Bitcoin, in search of a legal status

By Karuna Mintaka Kumar, Columnist

“Bitcoin is not the only digital currency, nor the only successful one. Gamers on Second Life, a virtual world, pay with Linden Dollars; customers of Tencent, a Chinese internet giant, deal in QQ Coins; and Facebook sells Credits. What makes Bitcoin different is that, unlike other online (and offline) currencies, it is neither created nor administered by a single authority such as a central bank”, The Economist recorded in its report on Mining Digital Gold, on 13th April earlier this year.

Bitcoin is a virtual currency used as a form of payment with a decentralized system and without a central issuer. Neither does it require the endorsement of any authority to open an account or make a transaction, nor does any authority have the power to confiscate Bitcoins or prevent users from transacting. A peer-to-peer computer network made up of users’ machines, similar to a file-sharing system and the audio-visual chat service, Skype underpins it. The computers mathematically generate the virtual currency through a procedure called mining, a number crunching task that makes it progressively difficult to mine Bitcoins over time and limits the total number that can be mined in a day to around 21 million. It is set up to sort of simulate gold, which is similarly limited in quantity and increasingly scarce. This in a gist, explains the fundamentals of Bitcoin.

After starting in 2010, Bitcoin has earned several advocates by 2013. Michael Sivy, a Chartered Financial Analyst and a former securities analyst for an independent stock research firm noted in his column, The real significance of the Bitcoin Boom and Bust, for Time, “The scale of the recent boom-and-bust has been staggering indeed. At the start of the year, a Bitcoin was worth $13.51. Earlier this week, it traded as high as $266. And on Thursday, it plummeted to less than $100, as one of the exchanges where Bitcoins are traded closed temporarily. This would be comparable to the exchange rate for the British pound soaring from $1.62 (where it was on Jan. 1) to $31.90 and then falling back to $12.”

The creation and transactions of Bitcoin are controlled by a concept called crypto-currency that standardizes, protects and promotes the use of Bitcoin money. The Bitcoin Foundation further elaborates, “As a non-political online money, Bitcoin is backed exclusively by code. This means that— ultimately—it is only as good as its software design. … Cryptography is the key to Bitcoin’s success. It’s the reason that no one can double spend, counterfeit or steal Bitcoins. If Bitcoin is to be a viable money for both current users and future adopters, we need to maintain, improve and legally protect the integrity of the protocol.”

The departure from central banks and monetary authorities makes Bitcoin an interesting option for those who fear the aggressive expansionary policies of the central bank. In an interview with The Telegraph in the UK, Warren Buffett condemned Bernanke’s monetary policy and pointed out that those who parked their money in cash equivalents or short term US Treasuries had missed the party over the last nine months as Wall Street rocketed to all-time highs. “It’s brutal. I don’t know what I would do if I were in that position”, he told Ambrose Evans-Pritchard, International Business Editor at The Telegraph.

Weak support for the central bank’s position on monetary policy through the ongoing financial crisis has lead to increased demand for gold and other ‘safe havens’ and a fertile ground for “virtual gold” to take root. “Bitcoin, rather than fixing the value of the virtual currency in terms of those green pieces of paper, fixes the total quantity of cyber currency instead, and lets its dollar value float. In effect, Bitcoin has created its own private gold standard world, in which the money supply is fixed rather than subject to increase via the printing press”, Paul Krugman, Economist and Professor at Princeton, noted in his column, Golden Cyberfetters. Of course, unlike gold, which has a natural limit, Bitcoin ultimately follows rules set by humans it would seem.

The payment system in Bitcoin involves reallocating a coin in the various registers from the payer to the payee. Each user has an electronic wallet and a key pair that does not require identification by any national regulator or financial institution. It is attractive for those that prefer anonymity whether for political reasons or for criminal activities. Just like cash, except its electronic.

Among the less-attractive features of Bitcoin is that transfers in the Bitcoin system are irrevocable and the wallet and key pair is the only way to access Bitcoins. If the key pair is lost, the coins are inaccessible and are lost. While the Bitcoin transaction is free, the users pay to acquire Bitcoins either from an intermediary or through a market. There might be a commission involved or a fee to complete the transaction.

