Virtual Currency - Creation of Monetary Value, Social Problems, and Depreciation of Linden Dollar - Essay Example

Virtual currencies Name Institution Course Instructor’s name Date of submission Introduction This paper reviews the report prepared by the European Central Bank to analyze the major issues surrounding virtual currency schemes as well as addressing ways through which the Governor of the central bank in Second Life can engineer the depreciation of the Linden Dollar. Major issues Definition of virtual currency The report defines virtual currency “is a type of unregulated, digital money, which is issued and usually controlled by its developers, and used and accepted among the members of a specific virtual community” (13). However, this definition is not conclusive as the report recognizes that this definition might be subject to change in the future depending on adopted characteristics. In fact, the Financial Crimes Enforcement Network in the US, which operates under the Department of Treasury, defines virtual currency differently as “a medium of exchange that operates like a currency in some environments, but does not have all the attributes of real currency” (FinCEN 2013). There are three types of virtual currencies. Where one evolves to another type is not sufficiently addressed in law or regulated. Such definition problems in the inclusive term of virtual currency and the three types might present problems in operationalizing legal measures on the phenomena as they do not clearly given the scope of virtual of money. For instance, it is noted that rewards programs such as points gained in frequent flier programmes might qualify as type two virtual currency. Additional, such financial laws require a stable definition given that such laws require cross border cooperation. Creation of monetary value Use of virtue currency has no distinctive framework on its relationship with real currency. This means that whether virtual money holds any real life monetary value is decided by the developers alone. This assigns the developers a role they are not equipped to handle, that of a financial institution and a financial regulator. Ordinarily, central banks are mandated with setting the value of currencies in given national boundaries thereby giving them legal tender status. However, in a virtual world there are no national boundaries and the virtual currency’s value is based on any real money currency that the developer deems fit. In the current case of virtual currency, and especially in type 3 virtual currency, real currency such as the US dollars can be converted into virtual currency and the virtual currency can be converted back into real dollars. This gives the virtual currency the same status as any real life currency. In fact, according to the developers of Bitcoin, the virtual currency aims to address the shortcomings of real life currency brought about by monopolistic control by central banks. Does this mean that virtual currency fulfils all the three functions of money as a store of value, medium of exchange and unit of account? Virtual currency fulfils two of the three functions of money adequately while the third functions as a store of value remains debatable. This is because the stability of the currency where it can be exchanged with real life currencies is not stable. The stability of the virtual currencies such as Bitcoin is affected by the fact that there is no central issuing authority. As for Bitcoin, they can be ‘mined’ or created by anyone who is has access to a powerful computer that can solve the increasingly complex mathematical problems. For this reason, Bitcoin’s value in the marketing has been fluctuating too much to function as a store of value. For instance, the St. Louis Post Dispatch reports that Bitcoin was exchanging at $15 in January this year which rose to a high of $266 by 10th April before slumping to $54 on 12th April. Following such fluctuations “Bitcoin appears unlikely to catch on as a super-currency. At best, it may become an interesting speculative vehicle, a casino where you can bet on the spread of financial chaos” (STL 2013). The financial Times is also very sceptical about virtual currencies as a store of value to say that they are only worthy because of their ‘comedy value’ (Financial times 2013). However, for the users of the virtual currency schemes, they are similar to electronic money transfer systems such as PayPal. Virtual currency schemes are similar to electronic moneys transfer systems and also different from them in various ways. The ECB reports notes that virtual currency schemes meet the criteria of electronic money transfer in three main ways: “1) A payment instrument is used as the means of authorising and submitting the payment 2) Processing and clearing involves a payment instruction being exchanged between the creditor and the debtor concerned and 3) Debits and credits are settled in the user’s account” (p. 17). The virtual schemes differ from electronic money system in three ways; 1) they use different agents because the currencies are held outside the traditional banking system 2) transactions are retail in the sense that payment is a virtual credit transfer and 3) payment instructions are passed and settled individually across the accounts of the payer and the payee in real time. This means that the transactions handled through virtual schemes are not subjected to financial regulations rules thereby exposing the schemes to possible abuse. Implications Virtual currencies are a direct threat to traditional central bank-issued currency. The increased acceptability of the Bitcoins and Linden dollars among other virtual currencies mean that they can easily replace the ordinary currency. As aforementioned, this