The brave new world of Bitcoin
Market trends Given the convenience of established currency and payment systems, what is driving the ever-growing interest in Bitcoin and other virtual currencies?
Bitcoin was developed largely as a response to the global financial crisis when the risks of relying on ‘trusted’ financial counterparties and intermediaries became obvious. The original white paper by Satoshi Nakamoto is a good starting point to understand some of the potential attractions of virtual currencies.
Many people are supportive of the fact that virtual currencies are not controlled by the government or banks. The global financial crisis – and perhaps even more so the response to it, such as the bailouts of private companies using public funds and the significant inflation of assets as a result – has led to a countercultural drive away from central government and traditional financial institutional means of control. In short, people have lost trust in public institutions.
Virtual currencies are assets that are largely held outside the existing financial system. In the event of currency crashes or hyperinflation, many holders perceive virtual currencies to be a safer store of value.
The use of virtual currencies is also attractive for sending and receiving money internationally, as it can be done quickly easily and involves minimal transaction fees and exchange rate costs. Virtual currencies can also be used by the unbanked and the underbanked to exchange value.
The phenomenal rise in the price of Bitcoin, Ether and other virtual currencies has given rise to speculative interest that attracts new people to the currencies and the underlying technologies.
One of the initial attractions of virtual currencies was the perceived anonymity in respect of the value held and transferred. However, criminal and terrorist organisations are beginning to realise that an immutable public ledger showing all transactions between participants is not the best means of avoiding detection – even if digital wallets are not directly linked to their personal data.
More recently, there has been significant interest in the use of virtual currencies as a form of largely unregulated crowdfunding – often referred to as ‘initial coin offerings’ – whereby blockchain-based tokens are issued in exchange for cryptocurrencies (often Ethereum) to develop new products, platforms, currencies and technologies.
Regulation Has your jurisdiction taken steps to regulate virtual currencies? What is their current status?
There is no legislation that directly regulates virtual currencies in the United Kingdom. Further, virtual currencies do not fit neatly into the existing financial regulatory regimes, such as those regulating financial instruments, securities, payment services, electronic money and anti-money laundering.
While transactions involving virtual currencies fall outside the scope of existing UK anti-money laundering laws, the government has announced its intention to apply anti-money laundering regulations to virtual currency exchanges and custodians. This corresponds with the proposed changes to the EU Fourth Anti-money Laundering Directive. It is anticipated that at some point in the future the use of virtual currencies will eventually be regulated to some degree, but it is unknown how and to what extent.
The UK authorities have taken a liberal and pragmatic approach to virtual currencies to date. This supportive environment is evidenced by the regulatory sandbox approach taken by the Financial Conduct Authority (FCA), which enables fintech innovation in areas of legal and regulatory uncertainty or potential public policy risk areas. The Bank of England is also taking steps to create its own digital currency and ensure that the use of new technologies and market participants can be factored into the wide-ranging review of the Real-Time Gross Settlement (RTGS) system.
This support from the UK authorities has not been mirrored by the major UK banks that control much of the sterling settlement system. Most banks – with some exceptions – have systematically and intentionally decided not to provide support for virtual currency-related businesses and transactions as a matter of policy. This is holding back the development of the sector in the United Kingdom.
In respect of the use of cryptocurrency for crowdfunding, the FCA is currently watching with interest while warning consumers of the risks. The FCA sandbox approach may prove to be helpful in this area.
Different EU member state authorities have thus far taken different approaches to the regulation of virtual currencies. Is this due to the different legal frameworks of the member states or (mainly) by institutional practices of the respective authorities?
There is no harmonised approach to the regulation of virtual currencies or the use of blockchain technologies in areas that overlap with more traditional financial services. The European Union is seeking to bring virtual currency exchanges and custodians within the scope of the European-wide anti-money laundering and counter-terrorist finance regime classifying them as ‘obliged entities’. This has been driven partly by concerns about terrorist financing and money laundering – particularly following a number of European terrorist atrocities, such as those in Paris and Brussels. This may be the first step on a long road to seeking more widespread agreement on the extent to which virtual currencies should be considered a regulated financial instrument or payment mechanism.
How likely is it that the regulation of virtual currencies will be harmonized at EU level? Could a consistent regulatory approach be reached through institutional guidelines for the competent authorities in the member states?
Other than in respect of laws to combat money laundering and terrorist financing risks, it seems unlikely that EU member states will be able to reach an agreement on and when operators in the virtual currency sector should be authorised for financial services purposes.
Virtual currencies represent a tremendous opportunity and challenge for governments, central banks and the existing financial services framework. Existing market participants, particularly banks, may not be incentivised to support the normalisation of virtual currencies in law. Given the unhealthy symbiosis witnessed between government, central banks and commercial banks in the previous financial crisis – which is potentially even more evident today – it is difficult to see how political opinion can be harmonised until after the next financial crisis when the existing architecture and influence of a small number of banks and financial institutions will have been or will need to be reduced. The Bank of England’s review of the RTGS system and the desire to open the sterling settlement system up to other market participants represents a healthy attempt to deconcentrate systemic risks from a small number of financial institutions and foster innovation.
