Understanding the risks of virtual currencies
With the rapid development of the Internet and information technology, the use of virtual currencies such as bitcoins is increasingly gaining traction yet has also raised concerns from various sectors in the local and international community. Speculation on bitcoins or its usage as a medium of payment continues to hit the headlines, but consumers may not have good understanding about this virtual currency. One thing worth noting is that virtual currencies are not real currencies; converting, trading or holding virtual currencies may have high levels of risks.
Legal tender versus virtual currencies
As legal tender, they are by law regarded as valid and legal means of payment to adequately and effectively fulfil payment obligations. Notes and coins issued in accordance with the Legal Tender Notes Issue Ordinance and the Coinage Ordinance are legal tender in Hong Kong. The system regarding the issue of Hong Kong currency and the reserve fund system is also prescribed by law. In particular, all Hong Kong’s notes and coins are fully backed by US dollar reserves held in the Exchange Fund.
In contrast, virtual currencies eg bitcoins do not constitute legal tender and are generally used for private or online transactions. As pointed out in the blog of the Financial Secretary, the value of bitcoins is not backed by any physically items or supported by the issuers; and there is no guarantee of their convertibility into a legal tender or commodities in the real economy. Furthermore, the operation mechanism of bitcoins still remains a puzzle and the inventor of bitcoins has never come to light in public. As a virtual commodity, the nature and features of bitcoins are totally different from those of the legal tender.
Risk of losing money
The Bitcoin frenzy gave rise to various exchange platforms which tend to be set up and managed by private enterprises and unregulated. If these exchange platforms cease operation, collapse, or are hacked, consumers may face the possible risk of losing money held on these platforms. Consumers should also be aware that these exchange platforms are not banks; if these platforms fail, there is no specific measure in place to protect their deposits.
In addition, consumers should consider the security risks once they have purchased virtual currencies and stored them in a 'digital wallet' on the computer or smart phone. Typically, there is a public key and a private key or password for the digital wallet. If the private key or password is lost, the virtual currency holding may be lost forever.
Consumers should also note that holding or using virtual currency may have tax implications in some jurisdictions. For example, if bitcoin is bought or sold like a commodity, the resulting gains could be taxable income or capital for the taxpayers.
The price of virtual currencies including bitcoins is subject to significant fluctuations. Although there are some merchants who accept bitcoins for their services and products, bitcoins have not yet been widely accepted as a means of payment. These merchants are willing to accept bitcoins largely due to anticipated appreciation rather than solid economical consideration and benefits. If the value of this virtual currency drops sharply, merchants who currently accept it could stop accepting it at any time at their discretion. Consumer should take into account the fact that the price volatility of bitcoin could affect its stability in value if you consider buying this virtual currency as a means of payment.
Misuse for criminal activities
Although the transactions of virtual currencies may be made public, the identities of the trading parties are not. Since these transactions are largely untraceable, virtual currencies may be misused for criminal activities, including money laundering or other scams such as Ponzi Scheme. If deemed to be engaged in criminal activities, law enforcement agencies may decide to close relevant exchange platforms as necessary, and prohibit the access of funds that these platforms are holding for consumers.
Globally, the acceptance of bitcoins remains uncertain. Some jurisdictions have issued risk warnings on bitcoins which in turn has further increased the liquidity risk of this virtual currency. For example, the financial regulators from mainland China has recently issued risk warning which banned any bitcoin transactions by financial institutions and mentioned that bitcoins should not be widely used as currency.
Consumers should be cautious when deciding to use, convert, trade, invest in or hold virtual currencies. Without full knowledge of the features, operation mechanisms and risks, you are advised not to follow the herd and participate in speculation. If you are in doubt, please seek professional advice.