10/11/2014 08:47 am ET Updated Dec 11, 2014

Follow the Money

When writing last week's article, Where Did That Money Come From?, a banker called my attention to "Bitcoin," a virtual currency introduced in 2009. An informal survey I took indicated that few people know very much about "virtual" currencies. So this week I decided to do a brief sketch of the historical development of the U.S. monetary system, hitting the highlights of what most of us have known and perhaps become a little foggy about, concluding in more detail with the development of virtual money. Acknowledging that I am not a currency historian, after extensive research I am using layman's terminology to explain things as I understand them.

The value of a country's currency is basically dependent upon the country's integrity and having the assets necessary to pay its debt and back up its currency. This was a real problem for early Americans prior to, and for several years following, the Revolutionary War.

It is quite understandable that foreign governments had no confidence in the paper money of a people waging war for their independence against England and later in the initial stages of forming their own government. The currencies of foreign governments, especially Spain and France, became the legal tender in the newly-born United States of America. And here is where we begin our historical sketch of the monetary system currently used in the U.S.A.

In 1789, after the U.S. Constitution was adopted, the U.S. Congress authorized the issuance of paper money backed by what assets we had as a new country. Three years later, Congress authorized the creation of the U.S. Mint in Philadelphia, and a year later we began minting our own coins.

In 1861, to help finance the Civil War, Congress authorized the Treasury to issue paper money for the first time in the form of non-bearing Demand Notes. A year later Demand Notes were replaced by United States Notes, paper money popularly called "greenbacks." In 1865, Congress authorized the Treasury to issue Gold Certificates that were backed by gold reserves. In 1866, National Bank notes were issued and became the predominant paper money. In 1878, Silver Certificates were issued, initially redeemable in the same face value as silver dollar coins and later in raw silver bullion. And in 1913, the Federal Reserve System was created to regulate the flow of money and credit.

The next major revision was the Gold Reserve Act of 1934. It outlawed most private possession of gold, forcing individuals to sell their gold to the Treasury, after which it was stored in our country's bullion depository at Fort Knox, Kentucky. There were exemptions for jewelry manufactures, dentists, artists, coin collectors, and the possession by individuals of personal jewelry.

The design of paper money changed many times in order to deter counterfeiting. The last silver dollars were minted in 1957. In 1965, the U.S. introduced layered composition coins made of a copper core, laminated between outer services of copper strengthened by other metals such as iron and manganese, and the silver content of dimes and quarters was totally eliminated. Kennedy half dollars contained some silver until 1971, when the half dollar's composition was changed to match that of the clad dimes and quarters. Also in 1971, issuance of United States Notes ("greenbacks") was halted after one hundred years. Greenbacks were replaced by Federal Reserve Notes, the paper currency used in the United States today. In 1975 it became legal again for Americans to own and trade gold.

Today, like the currency of most nations, the U.S. dollar is primarily backed by the integrity of the United States Government. Holders of Federal Reserve Notes cannot demand asset such as gold or silver from the government in exchange for the notes.

This brings us to the modern era of virtual currencies.

Virtual money exists on software programs and is accessed via computers, smart phones, tablets, or any device that connects with the Internet. Virtual money does not exist in physical form, but is an electronic money that is visualized in one's mind.

Bitcoin, introduced in 2009, is the major form of virtual or software currency. Bitcoin is the world's most widely used virtual payment system with a total market cap of approximately $5.3 billion. Bitcoin is a decentralized network made up of thousands of computers run by individuals worldwide.

Bitcoin is an electronic payment system, with one's supply of bitcoins stored in a "digital wallet," also existing on a user's computer. The wallet is a kind of virtual bank account that allows users to send or receive bitcoins, making it possible to pay for goods, store money, or send bitcoins to another person's or company's virtual wallet. Unlike real bank accounts, bitcoin wallets are not insured by the FDIC. Computers are always susceptible to hackers or computer crashes, making it possible to lose your wallet to thieves or mechanical breakdown. There are several online wallet services available that are more secure, the most popular one being Coinbase. But no computers, regardless of their safeguards, are completely safe. Several marketplaces, called "bitcoin exchanges," allow people to buy or sell bitcoins using different currencies--that is real money from about any country.

Bitcoins are created by people using computers to solve complex math puzzles, which is called "mining." The winner of a different math puzzle is rewarded about every ten minutes with a specified number of bitcoins. Winners may be an individual or a group of people working together. Growth of the bitcoin supply is predefined by Bitcoin Protocol. Two months ago, there were about thirteen million bitcoins in circulation. Litecoin and Ripple are newer systems of virtual money, but lag far behind the capitalization of Bitcoin.

Time will tell if virtual currencies are a fad or will become of major importance. In The New York Times (October 7, 2014, page B3,) Sydney Ember wrote: "In developed countries, virtual money is still largely the plaything of technology enthusiasts and speculators." However, some merchants are already accepting payment of goods by bitcoins.

With the rapid growth and use of electronic communication, virtual currencies may just become a major player in the world's monetary systems!