What’s the deal with Bitcoin?

By Robert L. Ellis

BitcoinsSo, what is the deal with Bitcoin? Is it really money? How does it work? How legal is it? If attorneys don’t start accepting it will they be left behind?

Bitcoin1 is the first and most prominent “decentralized online virtual currency.” According to the U.S. Treasury Department, a 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.”2 Almost anything can function as a virtual currency: beaver pelts, gift cards, frequent flier miles, credit cards, checks. Unlike other types of virtual currency, an online virtual currency has no physical form; all transactions must take place online.

Online virtual currencies are common. Transactions involving gift cards or frequent flier miles often must be done online. What makes Bitcoin so unusual is that its transactions are decentralized. There are two types of online virtual currency transactions: First, those that use a trusted central repository or clearinghouse system (everything prior to Bitcoin), and second, Bitcoin transactions, which function by using peer-to-peer transactional networks rather than any trusted central hub.

How does it work?
The threshold test for viability for any decentralized virtual currency is its ability to solve the “double-spending” problem: Making sure that if a person owns X amount of the currency and sends it to A, he or she cannot send the same X amount to B. Traditionally, double-spending has been precluded by either physical forms of cash or by centralized ledgers maintained by trusted third parties, usually banks. Bitcoin is the first currency to solve the double-spending problem without using either cash or a centralized trusted third party ledger. Instead, Bitcoin uses a decentralized ledger maintained on a multiple peer-to-peer basis. Every Bitcoin transaction that has ever occurred (but not the identity of parties to the transaction) has been recorded and is viewable online on the ledger, which is called the “block chain.”3 

Bitcoin is based on cryptography. The integrity of the block chain is achieved by using public-key cryptography (explained below) plus the fact that hundreds of copies of it are maintained—and all transactions validated—by multiple volunteers throughout the world. A Bitcoin transaction is not considered validated until it is has six independent verifications. These self-appointed volunteers, who provide computing resources that verify transactions and maintain copies of the block chain, are not acting out of altruistic fervor; rather, the Bitcoin protocol has a built-in “reward” function that compensates them by creating, and issuing to them, new bitcoins at a pre-defined rate. Because the work that such volunteers perform results in the creation of new currency, they like to call themselves “miners,” in an apparent attempt to characterize themselves in the same light as those who extract minerals from the earth. The difference, as the Chicago Fed has pointed out, is that unlike minerals, bitcoins have no intrinsic value. “Once created, the bitcoin has no value other than in exchange, contrary to a gold coin.”4 Not all volunteers are rewarded; only those who can verify the transaction and solve a complex computational problem (to prove they have sufficient computing resources to serve as transaction validators) more quickly than most others.5 The Bitcoin protocol presumes that computing power will increase, so the reward for being “first to verify and solve” is set to gradually reduce over time yet require increased computational effort. Once the reward becomes so low as to not be an incentive, the protocol substitutes transaction fees as the reward; indeed, this is already occurring.6  

The second test for viability of any decentralized currency is its ability to prevent counterfeiting. The Bitcoin protocol solves this issue by using decentralization to its advantage: Any bitcoin transfers from a sender to a recipient would have to be verified multiple times by independent volunteers chosen solely on the basis of “first to verify and solve.” Any attempt to insert unauthorized new currency into the system and falsely verify it would require computing power sufficient to overwhelm the independent verification of all other block chain administrators in the world, something that would be practically impossible.

Once a system is in place that meets these two tests, actual currency transactions are relatively straightforward. When a sender (S), wants to send a certain sum (e.g., 1.02335 bitcoins) to a receiver (R), the process is as follows:

  • Each user downloads software containing the Bitcoin cryptography protocol.
  • The software generates a public key/private key pair for that user. (The user can post his or her public key online. Anyone can use it to encrypt messages, which only the private key can decrypt.)
  • Next, the software generates a unique alphanumeric identifier, and encrypts it with the user’s public key. The result (a long alphanumeric string) is that user’s “Bitcoin address”the address to which anyone can send payments.
  • R posts his payment address online, probably using the same software he had downloaded.
  • Using her software, S generates a transactional instruction to pay 1.02335 bitcoins to R’s payment address. S’s software encrypts this instruction using her private key—meaning that anyone in the world will be able to use her public key to confirm that S and only S could have generated the instruction; i.e., it is genuine.
  • S clicks on “pay” and the software submits this payment instruction to the block chain, where, after several independent volunteer verifications (which take a few seconds), the payment is validated and the block chain is updated to show that S has 1.02335 fewer bitcoins and R has 1.02335 more bitcoins.
  • Each user’s software generates a transaction serial number called a transaction hash that is forever linked to the payment addresses of both users, so both users can look up all transactions they have ever conducted, as well as their current balance.

