Everyday there’s a new story about virtual currencies. This space is moving so fast, it’s hard to keep track of the latest developments.

News ranges from the worrying — with the closure and bankruptcy of the Mt. Gox exchange after US$372M in Bitcoins went missing, to the doomsayers — who predict the Bitcoin bubble will burst and say that it has no real value. But its popularity continues to grow, speculators continue to invest and, increasingly, merchants accept virtual currencies as payment.

Virtual currencies are not yet widely adopted by the public, and governments around the world are struggling to address them coherently. On the one hand, last year’s U.S. Senate hearings on virtual currencies appeared to be a significant step in legitimising virtual currencies — Bitcoin’s value soared following Senator Chuck Schumer’s “endorsement” highlighting the potential for a new payment platform and the rise of alternative currencies and Federal Reserve Chairman Ben Bernanke’s earlier statement that such currencies “may hold long-term promise, particularly if the innovations promote a faster, more secure and more efficient payment system”. On the other hand, the central bank in China issued guidelines preventing financial institutions and payment processing companies from dealing with Bitcoin.

Gaining traction
There is plenty of ground in between as well: some countries like Canada and Venezuela are developing their own virtual currencies; the UK’s HMRC (Her Majesty’s Revenue and Customs) announced that it will end the 20 per cent VAT on Bitcoin transactions, altering its treatment of Bitcoin as a voucher; Norwegian tax authorities placed a tax on Bitcoin treating it as an asset subject to capital gains tax; in Singapore, where Bitcoin ATMs recently opened, the MAS (Monetary Authority of Singapore) said that it does not recognise or regulate Bitcoins and warned citizens about the use of virtual currencies; and the Singapore government also issued guidance on how it will tax Bitcoin transactions. Regulators are struggling to deal with virtual currencies.

But virtual currencies are here to stay. The existing forms have faults but they offer a number of potential advantages, including speed, cheaper transaction fees and freedom across international borders. These advantages are lacking in traditional currencies and payment methods to date, and are enough to keep the virtual currency momentum.

Biggest innovation since credit cards?
The competition in the space of virtual currencies proves this point. To name a few: Bitcoin, Litecoin, Peercoin, and other digital payment initiatives such as PayPal’s digital wallets. The world of payments and currencies is ripe for its biggest innovation since credit cards and ATMs.  So what’s stopping widespread adoption?

The biggest challenge is persuading large numbers of people that these systems are a genuine alternative. There are a number of issues.

Trust: Possibly the most important issue affecting virtual currencies. When things go wrong with traditional currencies, we rely on central banks, authorities and regulators for help (although the systems aren’t flawless). But who do we rely on if something goes wrong with a virtual currency? If you lose your code, there’s no authority to help you retrieve it. If demand dries up, who manages the situation? Who supports the and maintains the stability of the regime?

Security: Dell SecureWorks Counter Threat Unit predicts that malware designed to steal virtual currencies will grow quickly. The Mt. Gox closure and loss of Bitcoins further demonstrates security weaknesses.

Volatility: The price jumps and fluctuation in demand deter widespread adoption.

Criminal use: Virtual currencies’ anonymity means they have found favour in the criminal world, another likely deterrent to widespread adoption.

Legitimacy: Regulators and law enforcement agencies continue to agonise over virtual currencies. Innovations will always present these challenges. Good (and internationally coherent) regulation will help this market develop. The advantages are too important to simply ban it.

The success of virtual currencies will be determined by market confidence and ubiquity. These issues can be addressed and, if they are, then we will be well on our way.  There is huge potential if this market can be developed successfully.

The author is partner at Olswang

The views expressed here are of the author, and e27 may not necessarily subscribe to them

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