Background

As the leading form of cryptographic currency currently available, Bitcoin is making headlines for various reasons, not all of them positive. This note considers some of the characteristics of cryptocurrencies, key issues and potential regulation in Australia.

Cryptographic currency: what is it?

Cryptographic currency, or ‘cryptocurrency’, is a form of virtual currency – an unregulated ‘digital currency system created to facilitate internet commerce’.1It is described as a ‘currency with no central bank, based on digital tokens with no intrinsic value’ and depends on ‘a distributed system of trust’.2 It is not reliant on its current existence on physical or tangible goods, on a regulatory framework or on underwriting by banks or governments. In the case of Bitcoin, the history of every Bitcoin transaction ever concluded is contained in a single transaction ledger which is shared by all computers participating in the Bitcoin system.

As a cryptocurrency such as Bitcoin is not ‘money’, ‘currency’ or ‘legal tender’ as understood by traditional legal conventions, it is important to bear in mind that Bitcoin’s extrinsic value is currently based solely upon voluntary acceptance by those that choose to trade in or otherwise accept it. Bitcoin is currently the most widely used form of cryptocurrency with the largest market capitalisation, trading on exchanges and through retailers. However, a number of alternative cryptocurrencies have been and are being developed, each with varying features and designs. Rates of exchange from Bitcoin into traditional currencies are published, but do not represent true market-based trading in Bitcoin. As with many artefacts, Bitcoin is only ever worth what someone is willing to pay for it or the value of goods which on any day, a Bitcoin or fraction of a Bitcoin can obtain.

Bitcoins can be bought, sold and traded via online exchanges. These exchanges can be based anywhere in the world and are unregulated, although some, such as Bitstamp - based in Slovenia -claim to voluntarily comply with anti-money laundering and terrorism legislation.3 Once bought, this type of cryptocurrency can be stored in these exchanges themselves, or on the user’s computer in digital ‘wallets’, until used or converted back to a fiat currency.

The conversion to a recognised or fiat currency will normally be through an exchange which will ultimately require an account held with a traditional bank. This is an example of how a cryptocurrency connects with a regulated entity such as a bank.

The legal and commercial basis of Bitcoin is being examined by governments and regulators in various countries. Finland’s central bank, for example, has characterised it as a commodity rather than a currency,4 and the UK has treated it as a ‘voucher’. However, this may change in future when it may be treated as an ‘asset’ or ‘private money’ to lessen the impact of VAT on traders and to attract capital gains tax instead.5

Sweden treats Bitcoin software as an ‘asset’, allowing it to apply capital gains tax to Bitcoin transactions, and Norway has categorised it a ‘taxable asset’.6 Canada has determined that Bitcoin is not a currency,7 but rather that transactions involving it will be considered barter trades, with the result that businesses receiving payment in Bitcoin must report their gain from the trade in Canadian dollars for the purposes of taxation.

It is therefore apparent that there is as yet little consensus on what Bitcoin is or how it should be treated.

What are some of the risks?

Central banks and monetary authorities around the world have issued warnings to consumers on the use of Bitcoin and other cryptocurrencies, citing various price and security risks.

The value of cryptocurrencies can fluctuate dramatically based on a wide variety of factors, from trends in popularity to government intervention in trade, and large amounts of money can be lost very quickly. For example, a Chinese Government announcement last year restricting the trade of Bitcoin by financial institutions caused the value of Bitcoins to practically halve overnight. The recent collapse and bankruptcy of Mt Gox, a leading Bitcoin exchange, has also had a significant impact on Bitcoin value, as users watched their cryptocurrency disappear.

There are also significant risks associated with storing cryptocurrencies. Digital wallets can be hacked, computer equipment can be lost or stolen and exchanges can be hacked or may close, taking the cryptocurrency with them. In addition to the losses arising from the Mt Gox collapse, in November last year alone, the contents of 4,000 digital wallets stored on the Czech exchange Bitcash.cz were stolen by hackers, and a further 4,000 Bitcoins were apparently stolen from an Australian Bitcoin ‘bank’.8 The European Banking Authority has also noted that losing the password to a digital wallet means losing the currency stored there, as ‘there are no central agencies that record passwords or issue replacement ones’.9

Bitcoin has been criticised because of its lack of transparency and inability to comply with anti-money laundering and counter-terrorism legislation. Reputational issues have arisen again following the recent arrest of the Chairman of the Bitcoin Foundation for money laundering and connections to the notorious Silk Road drug marketplace.10 Many have noted the link between Bitcoin and online criminal activity, such as illicit drug markets like Silk Road. The pseudonymous nature of Bitcoin means that businesses trading legitimately may have no means of knowing where the currency they receive has come from or where their payments are going, risking unwitting involvement in illegal activity. Businesses also face the risk of fraud by suppliers taking advantage of Bitcoin’s irreversible transactions. Similarly, consumers falling victim to fraudulent sellers do not have the benefit of consumer protection legislation.

The risks associated with Bitcoin are significant. The nature of these risks and the rising popularity of Bitcoin make it likely that either domestic or global authorities will attempt to regulate it and potentially, other cryptocurrencies. In the absence of a clear understanding of the nature of Bitcoin and other cryptocurrencies, the task of regulation will be made more difficult, necessitating a shift in thinking that may result in a hybrid approach by financial product, electronic transactions and commodity regulators.

How might it be regulated?

