Digital currency, especially Bitcoin, picked up in popularity this year as the concept began garnering positive attention from payment players — but a series of negative incidents kept the skepticism alive as well.

"Digital currencies still have not been totally accepted by the payments space," says Jon Holmquist, head of marketing at Coinabul, a company that exchanges bitcoins for silver or gold. "The industry is a little hesitant to move off of the rails of the banking system and onto new unsteady currencies."

By early next year, Chris Larsen, founder of eLoan and Prosper, plans to launch a new digital currency that is more applicable than Bitcoin.

"We see the time has come for virtual currencies," Larsen says.

Banks already see opportunities to expand their services with digital currencies. Industry experts told banks to keep an eye on Bitcoin, a digital crypto-currency with many of the same properties as cash. Banks could process payments, provide escrow services, help customers exchange their money for bitcoins and facilitate international cash transactions.

After the Bitcoin market started gaining traction, other digital currencies came to the forefront, including Facebook Inc.'s digital currency, Facebook Credits. The credits, which Facebook is phasing out, are used to purchase digital items or upgrades in games played on the social networking site. Especially now that Facebook is switching to a payments system based on local currencies, the company could disintermediate banks for online payments.

The social network also opened its platform to third parties this year, creating an outbreak of virtual currencies and its own payment ecosystem. American Express Co. was one of the first payments players to take advantage of the growth in virtual currencies within Facebook. In a deal with Zynga, Amex made the process of activating its Serve digital wallet a goal within the popular Farmville game. Players can also use an attached prepaid card to earn rewards.

And there's no doubt that virtual currencies, such as Bitcoin, Facebook Credits and World of Warcraft gold, have captured an audience. Twenty-one percent of social network users have earned or purchased a virtual currency, according to research published in July by Javelin Strategy & Research. Eleven percent earned the virtual currency, 5% purchased it and 4% have both earned and purchased it, the report says.

This year was the first annual Bitcoin Friday, a play on Black Friday, where some 74 merchants offered online discounts on products when purchased with bitcoins.

But digital money's shine is fading.

Even in early 2012, merchants, such as hotel manager Jefferson Kim, said the digital currency was just too much of a hassle to use. And while the marketplace has gotten a bit less complicated with launches of companies that would easily transfer dollars to and from bitcoins, merchant adoption hasn't been remarkable.

Bitcoin has been a bit volatile, plus regulation and hacks have stunted the growth of digital currency businesses. One Bitcoin exchange, Tradehill, got caught in the regulatory crosshairs, suspending operations until it got a money transmitter license. Tradehill officially shut down in February.

A month later Tradehill claimed that by falsely advertising a no-chargeback policy, Dwolla Corp. was responsible for the exchange's demise. Tradehill sued Dwolla for $2 million, but the case was dismissed in May 2012. Bitfloor, the fourth largest exchange dealing in U.S. dollars, was hacked in September. The equivalent of about a quarter of a million dollars in bitcoins was stolen from users, but the exchange reopened shortly after the incident. Founder Roman Shtylman promised to reimburse customers.

Bitcoin's biggest challenges are often its own.

While the digital currency can perform the same functions as financial institutions and other financial companies, such as PayPal and Western Union, the network is riddled with complications most consumers won't want to deal with. Most notably, if bitcoins are stolen, they are usually untraceable and can't be returned.

Complex infrastructure is also impairing Bitcoin's growth. Consumers must research the currency on their own, find a reputable exchange and wallet and secure a funding method.

"The main thing holding bitcoin back from greater adoption is simplicity of applications and wallet management," says Jon Matonis, a payments industry veteran who evangelizes for Bitcoin on his blog, The Monetary Future. "Average users do not want to have to worry about so many various addresses and the online security/encryption/backups of their wallets."

Part of Bitcoin's challenge has been the negative connotation of much of the coverage the currency received by mainstream news outlets. A blackmailer, claiming to have Mitt and Ann Romney's tax records, demanded the equivalent of $1 million in bitcoins as ransom. In another instance, an online hedge fund called Bitcoin Savings and Trust turned out to be a Ponzi scheme.

"But each patch of rain was followed by a patch of sunshine, be it Wordpress accepting Bitcoin, Bitcoin-Central gaining a banking license and BitcoinStore.com opening and proving that Bitcoin transactions are cheaper," Holmquist says.

Matonis shares Holmquist's positive outlook.

"Remember, Bitcoin is only four years old now so what we have seen to date is extraordinary for a bootstrapped currency," Matonis says.

It is possible that Bitcoin and other digital currencies will eliminate the need for cash, coin and card among some consumers. At a recent Bitcoin Meetup, a New York event for Bitcoin enthusiasts, Eric Voorhees of BitInstant said he gets his whole paycheck in bitcoins.

In the last couple months of 2012, Bitcoin and other virtual currencies clawed their way out of the slump with a growing number of merchants and a move towards regulation. 

Like Bitcoin itself, the news about the currency fluctuates dramatically from day to day. While some industry analysts think anonymous digital currency is only for drug dealers and gamblers, more merchants are signing on to the experiment. WordPress announced it would accept bitcoins as a payment method in November. And Aqoba, a payment services provider, partnered with Bitcoin-Central in France to allow the exchange to function more like a bank, adding oversight by regulators.

 "The next year is going to be filled with partnerships, competition, and a constant struggle between convenience and security," Holmquist says. "A lot of growth was made in the development of infrastructure around decentralized digital currencies."

But while next year will likely bring more attention to digital currency, 2013 may also bring more regulation.

"Authorities worldwide will attempt to shoehorn Bitcoin and other digital currencies into the existing Anti Money Laundering/Know Your Customer regulatory framework without actually defining it as a currency," Matonis says.

"Digital currencies are still in relatively uncharted territory," he says. "Whether the regulation will be friendly or not is the big question."

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