One of the most intriguing developments in financial instruments in recent years has been the rise of Bitcoin. It already has a history that sounds like legend: the virtual currency was tied to the online underground marketplace the Silk Road, it was dubbed the "wild west" of financial products by the Consumer Financial Protection Bureau, and even has its own pirate known as Dread Pirate Roberts, who was indicted earlier this year for his actions in connection with the Silk Road.
Bitcoin poses serious risks for investors as shown by comments made by the bewildered posters on a Bitcoin forum as Mt. Gox collapsed and filed bankruptcy earlier this year. But Bitcoin also promises a simpler, cheaper, more private way to transact online, and advocates argue that Bitcoin can be a democracy and economy builder around the globe.
This Top Ten will cover the top questions and issues regarding Bitcoin, from Bitcoin's beginning, how it is acquired, federal and state regulators' opinions on Bitcoin and other issues involving this trendy virtual currency.
1. What is Bitcoin?
First, what is Bitcoin? Bitcoin has been defined as a peer-to-peer financial transaction network and protocol. It is a virtual currency, and was first mentioned in a white paper in 2008 by someone or a group of people using the name Satoshi Nakamoto. Nakamoto's identity has sparked worldwide interest, but the creator of Bitcoin remains a mystery. Its main advocacy group, the Bitcoin Foundation, lobbies for policies favorable to Bitcoin.
Bitcoin is referred to as cryptocurrency because of the way it is produced. After users' computers solve highly difficult math problems in competitions, the users are rewarded with bitcoins. A finite number of bitcoins exist — roughly 21 million bitcoins may be mined by 2040, at which point bitcoins can no longer be mined. As of today, over 13 million bitcoins are in existence.
No central government backs or controls Bitcoin, which makes it a decentralized virtual currency that is attractive to many users. Bitcoins only exist in virtual marketplaces and virtual wallets of Bitcoin users; bitcoins cannot be stored in banks. Unlike with funds deposited in a U.S. bank that come with the backing of the Federal Deposit Insurance Corporation, Bitcoin users usually have no recourse if their wallet is hacked or stolen.
Bitcoin users can use bitcoins as payment with any person or retailer that accepts bitcoin. According to BitcoinStore.com, over 100,000 retailers now accept bitcoin including well known companies like Overstock.com and Expedia. Along with Bitcoin, other examples of virtual currencies include Bitstamp, Kraken and Coinbase.
2. Mining for Bitcoins and other ways to acquire the currency.
Bitcoins get into circulation after someone dedicates their computer (or networked computers) to mining for bitcoin by solving a complex mathematical problem. Like the gold miners of the Gold Rush, bitcoin miners take on the task of mining bitcoin. And like the Gold Rush, as bitcoin miners solve the easiest problems, bitcoins become harder to obtain as greater amounts of computing power are required to solve the problems. The last bitcoin will be mined in 2040.
Bitcoin transactions are tracked on a public ledger called a block chain, showing time-stamped transactions as the bitcoin is moved from one IP address to the next. Once bitcoins enter circulation, they may take wild and circuitous journeys through underground exchanges and in payment for goods or services rendered on online marketplaces like the Silk Road. Bitcoin can be obtained by receiving it as payment for goods or services, by transferring between users, or by buying bitcoin on an online exchange. Because they can be exchanged for paper fiat, bitcoins are considered a convertible currency.
3. It's the "wild west" of financial products.
Director Richard Cordray of the Consumer Financial Protection Bureau recently eviscerated Bitcoin claiming that "consumers are stepping into the Wild West when they engage in the market." The agency also issued a consumer advisory on Bitcoin warning investors of potential for huge losses. Bitcoin's lack of fraud protection and irreversibility of transactions are frequently cited as the most dangerous elements of Bitcoin for consumers.
Hacking threats also loom large for Bitcoin users as their bitcoins are not guaranteed to be protected against loss, and many virtual currency companies have provided very little help in previous Bitcoin wallet hacks. Bitcoins have also been used in the commission of hacks, threatened hacks, or extortion as a way to maintain the hacker's anonymity.
