Putting a value on virtual money

Virtual currencies may be flawed, but there will be a winner one day, says financial commentator Chris Skinner

With recent headlines of Liberty Reserve being closed down in a $6-billion money laundering scam and the spotlight on Bitcoin, you might think that virtual currencies are dead and buried. But you would be wrong. They’re alive and kicking.

The challenge is to work out which one to bet on. That’s the real issue because there are many virtual currencies out there being traded as real currencies.

Virtual currencies have been around for over a decade, but most disappear as fast as they appear. For example, in a flurry of activity a few years ago, Facebook introduced Facebook Credits and everyone believed this would be the biggest digital currency of the future.

However, Facebook found that people did not really understand and preferred using real money – dollars and pounds. Facebook have now reverted back to offering goods and services in exchange for traditional currencies.

Exchanging hard-earned money into some digital credit is the first barrier to adoption

It’s easy to see the problem virtual currencies face from the start: do people understand them?  Exchanging hard-earned money into some digital credit is the first barrier to adoption, which is why mainly geeks get these currencies.

The second challenge is how to mandate them. This was a challenge highlighted by Second Life, the virtual world that became a big deal in the late-2000s. Second Life had its own currency, the Linden dollar, which operated on the basis of one real US dollar was worth 275 virtual Linden dollars. You could use this currency to buy and sell virtual goods, and rapidly a multimillion dollar economy came to life as millions of users logged on.

Then the system imploded when the organisers of the virtual world banned gambling, which had become a major part of the economy. The gambling ban led to a run on the banks with hundreds of users asking to withdraw funds from their virtual bank accounts.

Unfortunately, the virtual banks turned out to be run by individuals who decided to just delete their accounts and, in so doing, the virtual banks were also deleted with thousands of real US dollars lost by those who had made deposits. This resulted in the virtual economy mandating that to be a bank in Second Life, you had to be a bank in real life with a real bank licence.

This is a core tenet of banking in the real or online world: there has to be some protection for the deposit holder. So it is all well and good exchanging real money to play in World of Warcraft (WoW) and accumulate WoW gold, but if there is no protection for your gold savings, then the investment you make in time and effort to accumulate such gold may become worthless.

Although this list is not exhaustive, another big challenge for virtual currencies is building critical mass. The many virtual currencies we have seen through the years have all failed for this reason. Back in the late-1990s, for example, a currency called Flooz emerged as the next big thing, only to fail as people stopped using it.

So when we ponder the continuing development of virtual currencies, a winner is likely to emerge in the not too distant future. Otherwise, why would there be so many attempts to build one? The question remains which will be the winner? Although, at present, Bitcoin is doing a pretty good job of proving itself the chosen one.

Author Chris Skinner is an independent commentator and chairman of the Financial Services Club, a European networking forum, which he founded in 2004.