Virtual currency companies have sprung up around the world in the last two years. Designed as an alternative to current payment systems, digital currencies, such as Bitcoin, XRP, and Dogecoin, are a way for people to track, store, and send payments over the Internet. While these virtual currencies have tremendous benefits, they also have obvious and hidden risks. To understand the risks, it is helpful to first understand what virtual currency is and how it operates in the digital world.
The idea of a virtual currency dates back to a concept called "cryptocurrency," which was first described in 1998 by Wei Dai on the cypherpunks mailing list. It was an idea of a new form of money that uses cryptography to control its creation and transactions, rather than a central authority such as the Federal Reserve Bank in the United States. Thus, as opposed to paper money, which relies upon a central authority or middlemen, virtual currencies like Bitcoin use a consensus network that enables a decentralized peer-to-peer payment network that is powered by its users. This network is not owned by any one person, much like no one owns email.
From a user perspective, virtual currency is similar to a mobile app or computer program that provides a personal wallet and allows a user to send and receive monetary denominations (e.g., Bitcoins). Behind the scenes, the network shares a public ledger that contains every transaction ever processed, allowing a user's computer to verify the validity of each transaction. The authenticity of each transaction is protected by digital signatures based on mathematics corresponding to the sending addresses, allowing all users to have full control over sending the virtual currency from their own addresses. In addition, anyone can process transactions using specialized hardware.
Virtual currencies have several important features that set them apart from normal fiat currencies.
- Payment freedom. It is possible to send and receive any amount of money instantly anywhere in the world at any time. No bank holidays or imposed limits. No borders.
- Easy to set up and use. Conventional banks make you jump through hoops just to open a bank account, whereas one can set up a digital address or wallet in seconds.
- Low fees. Many digital currency payments are processed with either no fees or extremely small fees.
- Fewer risks for merchants. Digital currency transactions are secure, irreversible, and do not contain customers’ sensitive or personal information. This protects merchants from losses caused by fraud or fraudulent chargebacks, and there is no need for PCI (Payment Card Industry) compliance.
- Potentially better security and control. Digital currency users are in full control of their transactions; it is impossible for merchants to force on them unwanted or unnoticed charges as can happen with traditional payment methods (but see concerns about hacking and scams below).
- Transparency and neutrality. Information concerning the money supply itself is readily available on the block chain for anybody to verify and use in real-time. No individual or organization can control or manipulate the protocol because it is cryptographically secure.
- Low inflation risk. One big problem with fiat currencies is inflation. Over time, all fiat currencies lose purchasing power because the issuing governments keep printing more of it each year. Digital currencies do not have this problem because the system is designed to be finite. For example, only about 21 million Bitcoins will ever be released (mined).
- Low collapse risk. Fiat currencies depend on the backing of the issuing government, which history has shown can fail occasionally. Remember how Greece’s recent debt default nearly collapsed the Euro? Or that the Mexican peso crisis (also known as the Tequila crisis) was sparked by the Mexican government's sudden devaluation of the peso against the U.S. dollar in December 1994? Such events either cause hyperinflation or a complete collapse of a currency, which can wipe out the savings of a lifetime in day.
These features and others have no doubt helped to fuel the explosion of virtual currency into mainstream America. For example, total Bitcoins in circulation has gone from 50 Bitcoins in January 2009 to over 13 million by September 2014. The number of Bitcoin transactions per day has gone from roughly 100 in 2009 to over 80,000 transactions per day in September 2014. The number of wallet users for Bitcoin had climbed from a single user in January 2009 to nearly 2.5 million by September 2014. The number of wallet transactions per day for Bitcoin has climbed rapidly from zero in January 2009 to nearly 40,000 transactions per day at present.
Students at Georgia Tech University in Atlanta, Georgia, will no longer need to stop by the ATM to pay for snacks and drinks when heading to a football game. The school recently reached a deal to become the first college program to use Bitcoin for concessions sales. The school announced in early October its agreement with BitPay, a Bitcoin-processing company, which allows fans to purchase concessions in the student section at Bobby Dodd Stadium using Bitcoin. Students on campus will also be able to use Bitcoin for dining and shopping on campus.
Earlier in 2014, the Sacramento Kings became the first professional sports franchise to accept Bitcoin. Fans are now able to buy gear at the team store and pay for tickets using the digital currency. In fact, the owners of the Sacramento Kings envision the acceptance of Bitcoin as a step closer to allowing their patrons to leave their wallets at home, thanks to what will eventually be a ticketless and cashless environment at the arena on game days.
