Virtual currency is not new. It has been around since the early 2000s in virtual world websites like Second Life and online role-playing game sites like World of Warcraft, where virtual currency is “earned” by completing virtual quests. But neither Linden Dollars earned in Second Life nor Facebook credits earned on Farmville could be spent outside of their restricted virtual worlds, even though some could be exchanged for dollars (or other real world currencies) on third-party websites. The bitcoin is changing this landscape. Some hail it as “the next great step in Internet and global currency.” (Although “bitcoin” is capitalized by some writers; the author elects to treat the word generically and use the lower case throughout.)
Bitcoin started in 2008 with a self-published white paper by a group of computer geeks using the fictitious name “Satoshi Nakamoto.” A bitcoin is essentially just a snippet of code, based on an algorithm first identified in the Nakamoto white paper. In 2009, the Bitcoin Network was established and actual bitcoins were first issued and its evolution since has been swift. Practitioners in cyberspace or commercial finance law need at least a working knowledge of this digital currency which has no borders and is unregulated by any governmental authority or central bank.
A central purpose of bitcoin according to Nakamoto was to reduce transaction costs incurred when parties validate transactions and mediate disputes. To that end, the bitcoin system is based on open source computing. Bitcoin users cooperate to validate transactions either by running a program implementing the bitcoin protocol on an individual’s own computer or by creating an account on a bitcoin website to run the protocol. Although creators of bitcoins originally used them for Internet-related tasks, like trading bitcoin for programming help, the currency has gained increasing acceptance in broader contexts.
The early use of bitcoin in online drug markets and casinos gave it a somewhat tarnished reputation. But bitcoin increasingly is used in legitimate commerce. Thus, early this year, Coinbase, a bitcoin payment processor, reported selling $1 million in bitcoins in one month at more than $22 each. Later, venture capitalists began pouring millions into startups that focus on bitcoins. In July 2013, the Winklevoss twins (of Facebook fame), having formed an electronically traded fund called the “Winklevoss Bitcoin Trust,” filed with the U.S. Securities and Exchange Commission (SEC) to sell shares in the trust to the public.
Creating Bitcoins
Bitcoins are created by “mining.” Bitcoin miners engage in a set of prescribed complex mathematical calculations in order to add “blocks” to the “block chain,” which is a transactional database shared by all nodes participating in the bitcoin system. The full block chain contains every transaction ever executed in bitcoin, starting with the very first one which is called the “genesis block.” This allows determination of the value belonging to each address at any point in time. Miners who succeed in adding a block to the block chain automatically receive a fixed number of bitcoins as a reward for their effort.
Space does not permit a detailed description of the mining process, but in essence a miner maps an input data set (i.e., the block chain plus a block of the most recent Bitcoin Network transactions and an arbitrary number called a “nonce”) to a desired output data set of predetermined length (the “hash value”), using Nakamoto’s algorithm. The miner then “solves” a new block by repeating this computation with a different nonce until hash of a block’s header having a value not more than the current target set by the Bitcoin Network is generated. Because each unique block can only be solved and added to the block chain from one source, all individual miners and mining pools in the Bitcoin Network are competing. Such competition spurs them to constantly increase their computing power in order to improve their ability to solve for new blocks. A miner can only build onto a block (referencing it in blocks the miner creates) if it is the latest block in the longest “valid” chain. A chain is valid if (1) it starts with the genesis block and (2) all of the blocks and transactions within the chain are valid.
A proposed block is added to the block chain once a majority of the nodes on the Bitcoin Network confirms the miner’s work. In addition to new bitcoins, the successful miner receives any transaction fees paid by transferors whose transactions are recorded in the block. This process has been described as a “mathematical lottery,” where miners with greater processing power (i.e., ability to make more hash calculations per second) are more likely to succeed. Because the method for creating new bitcoins is mathematically controlled, the total bitcoin supply grows at a pre-set, limited rate. The fixed reward for solving a new block is currently 25 bitcoins per block, but will decrease to 12.5 bitcoins per block around the year 2017. The number of bitcoins in existence will never exceed 21 million, and bitcoins cannot be devalued through excessive production unless the Bitcoin Network’s source code and the underlying protocol for bitcoin issuance are changed.
The targets established by the Bitcoin Network constantly increase in difficulty, meaning that miners constantly need more expensive processing power to compete. Early on, a bitcoin could be bought for 25 cents on an exchange, and a miner with just a laptop’s CPU could make a handful of new bitcoins a day. Computers now are specially designed solely for bitcoin mining, and the newest rigs use an application-specific integrated circuit (ASIC) built specifically to execute the hash operation. This bitcoin “arms race” led to a 2013 venture funding of $200 million in the maker of high-end servers designed specifically for producing bitcoins, with the deal also including the maker of state-of-the-art microchips to power the hardware.
