Liberty Reserve is/was a [payment processor with its [URL="http://en.wikipedia.org/wiki/Digital_currency"]own form of digital currency](http://en.wikipedia.org/wiki/Payment_processor).
It has been shut down by the US government because of allegations of money laundering.
All of these digital currencies (and there are several--bitcoin is another you may have heard of) are extremely volatile, as they tend not backed by anything tangible, by central banks, or by any nations.
There's nothing illegal about the creation and use of digital currency--it's just that they aren't widely used or recognized. For example, many video games use the concept of digital currency--you buy in-game currency with real money, which then can be used in-game to make purchases within the game.
Digital currencies only start to become a problem when accounts and transfers become relatively anonymous, thus making the money pretty much untraceable and easily laundered.