Bitcoin – virtual financial innovation or tax haven?

As virtual currencies are increasingly becoming functioning means of payment in the real world, regulators are slowly waking up to the potential for crime, money laundering and tax evasion. But commentators warn that cryptocurrencies, like bitcoin, offer many benefits from lower transaction costs to financial innovation, which could be stifled by overregulation.  

 

As far as virtual currencies go, bitcoin, a decentralized peer-to- peer payments network, is the most widely used and successful among attempts at establishing currencies for the online world.  

Bitcoin has reached a market capitalization of more than $1 billion, the size of the economy of a small country. Consumers can use it to purchase anything from electronics to food, pay for services or place bets in bitcoin-only casinos online. At the same time, the infrastructure and related services for the storage and exchange of bitcoins is proliferating.  

As a result, bitcoin has attracted much attention from both the media and regulators, often oscillating between hyperbole and fear-mongering. Much of the coverage has focused on the relative anonymity of the encryption-based payment system. This, it is claimed, opens the virtual currency up to all kinds of potential illicit activity, from money laundering and tax evasion to the online purchase of drugs via Deep Web encrypted sites such as Silk Road, where it is the only accepted currency.  

 

The regulatory challenge  

Two inherent attributes of the payment system are at the heart of regulators’ concern: Bitcoin is relatively anonymous and it is decentralized. When payments are made, the payer and payee interact directly without a middleman. This poses a problem for those interested in regulating. Traditional payment systems rely on financial intermediaries, like banks or credit card companies, which are also the point where personal customer data is collected and most regulatory action takes effect. 

Online transactions that require a third-party intermediary are not anonymous because the service provider, for example PayPal, will collect personal data linked to bank accounts or credit cards.  

Since bitcoin is based on a decentralized peer-to-peer network, like a file-sharing system, some observers have argued that bitcoin enables money laundering and other criminal activity online. 

In a July 2013 paper, Omri Marian, assistant professor of law at the University of Florida Levin College of Law, raises the prospect that cryptocurrencies such as bitcoin, can be used for tax evasion. He notes that cryptocurrencies display the traditional characteristics of tax havens: earnings are not subject to taxation and taxpayers remain anonymous. In addition, their operation is neither dependent on the existence of financial institutions nor confined to specific jurisdictions, making taxation at the source, as well as tax information exchange difficult, if not impossible.  

With the unregulated cyberspace being the ultimate “offshore,” bitcoin could become the “ultimate offshore account,” and a tool to conceal earnings from tax authorities, he notes. 

Bitcoin also received negative press because it is the only currency that can be used for purchases on Silk Road, the anonymous, encrypted Deep Web peer-to-peer network, infamous for the sale of drugs, as well as other licit and illicit goods. 

The use of bitcoins on Silk Road prompted the U.S. Senate Committee on Homeland Security and Governmental Affairs in August to ask a number of federal regulatory bodies what policies or procedures they had in place to prevent the use of virtual currencies for criminal activity. 

“[Virtual currencies] can be sent nearly anonymously, leaving little or no trail for regulators or enforcement agencies,” the committee’s letter said. “Their near anonymous and decentralized nature has also attracted criminals who value few things more than being allowed to operate in the shadows.” 

Meanwhile, the U.S. Securities and Exchange Commission charged a Texas resident with operating a Ponzi scheme and selling fraudulent investment securities in exchange for bitcoins. Regulators argue that since bitcoins are more anonymous than other transactions online, the potential for criminal activity is larger. Often overlooked in this debate is that bitcoins display qualities in the online world similar to those that make cash the payment choice for illicit transactions in person. But just as with cash exchanges, the vast majority of bitcoin payments are made for legal and perfectly valid reasons. 

A study by Nicolas Christin, Carnegie Mellon INI/CyLab, estimated the monthly trading volume on Silk Road in 2012 to be around $1.9 million. He believes the volume may have since doubled. The total Bitcoin transaction volume in June alone was $770 million. 