The current mining protocol makes it increasingly difficult to solve for new blocks as computer processing power dedicated to mining increases (in order to maintain a 10-minute per block average). Because the difficulty in finding valid hash values has grown exponentially since the first block was mined, one individual can no longer mine bitcoins successfully. Mining “pools” have formed, in which multiple miners combine their processing power. When pool members solve a new block, they allocate the reward according to the processing power each contributed to the solution. Such pools give participants access to smaller, but steadier and more frequent, bitcoin payouts. The Wall Street Journal reported on November 6, 2013, that the speed of bitcoin mining was now 40 times faster than in January 2013. It was estimated in August 2013 that about 11.5 million bitcoins were in existence, with the amount steadily increasing. Estimates are that 90 percent of the 21 million bitcoin limit will have been produced by 2020.
The Bitcoin Network is designed so as to decrease the reward for adding new blocks to the block chain over time. Ultimately, miners will need to be compensated in transaction fees in order to provide adequate incentives for miners. (However, as of publication of this article, transaction fees still accounted for but 1 percent of miners’ total revenues.)
Trading For Bitcoins
To buy or sell bitcoins, one must have Internet access to the Bitcoin Network, where such transactions are consummated within seconds. Double-spending of any single bitcoin is avoided by having the user give information on the transaction to the Bitcoin Network of the transaction, which uses the block chain to memorialize every bitcoin transaction.
A bitcoin trader first installs on a computer (or mobile device) a software program allowing the trader to generate a digital “wallet” for storing bitcoins. The wallet can either be stored in the trader’s own computer or hosted on a third-party website. The trader then connects to the Bitcoin Network and engages in the purchase, sale, and receipt of bitcoins. A trader can have an unlimited number of digital wallets, each with a unique address and verification system consisting of both a “public key” and a “private key.” Because the system relies upon peer-to-peer networking and cryptography, it is a distributed model resistant to central control. The private key, used to authorize bitcoin transactions, has no information about the user, although the transactions are traceable by means of the public key. The result is that the address of a bitcoin is traceable on an individual’s own computer, but ownership of each address remains anonymous.
One way to buy bitcoins is to identify someone willing to sell bitcoins, then offer to buy them with conventional currency. Once a price is set, the seller transfers the bitcoins to the buyer’s wallet. Another and more organized way is to use a bitcoin exchange. As with conventional currency exchanges, price is usually not individually negotiated, but instead based on the aggregate supply of and demand for bitcoins in the system. While using an exchange adds to the transaction cost, it is both more efficient and better monitored.
There are estimated to be approximately 12 currency exchanges around the world where consumers and businesses can trade bitcoins for local currency. Because the technology is open source, new services are created almost every week. Among the more active are Mt. Gox in Japan, BitBox and Bitstamp in the United States, and Bitcurex in Poland. Banks like Morgan Stanley and Goldman Sachs reportedly visit bitcoin exchanges up to 30 times a day. Bitcoin exchanges are not problem-free: Mt. Gox in Tokyo, the largest exchange, reported in 2013 that its services had been disabled for hours by an Internet “denial-of-service” attack. Mt. Gox said attackers wait until the price of bitcoins reaches a certain value, then sell, destabilize the exchange, wait for panic-selling to cause the bitcoin price to drop to a certain amount, then stop the attack and start buying as much as they can. Such volatility caused bitcoin to rise from roughly $5 in June 2012 to a high of $266 in April 2013, before dropping to $108 in May 2013.
Using Bitcoin in Day-to-Day Commerce
A retail customer can pay in bitcoin by using a smartphone to scan a barcode provided by the retailer. Retailers see an advantage in avoiding credit card fees that can run as high as 3 percent, compared to less than 1 percent for bitcoins. Moreover, bitcoin transactions are final, whereas credit card charges can be disputed. This kind of advantage helped BitPay, Inc., of Atlanta in 2012 sign up more than 8,000 merchants worldwide to accept bitcoins and to set what was then a new record for bitcoin payment processing, with orders and payments from 17 different countries such as Belgium, Russia, and Poland. Since bitcoin is a currency run by those who use it, a bitcoin’s value is determined by the marketplace; in other words, a bitcoin is worth whatever someone will take for it.
Venture Capital and Bitcoin
Startups focused on marketing bitcoin services have attracted increasing interest from venture capitalists. For example, in 2013, venture firms invested more than $2 million in OpenCoin, Inc., and $5 million in Coinbase, which operates an online service allowing users to buy and store bitcoin in a digital wallet and pay merchants for goods and services. Coinbase claimed some 116,000 members who had converted $15 million of real money into bitcoin, and dollar conversions increasing by about 15 percent a week. The San Francisco venture firm Kleiner Perkins Caufield & Byers reports that it is exploring bitcoin-related investments and has reviewed over two dozen companies.
Electronically-Traded Funds
As noted earlier, the Winklevoss twins filed a registration statement with the SEC in 2013 for their “Winklevoss Bitcoin Trust,” an ETF. The filing, which contains over 17 pages of “Risk Factors,” observes that (1) the value of bitcoins is determined by the supply of and demand for bitcoins in the bitcoin exchange market, as well as the number of merchants that accept them, and (2) bitcoins have little use in real-world retail and commercial markets compared with their “relatively large use by speculators.” Columnist Chuck Jaffe opined that the twins face a long, uphill battle just to get their fund to market, adding that “chances are good it will still be viewed for years as a granular, niche fund – more like one specializing in Bulgarian stocks than with mainstream applications.”
