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The rise of Bitcoin

Nov 11, 2013

It is commonly understood that a “real” currency is legal tender issued by a central bank. In contrast, a virtual currency does not have legal tender status and is not issued by a central bank but is accepted among the members of a particular virtual community as a digital form of payment.

These virtual currencies have received more and more attention in the press in recent months with the best known of them being Bitcoin.  In just the last two weeks, headlines have been written after the launch of the first Bitcoin ATM in Vancouver and also reports that one Norwegian man’s $27 investment in 2009 turned into a forgotten $886,000 windfall. However, the world’s “first decentralised digital currency,” attracts confusion and intrigue in equal measures, not least because it was launched in 2009 by an as yet unidentified individual using the pseudonym Satoshi Nakamoto.

Bitcoin is run by a computer network made up of its users’ machines with Bitcoins. The “coins” are a reward for users completing complex mathematical tasks in a process known as “mining.”  These exercises increase in difficulty as more and more Bitcoins are mined with the total number that can ever be mined limited to around 21m (It is predicted that this total will be reached in 2140). This maximum limit is designed to prevent the market being flooded with Bitcoins and explains why their value has increased so dramatically in recent years. With no central bank, there is no way for an issue of Bitcoins flooding the market and devalue those already in circulation.  However, with the advent of the ATM, users can now transfer up to a maximum of $1,000 a day to purchase Bitcoins.

The entire Bitcoin network is used to monitor and verify both the creation of new Bitcoins through mining, and any transfers of Bitcoins between users. A central log is maintained of all transactions, with every new transaction broadcast to Bitcoin users across the Bitcoin network. In essence, this means that there is an ongoing live feed similar to those seen on stock exchanges.

Bitcoins (or fractions of Bitcoins known as satoshis) can be bought and sold in return for traditional currency on several exchanges, and can also be directly transferred provided that users have the correct software. This makes Bitcoin a potentially attractive way in which to settle international transactions for it removes the need for bank charges or exchange rates. Indeed, some internet services already can be paid for via Bitcoin, such as online gambling.  Even Wikileaks will accept donations through this nascent currency.

However, there are several obvious problems with all this anonymity and opaque infrastructure.  There are widespread fears over Bitcoin’s use by criminals who may choose to money launder or pay for drugs using it rather than more traditional methods.  Recently, the FBI’s closure of the Silk Road website, dubbed “Amazon for Drugs” by some commentators, saw the value of Bitcoins drop dramatically though they have once again recovered. An additional problem is the sheer complexity of the currency and also the IT software required to getting hold of Bitcoins, notwithstanding the solitary ATM in Vancouver.  There are also several other legal issues arising from Bitcoin, particularly as the US seems keen to legislate to deal with this rapidly developing area.

Furthermore, there is the lex monitae principle which stipulates that that the units referred to in a monetary obligation contained in a contract are defined by the law of the issuing state of that currency. This is regardless of whether the contract is governed by that state’s law. In practice, this means that, the law of the issuing state determines what constitutes legal tender, and how, following a currency alteration, sums expressed in the former currency are converted. Therefore, the question parties to a Bitcoin transaction need to ask themselves is what the consequence of the monetary obligation are if the virtual currency ceases to exist or the basis of its definition outside the contract changes.

There is currently no legislation that specifically addresses virtual currencies and their accompanying risks, and a virtual currency may fall outside the scope of the present UK and EU regulatory regime for financial services. This may change in the future as appears (to some extent) to be starting to happen in the US.

It is perhaps not surprising that legislators are trying to keep pace with these virtual currencies due to the myriad of legal issues arising from their existence. It is likely that the US will get there first as some of the judicial rulings this year on Bitcoin have stated that it should be subject to anti-money laundering regulations.

The Department of Financial Services in the US is currently considering drawing up new guidelines specifically to address the virtual currency industry, which would include safety and soundness requirements for virtual currency businesses, requirements to ensure prompt processing of virtual currency transactions, steps to combat illegal activity associated with virtual currencies, and also ways to improve transparency and accountability in the industry in order to promote sustained and long-term investment. Some observers see this as a prelude to legislation that caters for Bitcoin and its imitators.

It is certainly the case that there have been many alternative forms of currency throughout history. One only needs to look at the bartering system but none has provided such a headache to legislators as Bitcoin. However, at the same time, it presents an exciting development in the world of IT companies with the potential for significant investment using Bitcoin or raising funds themselves from an alternative source through “mining” providing that you have the nous to crack the codes. Additionally, several companies have sprung up in recent months that specialise in mining or processing Bitcoins with one, Circle.Com, attracting £9million of investment.

Some have referred to Bitcoin as the new Napster or BitTorrent, things that seemed strange and unusual at the time but are now considered commonplace. However, Bitcoin has the major advantage of being legal over these websites and only time will tell what regulators have in mind for virtual currencies.