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Originally published May 20, 2014
Bitcoin is an innovative payment network and a new kind of money. This is the opening sentence on the official Bitcoin website, and hence the way that it attempts to convey meaning for the word Bitcoin. Yet, we know that it takes more to describe or define Bitcoin. A peer-to-peer payment system, virtual currency, cyber money, cryptocurrency and several other terms provide additional insights into what it is that we are dealing with.
Entering the marketplace as open source software in 2009, Bitcoin was initially touted as being a way to pay for goods or services online, peer-to-peer. But it didn’t take long for Bitcoin to go beyond that initial purpose and become an asset in itself to be created, stored, traded and speculated with in the open marketplace. In effect the virtual money, issued by no government, regulated by no central bank, and with an origin shrouded in mystery,1 had become as real as the dollar, the euro, yen, ruble, rupee, pound, won, peso or shekel in being accepted in payment for goods, services or in exchange for other currencies themselves. Today we can even see Bitcoin ATMs in several places around the world. To the $, €, £, ¥, ₩, ₪, ₫ or ₹, we must now add , which while it is not yet recognized by the International Standards Organization (ISO), is already being used in several financial exchanges.
And by the way, Bitcoin is only one virtual currency. It happens to be the one that has attracted the most attention and is forcing investors, banks, markets and now also governments to look at this new phenomenon. Other virtual currencies. like Mastercoin, Namecoin, Peercoin, Auroracoin, Litecoin, Coinye, Dogecoin, Saturncoin or Ripple, have their own particular characteristics, dissemination mechanisms and encryption rules.
In a way, Bitcoin is a business intelligence maven’s dream come true. You can actually mine money directly on your computer, and the process is even referred to as “mining Bitcoins.” To get into the game, you must participate in the Bitcoin network and contribute compute power to solve a cryptography problem that protects the integrity and the chronological order of the transaction chain, mainly finding the key that matches a hash number accompanying a collection of transactions.
Let me simplify the way it works. A Bitcoin transaction is defined as a “transfer of value between Bitcoin wallets” or accounts. Groups of transactions are chronologically collected as “coins” in a lockbox, called a block, to which the key has been thrown away. In order to “deposit” the Bitcoins in a given block, they must be entered into the universal Bitcoin ledger, called the block chain. But for this you need to find the key that opens the box. The equivalent of producing random physical keys until one works is accomplished through a cryptographic algorithm similar to hashcash (see A. Back, "Hashcash – a denial of service counter-measure," 2002). Cracking this encryption algorithm takes a very large amount of compute power. Hence, a network of CPUs collectively attacks this task; and the one that actually finds the right key, or cryptographic nonce, literally “wins the lottery.” At that point all the Bitcoin transactions in that block are entered into the block chain and the computer account that found the right key is rewarded with some extra Bitcoins.
So what does any of this have to do with governments? Until a few weeks ago, not much. Bitcoin was seen with some concern or even alarm by banking and securities agencies as a decentralized currency that was being mainly used on the Internet in a variety of transactions. And then things changed.
Over the last eighteen months, Bitcoin has had significant volatility as several speculators have been at work trying to milk the Bitcoin market. Among the most important players are the Winklevoss twins, of Facebook fame. They started a fund called the Winklevoss Bitcoin Trust; provided seed funding of BitInstant, a bitcoin payment processor; and launched Winkdex, a financial index tracking the price of Bitcoin. As often happens with speculation many investors got hurt and that, in turn, attracted a lot of attention from central bankers and regulators.
But the straw that broke the camel’s back was the Silk Road incident. We all know that with the growth of e-commerce the Internet has become a marketplace for just about everything, and not all good. Silk Road, operating as a Tor hidden service in the Deep Web, became the principal cyberstore for goods and services that were either illegal or unethical or both. You want drugs, weapons, porn? Do you need to buy a kidney for a transplant? Do you want to put a hit out on someone? Go to SilkRoad.com.
