountable, transparent, and effective because this will also reflect on the national economy (European Central Bank, 2012). Conclusion For virtual currency schemes to operate, they should maintain their stable nature and avoid contact or relation to real money and real economy (European Central Bank, 2012). They should uphold their reputation and credibility in delivering their services to users in a manner that does not raise concern as far as legal issues are concerned. Even though these systems pose a threat to public authorities, they should in a way operate within certain regulated rules so as to avoid illegal activities (European Central Bank, 2012). Bibliography European Central Bank, 2012. Virtual Currency Schemes, Frankfurt: European Central Bank. King, B., 2012. Bank 3.0: Why Banking Is No Longer Somewhere You Go But Something You Do. 1st ed. New York: John Wiley & Sons. Rymaszewski, M., 2007. Second Life: The Official Guide. 3rd ed. New Jersey: John Wiley & Sons. Read More