Virtual currencies, such as Bitcoin, Litecoin and others, have become increasingly prevalent, especially in the areas of e-commerce, online payment and trading, with a considerable amount of money invested in virtual currency-related start-ups.

According to the European Banking Authority (EBA), there are currently more than 200 different virtual currency schemes in circulation.  It is expected that virtual currencies will rise in importance as large online businesses include them in their payment schemes, marketplaces and online platforms.  As a consequence, virtual currencies have been getting a lot of media attention, much of which is far from positive.  Some reports are positively alarmist and focus on issues which may scare off potential users and investors, such as theft, fraud, bankruptcy, hacker attacks and money laundering issues.  In a relatively new field, there is also the risk of serious reputational damage when things go wrong as we saw when the prominent "Mt.Gox" (market leading exchange) faced allegations that it lost track of 850,000 Bitcoins, then worth $480m).

A virtual currency can be seen as a digital representation of value that can be traded and used as a medium of exchange; and/or a unit of account; and/or a store of value – but only by agreement within the community of users. Of course, it is important to understand the taxonomy of virtual currency to identify how to mitigate the risks or exploit the opportunities they present.

The reasons for the unease are fairly obvious. Generally, virtual currencies are created mathematically using complex algorithms – a process called mining. Mining involves expensive, customised software and hardware, plus expertise. Virtual currencies can be transferred to a new owner through private cryptographic keys and codes. The identities of those transacting in virtual currencies are hidden but the fact that a transaction has occurred and the amount transferred are logged (the block chain). The vulnerability is that transactions are irreversible and the encrypted keys and online wallets in which they are stored are easy targets for theft, fraud, cyber-attack and hacking. And, of course, the virtual currencies are not backed by governments or central banks.

The EBA Opinion on virtual currencies

In its Opinion on virtual currencies, the EBA identified at least 70 risks related to virtual currencies and concluded that the European regulatory framework should be amended to address, supervise and mitigate them. Of particular concern is the anonymity granted by the system and the general absence of regulation which make virtual currencies ideally suited to illegal transactions (such as weapons and drug dealing, fraud, extortion, money laundering and finance of terrorism). Other key risks include the sector's global reach and the overall lack of probity (e.g. 

refunds or price guarantees, complaint handling processes, protection schemes or stabilising authority (like the role a central bank would play with traditional currencies)). As a consequence, the EBA concludes that virtual currencies need regulation and the introduction of a "scheme governance authority" together with "customer due diligence" proceedings and the imposition of fitness and probity standards as well as requirements for secure IT systems and capital regulation. The EBA discourages credit, payment and e-money institutions from transacting in or with virtual currency.

The Financial Action Task Force

In June 2014, the Financial Action Task force (FATF) published its report on risks with virtual currency. While recognising the economic benefits of virtual currency (such as efficiencies and lower transactions costs), FATF outlined the characteristics of virtual currency that expose them to abuse. FATF highlights a number of recent examples of money laundering cases, neatly demonstrating the global nature of these risks. By suggesting a framework for understanding and addressing money laundering and terrorism financing, while recognising legitmate uses, the paper will be important for firms as they seek to move into this space. It should be read alongside FATF's 2013 New Payment Products and Services Guidance. A key point to note is the definition of virtual currency: the FATF paper describes the EBA paper as "too limited".

The German legal position on Bitcoins

There are currently an estimated 50,000 Bitcoin transactions per day worldwide but the majority of these take place without an understanding of how virtual currencies are regarded in legal terms.  In Germany, there are a number of issues.

Civil law issues

First of all, under German civil law, Bitcoins do not qualify as a "thing" (Sache) within the meaning of para 90 of the German Civil Code (BGB), but as an "object".  This has various implications, including that: there is no German civil law ownership right in Bitcoins; it is difficult to apply the BGB regulations and protections to their purchase; and transfer in ownership, torts and liability issues are problematic.  While there are no laws and regulations directly on point, it is possible to draw on existing, analogous, provisions to identify how virtual currency should be treated for these purposes.

Intellectual property rights are also complicated because Bitcoins neither qualify as computer programmes nor does their mining count as a required "creative act" because it is seen as simply solving a mathematical function.

Although Bitcoins do not qualify as money (as they do not fall within the definitions of cash, deposit currency or e-money), the German regulatory authority (Bundesanstalt für Finanzdienstleistungsaufsicht "BaFin") currently classes Bitcoins as an "accounting unit" (Rechnungseinheit), which is necessary to be able to treat activity relating to such virtual currency as within the scope of financial services regulation in Germany.

Criminal law issues

Virtual currencies present something of a challenge for German criminal law.  According to the German Penal Code (Strafgesetzbuch), as Bitcoins do not qualify as a "thing", criminal actions would not be covered by laws on theft or fraud. Currently only data-related criminal offences (like hacking or collecting or altering data) might apply. The lack of criminal sanctions can make it difficult for regulators to police emerging technology effectively and leaves users and investors at risk. Of course, not all those active in the virtual currency market are nefarious but the absence of credible deterrents makes it harder to identify those who are.

Tax issues

Under the German taxation regime, the surplus resulting from Bitcoin transactions might become subject to German income taxation as Bitcoins can be regarded as an "economic good" (Wirtschaftsgut).  In addition, while it is unlikely at the moment, the question of whether Bitcoin transactions could be subject to Value Added Tax also remains open.

