Making Cents of Bitcoin

Hilary Tuttle


May 1, 2014

bitcoinOn Feb. 24, one of the biggest bitcoin exchanges, Japan-based Mt. Gox, suddenly went offline after highly public technical glitches allowed irreversible overpayments. CEO Mark Karpeles disappeared, reemerging four days later as the company filed for bankruptcy protection in Japan, confirming rumors that the exchange had lost almost 750,000 of customers' bitcoins and approximately 100,000 of its own. This figure represents 7% of all bitcoins in circulation, totaling more than $470 million.

Within a week, another "bitcoin bank," Flexcoin, was forced to close after hackers stole 896 bitcoin, worth over $590,000. Lacking the resources to recover from the loss, the site closed immediately. Smaller firm Poloniex also acknowledged a hack the same day. While 12.3% of its reserves were stolen, the company committed to operating at a fractional reserve until it makes up the losses, and the owner even pledged personal funds to help speed the process.

A Currency on the Rise
Three-quarters of Americans are unfamiliar with bitcoin, according to a study by TheStreet and research firm GfK, and almost 80% said they would not consider using it. Yet, in the six years since its introduction, the digital currency has grown exponentially, both in terms of value and marketshare. Total market capacity has reached about $10.4 billion, CoinDesk reports, which puts it on a level with smaller currency markets like the Hungarian forint. Not bad for the relatively recent invention of technophiles and libertarians.

Bitcoin is a peer-to-peer digital currency that is sent and stored in digital wallet software. It is earned in exchange for ordinary goods and services or "mined" by individuals who dedicate vast amounts of their own computer power to complete complex calculations that help monitor transactions throughout the market. In exchange, they earn a small portion of transaction fees or freshly minted bitcoins.

Public and press interest led a range of companies, from to Tesla Motors, to begin accepting the currency for commercial transactions. Lower transaction costs than traditional credit cards and banks increase the currency's appeal to ordinary consumers. Its meteoric rise in value has also drawn the attention of hedge funds and private investors, who have begun to purchase or mine for personal use. This is also advancing a cottage industry that seeks to build more powerful computers to complete the complex mathematical problems that earn bitcoins.

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In the past year, a flurry of speculation led to tremendous price volatility. Technical glitches in the online marketplaces that trade bitcoin have created further uncertainty among prospective investors. In March 2013, a single bitcoin was worth about $30. By December, that figure had increased 3,900% to just over $1,200, then plummeted to about $550 by the beginning of March 2014. Prices also experience wild fluctuation both during the day and across different markets.

But the traits that made bitcoin grow have also inhibited its reach. Identified by unique number keys made anonymous through cryptography, each bitcoin is tracked in the marketplace. Users are not, however, allowing for anonymity that appeals to both privacy advocates and criminal enterprises. After its introduction in 2009, bitcoin quickly became a key currency for the online black market, offering international value without ties to any government's regulatory system or formal taxing authority. In October, when the FBI shut down the Deep Web drug market Silk Road, which used the digital currency exclusively, it seized 114,000 bitcoins worth $28.5 million.

"Without stronger government oversight in this area I believe we are going to be permitting cybercriminals, identity thieves and even traffickers of child pornography and other criminal actors to operate in what would be a digital Wild West," said Cyrus R. Vance, Jr., district attorney of New York County.

Ties to criminal enterprise further obfuscate the path for investors under current law. As Peter Coy pointed out in Bloomberg Businessweek, the currency suffers from a problem of nemo dat quod non habet, Latin for an old principle of English common law that "no one gives what he does not have." Those who earn bitcoin for illegal transactions cannot legitimately give them to others because they never rightfully owned them. Thus, federal authorities can seize bitcoins directly involved in crime. Even bitcoins that have been run through digital "tumblers" to erase their ownership history have been successfully traced later. According to technology strategist Alex Daily, government seizures are rapidly altering the currency's landscape. "The FBI already owns 5% to 10% of them, which are now out of circulation," he told Businessweek.

Banning Bitcoin
Concerned by price volatility and criminal associations, some nations have already banned bitcoin. This year, China, Canada, France and Russia all declared bitcoin illegal, and their national banks have issued explicit warnings about the inherent risk of investing in it.

