United States: Bitcoin: The Virtual Currency Market Emerges

Bitcoin is a "virtual" currency that was developed in 2008 and has gained increased acceptance as a form of payment and as a recognized asset in currency exchange markets, as reflected by the granting in 2013 of "XBT" as its ISO currency code. Alternative virtual currencies also have been established, but none has approached the popularity of bitcoin.

The founder (or, perhaps, founders) of bitcoin used the pseudonym of "Satoshi Nakamoto" and remains unknown, although certain news sources recently claimed to have identified him. However, this founder was present on bitcoin blogs for some time, where he articulated that bitcoin was intended to be immune from the possibility of corruption by governments, central banks and other third parties because such entities would not be empowered to directly affect the issuance or exchange of the currency. Instead, as further described below, bitcoin is a decentralized, peer-to-peer digital-payments system. The Bitcoin Foundation, an advocacy group, "standardizes, protects and promotes" the use of bitcoin. It has been primarily funded by grants from for-profit companies that depend on bitcoin, such as CoinLab (an investor in new technologies and business in the bitcoin marketplace), Mt. Gox (formerly a bitcoin exchange based in Tokyo) and BitInstant (formerly a means to rapidly pay traditional funds to bitcoin exchanges). The latter two companies are now defunct.

Similar to traditional currencies, bitcoin is accepted by an increasing number of merchants and others. For example, Overstock.com began accepting bitcoin on January 9, 2014 and expects bitcoin sales to reach between $10 million and $15 million this year. Also, similar to traditional currencies, bitcoin may be traded in the currency markets; the current USD/XBT exchange rate is approximately 0.0017. Significantly, spikes in that exchange rate sometimes have coincided with insecurity about traditional currencies. For example, when the Cypriot government announced in March 2013 that citizens would be assessed a 6.75% tax on bank deposits in response to the banking crisis, the value of bitcoin rose abruptly and substantially; it has been suggested that this spike was caused, at least in part, by citizens of other struggling nations desperate for safekeeping of their savings.

There are currently some 12 million bitcoins in (virtual) circulation, worth over US$7.2 billion. Through the use of "public key cryptography," each bitcoin user is assigned a private key and a public key (also known as a "bitcoin address"). When a user transfers bitcoins to another user's virtual "wallet," a transaction message is created that contains both users' public keys but is "signed" using the transferring user's private key. The transaction, including the two public keys, is recorded in a "block chain," which is publicly viewable. Because the public keys are not tied to anyone's identity, however, the block chain allows for a certain degree of anonymity. Meanwhile, the use of private keys, of course, helps protect against theft and fraud.

A process known as "mining" causes both bitcoins to be generated and transactions to be validated. Generally, a peer-to-peer network of some twenty thousand independent nodes—i.e., very powerful and expensive computer systems—act as virtual "miners," competing to find sequences of data (referred to as "blocks") within a complex mathematical problem. As noted above, all transactions in bitcoin are publicly viewable in a universal ledger called the block chain; a transaction can be added to the block chain only if a miner certifies it by including a block (again, a sequence of data that has been found in the complex mathematical problem). Thus, every ten minutes, miners attempt to use their blocks to add recently-broadcast proposed transactions to the block chain for a reward consisting of a certain number of bitcoins as well as an additional transaction fee. Authentication by the miners is critical to the legitimacy and integrity of the system and, among other things, prevents double-spending of the same bitcoin.

Since bitcoin's development, computer systems with ever-increasing power have been engaged in mining, as the more powerful systems are better equipped to be the first to solve the mathematical problem and, of course, win the bitcoins reward. As bitcoins are mined, the difficulty of the math problem is increased while the amount of the reward is reduced.

Unlike typical currencies, bitcoin is completely independent of any national or trading block central bank or system, such as the Federal Reserve System in the United States or the European Central Bank. This means that, among other things, bitcoins are not "printed" or generated by a government or central bank and they are not directly impacted by the actions of such an entity (for example, a decision to print more currency). As the Financial Crimes Enforcement Network of the United States Treasury Department ("FinCen") has stated: "In contrast to real currency, 'virtual' currency is a medium of exchange that operates like a currency in some environments, but does not have all the attributes of real currency. In particular, virtual currency does not have legal tender status in any jurisdiction."1

Nevertheless, global financial regulators have begun implementing measures that are intended to curb the use of virtual currency for money laundering and other criminal activities and, to some extent, regulate the virtual currency market. For example, in March 2013, FinCen issued guidance clarifying that "the definition of a money transmitter does not differentiate between real currencies and convertible virtual currencies. Accepting and transmitting anything of value that substitutes for currency makes a person a money transmitter under the regulations implementing the [Bank Secrecy Act]."2 In addition, in May 2013, the Government Accountability Office published a report to the U.S. Senate Finance Committee stating that income earned by trading virtual currencies is taxable.3 More recently, the CFTC announced in March 2014 that it is studying whether it should use its anti-manipulation authority to regulate virtual currencies such as bitcoin, and also whether derivatives contracts based on bitcoin should come under regulation. In her testimony before the Senate Banking Committee on February 27, U.S. Federal Reserve Chair Janet Yellen added: "The Fed does not have authority with respect to Bitcoin . . . but certainly it would be appropriate for Congress to ask questions about what the right legal structure would be for digital currencies."4 Moreover, Russian authorities recently issued warnings against using Bitcoin, stating that the virtual currency could be used for money laundering or financing terrorism and that treating it as a parallel currency is illegal.5 In December, the People's Bank of China decreed that merchants may not accept bitcoin and forbade banks and payment processors from converting bitcoin into yuan.6 Promptly thereafter the price of bitcoin fell below US$500 per bitcoin.

