What is Bitcoin?
Bitcoin was first proposed in 2008, through a research paper signed with the nickname Satoshi Nakamoto. Very little is known about the mystic figure/s hiding behind that pseudonym. Nakamoto presented himself as a 37-year-old male based in Japan, but speculations persisted that he may not be Japanese due to his occasional use of British English terminology and spelling as well as the fact that his bitcoin software was not labelled in Japanese. Additionally, many from the early Bitcoin community observed that the system was too well designed to be the deed of a sole creator thus suggesting that there might be a group of developers behind the pseudonym. In one of his latest public postings on 11 December 2010 Nakamoto expressed his displeasure that a huge portion of the public attention to the new cryptocurrency was channeled by Wikileaks – “It would have been nice to get this attention in any other context. WikiLeaks has kicked the hornet’s nest and the swarm is headed towards us.” At that exact moment most of the credit card companies had blocked Wikileaks from receiving donations and Bitcoin was the only remaining viable option for the organization to take in financial contributions. Adding further layers of mystery and inviting speculation, Satoshi Nakamoto published his last posting on the next day – 12 December 2010, and disappeared forever from the public eye. His legacy, however, keeps growing ever more influential as time passes by.
Nakamoto’s creation – Bitcoin (or BTC), can be described as a decentralised digital currency that relies on a distributed network of users and advanced cryptography techniques. Notably, BTC is not backed by any government. Furthermore, there isn’t a bank or a company that issues and manages it. At a very basic explanatory level, a bitcoin is just a computer file, in the same way as an audio file or a digital text document, which can be stored on a hard drive. This file contains a series of digital signatures that represent the transactional history of the specific unit so that the system may confirm its authenticity and potentially facilitate a change in ownership. Additionally, Bitcoin transactions can be described as pseudonymous (but not anonymous), as the system makes it possible to trace the transactions without linking them to a concrete identity. For identification to occur significant additional efforts would be needed.
Bitcoin users have the opportunity to download open-source software and store bitcoins in a digital wallet on their computer or smartphone or alternatively use a third-party provider as a storage platform. A user’s wallet normally consists of the bitcoins it contains, a public key, and a private key. The public key plays the role of an address to which another party can send bitcoins, and the private key enables the owner of the digital wallet to send his own bitcoins to someone else. Both ways of storing BTC are naturally risk-prone. When a user relies on his own computer this leaves him vulnerable to hacking and hard drive failures. As a bitcoin is nothing but a computer file, with the loss of that file comes the loss of value. Third-party platforms that provide wallet services are also susceptible to the same risks despite a general presumption that they implement stronger security and back-up solutions.
Arguably, the two greatest achievements of Bitcoin as a digital currency are the elimination of the financial intermediary in online transactions and the solution to the problem of “double spending”.
Nowadays, many methods exist for fast money transfers across national borders. However, most of them involve significant transaction fees – banks, credit and debit card companies and PayPal normally take their own cut out of a transaction. In his paper Nakamoto pointed to a fundamental flaw of e-commerce: the necessity for a financial institution to perform processing of the payments (including verification of the authenticity of payments and fraud prevention) and thus to impose costs on the parties to a transaction. Nakamoto then proposed an elegant solution – a peer-to-peer network could replace the financial intermediary and fully engage with payment processing, thus decreasing transaction costs to practically zero. This peer-to-peer network would operate using the processing power of individuals’ personal computers, as they would receive payment in bitcoins in exchange for their service. Thus, the Bitcoin system would be independent and self-sustainable.
As for the issue of double spending, the proposed solution involved the use of a ledger – the so called blockchain. As a rule, all transactions with bitcoins have to be recorded chronologically on a public ledger (the digital equivalent of an accounting book) that makes it possible for every Bitcoin user to follow the transactions. Similar to the regular files held on a home computer, bitcoins can be copied and transferred between parties. After a bitcoin is sent, the original copy remains on the sender’s hard drive and can potentially be re-used in further transactions even though the actual value has already been spent. However, every computer connected to the Bitcoin network has a copy of each transaction on the ledger. Thus, as transactions take place and changes in ownership occur, a permanent digital trace is left. The ledger documents the movement of each bitcoin. When a transaction occurs it is added to the Blockchain and time-stamped. Therefore, if bitcoins are used more than once by the same party, the transaction with the earlier time-stamp will be treated as the valid one, and all subsequent transactions made by that party, using the same bitcoin will be considered invalid.
