Bitcoin - Virtual Currency of the Future? - Part One

by Dorsey & Whitney LLP
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Introduction

“Virtual currencies”, and bitcoin in particular, have recently received much attention from law enforcement agencies, the business community, the financial sector and government authorities, who are all trying to understand and analyze how this instrument fits into the existing financial and regulatory frameworks. The nature of bitcoin and its prospects have been keenly debated. These issues again came into the limelight at recently held U.S. Senate committees’ hearings. This eUpdate is the first part in a series of eUpdates on bitcoin-related topics and issues.

The second part will explain the legal status of bitcoin and how it is approached in different countries. The third part will analyze the effects of the Chinese demand on bitcoin, as well as how bitcoin is defined in China. The fourth part will analyze risks that virtual currency users may encounter. The fifth part will further explore part three of the series.

What is bitcoin?

Virtual communities, i.e., places in cyberspace where individuals interact, have noticeably proliferated in recent years – a phenomenon triggered by technological developments and by the increased use of the internet. In some cases, these communities have created and circulated their own currency for exchanging the goods and services they offer, thereby providing a medium of exchange and a unit of account (meaning a standard numerical unit for the measurement of value and costs of goods and services alike) for that particular virtual community.

A virtual currency can be defined as a type of unregulated, digital money, which is issued and usually controlled by its developers, and used and accepted among the members of a specific virtual community. Virtual currency differs from electronic money, insofar as the currency being used as the unit of account has no physical counterpart with legal tender status.1

Bitcoin is also in essence a virtual currency which was launched approximately four years ago, when the bitcoin algorithm was first released online by an anonymous computer programmer known as “Satoshi Nakamoto” (this is a pseudonym2). Bitcoin has other aliases as well, e.g., cryptocurrency, derived from the fact that it relies on cryptographic software protocols to generate the currency and validate relevant transactions. An electronic bitcoin can be defined as a chain of digital signatures.3 The bitcoin system allows users to mine, buy, sell, and accept bitcoins anywhere in the world. Every single bitcoin carries the entire history of the transactions it has undergone, and any transfer from one owner to another becomes part of its code. Bitcoin is stored in such a way that the new owner is the only person who can spend it. Bitcoins are either “mined” (i.e., generated and given for free, as a reward, to the people engaged in the process of validating bitcoin codes as well as processing transactions by using powerful computers), or purchased with the real-world cash via online currency exchanges, such as BTC China (China) and Mt. Gox (Japan).

A bitcoin has some specific characteristics:

  • It has no intrinsic value.
  • It is not regulated or backed by any real-world commodity, such as gold or silver, or any central bank or government or pegged to any real-world currency.
  • It is backed by mathematics. It has the characteristics of money (durability, portability, fungibility, scarcity, divisibility, and recognizability) based on the properties of mathematics rather than relying on physical properties (for instance gold and silver) or trust in central authorities (such as fiat currencies).
  • It is based on a decentralized, peer-to-peer network, i.e., it does not have a central clearing house, nor are there any financial or other institutions involved in the transactions. The bitcoin users perform these tasks themselves. There is no central authority in charge of the money supply. Its decentralized feature is unique among virtual currencies.

The theoretical roots of bitcoin can be found in the Austrian school of economics, its criticism of the current fiat money system, and the interventions undertaken by various governmental and other agencies, which, in their view, result in exacerbated business cycles and massive inflation.4

Bitcoins operate in cyberspace. In order to start using bitcoins, users need to download the free and open-source software. Purchased bitcoins are thereafter stored in a digital wallet on the user’s computer. Users have several incentives to use bitcoins. First, transactions are virtually anonymous, as accounts are not registered, and bitcoins are sent directly from one computer to another.5 Also, users have the possibility of generating multiple bitcoin addresses to differentiate or isolate various transactions. Second, transactions are carried out and processed faster and more economically than with conventional means of payment. Transaction fees, if any, are very low, and no banking fee is charged.

The bitcoin system allows users to exchange online credits for goods and services from selected retailers, contractors and online trading houses that accept bitcoins for payments. When a transaction occurs, the bitcoin is automatically sent directly from the buyer to the seller through an encrypted method. Transactions and payments made by using bitcoins are irreversible. Bitcoins can be spent on both virtual and real goods and services, hence competing with official currencies like the euro or U.S. dollar. An increasing number of establishments are accepting bitcoins for payments. The bitcoin system maintains a database that lists products and service providers which currently accept bitcoins.6 These products and services range from internet services and online products to material goods (e.g., clothing and accessories, electronics, and books etc.) and professional or travel/tourism services. Bitcoins are divisible to eight decimal places enabling their use in any kind of transaction, regardless of the value. Using bitcoins, users can spend as much as they want – as long as they have sufficient number of coins in their “wallets” to cover the charge. Users can also transfer funds wherever they wish.