Further, on January 27, the Manhattan U.S. Attorney announced charges against the CEO of a bitcoin exchange company and a co-conspirator for engaging in a scheme to sell over $1 million in bitcoins to users of "Silk Road," an underground website that enabled users to buy and sell illegal drugs anonymously.7 On March 11, the New York State Department of Financial Services announced that it would begin considering proposals and applications for virtual currency exchanges based in New York and expected, by the end of the second quarter, to propose guidance on the regulation of virtual currencies.8

The maximum number of bitcoins is set at 21 million, with the final mining projected to occur in 2140. After the final bitcoin is mined, it is contemplated that the transaction fees described above will continue to motivate miners to verify transactions. The very limited supply of bitcoins is viewed by some as protection from inflation.

Bitcoin has experienced crises and bouts of high volatility during its brief existence. For example, in June 2011, hackers caused the price of bitcoin on Mt. Gox, then the most popular exchange, to nearly collapse within minutes. In recent weeks, Mt. Gox filed for bankruptcy after revealing that almost $500 million in bitcoins stored by the exchange had been stolen, apparently by hackers.

The financial community continues to debate the potential of bitcoin, with some questioning its sustainability and others suggesting it could have the potential not only to compete with traditional money-transfer services for remittances, but also to compete with gold as an asset for investors to store value. (Of course, unlike gold, the uses of which span jewelry, medicine and electronics, bitcoins are "virtual" and do not have alternative uses.)

Investments in bitcoin can be made in several ways, in addition to sourcing the bitcoins through mining. First, an investor could purchase bitcoins outright from one of several websites located globally. Such a purchase could have resulted in an enormous payoff for speculators in 2013, as bitcoin values began at around US$14 per bitcoin and reached a high in November 2013 of around US$980 per bitcoin.9 However, this wide differential also evidences the extreme volatility of bitcoin, at least at this stage of its existence.

In addition to direct purchases, in the future investors may gain exposure to the bitcoin asset class through public investment vehicles. For example, the Winklevoss Bitcoin Trust (Trust) has filed a registration statement (not yet effective) with the Securities and Exchange Commission to issue Winklevoss Bitcoin Shares (Shares), which will represent units of fractional undivided beneficial interest in and ownership of the Trust whose purpose is to hold bitcoins. Also, the Bitcoin Investment Trust by SecondMark is an open-ended private trust that invests only in bitcoin, but is not publicly traded. Moreover, Fortress Investment Group, Pantera Capital and two venture capital firms together are creating a fund for investments focused on virtual currencies, which will be known as Pantera Bitcoin Partners LLC.

Besides funds and ETFs, derivatives based on bitcoin are beginning to develop. For example, ICBIT, a bitcoin exchange based in Russia, has introduced a market in futures contracts on the USD/XBT rate. Predictious, an Ireland-based prediction market, offers an option spread market in bitcoin, where users may speculate that the price of bitcoin will be above or below certain thresholds at specified future dates. Using BTC.sx, a bitcoin trading platform based in Singapore and London, customers can short bitcoin and may use bitcoin to open leveraged positions, allowing them to profit from small market movements.

Footnotes

1. Financial Crimes Enforcement Network of the United States Treasury Department, Application of FinCEN's Regulations to Persons Administering, Exchanging, or Using Virtual Currencies, FIN-2013-G001 (March 18, 2013).

2. Id.

3. See Government Accountability Office, Report to the Committee on Finance, U.S. Senate, Virtual Economies and Currencies: Additional IRS Guidance Could Reduce Tax Compliance, GAO-13-516 (May 2013).

4. Semiannual Monetary Policy Report to the Congress: Hearing Before the S. Comm. on Banking, Housing, and Urban Affairs.

5. For example, according to Reuters, the Russian Prosecutor General's Office stated on February 6, 2014: "Systems for anonymous payments and cyber currencies that have gained considerable circulation – including the most well-known, Bitcoin – are money substitutes and cannot be used by individuals or legal entities." Russian Authorities Say Bitcoin Illegal, Reuters, February 9, 2014 (available at: http://www.reuters.com/article/2014/02/09/us-russia-bitcoin-idUSBREA1806620140209).

6. See, e.g., Gerry Mullany, China Restricts Banks' Use of Bitcoin, New York Times, December 5, 2013 (available at: http://www.nytimes.com/2013/12/06/business/international/china-bars-banks-from-using-bitcoin.html).

7. See Press Release, the United States District Attorney's Office, Southern District of New York, Manhattan U.S. Attorney Announces Charges Against Bitcoin Exchangers, Including CEO of Bitcoin Exchange Company, for Scheme to Sell and Launder Over $1 Million in Bitcoins Related to Silk Road Drug Trafficking, January 27, 2014 (available at: http://www.justice.gov/usao/nys/pressreleases/January14/SchremFaiellaChargesPR.php).

8. See, e.g., Saumya Vaishampayan, New York Opens Door to Regulated Bitcoin Exchanges, Marketwatch.com, March 11, 2014 (available at: http://www.marketwatch.com/story/ny-bitcoin-regulation-seen-by-end-of-2nd-quarter-2014-03-11).

9. As of the date of this publication, values are around US$615 per bitcoin.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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Authors
Nikiforos Mathews
Jonas Robison
 
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