“Virtual currencies”, and bitcoin in particular, have recently received much attention from law enforcement agencies, the business community, the financial sector and government authorities, all of which are 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 under scrutiny at recently held U.S. Senate committee hearings. This eUpdate is the second part in a series of eUpdates on bitcoin-related topics and issues.

The first part of the series described what bitcoin is. 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 discuss further steps taken by Chinese government towards regulating virtual currencies and their impact on the bitcoin market. The sixth part will discuss continuing concerns about bitcoin and on developments in the bitcoin market. The seventh part will discuss Mt. Gox’s demise and its effect on the bitcoin market. The eighth part will explain how recent shutdowns have led to renewed and intensified calls for government authorities from around the world to start regulating virtual currencies.

Legal status of bitcoin

The existence of competing currencies is not new, as local, unregulated community currencies had existed long before the digital age. These currency systems arguably have positive aspects if they contribute to financial innovation and provide additional payment alternatives to consumers. However, they can also pose risks for their users, especially in view of the lack of regulation. Taxation of individual income earned through virtual currency transactions, as well as the definition, security and protection of virtual properties remain unclear.

The absence of a clear legal basis for virtual currencies is an illustration of the current overall lack of understanding about virtual economies, as well as their impact on the real economy. The global scope of virtual communities means that the location of participants and the owners are hard to establish. As a consequence, governments and central banks would face serious difficulties if they attempt to control or ban any virtual currency, and it is not even clear to what extent they would be permitted to obtain information from them, let alone regulate.

At present, there is no existing legal framework which addresses the unique features and functionality of bitcoin. Regulators from various jurisdictions are taking steps to provide individuals and businesses with rules on how to integrate this new technology with the formal, regulated financial system.

In addition, as bitcoin displays certain features that enable it to function as a commodity (such as the self-imposed limit of 21 million bitcoins and the volatility of its value) and as a security (such as its usage as an investment object), regulators have expressed concerns over the legal status and regulation of bitcoin.

Approach to bitcoin in the United States

The U.S. federal authorities have been concerned about virtual currencies for many years, at least since e-Gold (an early digital currency provider that operated until 2007) ceased operations. In March 2013, the U.S. Financial Crimes Enforcement Network (FinCEN), a bureau in the U.S. Department of the Treasury, issued non-binding guidance on how it characterizes certain activities involving virtual currencies.1 The guidance defines “virtual currency” and circumstances under which virtual currency users could be categorized as “money services businesses” (MSB) and become subject to FinCEN’s MSB regulation. “Real” currency is understood as “the coin and paper money of the United States or of any other country that (i) is designated as legal tender and that (ii) circulates and (iii) is customarily used and accepted as a medium of exchange in the country of issuance.” A convertible virtual currency means a medium of exchange which operates like a real currency in some environments, but does not have all the attributes of a real currency (for instance, it does not have the legal tender status in any jurisdiction) and either (i) has an equivalent value in real currency, or (ii) acts as substitute for real currency. Furthermore, FinCEN defines a de-centralized convertible virtual currency as a convertible virtual currency that has no central repository and no single administrator, and that persons may obtain by their own computing or manufacturing effort. Under FinCEN's guidance, virtual currencies are not “currencies” per se, such as legal tender or fiat currencies.

Bitcoin seems to fall under the category of de-centralized convertible virtual currency. Pursuant to FinCEN’s guidance, bitcoin users are not subject to FinCEN’s MSB registration, reporting, and recordkeeping regulations. On the other hand, “miners” (if recognized as bitcoin system administrators or on the basis that they create units of convertible virtual currency and sell those units to other persons for real currency or its equivalent) and bitcoin exchanges can be categorized as MSB, specifically, as money transmitters, and, therefore, be subject to FinCEN’s MSB regulations (they must register with FinCEN, and institute certain recordkeeping, reporting and anti-money laundering program control measures).

Defining bitcoin as a de-centralized convertible virtual currency, but not as “currency”, is not free of doubt in the United States. For instance, a judge in the U.S. federal court for the Eastern District of Texas ruled that bitcoin is a currency or form of money2, giving a go-ahead to the U.S. Securities and Exchange Commission (SEC) to sue an individual who offered and sold bitcoin related investments over the internet as a Ponzi scheme operator.3

Recent consideration of bitcoin by U.S. authorities

The scrutiny of bitcoin has recently intensified in the United States. The U.S. Senate Committee on Homeland Security and Governmental Affairs held the first ever hearing on virtual currencies on November 18, 20134, followed by another hearing held by the U.S. Senate Committee on Banking, Housing and Urban Affairs on November 195. These hearings were the culmination of a specific three-month investigation into bitcoin and other virtual currencies by U.S. agencies, including the FBI.

There are two main reasons for the hearings. First, in October 2013, Silk Road, an online marketplace, ceased to operate due to allegations that it allowed more than a billion U.S. dollars of illegal drugs and illicit services to be bought using bitcoin. Second, China has been extremely active in the bitcoin world. At present, about a third of the world’s bitcoin transactions flow through BTC China, a China-based bitcoin exchange.6 U.S. lawmakers might therefore be concerned that overzealous legislative actions could drive innovation in financial services to other countries with fewer constraints. As mentioned by Jeremy Allaire, the founder of a startup called Circle Internet Financial, in written testimony provided as part of his appearance at the hearing, “We do not think that it is in anyone’s best interest for digital currency to become an offshore industry, or an industry dominated by China.”7 In May 2013, the U.S. Department of Homeland Security began seizing U.S. bank accounts belonging to Mt. Gox, a Japan-based bitcoin exchange, citing that it had not properly registered itself as a money transmission business; this sent a chilling message to the U.S. businesses working in the bitcoin space. This demonstrated the effect and consequences which the rigid regulation in a given country might have on the virtual currency market.