Regulatory aspects

It is important to consider whether conducting business with Bitcoins might lead to a licensing requirement under the German Banking Act (KWG).  Dealing with Bitcoins in their capacity as "calculation units" could trigger a licensing requirement if banking businesses, financial services or payment / e-money services are performed commercially or on a scale requiring a proper business setup in Germany. If firms start to trade in the Bitcoins themselves (so they move on from being an instrument for payment), they will have to consider whether they need a licence to trade in the Bitcoins as a financial service. The same holds true if Bitcoins are collected and sold against real currency e.g. by providers of trading platforms conducting investment or contract brokerage within the meaning of the KWG. At the moment, in Germany, there is no final regulatory position on how to deal with virtual currencies and licensing requirements.

Deposit protection

Germany operates a compulsory deposit protection scheme (Einlagensicherungs- und Anlegerentschädigungs-gesetz), but it only applies to money and deposits made in Euros. Since Bitcoins are not regarded as money and are not made in Euros, they are not covered by the scheme. This presents a consumer protection risk in the event of the insolvency or failure of a virtual currency issuer.

The UK position

In August 2014, the UK government announced plans to consider whether the UK wants to regulate virtual currencies. Regulation would probably be a positive step for virtual currencies, 

helping them gain trust and momentum, addressing negative perceptions of investor protection, lack of clarity on taxation and the risk of exploitation for financial crime. Perhaps most significant for the UK regulators is whether they even have jurisdiction over persons creating virtual currency algorithms, mining, promoting, exchanging and transmitting virtual currencies. If they cannot get comfortable on this point, we are unlikely to see a push to overcome the practicalities hindering widespread adoption.

That being said, on 11 September 2014, the Bank of England (Bank) released its Q3 2014 Quarterly Bulletin. The Bank acknowledged the door to the UK is ajar for digital currencies but highlighted that virtual currency could pose a material risk to monetary or financial stability since the Bank may not be able to bring its usual influence to bear in this sector (e.g. through the use of its macro prudential tools). The Bank will be keeping a keen eye on this area.

The Financial Conduct Authority (FCA) and the emergent Payments System Regulator are also relevant in the UK. The FCA is circumspect on much financial innovation. It considers that the UK regulatory framework (including the Financial Services and Markets Act 2000, related secondary legislation, such as the Regulated Activities Order, and regulator rules and requirements) are designed to be flexible enough to keep pace with such innovation with, perhaps, only a little tweaking. As such, those entering into the virtual currency market, should keep in mind the same sort of considerations as other financial services firms and, in a similar vein to the German market, also consider the relevance of existing laws by analogy and with more than a passing nod to the spirit of UK regulation.

As the FCA's approach is said to be "media neutral" or sufficiently flexible to be applicable to whatever format of advertising, it might seem challenging to identify what the FCA requires firms to do in specific circumstances. But this allows for creativity in the approach to compliance, which should be welcomed. It is also important to ensure that any business model adopted now can be easily adapted if and when tighter regulation of this field arrives. It may be useful to look at jurisdictions, like the USA, to spot the direction of travel in regulation and, particularly, to identify any areas on which interested parties could work with the UK regulators to ensure they do not get bogged down in the EU and UK environments.

To ensure sufficient airtime is being given to consumer protection, the FCA would be expected to look across a range of firms, such as those engaged in the receipt, transmission, securing, storage, and custody of virtual currency as well as firms performing retail conversion services and those trading, controlling, administering or issuing virtual currency. As usual, the FCA would most likely seek assurance on the terms of any virtual currency-related product, looking at responsibility and liability within the firm and in the transaction chain, how price stability could be delivered, processes and protections for redemption and exchange, and operational issues such as settlement norms and adverse event mitigation. A key concern would be whether consumers will have sufficient information to understand the risks they face in these areas.

The economics of a virtual currency offering will also be of interest. There is a lack of transparency over virtual currency usage (e.g. in terms of volumes, who and what for), with suggestions that the initial interest is waning. The early appeal to users attracted to innovation for its own sake, may not be replaced by a move towards genuine traction as a currency of exchange in transactions. The UK regulators will want to know that firms offer prudential security to reduce the risks and that the vagaries of insolvency protections in this area are actually tested.

The discussions in the Bank of England's Quarterly Bulletin (in contrast with the EBA Opinion) are, in fact, fairly dismissive of the risks at the present time, based on the scale of penetration by virtual currencies in the UK market. But the Bank seems reasonably excited that certain concepts (e.g. decentralisation) could be widened to other areas of the financial services sector. While there are many uncertainties, in the end, the true value of the sector could be as a springboard for innovation in other areas. It may be that the risks should be unravelled, regulated and mitigated further down the line, rather than in the immediate future, in order not to hamper a truly useful step forward now.

Conclusion

The lack of clarity as to how existing law and regulation can be applied to virtual currency brings opportunity and allows for rapid development in this sector but it also creates a number of legal challenges. If the use of virtual currencies continues to grow, especially in the e-commerce arena, it is to be expected that existing regulation will be amended to deal with the challenges that virtual currency represents.  The EBA Opinion on virtual currency, together with its suggestion to put virtual currency under regulation, is a clear sign that, at least on a European level, there is the impetus to cover the legal issues around virtual currency, even though the Bank takes more of a 'wait and see' approach.