Regulators Try to Get a Handle on Bitcoin

Regulators Try to Get a Handle on Bitcoin

 by Korey Clark

Although cryptocurrencies, most notably bitcoin, have been around for a few years, they've been of interest mainly to tech-savvy libertarians and investors with low aversion to risk. Few state lawmakers have devoted much attention to them. But that isn't likely to last with the presence of virtual currencies growing globally.
As a currency system, Bitcoin with a capital "B," came into existence in 2009 when a computer programmer known only by the pseudonym Satoshi Nakamoto released open-source software allowing the secure exchange of digital currency — bitcoins with a lower-case "b" — through the use of computerized encryption and decryption algorithms. According to a paper Nakamoto posted to a cryptography email list the year before, he wanted people to be able to exchange money securely without the need for a third party such as a bank or credit card company. 
Other programmers, responding to Nakamoto's open invitation, contributed their own code to Bitcoin, expanding its size, according to a presentation last month by David Andolfatto, Vice President of the Federal Reserve Bank of St. Louis, to 17 MB — roughly the equivalent of 500 phone books — and making it indecipherable to anyone without "a PhD in computer science, cryptography and game theory." 
But as described in MIT Technology Review, when a Bitcoin user downloads and runs the software, he or she is connected via the Internet to the global network of other Bitcoin users and a pair of unique mathematically linked keys is generated. One of those keys is private and the other is public. When a user initiates a transaction, Bitcoin performs a mathematical calculation combining the user's private key and the amount of bitcoins he or she wants to transfer with the other party's public key. The result of that calculation is sent out across the network where all other users who are online at the time verify the transaction. Some of them, known as "miners," then race to add the new transfer to a public ledger of all Bitcoin transactions called "the blockchain" by solving a cryptographic puzzle. Once one of them does so — and is rewarded for the effort with a certain number of newly minted bitcoins — the updated blockchain is passed along the network. 
Numerous other cryptocurrencies based on similar protocols have sprung up in recent years, including Ripple, Litecoin, Peercoin and Dogecoin. As of November 2013, there were more than 60 such currencies trading at online exchanges, according to a report by The Guardian. 
The idea of a currency free from manipulation by any government or central bank has been especially appealing to libertarians, who according to an online survey conducted last year by Lui Smyth, a University College London researcher, make up over 40 percent of Bitcoin users. So-called "techno-libertarians" — a population evidently concentrated in California's Silicon Valley — have also been drawn to the improbable story of a bunch of computer programmers remaking the global financial system, which Salon's Andrew Leonard said "felt like it was ripped from the pages of a classic cyberpunk science fiction novel." 
Bitcoin has also been very attractive to investors. Daniel Knowles of The Economist remarked on the BBC's Newsnight that Bitcoin was designed to be "a sort of virtual gold." (He also added: "that's why we should be skeptical of [it]," alluding to the fact that the United States and other industrialized countries moved away from the gold standard because it opened them up to inflation and deflation caused by rising and falling demand. The St. Louis Fed's Andolfatto, however, pointed out that you could never have a true shortage with bitcoins because even when "mining" of them ceases — which will happen once the number of bitcoins in circulation reaches 21 million — they will still be infinitely divisible.) 
Last year, speculative interest, particularly in China, helped drive the value of a single bitcoin from around $13 up to over $1,100 (before it plunged back down to around $500). The accompanying rise in demand also helped transform a relatively unknown Shanghai company called BTC China into the world's largest Bitcoin exchange, trading more than 100,000 bitcoins, $100 million worth, in a single day, Forbes reported earlier this year. 
U.S. investors have shown considerable interest as well. Late last year, the venture capital firm Andreessen Horowitz raised $25 million in funding for Coinbase, a San Francisco-based Bitcoin exchange and digital "wallet" service for storing as well as sending and receiving bitcoins. And the Winklevoss twins, Cameron and Tyler — best known for their claim of having come up with the idea for Facebook — amassed a Bitcoin portfolio valued at nearly $11 million a year ago. 
"We have elected to put our money and faith in a mathematical framework that is free of politics and human error," Tyler Winklevoss told The New York Times. 
Some national governments, however, haven't been as willing to put their faith in the cryptocurrency. In December of last year, the People's Bank of China, that nation's central bank, prohibited financial institutions from engaging in Bitcoin-related business. And this past February, Russia's Prosecutor General's Office released a statement declaring that according to Russian law, "the official currency of the Russian Federation is the ruble" and the use of "other monetary units and money substitutes is prohibited." 
One reason for such actions is simply that the countries view Bitcoin as a potential threat to their national currencies. The People's Bank, for instance, stated its action was taken "in order to avoid harm to the public and to the legal monetary status of the renminbi [a.k.a. the yuan] that might occur as a result of 'excessive speculation' in Bitcoin and other virtual goods," according to a post by Anita Ramasastry, a professor at the University of Washington School of Law, on the legal commentary website Verdict. 
Perhaps an even bigger reason for the bitcoin bans is the recent association of the virtual currency with criminal activity. Last year, agents with the Federal Bureau of Investigation shut down the Silk Road, an underground website that had offered illegal drugs, computer hacking services and even hit men, and that had conducted well over $1 billion in business since 2011, all of it in bitcoins. And in February, Mt. Gox, the world's second largest Bitcoin exchange, based in Tokyo, suspended trading, shut down its website and filed for bankruptcy, and its CEO, Mark Karpeles, revealed that 750,000 of Mt. Gox customers' bitcoins, worth nearly half a billion dollars, had disappeared. 
