Virtual currencies have recently been in the news as a result of the US Securities and Exchange Commission’s ruling that offers and sales of digital currencies are subject to federal securities requirements (there has not yet been any equivalent ruling in the UK). Nevertheless, digital currencies have continued to grow in popularity; Bitcoin, the most widely used, has quadrupled in value since the beginning of the year, as a result of the activity of speculators.

The use of bitcoin for transactions has also increased: there are now over 16 million bitcoins in circulation, with between 200,000 and 300,000 bitcoin transactions recorded every day. While bitcoin is not yet accepted by many large retailers, it can now be used in an increasing number of smaller outlets and is accepted by some online merchants.

So what is bitcoin, and should retailers accept it as a means of payment?

How does bitcoin work?

Bitcoin is a peer-to-peer cryptocurrency based on distributed ledger technology. It allows one person to transfer virtual currency to another without the need for processing by a financial institution. The technology on which it is based was developed in 2009 and published in a paper purportedly written by Satoshi Nakamoto; it is uncertain whether Nakamoto is a real person or whether the name is a pseudonym.

Bitcoins are produced when members of the bitcoin network, using specialised hardware, solve complex algorithms in a process called mining. Bitcoin miners are rewarded for their work with new bitcoins, created at a fixed rate, so that mining is very competitive. In an attempt to avoid inflation, the rate at which bitcoins are created halves every four years; in 2140, when a maximum of around 21 million bitcoins will have been created, it will be reduced to zero.

The creation and transfer of bitcoins are validated by the use of a public–private pair of cryptographic keys. Bitcoin transactions are confirmed by being included in a block with a mathematical proof of work. A proof of work is hard to generate – and becomes harder as more people become miners – but easy to verify once created. Each block is linked with the previous block in a blockchain, making it very difficult to reverse previously approved transactions.

The blockchain (or distributed ledger) is broadcast to the whole bitcoin network and updated approximately every ten minutes when updates are approved by the bitcoin community. Falsification is said to be almost impossible, because all nodes would reject any block containing invalid data. Blockchains have been described as technologically closed but functionally open: the principles on which the blockchain is based are fixed and cannot be altered (other than by consensus of the whole bitcoin network), but anyone can access the blockchain and become a miner.

Distributed ledger technology has the potential to be used for many other applications apart from virtual currencies, including tax collection, benefit payments, land registries, passport issues and smart contracts. The Australian Stock Exchange, for example, is developing a distributed ledger solution to replace its current platform for clearing and settling trades, and the Republic of Honduras is considering a blockchain-based land registry.

Legal status and regulation

Bitcoin is a virtual currency accepted among the members of the bitcoin community as a digital medium of exchange. It is not legal tender, nor is it issued by any central bank or pegged to any local currency, but it may be exchanged for local currencies against which it has a floating value. Like most currencies, it is materially worthless: its value depends on individuals continuing to believe in its worth, which in the case of bitcoin is based on the mathematical principles it embodies. While bitcoin is a poor store of value, because of its volatility, the Financial Markets Law Committee has concluded that its status as a medium of exchange within a significant user community gives it a good claim to be regarded as money.

Regulation of virtual currencies is not yet developed, with the Financial Conduct Authority in the UK expected to publish proposals later in the year. The European Commission has proposed amendments to the Fourth Money Laundering Directive so as to include virtual currency exchanges and wallet providers in its anti-money-laundering framework, but these have not yet been enacted. In the US, the Securities and Exchange Commission has recently found that tokens offered and sold by a virtual organisation known as ‘The DAO’ were securities and therefore subject to federal securities laws.

In general, the attention of regulators has focused on the use of virtual currencies as an investment, or on providers of virtual currency services, rather than on the bitcoin network itself or those using it for day-to-day transactions. Most authorities are letting the technology mature before regulating such areas as data transfer and security. While it is important that virtual currencies do not prejudice the integrity of the market, and that the interests of users are protected, it is also considered that the development of new technology, which may bring significant benefits in the long term, should not be stifled by premature regulation. The present position, therefore, is that customers and merchants use bitcoin at their own risk.

Practicalities

Users may buy bitcoins at a bitcoin exchange. Payment usually needs to be made by some means other than a credit card or PayPal, because of the risk to the exchange that the transaction could be reversed by a chargeback. Bitcoins are stored in a virtual wallet, usually provided by a third-party application.

Having obtained their bitcoins, a customer can then use their wallet application to make a payment, by entering the recipient’s address and the payment amount and pressing send. Alternatively, if the customer is making a purchase in a shop, the merchant can use a tablet running a bitcoin payment application to display a quick response (QR) code with the merchant’s address and the price. The customer uses their wallet app to scan the QR code on their smartphone, and the bitcoin passes. Notification of payment is almost instant, but there is a delay of about ten minutes before the payment is treated as confirmed by having been included in a block.

In contrast to payments by debit card, the customer will pay a small fee to make a payment by bitcoin, whereas the merchant will pay nothing to receive it. The merchant will, however, usually pay a subscription fee to a third party to use a bitcoin payment application. They will then use that application to convert the bitcoins received into normal currency. It is considered best practice to do this at the end of each day, to avoid adverse effects from currency fluctuations.