Why is Bitcoin so controversial?

Bitcoin offers some interesting advantages, but also has significant disadvantages.

On the plus side, Bitcoin transactions are fast and cheap. Unlike checks, credit cards, or wire transfers, online virtual currency transfers are instantaneous and processing fees are close to zero. International transfers do not require currency conversion. Because Bitcoin payments cannot be undone, customer charge-back fraud is not possible. Moreover, unlike credit cards, which use the same credit card number over and over for a particular cardholder, each Bitcoin transaction uses a unique encrypted number, eliminating the possibility of stolen credit-card fraud. Finally, all Bitcoin transactions are anonymous.

On the minus side, a virtual currency such as Bitcoin can be used to purchase real-world goods and services only to the extent that sellers who accept it are confident that they can convert it to an acceptable sum in legal tender currency. That confidence is virtually non-existent with Bitcoin because the currency has been extraordinarily unstable. Online merchants who accept Bitcoin often are unable to hold their prices for longer than 15 minutes; conversion rates valid for less than a minute are common.7 Any seller who does not immediately convert virtual currency received into legal tender currency (or barter it for other goods or services) becomes a speculator. The same applies to any buyer who maintains Bitcoin accounts. The Bitcoin world is dominated by speculators.

A second major disadvantage is storage insecurity. Although the Bitcoin protocol offers excellent transactional security by virtue of encryption and shared public ledgers, it offers very little storage security. There is no governmental entity to insure Bitcoin accounts, and their vulnerability to complete loss as a result of malware, password loss (no organization to contact to request a password reset), theft, fraud, or other failures has been widely noted.8 Once Bitcoin is gone, it is lost forever.

The third major disadvantage of Bitcoin is its lack of legitimacy. The very origins of Bitcoin9 are shrouded in mystery: It was created without any public discussion by a person or persons whose identity has never been revealed, leading some to conclude that is nothing more than a get-rich-quick scheme10 or a scam.11 It has been banned in several countries,12 and numerous others have issued warnings about its use. Apple has prohibited from its app store any apps for making virtual currency payments.

The fourth disadvantage of Bitcoina side effect of its anonymous transactionsis its association with criminality such as drug running, money laundering, tax evasion, fraud, gunrunning, and child pornography. Because it operates outside the national and international financial system, Bitcoin makes it almost impossible for law enforcement to “follow the money.” Another troubling aspect of Bitcoin in this context is that its decentralized administrative structure, requiring a lot of computing power and energy to run, attracts dishonest operators who, instead of making the necessary investment in computer equipment, use tactics such as botnets or malware to harness the computing power of unsuspecting Internet users in the hopes of receiving the “mining” rewards.

One other problematic aspect of Bitcoin is that it appears to have been designed to promote an anti-government ideological agenda.13 Some analysts believe that Bitcoin’s suitability for money laundering and tax evasion may have been intended.

Nonetheless, with Bitcoin there is much more smoke than there is fire. Even if one accepts speculative valuations, the global supply of Bitcoin as of the end of 2013 was about $8 billion, compared to about $70 trillion of M2 money. In a comparatively recent twelve-month period, Bitcoin users processed $8 billion in transactions, compared to $81 billion processed by Western Union, $145 billion by PayPal, $37 trillion by ACH, and $244 trillion by Bank of America. As of late 2013, the Bitcoin system had a processing limit of just seven transactions per second as opposed to Visa’s limit of 20,000 transactions per second.

Legal and regulatory aspects

Several federal statutes come into play regarding virtual currency: The Money Laundering Control Act14 and regulations thereunder exercise broad authority over money transfers, and includes identify verification and recordkeeping requirements. The Bank Secrecy Act15 (BSA) empowers the government to track all types of currency. It authorizes the Treasury Department to regulate “financial institutions,” a term that is extremely broadly defined to include any person or business who engages in currency exchange or funds transmission, issues or redeems traveler’s checks, or engages in any similar or substitute activity.16 Pursuant to the BSA, the Financial Crimes Enforcement Network (FinCEN), an agency of the U.S. Treasury Department, has issued regulations pertaining to “money services businesses” (MSBs).17 According to FinCen, someone who obtains virtual currency to purchase goods or services is merely a “user” of virtual currency and is not subject to regulation. On the other hand, someone who puts e-currency into circulation is an “administrator,” and someone who is in the business of exchanging or converting one currency (whether real or virtual) into another is an “exchanger.” Administrators and exchangers are subject to registration, reporting, and licensure requirements. Only a small percentage of virtual currency exchangers and administrators in the U.S. have registered.