According to Wikipedia, the site’s catalog of products included “child pornography, stolen credit cards, assassinations, and weapons of mass destruction” as well as other legal offerings. The principal form of payment on Silk Road was Bitcoin, through a Bitcoin-based exchange. Silk Road, of course, has now been shut down as a result of the arrest of its reputed mastermind on charges of money laundering and other black market transgressions.
Then we had the crash of one of the most important Bitcoin exchanges, Mt. Gox, as a result of a massive hacking incident that resulted in significant losses. Exchanges like Mt. Gox are where people go to convert Bitcoins into real currencies like dollars, yen or euros. Well, the Mt. Gox incident caused a loss of about $348 million in Bitcoins – although it has recently announced it has recovered $120 million – and led to its declaring bankruptcy.
So what does all this mean? That Bitcoin, which was designed to be unregulated and not controlled by any nation’s banks or central authority, is under significant amount of pressure to accept some level of regulation and oversight.
The pressure is coming, first, from investors who are now flocking to their government regulators at national and provincial levels for help. The Tokyo-based Mt. Gox received a subpoena from the state of New York and Japan is also carrying out its own investigation. In order to capture investor confidence, some other exchanges have stated that they plan to comply with all SEC regulations.
On the government side, there is also a strong desire to bring Bitcoin into the fold. Already California has seen action in the state senate to make Bitcoin a legal currency, and New York state has indicated that it will introduce some type of plan to regulate it. (See “New York Might Be First to Regulate Bitcoin,” by Catherine Hollander, National Journal, February 21, 2014.) And recently the Federal Election Commission gave its approval for Bitcoin campaign donations.
Then there are issues of intellectual property, also the domain of government, through patents and copyrights. As an MIT alum, I was surprised to see an open letter to all alumni from MIT President L. Rafael Reif. In it he comes out in support of Tidbit, “…a proof-of-concept code for a novel Bitcoin-harvesting strategy.” Turns out that several MIT students had developed this software and received an award at a hackathon, only to be hit with a subpoena from the State of New Jersey Attorney General demanding that they “turn over all versions of the source code, all Bitcoin wallets associated with Tidbit, all agreements and communications with third parties, the name and IP addresses of everyone who mined Bitcoins using Tidbit,” etc. Needless to say they are fighting back, with the support of the MIT community.
But even the tech community is concerned. Bitcoin is the currency of choice in many cyberattacks where the bad guys are requesting ransom or protection money from distributed denial-of-service (DDoS) attacks. Recent targets have included a number of technology startups, such as Meetup, Vimeo, Shutterstock and MailChimp. (See the blog “Tech Start-Ups Are Targets of Ransom Cyberattacks,” by Nicole Perlroth and Jenna Wortham, New York Times, April 3, 2014.)
Lastly, there is the issue of taxation. Thus far, only Singapore, among the significant financial players, is taxing Bitcoin, but a lot of other jurisdictions are chomping at the bit. And a few weeks ago, the IRS finally spoke out on Bitcoin. (See “I.R.S. Takes a Position on Bitcoin: It’s Property,” by Rachel Abrams, New York Times, March 25, 2014.) Interestingly enough, it clarified that Bitcoin does not have legal tender status in any jurisdiction. For purposes of U.S. taxes, Bitcoin is being considered property rather than currency. This means, among other things, that owners of the asset will have to compute the delta change in value of each Bitcoin from when it was obtained to when it was spent and that gain (or loss) will be taxed accordingly.
The most important aspect of all this is that the cat is out of the bag. Cyberspace is a parallel multiverse where authority from nation states is not as easy to establish. Money, that indispensable artifact that facilitates the easy exchange of goods and services in free markets, has its equivalent in cyberspace and it has until now not been issued, controlled or regulated by any government. That game is playing out right now for Bitcoin and other virtual currencies. It is very interesting and important to see what the end game will be.
Recent articles by Dr. Ramon Barquin