At the hearings, officials from the U.S. Department of the Treasury, the U.S. Department of Justice and the U.S. Secret Service said that while they could see benefits in digital forms of money, they could also see the risks. The authorities recognized that many virtual currency systems offer “legitimate financial services”. Bitcoin supporters testified at the hearings that bitcoin could bring major changes to the financial system by cutting out intermediaries, which could have a major impact on banks. The authorities also recognized that such systems offer lesser transaction costs, and more efficient, faster and secure payment system, which facilitate more efficient global commerce. However, they also expressed concerns about anonymity, and the decentralized and deregulated nature of some virtual currencies, which could help evade payment of taxes and facilitate illegal activities, as well as lead to the possible creation of a speculative financial bubble.

The officials noted that basic questions about the definition of virtual currencies, including their classification as commodities or securities, still need to be answered. This will determine the regulatory agencies which will regulate such currencies and their treatment under the law.

Approach to bitcoin in Europe

Some initial attempts to define the legal status of bitcoin are already underway in European countries. French courts dealt with this issue after local banks shut down the currency exchange facility for accounts handling the currency, on the presumption that bitcoin should conform to electronic money regulations.8 The issue of bitcoin’s legal framework was raised in the European Commission’s Payments Committee. The German government categorized bitcoin as a “unit of account”, thus officially recognizing it as money taxable under capital gains, which led many to speculate that other countries in the European Union may soon follow suit.

Approach to bitcoin in Hong Kong

In Hong Kong, bitcoin is viewed as a virtual currency that can be traded privately or online and does not represent an electronic currency or form of money. It is currently not regulated. According to John Tsang, the Hong Kong Financial Secretary and the Chairman of a number of the Committees within the Hong Kong Monetary Authority, “The scale of bitcoin usage at present is negligible… but if in the future bitcoin, with its cost-cutting advantages, attains critical mass, the prognosis would be different. The speculative factor is all too prevalent, which would only hinder bitcoin’s development”. Mr. Tsang also warned that “People and businesses should be extremely careful when it comes to investing in or accepting bitcoin. It is important to understand the associated risks. Whether the bitcoin is a bubble which would burst or whether it will become an independent cross-national electronic payment system is difficult to tell”.9

Approach to bitcoin in some other countries

The Reserve Bank of India (India’s central bank) was said to be “watching” bitcoin and gathering information in an attempt to understand the virtual currency.10 India will hold its first official bitcoin conference on December 14 and 15, 2013. The event is expected to see participation from the Reserve Bank of India as well as State Bank of India, the country’s largest bank.11

Canada defined bitcoin as a digital currency, i.e., virtual money that can be used to buy and sell goods or services on the internet, and announced that it will tax bitcoins in two ways: transactions made for goods or services will be treated under its barter transaction rules, while profits made on commodity transactions will be treated as income or capital under its regulation on transactions in securities.12

However, not all governments are so welcoming. In July 2013, reports suggested that Thailand has banned bitcoin. It was later reported that the Bank of Thailand, which was the regulatory authority to ban bitcoin, was only considering whether to give a license to the bitcoin exchange in question. Noticeably, some of the exchanges in Thailand continued trading in bitcoin on the basis that the Bank of Thailand did not have the legal power to stop them. The Governor of the Bank of Thailand admitted that “Because they have not been granted a license, this does not automatically mean that an individual in Thailand selling or buying bitcoins with a bitcoin exchange in another country, e.g., Mt. Gox, is breaking the law.”13 Some jurisdictions (such as Argentina) severely restrict or ban any foreign currency, including any virtual currency.14

Our next eUpdate will provide more details on the effect of the Chinese demand on bitcoin.

1    http://www.fincen.gov/statutes_regs/guidance/pdf/FIN-2013-G001.pdf
2    http://www.lawfareblog.com/wp-content/uploads/2013/10/SEC-v.-Bitcoin-Savings-and-Trust.pdf
3    http://www.sec.gov/News/PressRelease/Detail/PressRelease/1370539730583
4    http://www.hsgac.senate.gov/hearings/beyond-silk-road-potential-risks-threats-and-promises-of-virtual-currencies
5    http://www.banking.senate.gov/public/index.cfm?FuseAction=Hearings.Hearing&Hearing_ID=955322cc-d648-4a00-a41f-c23be8ff4cad
6    http://bitcoincharts.com/markets/
7    http://www.hsgac.senate.gov/hearings/beyond-silk-road-potential-risks-threats-and-promises-of-virtual-currencies
8    http://www.finextra.com/news/fullstory.aspx?newsitemid=22921
9    http://www.news.gov.hk/tc/record/html/2013/12/20131201_132949.shtml
10   http://articles.economictimes.indiatimes.com/2013-08-14/news/41409715_1_bitcoin-gox-virtual-currency
11   http://articles.economictimes.indiatimes.com/2013-11-26/news/44486904_1_bitcoin-virtual-currency-mt-gox
12   http://www.cra-arc.gc.ca/nwsrm/fctshts/2013/m11/fs131105-eng.html
13   http://www.coindesk.com/information/is-bitcoin-legal/
14   http://www.bloomberg.com/news/2013-03-20/argentine-president-tightens-foreign-exchange-controls-timeline.html; http://bitcoin.org/en/faq