As noted above, various countries are assessing the impact of Bitcoin and addressing taxation and regulatory treatment. As Bitcoin raises questions about consumer protection, fraud, anti-money laundering, counter-terrorism legislation and trade in illicit goods, it is likely that government policies will evolve to regulate cryptocurrency trades more broadly. But how might that be achieved?

Bitcoin.org contemplates the possibility of regulating Bitcoin in terms of the purposes for which it is used, in the same way as fiat currency,11 but regulation in practice would need to overcome some challenging obstacles arising chiefly from the pseudonymity and irreversibility of Bitcoin transactions and the locations of the primary exchanges. How are exchanges to be regulated if they are based offshore? How are transactions to be regulated when both the buyer and seller are pseudonymous? How are fraudulent transactions to be invalidated when every transaction is irreversible?

There are various sources of government power under which Bitcoin might be regulated in Australia. Those concerning currency and the internet include sub-ss 51 (v), (xii), (xiii), and (xvi) of the Commonwealth of Australia Constitution Act 1900 (Cth), the Reserve Bank Act 1959 (Cth), the Currency Act 1965 (Cth) and the Corporations Act 2001 (Cth).

As all financial transactions in Australia must be made in Australian currency or the currency of another country, it is unlikely that Bitcoin or any other virtual currency would be considered valid currency or legal tender.12 It might be possible, using the above powers, to seek to regulate Bitcoin as a ‘token’ for the purposes of the Currency Act and follow China’s lead in prohibiting trade in them by financial institutions.13 However, this would not prevent individual users from continuing to trade, nor would it provide consumer protection. There has also been some debate as to whether intangible property would constitute a ‘token’. It has also been argued that Bitcoin is a ‘financial product’ for the purposes of the Corporations Act, used to make ‘non-cash payments’ as described in s 763D, so that service providers such as exchange operators are performing a regulated financial service and therefore are required by the Act to hold an Australian Financial Services licence.14 In both cases, there may be significant enforcement challenges if, as is likely to be the case currently, institutions or trading platforms involved are located offshore.

It may be possible to impose regulation on banks that hold accounts belonging to the exchanges or to users. However, with the advent of Bitcoin ‘vending machines’ allowing people to buy Bitcoin without making an online transfer from a bank account15 and the frequency with which new exchanges and virtual currencies appear, such regulations are likely to be of limited effectiveness. If considered to be a payment system, Bitcoin may fall under the jurisdiction of the Reserve Bank, but without the co-operation of the Bitcoin community, any controls would be difficult – if not impossible – to enforce.

Regulating through tax laws has been a common starting point for those countries addressing Bitcoin regulation, capturing businesses trading in Bitcoin rather than anonymous users or offshore exchanges. However, the current inconsistency between national regimes—such as between those terming Bitcoin an ‘asset’, a ‘commodity’ or ‘private money’—may result in confusion and competition problems, causing businesses to move offshore where rules might be clearer or less onerous.

Despite this, and despite the determination of cryptocurrency to bypass banks and other financial ‘middlemen’, banks may be part of the solution. In December 2013, JPMorgan Chase applied for a patent for a new online payment scheme that would allow users to make payments anonymously with currency stored on their computer memories and with a common log to be used for verifying transactions, as is currently used by Bitcoin.16 If large international banks were to run similar online payment systems, it is arguable that users may receive some of the benefits of Bitcoin – the speed, the convenience, and the anonymity - as well as the stability and protection provided by transacting through a large regulated institution. However, the key libertarian element of Bitcoin – a lack of fee or charge for its use or exchange - is unlikely to be present in bank-run cryptocurrencies.

How could it affect your business?

Bitcoin and other cryptocurrencies have the potential to affect all kinds of businesses. Perhaps your overseas suppliers are asking to be paid in Bitcoin to reduce fees associated with paying in foreign currency, or with transacting through a bank, or to reduce their tax liabilities. Perhaps you are asking to be paid in Bitcoin to reduce the risk of managing cash on the premises of your restaurant or café. You may be a business that needs to be seen to be at the cutting edge of payment technology, or perhaps your customers have asked for it. If you are a credit card provider, perhaps customers are bypassing your services entirely and choosing instead to transact online in virtual currency.

Choosing to engage with Bitcoin may give rise to significant concerns for businesses in terms of compliance with anti-money laundering and counter-terrorism legislation, and of the potential reputational risk in being associated with a form of payment that is unregulated and non-transparent.

What could you do to manage these risks?

Businesses may wish to monitor the use and discussion of Bitcoin and other popular cryptocurrencies to assess whether they are likely to impact their operations and the risks and benefits of becoming involved. The Bitcoin Wiki page provides useful security information for traders and may be a source of information for interested businesses.17If you already are dealing in Bitcoin, converting the currency received into an official currency at the close of business every day can minimise the risk of fluctuations in value.

A Bitcoin storage service covered by insurance is also now available through Elliptic Vault, which is underwritten by insurer Lloyd’s of London.18 Such services may provide greater security and confidence for businesses considering trading with Bitcoin.

For businesses that are in regulated industries such as banking, financial services, telecommunications and life sciences, there may be future limits on how they could use Bitcoin, so risks could be regulated through those limits. For less regulated industries, due diligence on Bitcoin participants, pre-payment or reservation of title provisions in contractual arrangements could minimise some of these risks. At this stage, much of the discussion is conjecture but there remains a wide range of stakeholders who are very interested in the development of this rather unique payment device.