The solvency and longevity of virtual currency exchanges also raises flags. Mount Gox, a Bitcoin virtual exchange, filed for bankruptcy late last year after losing about $650 million in bitcoins. Investors who held their bitcoins with Mount Gox are trying to claw back their holdings in the bankruptcy proceeding, but without much leverage.
By virtue of the anonymity that the Bitcoin network offers users, bitcoins have become a favored currency for drug traffickers and others pursuing illegal activity. Recently, regulators and law enforcement have criminally charged principals of virtual exchanges who they allege have knowingly allowed exchange users to buy and sell bitcoins to others engaged in illegal activity. A Bitcoin promoter and a virtual currency exchange operator recently pleaded guilty on separate charges involving a conspiracy to sell bitcoins to users of the Silk Road, an online marketplace frequently used for illegal drug trafficking.
And Ross Ulbricht, also known as "Dread Pirate Roberts," was indicted in federal court early this year as the owner and operator of the Silk Road. Ulbricht is alleged to have built the Silk Road on the Tor network, a special network designed to hide the IP addresses of computers on the network. He also incorporated a Bitcoin payment system for the Silk Road, which allowed users to conceal their identities during transactions. He is scheduled to be tried in November 2014.
4. Counterpoint: Bitcoin makes transactions easy, private and cheaper.
With all the splashy headlines on illicit underground marketplaces, dread pirates, and drug trafficking, Bitcoin's positive attributes can get lost behind the headlines.
One advantage is no credit card or foreign transaction fees to exchange Bitcoin, resulting in real savings for individuals and businesses alike. Second, Bitcoin users don't need a bank account or credit card, removing a barrier for the unbanked and those lacking good credit. Users also do not need to disclose private information such as credit card numbers, which allows for greater privacy and data security among users. Finally, though transactions and identities are encrypted, Bitcoin transactions can be confirmed by smartphone or computer using the Bitcoin system.
With barriers to entry costing no more than a smartphone, no or low costs for transactions, and privacy paramount among users, Bitcoin offers a convenient, mobile payment option for merchants and consumers.
5. Another counterpoint: Bitcoin can be a democracy and economy builder.
Advocates also argue that Bitcoin can support budding democracies, businesses and economies. David Cohen, undersecretary of Terrorism and Financial Intelligence, spoke of the "promises and pitfalls of virtual currency," including Bitcoin in March 2014. He acknowledged the viewpoint of Bitcoin advocates that Bitcoin and other virtual currencies have the potential to "empower users, lower transaction costs, increase access to capital, and bring financial services to many unbanked individuals all around the world." The undersecretary also noted the innovative value of virtual currencies as a tool for entrepreneurs and businesses.
Bitcoin transactions provide for the anonymity that democratic agitators in oppressive regimes need to fund democratic activities or to donate to controversial charitable organizations. And for unbanked individuals and small businesses, the ability to transact without a bank account or credit card and with low or no transaction fees increases the flow of commerce. Bitcoin is especially useful in the context of micropayments (typically defined as payments less than $1 USD), which can aid small entrepreneurs to grow their businesses without to pay fees to a third party.
6. Bitcoin for wages?
Might employers pay their employees' wages in bitcoins in the near future? Undoubtably, Bitcoin enthusiasts may soon be asking their general counsel this question. In a recent Q&A on Thomson Reuters' Corporate Counsel blog, David Prather commented on this question.
Prather noted that the federal Fair Labor Standards Act (FLSA) is the guiding standard for employee compensation, which requires employers to pay a minimum weekly standard wage. While meals and lodging or fair market value of facilities may be considered part of a wage under certain circumstances, the FLSA does not currently permit other forms of payment or currency to be considered as part of the minimum weekly wage. Second, state laws frequently have similar minimum pay and currency requirements.
But the question of whether bitcoins may be paid out for wages beyond the minimum weekly standard wage is still unanswered. Employers and employees may soon have the opportunity to consider Bitcoin as a payment option.
