What are virtual currencies?

Virtual currencies are digital currency or electronic money. They do not physically exist as coins or notes. Many digital currencies (also called crypto currencies) started in online gaming communities or on social media.

Although they can be used as a form of payment if another person is willing to accept them, they are not legal tender. The value of virtual currency can fluctuate significantly, they may not be accepted in many places and they are not guaranteed by any bank or government.

How do virtual currencies work?

Users can 'earn' or create virtual currency. For example, in the Bitcoin network, users (known as Bitcoin Miners) can participate by using computer-intensive software to validate transactions that have been made through the network and earn new bitcoins as a reward.

There are usually only a fixed number of virtual currency units available.

Virtual currencies can be bought or sold on an exchange platform using conventional money. Trading fees are charged and are usually based on the trade value. As virtual currencies have become more popular, new ways to buy and sell them have developed. For example, bitcoins can be bought or sold for cash through special ATMs.

Virtual currencies are kept in a digital wallet and can be used to pay for actual goods and services from any person willing to accept them as payment. Virtual currency payments are made online, however some merchants have facilities in place to accept virtual currency payments in store using mobile devices. Virtual currency networks generally have no or low transaction fees.

What are the risks?

If you want to buy, trade or invest in virtual currencies the risks include:

Virtual currencies have less safeguards

The exchange platforms on which you buy and sell virtual currencies are generally not regulated, which means that if the platform fails or is hacked, you are not protected and have no statutory recourse. Virtual currency failures in the past have made investors lose significant amounts of real money. Some countries are moving towards regulating virtual currencies, however virtual currencies are not recognised as legal tender.

Values fluctuate

The value of a virtual currency can fluctuate wildly. The value is largely based on its popularity at a given time which will be influenced by factors such as the number of people using the currency and the ease with which it can be traded or used.

Your money could be stolen

Just as your real wallet can be stolen by a thief, the contents of your digital wallet can be stolen by a computer hacker.

Your digital wallet has a public key and a private key, like a password or a PIN number. However, virtual currency systems allow users to remain relatively anonymous and there is no central data bank. If hackers steal your digital currency you have little hope of getting it back.

You also have no protection against unauthorised or incorrect debits from your digital wallet.

Popular with criminals

The relatively anonymous nature of virtual currencies makes them attractive to criminals who may use them for money laundering and other illegal activities.

Are virtual currencies taxed?

If the cost of your bitcoins is less than $10,000 and you are only using them to pay for personal goods or services, they are not taxed. However, according to the ATO, if you are using crypto-currencies such as bitcoins for other purposes, you will be taxed. Here is an outline of the ATO's proposed tax treatment of crypto-currencies:

• Investment - If you are holding bitcoins as an investment you will pay capital gains tax on any profits when you dispose of them
• Trading - If you are trading bitcoins for profit, the profits will form part of your assessable income
• Carrying on a business - If you are using bitcoins as payment for goods or services or accepting bitcoins as payment for goods or services, the transactions will be subject to GST
• Mining bitcoin - If you are mining bitcoins, any profits you make will be included in your assessable income
• Conducting an exchange - If you are buying and selling bitcoins as an exchange service you will pay income tax on the profits and transactions will be subject to GST

Where can I find out more?

A Senate Committee has completed an inquiry into digital currencies. The inquiry report, Digital currency - game changer or bit player, highlights the opportunities that these new technologies and payment methods are providing, but also acknowledges the risks.

If you decide to trade or use virtual currencies you may be taking on a lot of risk with no recourse if things go wrong.