Bitcoins can also be traded on a number of exchanges or swapped privately. Its exchange rate with respect to other currencies is determined by supply and demand in the market. The value of bitcoins in real-world currencies fluctuates wildly. There are several exchange platforms for buying bitcoins that operate in real-time7, the largest being BTC China (China), Mt. Gox (Japan) and Bitstamp (Slovenia).

The bitcoin system is designed so that there will never be more than 21 million bitcoins in existence. The supply is expected to be exhausted by approximately 2030, after that the bitcoins could only be obtained via exchanges, and “miners” are expected to finance themselves via transaction fees. At present, there are more than 12 million bitcoins, with a total value over US$1.5 billion in circulation.

There are also several payment innovative products linked to bitcoin such as a payment instrument called Bitbills (the prepaid cards for storing bitcoins or for conducting point-of-sale payment transactions in regular shops) and Bitcoin 2 Credit Card (a virtual credit card offered in exchange for bitcoins that could be used for purchases where a physical plastic card was not required, such as for online and telephonic purchases).

Other Virtual Currencies

Bitcoin is one of the many virtual currencies currently in existence. The examples of the other popular virtual currencies include:8

  • Litecoin: a peer-to-peer internet currency based on the bitcoin protocol that enables instant payments; the litecoin network is scheduled to produce 84 million currency units;9
  • Peercoin (also known as PPCoin and Peer-to-Peer Coin): the first cryptocurrency based on an implementation of a combined proof-of-stake/proof-of-work system; the creation of this currency was inspired by bitcoin, and shares the source code and technical implementation of bitcoin.10

The following virtual currencies with the characteristics different from bitcoin were more popular in the past:

  • WebMoney: a virtual payment system that enables internet users to conduct transactions in real time using WebMoney units (WM-units);11
  • Pecunix: a gold backed digital currency;12
  • World of Warcraft (WoW) Gold: a virtual currency used by a well-known online role-playing game designed by Blizzard Entertainment;13
  • Nintendo Points: a virtual currency set up by Nintendo that can be redeemed in Nintendo’s shops and its games;14
  • Linden Dollars (L$): a virtual currency issued in Second Life, a virtual world where users create “avatars”, i.e., digital characters that can be customised.15

Some virtual currencies ceased to operate:

  • Facebook Credits: a virtual currency introduced by Facebook in 2009 which allowed users to buy virtual goods in any application on the Facebook platform; it ceased to operate in 2012;16
  • Liberty Reserve: a Costa Rica-based centralized digital currency service that promoted itself as the "oldest, safest and most popular payment processor ... serving millions all around a world"; the site had over one million users when it was shut down by the U.S. government on accusations of money laundering and operating an unlicensed financial transaction company.17

As virtual currencies, in contrast to traditional payment systems, are not regulated, the legal uncertainty surrounding these currencies might constitute a challenge for the government authorities. Our next eUpdate in this series will discuss the legal status of bitcoin and regulatory issues related to it.

1    http://www.ecb.europa.eu/pub/pdf/other/virtualcurrencyschemes201210en.pdf
2    https://en.bitcoin.it/wiki/Satoshi_Nakamoto
3    Satoshi Nakamoto, “Bitcoin: A Peer-to-Peer Electronic Cash System”, available at http://bitcoin.org/bitcoin.pdf 
4    http://www.ecb.europa.eu/pub/pdf/other/virtualcurrencyschemes201210en.pdf
5    However, all bitcoin transactions are recorded and can, under certain circumstances (e.g., law enforcement), be traced.
6    https://en.bitcoin.it/wiki/Trade
7    These are BTC China, Mt. Gox, Bitstamp, Bitfinex, emeBTC, Crypto-Trade, Kraken, upBit, The Rock Trading, Vircurex, Cryptonit and others.
8    http://coinmarketcap.com/
9    https://litecoin.org/
10  http://en.wikipedia.org/wiki/Peercoin
11  http://en.wikipedia.org/wiki/WebMoney
12  http://wiki.dgcmagazine.com/index.php?title=Pecunix
13  http://en.wikipedia.org/wiki/World_of_Warcraft
14  http://en.wikipedia.org/wiki/Nintendo_Points
15  http://en.wikipedia.org/wiki/Linden_Dollars
16  http://en.wikipedia.org/wiki/Facebook_Credits
17  http://en.wikipedia.org/wiki/Liberty_Reserve

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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