Bitcoin and similar virtual currencies can now be exchanged for paper currencies or used at a growing number of participating online vendors. Dell, the well-known global computer manufacturer, accepts Bitcoin for purchases made from Dell.com. After selecting their product and filling in the shipment details, customers just need to select Bitcoin from amongst the various payment options. Similarly, Overstock.com, a major online retail destination, allows shoppers to pay using Bitcoin for the full array of its offerings. The company’s Bitcoin sales were reported to be over $2 million (1 percent of total sales) after eight months of launching its Bitcoin platform.
Expedia, Amazon, Home Depot, and 1-800 Flowers.com all also accept Bitcoin as a mode of online payment. Expedia recently started accepting Bitcoin for reservations of hotel bookings. Expedia reportedly plans to expand the payment system using Bitcoin to other segments of its business, such as airline reservations. DISH Network also allows its satellite customers to pay for their service using Bitcoin.
A number of brick-and-mortar retailers, such as Lord & Taylor and REEDS Jewelers, are also accepting virtual currencies. While spending options among traditional shops are far fewer than modern e-commerce companies, all retailers will likely follow the trend of accepting Bitcoin in the future. The acceptance of virtual currencies is rising across the board.
However, despite this movement towards acceptance, there remain several risks associated with using virtual currencies. First and foremost, virtual currencies are not backed by any government or central bank. Therefore, if a digital currency company fails – as many have – the government will not cover the loss.
In fact, the Consumer Financial Protection Bureau (“CFPB”) recently issued a consumer advisory warning consumers about the risks of virtual currencies such as Bitcoin. The potential risks include the threat of hacking and scams, volatile exchange rates, unclear costs, and the risk that companies offering virtual currencies may not offer help or refunds for lost or stolen funds.
The CFPB also announced that consumers who encounter problems with a virtual currency may now submit a complaint with the Bureau. Text of the complete virtual currencies consumer advisory is available here.
When dealing with a virtual currency company, consumers should carefully consider the following:
- Beware of the threat of hackers and scammers. Virtual currencies are targets for sophisticated hackers and scammers. For example, if a hacker gains access to a consumer’s Bitcoin “private keys,” which are 64-character codes that unlock the consumer’s funds, the consumer can lose all of his virtual currency. The CFPB warns that scammers have taken advantage of the hype surrounding virtual currencies to pose as Bitcoin exchanges or traders to lure consumers into sending money, which is then stolen. Most recently, a federal court forced a Kansas company, called Butterfly Labs, to cease selling computers that were marketed as able to produce Bitcoin on the grounds that the company failed to deliver its technology in a timely or effective manner. The company’s failures cost consumers tens of millions of dollars. According to the Federal Trade Commission, Butterfly Labs sold thousands of so-called BitForce computers, beginning in 2012. Customers were required to pay in full and up front for the computers, which ranged in cost from a few hundred dollars to nearly $30,000. However, more than 20,000 consumers never received their purchased computers.
- Beware of exactly who you are dealing with. The CFPB warns that some virtual currency companies do not identify their owners, provide phone numbers or addresses, or even specify the country in which they are located. Therefore, before using a company’s products or services, consumers should carefully consider whether they will be able to contact the company in the event of a problem.
- Carefully review your contractual rights because companies may not offer refunds for lost or stolen funds. Consumers should carefully review the contractual rights with the virtual currency company. Some virtual currency companies contractually disclaim any responsibility for consumer losses if funds are stolen or lost, leaving the consumer without any recourse.
- Beware of volatile exchange rates and costs. The exchange rates of Bitcoins to U.S. dollars in 2013 fell as much as 61 percent in a single day. In 2014, the value of Bitcoins dropped by as much as 80 percent in a single day. The CFPB warns that consumers who buy virtual currencies should be prepared to weather this kind of volatility. Consumers should also consider whether there are markups or other fees when using an exchange. Companies may charge consumers to buy, spend, or accept virtual currencies.
- Understand the degree of acceptance. While digital currencies are becoming more widely accepted, most businesses and people do not accept them as a means of payment. Unless we see wider acceptance, digital currencies will not benefit from network effects, i.e., the effect that one user of a good or service has on the value of that product to other people. Social networks like FaceBook have benefitted from the network effect because the more people use it, the more valuable it becomes to the user.
Published November 17, 2014.