Bitcoin also does not support any central registers to record the transactions. Instead, there are a series of records, synchronized across a peer-to-peer network, of the entire history of Bitcoin transactions that can be used to check which wallet and key pair a given coin was last transferred. A large number of copies of the register are kept across the network and this proves helpful since there is little incentive or gain for any particular register keeper to falsify the record. In addition, creating a false competing record of equal or longer detail than the others can be mathematically very difficult. However, an inherent risk is that the number and quality of record keeping nodes are likely to diminish over time since the voluntary register keepers will get tired of the effort involved and for-profit nodes will become uneconomic as the mining of coins becomes harder.

The wiki page on Bitcoin suggests that the protocols and rules underlying Bitcoin are public domain. Security is not based on secret codes and protocols or private networks but a distributed system that makes fraud difficult and uneconomic. However, it also accepts that a flaw in the protocols may be discovered at a future time allowing for additional coins to be created or the transaction record to be surreptitiously altered.

Currently several questions around the legality of Bitcoins, or at least how they are being used, are being raised.

Circulatory property rights sits on top of the list. Unlike other forms of intangible private property, Bitcoins are not recognized by any international treaty or domestic legislation. This undermines its legal status. Additionally, there is not a clear issuer or party responsible for creating, distributing and honoring Bitcoins. The Bitcoin Foundation oversees this, where a loose collection of individuals operate the system. Unlike most payment systems, the participants are not bound by a set of central rules.

“At their core, most payment facilities rely on contracts to set out the rights and responsibilities of each party. Legislation, common law and industry codes also have some impact. That is, the contracts do not set out exhaustively the rights and responsibilities of each party. Alan Tyree, at the University of Sydney, Faculty of Law, elaborates on the ambiguity of the participants’ roles and responsibilities.

Besides cash, currently most payment facilities operate on the basis of accounts kept by trusted intermediaries. There are however differences in the character of more centralized payment facilities like cheque accounts and less centralized facilities like anonymous smart cards. Different regulatory and policy issues are also likely to arise with different payment systems. Bitcoin is a decentralized account based payment system without an issuer or central counterparty that involves the circulation of valuable rights transferred irrevocably by electronic order.

Regulatory issues embracing Bitcoin range from financial services regulation and banking regulation to currency regulation and legal tender. The United States has a complex and fragmented legal framework and regulatory structure governing payment services. Article 4A of the Uniform Commercial Code, adopted by most US states, regulates various issues of non-cash payments, the revocability of payments and the rights and obligations of funds transfer. The Official Commentary on Article 4A however also states that it is deliberately limited to funds transfers through the banking system and excludes payments via remittance dealers and other arrangements. This implies that is does not include virtual currencies like Bitcoin.

The US Treasury Financial Crimes Enforcement Unit (FinCEN), in its Application of FinCEN’s Regulations to Persons Administering, Exchanging, or Using Virtual Currencies, suggests that persons carrying on a business of brokering Bitcoins or running an organized exchange will be regulated as financial services firms, but not the user.

Bitcoin participants may not require licensing under the US banking regimes but taking deposits and making loans denominated in Bitcoin currency will call the attention of US regulators. Another compelling point of contention in the regulatory space around Bitcoins is that they are not legal tender and are unlikely to be so in the short-medium term.

Several aspects of Bitcoin stand in question and its long term viability is debatable but it has proved the concept of a decentralized non-issued electronic currency and has given reason to believe that virtual currencies could have a future. At present, the commercial and contractual laws that apply to financial intermediaries and market operators will apply to participants of Bitcoin.

Ryhs Bollen, Senior Associate at RMIT University, Australia, in his paper, Best practice in the regulation of non-cash payment services, argues that a well designed and proportionate legal and regulatory regime will support user confidence in, and therefore growth of, innovative payment systems such as virtual currencies. Supporting Bollen, Supriya Singh, Faculty at RMIT University, in her research, Designing for Money across Borders, puts it articulately, “There is nothing inherent in a piece of paper, a plastic card or electronic information that converts it into money. Money is money only when it is trusted that it will be honoured in your networks of use and exchange. Creating and protecting trust therefore becomes a crucial issue in the regulation of payment services.”


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