 

Not necessarily anonymous  

However, Bitcoin is not as anonymous as it is made out to be. In contrast to a cash transaction, bitcoin payments leave a trace. A public ledger – called the block chain – of all transactions using bitcoins is made available to every user on the peer-to-peer network. Each transaction, or block in the chain, contains the public encryption keys, or bitcoin addresses, of the parties involved, as well as the time, the amount and other information.  

While the public key is not directly connected to personal information of the user, it is not impossible to tie the identity of the user to the key. For instance, the IP address of a user is recorded when making a transaction at a website or when exchanging regular currency for bitcoins at a bitcoin exchange.  

Even when an anonymization software, such as Tor is used, experiments have shown that the identities of some users could be gleaned using behavior-based clustering techniques.  

But regulators are correct in highlighting that bitcoin is more anonymous than other Internet payment systems. As regulators are becoming more aware of bitcoin and other virtual currencies, it can be expected that bitcoin intermediaries, such as exchanges, will be forced to collect personal data from their customers. 

 

Users and money service businesses  

In March, FinCEN, the Financial Crimes Enforcement Network of the U.S. Department of Treasury, issued a guidance on the regulation of the administration, exchange and use of virtual currencies. It distinguishes between the users of virtual currencies, who are not subject to regulations, and administrators and exchangers, which have to register as money service businesses and as such must follow reporting and recordkeeping regulations. 

In a comment on the Bitcoin Foundation’s website, Patrick Murch, the general counsel of the organization charged with the standardization, protection and promotion of bitcoin, expressed a mixed reaction to the guidance. But others who had feared more draconian measures saw it as a positive development.  

Gavin Andresen, the Bitcoin Foundation’s chief scientist, told the New Yorker that the new regulation reassures users that making purchases with bitcoins is legal, and it provides bitcoin intermediaries and merchants with regulatory certainty about their responsibilities and how they are going to be classified by regulators. 

However, other U.S. federal regulators can be expected to weigh in. And while acknowledging the potential for criminal activity and the need for consumer protection, some commentators have warned that overzealous regulators could stifle the benefits that bitcoin and other virtual currencies bring.  

 

Benefits  

The most important advantage of bitcoin is that its transactions are significantly cheaper than traditional online payment methods due to lack of third-party financial intermediaries in the payment system. The lower transaction costs could have a positive effect, particularly on small and medium-sized businesses that are able to replace costlier credit card and cash transactions. 

Merchants are also able to pass on the transaction cost savings through lower prices to consumers who pay with bitcoins. Retailers following this business model are already emerging. 

While some users will prefer the protection and additional services of credit cards, through the option of charge-backs and the ability to revoke payments, for example, others may value the lower transaction costs and greater privacy of cryptocurrencies. 

Bitcoin and similar virtual currencies also have the potential to enable micropayments and improve remittances. Online payments involving small amounts of money are widely considered to be uneconomical for merchants and consumers. This is not the case with bitcoins.  

In areas with less developed banking systems, cheap alternative payments help alleviate poverty and widen access to financial services. In countries like Kenya and Tanzania, payment systems using mobile phones, such as M-Pesa, have proven very successful by making services available in areas that have no banks or wire transfer providers.  

Kipochi, a bitcoin wallet service, launched a mobile solution in July that allows users to send and receive bitcoins and to convert the currency to and from their M-Pesa balance. It can be used even with the simplest mobile phones and reduces the cost of making payments. 

Cross-border remittances sent by migrant workers back to their home countries are particularly expensive. Wire service transactions cost on average about 9 percent of the value of the transfer, whereas bitcoin transaction costs are less than 1 percent, note Jerry Brito and Andrea Castillo, from the Mercatus Center at George Mason University in their 2013 paper, “Bitcoin – a primer for policymakers.” 

Bitcoin also offers an alternative in countries with high inflation and strict capital controls. The issuance of bitcoins is capped and cannot be manipulated by a central authority.  

“Bitcoin therefore provides an escape hatch for people who desire an alternative to their country’s devalued currencies or frozen capital markets. We have already seen examples of people turning to Bitcoin to evade the harmful effects of capital controls and central-bank mismanagement,” Brito and Castillo write, pointing to the example of Argentina, where Bitcoin has gained popularity. 