In spite of those high-profile incidents, the U.S. government hasn't sought to ban Bitcoin, although there does seem to be some difference of opinion about exactly how to deal with the cryptocurrency system. Last year the U.S. Treasury Department's Financial Crimes Enforcement Network, or FinCen, issued guidance stating that virtual currency exchanges would be considered money-transmitting business like Western Union and would consequently be required to collect information about their customers. But last month, the Internal Revenue Service issued guidance stating that bitcoins would be treated as property rather than currency for tax purposes, meaning capital gains would have to be tracked and reported on all bitcoin transactions, a potentially onerous requirement that would seem to make bitcoins far less attractive as a currency than as an investment. 
"People might just be tempted to hoard rather than spend, because as soon as they spend they would be liable to incur capital gains taxes," Pamir Gelenbe, a partner at the venture capital firm Hummingbird Ventures, which recently invested in the Bitcoin exchange Kraken, told The New York Times. 
U.S. Senate Homeland Security Committee Chairman Tom Carper (D-Delaware) may have summed up the federal governments' stance on the issue best in his remarks to The Times late last year. 
"Virtual currencies, perhaps most notably Bitcoin, have captured the imagination of some, struck fear among others and confused the heck out of many of us," he said. "Fundamental questions remain about what a virtual currency actually is, how it should be treated and what the future holds." 
At the state level, Illinois is considering a measure (HB 5886) declaring that virtual currencies don't have "legal tender status" in the state, according to the LexisNexis State Net legislative database. But the policy-making bellwether states of California and New York appear to be taking a less restrictive approach. 
California is currently considering a measure (AB 129) that would amend a section of its Corporations Code to clarify that the current prohibition against putting into circulation anything other than "the lawful money of the United States," doesn't prohibit anyone "from issuing or using an alternative currency that is redeemable for lawful money of the United States," which would certainly seem to apply to bitcoin. The bill has already passed the state's Assembly and is now in the Senate. 
Meanwhile, New York's top financial regulator, Superintendent of Financial Services Benjamin Lawsky, began accepting applications last month for "BitLicenses" from companies dealing with the virtual currency. 
"Our objective is to provide appropriate guardrails to protect consumers and root out money laundering — without stifling beneficial innovation," he said at a conference in Washington., D.C. 
Among other things Lawsky wants exchanges to be required to inform their customers that bitcoin values are extremely volatile and that they should carefully safeguard the keys to their digital wallets. 
"We've found in other areas of the financial world that strong, clear, concise disclosures are critical to earning the long-term trust and confidence of consumers," he said. 
Trust definitely appears to be an issue for Bitcoin. A recent Harris Interactive poll indicated that while 48 percent of Americans know what Bitcoin is, few trust it and actually the more they know about it the less trust they have. 
Many of the advocates for regulation seem to hold the view that the alternative of banning virtual currencies like bitcoin isn't really viable. As Jerry Brito pointed out in the December issue of the free-market Reason Foundation's monthly magazine, Reason, because of the decentralized nature of Bitcoin, there's no "company to subpoena, no headquarters to raid, not even a server to shut down." 
Another consideration likely to have crossed the minds of those pushing for regulation was one voiced by Jeremy Allaire, CEO of the virtual currency company Circle Internet Financial, at a hearing conducted last year by the U.S. Senate Committee on Homeland Security and Governmental Affairs. 
"We do not think that it is in anyone's best interest for digital currency to become an offshore industry or an industry dominated by China," he said. 
Whatever his motivations, New York's Lawsky had high hopes for the developing regulations. 
"If we get those rules right, perhaps we can make New York and the United States a magnet for legitimate, well-regarded exchanges and other virtual currency firms," he told CNN Money. 
Some virtual currency businesses seem open to that prospect. 
"We think California and New York will set the tone for everything else," Fred Ehrsam, chief executive of Coinbase, told Bloomberg in January. "When that tone is established, we're ready to hand in licensing applications immediately." 
Libertarians, however, aren't likely to be as receptive to regulation. But as Peter J. Henning, a professor at Wayne State University Law School and co-author of Securities Crimes (2d edition) wrote for The New York Times in February, "The idea that Bitcoin could be an alternative to traditional money that would allow users to conduct transactions anonymously beyond the pale of intrusive government regulators has proved to be little more than a pipe dream." 
Henning said the current regulations governing virtual currency exchanges "may not be enough to satisfy law enforcement's desire to keep criminals from creating a new avenue for transferring value across borders." He added that Bitcoin's volatility is also "an invitation to unscrupulous dealers and merchants to overcharge or underpay." 
And he concluded his piece by stating: "The days of anonymous transactions in Bitcoin and operating an exchange with no outside interference are over. As virtual currencies develop, firms devoted to aiding trading, and perhaps even their users, will encounter greater government regulation, along with the costs that come with compliance."

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