From a tax standpoint, the IRS has, for now, classified bitcoins as property (not currency) for federal income tax purposes. Accordingly, gains or losses in Bitcoin are recognized based on their fair market value at the time of the gain or loss transaction, and are eligible for capital gains treatment.

Bitcoin could be considered the “beta” of virtual currencies. It presents numerous practical and legal challenges. Lawmakers have only just begun to address the latter, but they will certainly catch up.

Author bio
Robert L. Ellis
is a partner at Hennis, White & Ellis LLP. He practices in the areas of international and domestic commercial transactions, internet and technology law, and intellectual property law.

1The term “Bitcoin” is used as a proper name for the virtual currency system and for its protocol. The terms “bitcoin” and “bitcoins” are used to refer to transactional amounts in that currency.
2Department of the Treasury, Financial Crimes Enforcement Network, “Application of FinCEN’s Regulations to Persons Administering, Exchanging, or Using Virtual Currencies,” p. 1 (March 18, 2013).
3The Bitcoin blockchain can be viewed in real time at https://blockchain.info/.
4Velde, “Bitcoin: A Primer,” Chicago Fed. Letter No. 317, pp. 2-3 (Dec. 2013).
5Nielsen, “How the Bitcoin protocol actually works,” p.10 (Dec. 6, 2013), http://www.michaelnielsen.org/ddi/how-the-bitcoin-protocol-actually-works/.
6Id., p.8.
7As of mid-March 2014 Bitpay, a company that converts Bitcoin into hard currency for merchants, was willing to hold its quoted exchange rates only for one minute. “Bitcoin Exchange Rates,” https://bitpay.com/bitcoin-exchange-rates (as visited March 14, 2014).
8A 2013 survey reported that out of 40 Bitcoin exchanges studied over a 3-year period, 18 had disappeared, “with customer account balances often wiped out.” Peterson, “When bitcoins go bad: 4 stories of fraud, hacking, and digital currencies,” Washington Post (Nov. 26, 2013). Major Bitcoin exchange thefts include: Mt. Gox (744,000 bitcoins stolen, valued at more than $450 million), Global Bond Limited (bitcoins worth $4.1 million stolen), inputs.io (bitcoins worth $1.2 million stolen), Bitfloor (bitcoins worth $250,000 stolen), Bitcoinica (lost 18,547 bitcoins), and Bitcoin7 (unknown amount stolen).
9Nakamoto (pseudonym), “Bitcoin: A Peer-to-Peer Electronic Cash System,” (Nov. 2008), available at https://bitcoin.org/bitcoin.pdf.
10Bitcoin’s anonymous creator “is believed to be sitting on a stash of roughly one million bitcoins. [T]hat stash is worth about $1.1 billion.” Liu, “Bitcoin Mints Its First Billionaire: Its Invetor, Satoshi Nakamoto,” Motherboard (Nov. 29, 2013), http://motherboard.vice.com/blog/bitcoin-mints-its-first-billionaire-satoshi-nakamoto.
11See, e.g., Securities and Exchange Commission, “Ponzi Schemes Using Virtual Currencies,” Investor Alert (Aug. 2013).
12As of early 2014, Bitcoin trading has been banned in China, Iceland, Thailand, and Russia.
13According to the European Central Bank, “the theoretical roots of Bitcoin can be found in the Austrian school of economics and its criticism of the current fiat money system and interventions undertaken by governments and other agencies. . . . ” European Central Bank, “Virtual Currency Schemes,” 22 (Oct. 2012).
1418 U.S.C. §§ 1956-1957 and amendments at Pub. L. No. 107-56, 115 Stat. 272.
15Codified at 12 U.S.C. § 1829b, 12 U.S.C. §§ 1951-1959, and 31 U.S.C. §§ 5311-5332.
1631 U.S.C. §§ 5312(a)(2)(J), (K), (R), (V), and (Y).
17Bank Secrecy Act Regulations – Definitions and Other Regulations Relating to Money Services Businesses, 76 Fed. Reg. 43585 (July 21, 2011); 31 C.F.R. § 1010.100(ff); FinCen, Application of FinCen’s Regulations to Persons Administering, Exchanging, or Using Virtual Currencies, FIN-2013-G001 (March 18, 2013).



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