When you buy a cup of coffee, you might pay in cash, with your debit or credit card, or even by scanning a code on your phone. All these transactions, even those that are entirely digital—no bills or coins change hands—are based on fiat currency.

Fiat currency

A fiat currencysuch as dollars, euros, pounds, or yen—is a trusted medium of exchange, or legal tender, that is issued by a recognized government or authority. U.S. dollars, for example, are backed by the “full faith and credit” of the United States government.

Fiat currency works through a system of intermediaries, typically banks. When you write a check or use your credit card, the amount you authorize is debited from your bank account. That same amount is credited to the account of the person receiving the check or the merchant from whom you made the purchase. The transaction is processed and reconciled by the banks, which provide both the buyer and seller with a record of the transaction.

There is no finite supply of a fiat currency. A government can increase the amount of currency in circulation simply by issuing more units of that currency. If things go haywire, the currency becomes essentially worthless, as it did in Zimbabwe in 2015, when a hundred-trillion dollar note was worth about 40 U.S. cents. But this situation rarely occurs, and most governments have procedures and policies in place to guard against runaway inflation.

Virtual currency

Like fiat currency, virtual currencies such as Bitcoin and Ether, are intended as a medium of exchange that enables two parties to transact business. But aside from this common purpose, there’s a world of difference between them.

Introduced in 2009 by an individual or group known as Satoshi Nakamoto (who may or may not actually exist), Bitcoin was designed to be “an electronic payment system based on cryptographic proof instead of trust, allowing any two willing parties to transact directly with each other without the need for a trusted third party."No physical coins or bills. Virtual currencies exist only in computer code. Except for visual representation of Bitcoin and altcoins in advertising and displays, and coin-like tokens that may be produced for marketing purposes, there are no actual coins or bills.

Not Legal Tender. Virtual currencies are not legal tender and are not issued or backed by a government. However, many virtual currencies, which are called convertible virtual currencies can be redeemed for fiat currency on a number of exchanges.

No Regulation. Virtual currencies are not regulated by any government agency or authority. However, regulation is being considered, especially where virtual currencies are traded on exchanges or used as a security to raise capital, functioning like stocks.

No Consumer Protections. There are no protections for consumers or investors using virtual currency, and no mechanism for appealing transactions. For example, once a virtual currency transaction is completed, there is no reversing it. It can’t be challenged like an incorrect credit card charge or an unauthorized ATM withdrawal.

To facilitate transactions, bitcoins can be divided into miniscule units. For example, there are units as tiny as a millionth of bitcoin, or even a hundred-millionth of a bitcoin, which is called a satoshi after the inventor. No intermediaries. Unlike fiat, virtual currency transactions are conducted directly between two parties, on a peer-to-peer basis, often using a decentralized computer network that involves no banks or other intermediaries. Trust in the system is based on digital proof, or the ability of all users to access a permanent record of all the transactions that have taken place.

Limited supply. Typically, there is a limited supply of virtual currency. In the case of Bitcoin, for example, the mathematical formula used to generate bitcoins gradually reduces the number of new bitcoins that are produced over time. The predictable rate suggests a cap of 21 million bitcoins, which would be reached by 2140.