Wider issues in respect of taxation, payment protection, cybercrime, accounting, data protection and distance selling also require serious consideration in this field.
Taxation How are transactions using virtual currencies as the medium of exchange taxed in your jurisdiction?
Virtual currencies are taxed in accordance with the purpose and nature of the transaction and are largely taxed in a similar way to other currencies. Virtual currencies are taxed as follows:
- Virtual currency mining is outside the scope or exempt from value added tax (VAT) on the basis that there is an insufficient link between the economic activity and the consideration to which it gives rise.
- For corporation tax purposes, profits and losses on currency exchange movements are taxed as per foreign fiat currencies.
- When owning and selling virtual currencies, if there is a realised gain or loss, it is treated the same way as a gain made in other commodities or currencies – the sterling value on acquisition and disposal is the relevant calculation method for any gain or loss.
- To the extent that an individual holds virtual currencies for personal reasons and not speculative purposes (eg, if they received the currency as personal income for services and paid income tax based on the sterling value at the date of receipt) then there is an argument that they should not also be subject to capital gains, in line with the treatment of forex conversions. However, UK law appears to apply this exemption only to credits in bank accounts (Taxation of Chargeable Gains Act 1992, Section 252(1). In addition, this contention would not work if an individual was deemed to be trading. Advice should be sought from Her Majesty’s Revenue and Customs (HMRC).
- When merchants accept virtual currencies for payment, it is similar to the acceptance of a foreign currency and the income should be booked using a justifiable reference rate on the date of the transaction.
- As with other payment mechanisms, VAT is not applied to payment transactions involving virtual currencies, but it is applied in the normal way to the underlying goods or services giving rise to the payment.
In its published guidance, HMRC has made it clear that:
- its approach is not a reflection of how virtual currencies are treated for regulatory or other purposes; and
- its existing approach is subject to change as it is dependent on how the European Union approaches the taxation of virtual currencies.
Inflation If virtual currencies were to become a mainstream payment system, how might this affect the ability to control inflation in your jurisdiction?
The orthodox understanding of inflation mechanics and the position apparently taken by most modern central banks, is that inflation can be controlled largely through the central bank interest rate – the rate payable by the central bank on reserves of commercial banks and lenders – and interest rate expectations set by the central bank in its communications. Money supply, lending and asset values can also be moderated directly through central bank intervention, as was seen in the recent period of quantitative easing.
In the United Kingdom, the total money supply is estimated to be approximately £2.3 trillion.
At present, the higher priced variant of Bitcoin (XBT) is the largest virtual currency within the sector and represents over 70% of the entire sector by value. It has a total supply of 21 million and there are approximately 16.5 million in circulation. The existing price per XBT is approximately £3,000 (giving a notional total value of £49.5 billion when priced in sterling).
Due to the limited value of virtual currencies in circulation, it is not regarded as a major issue. However, if the use of virtual currency continues to grow at the existing rate and large volumes and values of virtual currency are used instead of fiat currency, this could seriously affect the ability of central banks to influence inflation with monetary policy. Some central banks are now considering implementing their own virtualised fiat currencies using blockchain technology.
The long-term implications of the widespread use of decentralised payment mechanisms for sovereign states with their own currencies are not yet known.
Fraud and money-laundering What are the potential risks of virtual currencies in terms of fraud? How would these be addressed in your jurisdiction? Have any specific instances emerged in which virtual currencies have been used for money-laundering or other fraudulent purposes?
As virtual currencies can, at least to some extent be held and spent outside the existing financial services frameworks, information on the payer and payee and the amounts held or transferred may not be easily available to the authorities. In addition, wallets holding virtual currencies can be decentralised smart wallets (ie, not a wallet controlled by an exchange or custodian). This makes investigating and tackling fraud difficult where criminals hack wallets or use virtual currencies to accept payments in respect of extortion and ransomware attacks.
However, the above factors could mistakenly be described as making virtual currencies anonymous. There are a number of tools available to identify links between wallets and transactions on the relevant blockchains – these tools can be helpful for the authorities when looking for criminal activities and syndicates. In addition, virtual currency transactions take place on an immutable public ledger. This means that there are also opportunities for law enforcement agencies to trace transactions that are not easily available for some other monetary transactions, such as cash and physical commodities.
In order to try to tackle some aspects of this issue, the government announced on March 18 2015 that it will apply anti-money laundering regulations to virtual currency exchanges in the United Kingdom. In addition, HMRC announced that it “intends to apply anti-money laundering regulation to digital currency exchanges, to support innovation and prevent criminal use”.
In addition, some work has been done by public policy think tanks in the education of police authorities in respect of the use and seizure of virtual currencies involved in criminal activity.
Virtual currencies have been used in a number of high-profile fraud and criminal cases. The notorious Silk Road marketplace – involving the use of virtual currencies to pay for illegal goods and services – and the collapse of Mt Gox with serious implications of fraud, have given rise to successful prosecutions in a number of countries, particularly the United States.