The authors also highlight the cryptocurrencies’ potential for further financial innovations as a major benefit. Bitcoins are in principle encrypted packets of data, which, in addition to currency, could contain other information, such as confidential documents, financial contracts or securities.  

Features that are already built into the bitcoin protocol include micropayments, dispute mediations or assurance contracts. Alternative protocols could be developed and placed on top of the bitcoin protocol, much like Web-browsers and email are run on top of the Internet’s TCP/IP protocol. 

Brito and Castillo therefore advocate “policymakers should take care that their directives do not quash the promising innovations developing within and on top of this fledgling protocol.” 

 

Challenges ahead  

The fledgling nature of the currency also means that significant challenges remain. Bitcoin exchange rates display massive volatility, both hyped by inexperienced investors in response to exuberant media coverage or technical issues, such as a hacking attack on one of the largest bitcoin exchanges. The bitcoin protocol and encryption, however, have proven very resilient. Successful attacks, including denial of service attacks and theft, have mainly targeted bitcoin exchanges.  

Some commentators argue that the volatility is only the precursor to the payment system’s undoing, while others believe it represents initial teething problems that will disappear once bitcoin users become more familiar with the payment ecosystem.  

Bitcoin price volatility is not necessarily a problem for merchants who are able to price goods and services in traditional currency and accept bitcoins at current exchange rates. However, anybody who is holding bitcoins longer term has to consider the exchange rate risk. There are also considerable differences in the exchange rate value of bitcoins on different bitcoin exchanges. Some exchanges have struggled with executing timely payouts. 

Users unfamiliar with bitcoin also run the risk of accidentally deleting their bitcoins or having them stolen through malware. In this sense, bitcoins are not different from cash; users have to learn to take appropriate precautions. 

 

Andresen, the head developer at the Bitcoin Foundation, acknowledges that bitcoin is still an experiment. The longer it survives among the volatility, hacker attacks and technical glitches, the more trust it will generate. 

Bitcoin is a decentralized payment system and virtual currency. The bitcoin payment system does not rely on centralized servers. Instead, it employs the machines of the users who interact directly with each other.  

Before bitcoin was invented in 2008, all online transactions were processed by third-party financial intermediaries.  

Since digital currency is nothing more than a computer file, when a payment is made, it is transferred from one party to the other. In principle it could be copied and used multiple times, just like email that remains on a user’s computer after it has been sent.  

To prevent this “double-spending” problem, digital currencies ordinarily need a central clearinghouse to keep a real-time ledger of all transactions, adding funds to the party that received the currency and deducting them from the party that paid. Bitcoin obviates the need for a legder-keeping trusted intermediary by distributing the ledger among all the users of the payment system via a peer-to-peer network.  

The ledger, called the block chain, records every transaction that has ever occurred using bitcoin, and new transactions are checked against it to prevent the same bitcoin from being spent twice by the same user. 

The bitcoin system relies on public key cryptography, which assigns each user two keys, a secret private key and a public key that is shared with other users. In a payment transaction, the person who makes the payment creates a message that contains the receiver’s public key and signs it with their private key. The money transfer is then recorded, time-stamped and displayed in one block of the block chain.  

 

Money supply  

In contrast to other currencies, bitcoins are not issued by a central authority. Instead, they are created by the community of users, who provide the computer power for the logging and reconciling of transactions and to authenticate the payment network. 

These users, called miners, connect their computers to solve increasingly complex math problems that verify the transactions in the block chain, and in the process are rewarded with newly created or “mined” bitcoins. 

The protocol is designed to replicate the extraction of natural resources such as gold, slowing the creation of bitcoins over time and capping it at 21 million bitcoins, which is expected to be reached in the year 2140. 

To some, growing the money supply at a predictable rate that cannot be manipulated by politicians or central bankers is an interesting prospect in today’s world of quantitative easing. 

Unlike real currencies that derive their value from gold or government-backed fiat, the exchange rate of a bitcoin is determined in an open market, totally dependent on the value that users assign to it. 

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