7. What does the I.R.S. have to say about Bitcoin?
This year, the Internal Revenue Services released guidance, Notice 2014-21, that treats bitcoins as property with all the corresponding federal tax implications. Public comments on the guidance ranged from the incredulous to the practical.
From a compensation standpoint, employees who are paid with bitcoins are subject to federal income tax withholding and payroll taxes. Employers must also report income paid in bitcoins. Similarly, Bitcoin payments to independent contractors and other service providers are taxable and self-employment tax rules apply.
8. Federal regulators and Bitcoin
Along with the I.R.S. guidance and the DOJ's pursuit of Silk Road actors, other federal agencies have taken steps to define and regulate Bitcoin. Among the first was the U.S. Treasury's Financial Crimes Enforcement Network (FinCEN) in March 2013. FinCEN's guidance advised that virtual currency exchanges would be considered "money transmitters" with record-keeping and recording obligations as required by existing anti-money laundering regulations. And exchanges that allowed users to buy or sell bitcoins in exchange for real currency would be required to file as money services businesses. Since then, FinCEN has issued more clarifying guidance on Bitcoin and has pursued enforcement action for failure to comply with its regulations in at least one case.
The Securities and Exchange Commission has also taken a corner on Bitcoin in a ruling that any investment in securities in the United States is subject to the SEC's regulation regardless of whether the investment is in U.S. dollars or virtual currency. To that end, the SEC has exercised jurisdiction in a Bitcoin Ponzi scheme. FINRA has also issued an investor alert on the "significant risks" of Bitcoin investments.
But Bitcoin also got a shot in the arm from the Commodity Futures Trading Commission in September. The CFTC approved the first derivative that allows a Bitcoin user to lock in a dollar value on their bitcoin, which provides some protection against the pendulous price swings that have been associated with Bitcoin. The swap is tied to the Tera Bitcoin Price Index, launched by Tera Exchange, with information from six different virtual currency exchanges.
9. State regulators and Bitcoin
Several states have considered regulating Bitcoin under state money transmitter laws. The New York Department of Financial Services indicated that it would begin requiring "bit licenses" for virtual currency operators serving customers in the state. California's money transmitter laws require that operators making domestic and international money transfers to be licensed, and the California Assembly recently passed legislation legalizing the use of virtual currency in all transactions occurring in California.
Other states like North Carolina have indicated that Bitcoin and other virtual currencies already fit within the ambit of existing money transmitting laws, and those states have aimed to clarify guidance on existing law rather than pass new legislation aimed specifically at virtual currencies.
10. Bitcoin as a global currency?
Outside of the U.S., Bitcoin has had tepid reception as countries around the globe consider whether to permit and how to govern virtual currencies. The United States and China account for about two in three Bitcoin transactions around the world. But China banned financial institutions and payment companies from dealing in bitcoins in December 2013, causing the currency's value to plummet. Chinese citizens are still permitted to buy and sell bitcoins.
About a week after China's ban, the Reserve Bank of India warned investors on the risks of Bitcoin investment, resulting in several online exchanges in India suspending operations.
Meanwhile in Russia, the Prosecutor General banned use of any monetary substitute for the ruble, but the Bank of Russia recently stated that along with the central government, the central bank was studying Bitcoin and might reconsider the ban.
UK authorities have given the cold shoulder with the Bank of England warning that a take-off in Bitcoin's popularity could jeopardize the financial stability of the U.K's banking system. Brazil and Australia have also decided to tax the capital gains on bitcoins, and Australia and New Zealand's central banks issued investment advisories on the significant risks of Bitcoin.
Could employees be paid in Bitcoin instead of U.S. dollars someday? Could bitcoins be a hedge for gold or stocks? While central banking and tax authorities have begun to consider Bitcoin regulation, it remains to be seen whether Bitcoin will grow from its shadowy beginnings to a respectable and reliable financial instrument in the marketplace.
Reprinted with permission from the Association of Corporate Counsel 2014 All Rights Reserved