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Bitcoin: A Not-So-Virtual Currency

by

Brandon R. Toensing, Sr Regulatory Attorney

Introduction

Traditionally, online transactions require the presence of a third party, an intermediary (usually a bank), to provide a conduit between the buyer and the seller. The presence of an intermediary in online transactions can, among other things, provide security and insurance to the parties. The presence of a third party eliminates the need for a buyer to give her bank account number to a seller who she may not wish to have such information, for example, and the seller is assured that the funds are legitimate before the transaction occurs. Bitcoin changes all that.

Essentially, Bitcoin allows its users to conduct business independently of third parties in the same way that cash allows in the real world. The need for a third party is eliminated by requiring all transactions to be publicly and mathematically confirmed through a series of complex calculations. It is Bitcoin’s unique and complex programming architecture that can provide users with the same kind of safeguards usually only provided by third parties. Though, despite these apparent safeguards, Bitcoin remains a largely prospective and undiscovered avenue for investors and regulators alike. As it gains maturity and notoriety in our economic world, Bitcoin is also likely to attract more scrutiny from regulators and lawmakers.

What is Bitcoin?

Bitcoin is a computer program. It is not a company. So there are no officers or presidents of Bitcoin. There are no stock options that exist on Bitcoin. Bitcoin is nothing more than a series of (thousands and thousands) of networked computers running the same proprietary software. Simply put: Bitcoin is the online, digital equivalent of cash. But unlike cash, it is not fiat currency, meaning it is not backed by any national government. Additionally, Bitcoin is not backed by gold, silver, or any other commodity. It is just a number on a computer (or phone) screen.

In this modern world, the ubiquity of mobile devices and internet connections has transformed “real money” into nothing more than a number displayed on a screen, too. Most of us don’t ever deal with physical, paper money or coins. In this sense, Bitcoin and real money are very similar. The main difference between real money and Bitcoin is the bases for their respective values. Real money is given value because it is backed by our Government. Bitcoin’s value is rooted exclusively in the user-community’s collective acknowledgment that it has value.

How are Bitcoins generated?

Bitcoins are produced by a process called, “mining.” As of right now, there are about eleven (11) million Bitcoins in existence, all of which were created by the mining process. According the Bitcoin rules, the maximum number of Bitcoins that can exist is twenty-one (21) million, which will be reached in the year 2140. Today, about 20,000 mining computers generate 3600 Bitcoins per day. The rate of Bitcoin production will exponentially decrease as more mining computers come onto the network.

What is mining?

As mentioned before, Bitcoin operates on a very unique and complex programming architecture. In order to carry out the Bitcoin transactions, the network relies on users who have advanced (read: expensive) enough equipment to volunteer their computers. Basically, the miners will leave their computers logged onto the network so they’ll be available for processing power. Each Bitcoin contains about 30,000 lines of code, hence the need for a lot of computing power. To verify a transaction, there’s a random lottery to determine which mining computer will do the actual computing to determine its legitimacy. As an incentive or reward for dedicating computer power to make the whole thing possible, miners are rewarded with Bitcoins. The actual amount of Bitcoins that are generated by each individual verified transaction is unknown. Mining is the singular origin of all Bitcoins in existence. Miners can exchange them for currency, goods, or services.

How does a Bitcoin transaction work?

Each Bitcoin is identified, digitally, by a long chain of code called a “hash” (think, serial number). The Bitcoin’s hash remains with it forever. Each user has a “wallet,” where they’ll store their Bitcoins. These wallets have their own serial number-type identifier, called a “private key,” which identifies that specific Bitcoin being owned by that specific owner for that period of time. When a transaction is executed between two parties, the transaction is given its own serial number, called a “nonce,” which is an arbitrary number used only once in any cryptographic communication.

The private keys for every single transaction will remain on the Bitcoin’s line of code for its entire life, creating a chronological “chain” which will identify it to the exclusion of others. If hundreds of transactions are being conducted every minute, the network will calculate that all the chains add up, so to speak. The architecture relies on mathematical certainty, so duplicating or predicting a chain’s path is nearly impossible. The broad network of mining computers will communicate with one another to confirm that the transactions they’re working on match up and coincide with the other hundreds of transactions being processed at that moment. As more transactions occur, the chains become longer and Bitcoin transactions, in theory, become more secure. Verification takes about ten minutes.

Can Bitcoin be regulated?