was one of the core factors that informed development of Bitcoins. This move is further supported by Austrian economics. Given that virtual currencies are issued by individual developers, it means that the role of the central bank is taken of over by the developers. Consequently, the central banks’ role in implementing monetary policies such as controlling supply of money in the economy will be compromised. In essence, the central bank uses such policies to regulate short-term interest rates and influence government spending and influence exchange rates among other functions. Furthermore, the central bank would have problems in measuring monetary aggregates. The magnitude of the virtual world markets is not known. This means that the real world market does not understand the potential threat that the virtual world markets carry. For instance, the creation of virtual goods in the virtual world such as Second Life follows no definite of known format. Developers can create imaginary goods which can trigger high demand in the virtual world. Such trends in the demand and supply of virtual goods and services can only be controlled by the developers and the acceptability of such goods and services to actors in the virtual world. However, there are estimates circulating on the internet that show that the virtual markets are most active in the US and Asia. The figures indicated differ very much with Sovtech VC placing the value of the US virtual world market by 2008 at US$ 200 million and Offerpal Media at US$2 billion. It is expected that with increased access to broadband internet in other areas of the world, the virtual markets will grow even larger. How the growth of such markets might respond to economic fluctuations in the real world is not well known. Social problems Use of virtual currency increases and encourages cyber crime. This is because the storage of currency in the case of Bitcoins is in a digital wallet in a specific computer. Such Bitcoins can be accessed and stolen by hackers who ordinarily have high level software and computers to carry out their criminal activities. On the other hand, users who have stored Bitcoins in their digital wallets have no adequate means of protection against such hackers. The only form of protection against hackers and cyber criminals that have is only antivirus software installed. The ease of storage of Bitcoins, the speeds of transactions and the anonymity involved in transacting in Bitcoins attract higher number of people as opposed to the conventional electronic money transfer system that is closely controlled. Additionally, the transaction fees are considerably low and no back fees are charged. The only shortcoming of virtual currency schemes as electronic money transfer system is that they are currently available in the developed world with the third world, which is a large recipient of global electronic money remittances, not covered. The virtual currency systems threaten the global economic system through potential deflation and increased cyber crime Taking for instance the Bitcoin currency, the developers implemented the scheme in the belief that it would alleviate the problem created by real life banking system where they create inflation through over supply of money. The Bitcoin system on the other hand has a predetermine mechanism of regulating money supply. Given that new currency in the Bitcoin system can be mined, at only six Bitcoins per hour, money will grow geometrically until it reaches a finite limit of 21 million in 2040. If the number of Bitcoin users grows at a very high rate disproportionate to the supply of money, then the currency will appreciate abruptly leading to a depreciation of prices of goods in Bitcoins. As such, Bitcoins are not suited to respond to changes in the market that influence monetary policies adopted by central Banks. With such a fixed monetary policy, victual currencies as they exist are not responsive to changes in demand and supply sufficiently. Depreciation of the linden dollar As it is, the value of the Linden dollar is pegged to the US dollar with an exchange rate of L$260= US$1. To depreciate the value of the Linden dollar as the governor of central bank of Second Life, I would inject more currency into the Second Life economy. This is possible through two ways: increasing money supply or devaluing the Linden dollar as pegged to the US dollar. The Second Life “central bank” uses a fixed exchange rate which has been set at L$ 260= US$ 1. This can men devaluating the Linden dollar downwards, for instance make it L$ 300= US$ 1. The second way would be to temporarily halt the irreversibility of the Linden dollar to the US dollars or other real life currency while people would continue buying Linden dollars with real currency to increase supply. Cancelling reversibility would guarantee that the current amount of the Linden dollar in circulation in the second life economy does not go down but goes up. Prices of virtual goods in the second life economy would go down. The third way would be increasing government expenditure by buying virtual goods from the virtual market. This would be for instance hiring services from the market and paying well to increase supply of money. Furthermore, government expenditure in the second life can be increased by government buying goods such as land to set up government utilities. An increased supply of the Linden dollar in the second life economy will likely devaluate the virtual currency. References European Central Bank. Virtual currencies. (2012). [Online] Retrieved from FinCEN (2013). [Online] Retrieved from, Financial times (2013). Virtual currencies [Online] Retrieved from St. Louis Diospacth. Virtual currencies. [Online] Retrieved from Read More