Advantages and disadvantages of bitcoin

What are the pros and cons of accepting bitcoin? Among the advantages are the following:

  • Low transaction fees – as mentioned, there is no fee to receive bitcoin, and only a small fee – within the customer’s control and unrelated to the amount transferred – to spend it: a higher fee can be paid for faster confirmation of the transaction, and the customer can usually review the fee before sending the funds. The fees paid by merchants to use payment applications and deposit funds in bank accounts are typically lower than those paid to credit card providers: while credit card processing fees can be from 2% to 4% of the value of a transaction, bitcoin could reduce that to less than 1%.
  • International transactions – bitcoin’s speed and low fees – they may be sent and received anywhere at any time, without the need for an intermediary – have made it popular with technology businesses needing to transfer funds internationally. Bitcoin may be attractive for a business seeking to expand to new markets where credit cards are not available or the risk of fraud is high.
  • Speed – payments made by bitcoin settle at the moment of transaction and are typically confirmed within about ten minutes. Funds will arrive in the recipient’s bank account within a day or so, when the bitcoins received are exchanged for local currency.
  • Convenience – there is no need for compliance with payment card industry standards, such as security checks.
  • Security – each bitcoin transaction is publicly verifiable, with all information readily available on the blockchain, and cannot be altered, since it is protected by peer-reviewed cryptographic algorithms and identical copies of the blockchain are shared between users. It would be very difficult for a malicious user to fake a transaction, since they would have to alter all subsequent transactions by creating blocks faster than the rest of the bitcoin network.
  • Anonymity – bitcoin payments themselves are made without any personal information being linked to the transaction. The risks of identity theft are therefore very low, although there are extensive public records of the transactions themselves. Bitcoin exchanges, on the other hand, collect personal information from their users, and in many jurisdictions are obliged to do so for regulatory reasons. Users can, and should, protect their bitcoins by using backup and encryption techniques.
  • Flexibility – as the value of bitcoin rises, bitcoins can be subdivided into smaller units, such as bits (1 million in a bitcoin) and satoshis (100 million in a bitcoin).
  • No chargebacks – payments made by bitcoin are irreversible, unlike payments made by credit card, which may be subject to a chargeback (along with a chargeback fee) if there is a dispute between the merchant and the customer or in case of identity theft.

Disadvantages of bitcoin include the following:

  • Volatility – bitcoin is subject to large fluctuations in value. This is partly because it is subject to speculation, and partly because the relatively small number of bitcoins in circulation means that comparatively minor events can significantly affect their value. For this reason, it is advisable for a merchant to convert bitcoins received into local currency frequently; a daily sweep is recommended. For larger transactions, it may be appropriate to include an exchange-rate-adjustment clause in the relevant contract.
  • Immaturity – while the fundamental characteristics of bitcoin are fixed and unlikely to change (since any change would require agreement by the whole bitcoin community), some tools and features are still in process of development. Perhaps as a result, bitcoin is not yet widely accepted: it cannot be used to make purchases from major retailers such as Amazon (one would first need to buy a gift card from a third-party provider), and its use is restricted in certain jurisdictions, including China and Bangladesh.
  • Risk of theft – bitcoins are themselves secure, since a bitcoin cannot be used without its associated private key, and transactions made using bitcoin are secured by the blockchain. Third-party providers of bitcoin services, however, such as bitcoin wallets and bitcoin exchanges, are subject to attacks by hackers, and bitcoins’ anonymity means that, once stolen, they cannot be traced.
  • Criminality – bitcoin has been associated with criminal activity, since its anonymity conceals the identity of those using it to buy and sell illegal drugs or engage in money laundering, for example, and most recently to demand payment for ransomware release. But in this respect bitcoin is really no different from cash, which is equally anonymous and usable for nefarious purposes.
  • Data collection – the fact that bitcoin is anonymous may make it more difficult for merchants to collect and monetise the spend data of their customers.
  • Lack of legal basis – because bitcoins are not issued by a national bank, the usual rule that units of account referred to in a contract are subject to the law of the issuing state of the currency concerned (known as lex monetae) does not apply. It may therefore be appropriate to include in any contract in which bitcoin is used a provision setting out what would happen in the unlikely event that bitcoin ceased to exist or the basis of its definition were to change.
  • Risk of loss – bitcoin wallets storing the private keys necessary to access bitcoins can be accidentally lost, deleted or stolen. In the case of loss, the bitcoins concerned will be dormant for ever, because without the private keys needed no-one will be able to spend them; there is no regulation to protect users of online wallets. It is therefore advisable to use service providers offering good levels of security and insurance, to keep secure records of passwords (including disaster recovery plans in case of hardware failure), to sweep bitcoin into bank accounts regularly, and to keep only small amounts in devices that could be lost or hacked.
  • Irreversibility – if an erroneous or fraudulent payment is made, there is no recourse to a bank, credit card company or regulator to reverse the transaction.
  • Large transactions – bitcoin probably offers few advantages for large transactions, where the adverse consequences that may arise from its volatility or the risk of loss will be greater.

Bitcoin is perhaps best suited to low-value, high-volume transactions, where the fact that no fees are payable to receive it is most advantageous to merchants. While the speed and low cost of transacting with bitcoin make it attractive, its volatility and the ease with which bitcoin could be lost are significant risks, best mitigated by using one or more reputable wallet applications and arranging frequent sweep-ups of bitcoin into local currency.

Despite the risks, the popularity of bitcoin and other virtual currencies continues to grow, and the blockchain technology on which bitcoin is based is likely to be increasingly used for other applications.