Bitcoin has become more and more ubiquitous in the last few years. To the extent that it can be traded on certain exchanges, it is very similar to any other currency. And just like the Euro, Yen, or Dollar, Bitcoin can be used purely as an investment vehicle. Bitcoin’s value, although very volatile, has realized huge increases over the years. In October 2009, the first Bitcoin exchange rate was published by the New Liberty Standard, which said $1.00 USD was worth 1,309 Bitcoins. In 2013, Bitcoin reached its highest ever value when a single Bitcoin was trading for over $1,000 USD. Currently, one Bitcoin is trading at a value of $493.00 USD.

Even though Bitcoin is being traded as a currency, regulating Bitcoin as a currency may prove to be difficult. The Government’s authority to regulate currency is rooted in Art. I, §8 of the U.S. Constitution, which says that Congress has power to, “…coin money [and] regulate the value thereof.” The Constitution establishes that Congress shall have authority over the country’s money to the exclusion of the states, but not to the exclusion of private issuance, like Bitcoin (even though Bitcoin isn’t even technically a “privately issued” currency). Slightly more recently, in the latter half of the 19th century, Congress addressed the issue of private currency with the passage of the Stamp Payments Act of 1862 (Stamp Act). Over the 150 year life of the Stamp Act, there have been many amendments but section two still sets out a punishment for, “[w]hoever makes, issues, circulates, or pays out any note, check, memorandum, token, or other obligation for a less sum than $1, intended to circulate as money or to be received or used in lieu of money of the United States…” This is the best hope for regulation, but it is not very applicable.

There is no modern case law interpreting the meaning of the Stamp Act, as it was last addressed in 1899. But at that time, the legislative intent was held to be in preventing competition with the nation’s currency. In the sense that Bitcoin users intend to transact with Bitcoin to the exclusion of the US dollar, and are pushing it to be widely accepted over the internet, and employ it in mictropayments (small purchases), there is a strong argument to be made that Bitcoin is violative of the Stamp Act. However, since Bitcoin’s value is based on supply and demand, and is not at all based on the US dollar, it is difficult to say its value is “…a less sum than $1,” as required by the Stamp Act. Also, since it exists purely online, it is more accurate to say it is competing with online payment processors such as PayPal, and not competing with the US dollar.

Bitcoin has no central database. There is no person or entity to hold responsible for its creation or alleged shortcomings. Bitcoin exists on a global peer-to-peer network, and since its value is not based on any government currency, regulating Bitcoin, itself, might be impossible. Completely banning Bitcoin might be a premature and disproportionate response, but in December 2013, China did just that when it prohibited its banks from trading in Bitcoin altogether. Such a measure is one of the only things that can be done at this time to directly regulate the virtual currency.

Bitcoin was likely “invented” in Japan and it now exists on an international scale. It is not a purely-domestic phenomenon. But, like all other currencies, Bitcoins can be exchanged at designated currency exchanges which can be found all over the world. Bitcoin exchanges could be designated as “money service businesses,” (MSBs) depending on their business structure. Regulation of this industry already exists on the state and federal level in the United States. Regulations over MSBs require registration with the Financial Crimes Enforcement Network (FinCEN), which is part of the US Dept. of Treasury. Also, these businesses must abide by strict reporting and record-keeping requirements, which include maintaining the identities of their customers. All that is missing is a definitive administrative ruling that the requirements applied to MSBs must also be applied to all Bitcoin exchanges. But, so far, the opinions issued by FinCEN indicate that regulation of Bitcoin, itself, is less and less likely. Even if a domestic federal regulation was implemented, enforcement on a global scale would require international cooperation and uniformity over all jurisdictions. The marketplaces where Bitcoin trades and exchanges occur remain to be the only true and logical point for regulation at this time.

Sources

Satoshi Yakamoto, Bitcoin: A Peer-to-Peer Electronic Cash System,

Joshua J. Goguet, The Nature of the Form: Legal and Regulatory Issues Surrounding the Bitcoin Digital Currency System, Louisiana Law Review, 2013. 73 La. L. Rev. 1119.

Bitcoin Frequently Asked Questions,

How Bitcoin Works,

Bitcoin Frequently Asked Questions,

Is Bitcoin a Triple Entry System?

Bitcoin Wiki,

Application of FinCEN’s Regulations to Persons Administering, Exchanging, or Using Virtual Currencies,

Application of FinCEN’s Regulations to Virtual Currency Mining Operations,

Application of FinCEN’s Regulations to Virtual Currency Software Development and Certain Investment Activity,

50 Insane Facts About Bitcoin,

The Definitive History of Bitcoin,

United States Constitution, art I, §§10 and 8.

The Stamp Payments Act, 18 U.S.C.A. § 336.

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SECURITIES DIVISION

New Mexico Regulation and Licensing Department

Toney Anaya Building ▪ 2550 Cerrillos Road ▪ Santa Fe, New Mexico 87505

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