Regulatory Issues
Bitcoin faces a number of unresolved regulatory issues. They involve FinCEN, the U.S. Department of Justice, the SEC, and state regulators of money service businesses (MSBs). As mentioned earlier, FinCEN this year issued regulatory guidance classifying digital payment systems like bitcoin as “virtual currencies,” on the basis they are not legal tender under any sovereign jurisdiction. While opining that a user of virtual currency is not an MSB and hence not subject to federal MSB regulation, FinCEN went on to state that U.S. entities that generate “virtual currency” (including bitcoins) could be deemed MSBs if the virtual currency were sold for “real currency or its equivalent.” Thus, miners of bitcoin within the United States may need to register and comply with federal MSB regulations if they sell bitcoins for dollars. American Banker online has asserted that at least three U.S. bitcoin exchanges elected to shut down as a result of FinCEN’s guidance. FinCEN’s director stated that its guidance aims to protect digital currency systems from abuse and ensure that information is available to prosecute “criminal actions,” and is not aimed at everyday bitcoin users.
In May 2013, the Department of Homeland Security seized an account controlled by Mt. Gox on the theory that the Japanese exchange was operating as an unlicensed MSB. Mt. Gox subsequently registered with the U.S. Treasury as an MSB. The various regulatory issues surrounding bitcoin has prompted bitcoin enterprises to form a self-regulatory group called the “Committee for the Establishment of the Digital Asset Transfer Authority,” which intends to set technical standards aimed at preventing money-laundering and insuring compliance with laws.
Fifty states also have laws regulating MSBs. Several, including California and New York, have reportedly warned companies involved in bitcoin that they may be violating such laws. Indeed, the California Department of Financial Institution already has in its files a detailed letter from a law firm on behalf of the Bitcoin Foundation, arguing that California’s law, the Money Transmission Act, has no application to bitcoins.
Turning to securities laws, in July 2013, the SEC filed a civil action in federal court in Texas, charging an individual and his company with using a bitcoin-based Ponzi scheme to defraud investors. The SEC alleged that the founder and operator of Bitcoin Savings and Trust had offered and sold bitcoin-denominated investments through the Internet using the monikers “Pirate” and “pirateat40.” The company allegedly received 700,000 bitcoins from investors valued at more than $4.5 million, based on the average price of bitcoin when the investments were sold.
The SEC claims the company was a “sham” where bitcoins from new investors were used to pay interest of up to 7 percent per week to existing investors and also to cover investor withdrawals. The SEC further alleges that the founder diverted investors’ bitcoins to trade for his own account on a bitcoin exchange and to trade for dollars in order to pay personal expenses. Such acts are alleged to violate the anti-fraud and registration provisions of Sections 5(a), 5(c), and 17(a) of the Securities Act of 1933, Section 10(b) of the Securities Exchange Act of 1934, and SEC Rule 10b‑5.
Criminal Issues
Two federal criminal indictments in 2013 have somewhat tarnished the bitcoin image. An indictment of Liberty Reserve, S.A., a Costa Rican currency exchange, and seven of its executives by a grand jury, alleged that operators of the exchange used bitcoin to run a $6 billion money-laundering operation in violation of Section 311 of the USA PATRIOT Act and provided a central hub for criminals trafficking in everything from stolen identities to child pornography. Prosecutors asserted that Liberty Reserve’s trading in bitcoin provided the kind of anonymous and accessible banking infrastructure increasingly sought by criminal networks, which they said “heralds the arrival of the cyber age of money laundering.”
Finally, October 2013 saw the federal government indict and shut down the “Silk Road,” an online marketplace where millions of bitcoins allegedly were swapped for drugs and black market products. As news of the shutdown spread, bitcoin values tumbled, initially dropping by about 20 percent (or close to $500 million) before turning around. On the Bitstamp exchange, bitcoins dropped from about $125 to $90 before climbing back to $115. Values on the Mt. Gox exchange dropped from $140 to $109 before returning to $128. The government simultaneously arrested Ross William Ulbricht, who allegedly operated the Silk Road website using the alias “Dread Pirate Roberts,” and who now faces drug trafficking, money laundering, and hacking charges. The FBI filed an affidavit in the case which asserts that digital currency is not just used in the black market, but can serve criminal purposes because of the ease of moving money anonymously.
The Future . . .?
The economist Paul Krugman stated earlier this year that, unlike gold or paper fiat currencies, bitcoin derives its value solely from a self-fulfilling expectation that others will accept it as payment. Herb Jaffe cited a Morningstar analyst as having called the Winklevoss ETF “a total gimmick,” that bitcoins are very illiquid, and that the current trading infrastructure “is riddled with security/efficiency problems.” Others see bitcoin as a major development in virtual currency. Robin Harris on ZDNet asserts that bitcoin or something like it is not going away, observing that dollar/gold convertibility ended in 1971 and floating exchange rates have prevailed since. There are many areas where the future of bitcoin is yet to be developed: Is it an investment? How will transactions be taxed? What will be the effect of China’s recent entry into the bitcoin market? In 2014, we can expect some answers, but also many new questions.