Under Russian law, for example, the ruble is the sole official currency, and introducing any other monetary unit or substitute is illegal. "Systems for anonymous payments and cybercurrencies that have gained considerable circulation-including the most well-known, bitcoin-are money substitutes and cannot be used by individuals or legal entities," the Russian Prosecutor General's Office said in February. In addition to the instability that accompanies such speculative trade, it warned, "citizens and legal entities risk being drawn-even unintentionally-into illegal activity, including laundering of money obtained through crime, as well as financing terrorism."

While making purchases with bitcoin is not illegal in all countries, many have mandated that their official local notes are the only ones that should be recognized in business transactions. China banned financial institutions and payments companies from handling virtual currencies, triggering a worldwide price crash with concerns about the future of the cryptocurrency's biggest market. But individuals remain free to trade the currency at their own risk, Chinese authorities said.

Virtual Regulation
Some countries have opted to try to regulate the virtual currency market rather than prohibit it altogether. Although the country does not recognize bitcoin as legal tender, the Monetary Authority of Singapore (MAS) announced plans in March to require intermediaries that facilitate digital currency exchange to verify customers' identities and report suspicious transactions. The rules do not mention the "safety and soundness" of the businesses involved, however, and MAS previously cautioned citizens about the potential risks of virtual currencies. Rather, the new measures are meant to address potential money laundering and terrorist financing, making it only the second country after the United States to attempt to regulate virtual currency exchanges.

In March 2013, the United States extended traditional financial regulation measures to curb illicit use of bitcoin. The Financial Crimes Enforcement Network issued guidance stating that anyone operating an exchange for virtual currencies would be considered to be running a money transmitting business. That designation requires exchanges to collect information about customers, as mandated under Bank Secrecy Act regulations intended to prevent transactions through anonymous accounts. District Attorney Vance suggested that virtual currency exchanges may someday be required to perform "enhanced due diligence" to establish users' identities and prevent fraud. FinCen went a step further than the Bank Secrecy Act to include anyone who puts into circulation a virtual currency. Thus, bitcoin miners are also subject to its regulations, though individuals mining for personal use are exempt.

The IRS announced plans in March to tax bitcoin as income or property, not as a currency. "General tax principles that apply to property transactions apply to transactions using virtual currency," it said in a statement. This guidance helps miners determine their tax burden-a potential disincentive to some-and clarifies that anyone cashing out will be subject to capital gains taxes. It does not, however, help regulate the market or the purchasing process for those using bitcoin as currency.

At the local level, no state has officially deemed virtual currency exchanges and companies as transmitters of money, so these exchanges have not been required to obtain state licenses, though they have had to register as money service businesses under federal guidelines. According to New York Department of Financial Services Superintendent Benjamin Lawsky, his state may be the first to establish a process to issue "BitLicenses." He has already convened hundreds of meetings and public hearings with bitcoin advocates and financial experts, and announced plans to release a regulatory framework later in 2014.

While those who cherish bitcoin for its libertarian nature resist regulatory efforts, many digital currency advocates have joined the call for oversight. Jonathon Johnson, executive vice chairman of of the first major retailers to accept bitcoin-said that he welcomes guidelines to help businesses clarify ambiguous policies from states and the IRS. Proponents, ranging from the Winklevoss twins of Facebook fame to payment processors, agreed that official policies would facilitate easier digital currency adoption, spell out taxation requirements and encourage greater consumer confidence.

The benefits of an official position may extend to the states and the financial market as a whole. "The single most important thing that we can do is to get some serious exchanges established here in New York that are focused on being mature trading platforms," said Jeremy Allaire, founder and CEO of digital currency company Circle Internet Financial. "Rather than having the market maker and liquidity provider for bitcoin be a 14-person company in Slovenia, have it be a well-financed and capable platform that is both closer to the oversight of New York and federal bodies."

Regulators must tread lightly, however, as rigorous interference could cause innovative companies to stay away, especially since all of the major bitcoin exchanges are currently located abroad. Nevertheless, regulation would not only impose some stability, but also bring in new business and tax revenue.

"Serious people in the technological and investment community are taking virtual currencies seriously," Lawsky said. "They are putting significant amounts of time, attention and capital behind them. We, as a regulator, cannot turn a blind eye to something like that. We don't really have a choice."

Hilary Tuttle is managing editor of Risk Management.