How to get one
There are several ways for obtaining bitcoins: (i) through “mining”, (ii) by purchasing them, or (iii) by selling a good or service and accepting payment in BTC.
Probably, the easiest way to obtain existing bitcoins is to purchase them through an exchange. There are a variety of exchanges but the core concept is the same: users are able to trade traditional currency for bitcoins at the current exchange rate which is determined solely by supply and demand. Furthermore, Bitcoin ATMs allowing users to both buy bitcoins and exchange them for cash are also getting ever more popular across the world.
As for new bitcoins, they can only be produced through a process known as “mining”. Every time a bitcoin transaction occurs, a computing process must be undertaken to verify its legitimacy. Due to the lack of a central server in the Bitcoin network, these operations have to be carried out by the users in the peer-to-peer network. Thus, the “miners” are in fact computer users who are running specialized software that undertakes the necessary calculations to support the network. Each new Bitcoin transaction is broadcasted to the network since it has to be added to the ledger – the blockchain. However, merely sending the information does not complete the process. New transactions are collected into a block that needs to be effectively added to the blockchain. The transactions are verified by checking against the ledger that the bitcoins are sent by someone who has received them earlier and that they have not been spent before. This part of the process is deemed to be computationally easy. However, for the addition to the blockchain to be recognized, a network participant must also complete “proof-of-work”, or in other words solve a complicated mathematical puzzle that is presented by the system. The puzzle is to be solved through brute calculation force – by trial and error. Therefore, the more computing power a miner has, the quicker he can go through potential answers, and the faster he can find the solution. The first miner to reach the solution is the one that attaches the block to the blockchain and receives bitcoins as a reward. All other miners in the competition lose the race, accept the block, and need to move on to other transactions. This results in a very competitive environment. Nowadays, successful miners in the Bitcoin network undertake serious investments in specially designed hardware. Mining further demands time during which the computing power could be spent on something else, and last but not least considerable amounts of electricity.
Pros and cons
There are several reasons for Bitcoin’s increasing popularity and success. First, the nature of the peer-to-peer network allows for sweepingly fast transactions across borders irrespective of factors such as location or working hours. Second, the transactional costs are extremely low. This is also attributable to the peer-to-peer system, because the function of a clearing house that ensures the validity of each transaction is taken up by the miners. Third, Bitcoin offers pseudonymous transactions – the users do not need to register with a dedicated central authority and provide it with their details and this naturally shields them from identity theft. At the same time, this partial anonymity has drawn a lot of criticism as it can also be used to facilitate criminal ends. An example on point is the case with the Silk Road – a black market for illegal drugs that operated on the darknet making use of TOR software and pseudonymous payments in Bitcoin, which was successfully shut down by the FBI back in 2013. It also has to be noted that from a consumer point of view BTC transactions are a bit more risky since they cannot be cancelled. Contrarily to traditional payment methods which can be annulled in case of errors, once finalized, a Bitcoin transaction is pretty much irreversible and can only be refunded voluntarily by the person on the receiving end. Last but not least, Bitcoin’s value is very volatile as unlike traditional currencies it is characterized with frequent price fluctuations within very short periods of time.
How is it regulated?
The reactions of regulators across the world towards Bitcoin are vastly diverse. For example, in countries such as Ecuador, Bolivia, Bangladesh, Nigeria and Kyrgyzstan the use of Bitcoin is banned. Notably, in Ecuador, the ban of Bitcoin was related to the roll out of a state-run digital currency – Dinero Electronico. Similarly, China’s Central Bank has also developed a prototype of its own cryptocurrency which is currently being tested. The Chinese regulatory response to Bitcoin over the years has been uneven. Initially, it appeared that China is taking a pro-libertarian stance towards the cryptocurrency leaving it largely unregulated. As a result Bitcoin experienced a great boost in popularity. This was evident not just in the consumer market but also in the investment market. Many wealthy individuals started recognizing Bitcoin as a more profitable venture than investment in property or stocks. Consequently, it did not take long for the Chinese government to intervene and come up with a regulatory strategy. As a result, back in 2013, China’s National Bank declared that Bitcoin is not a currency but a “virtual commodity” and financial institutions were precluded from exchanging it on the market, although individuals remained free to buy or sell bitcoins among themselves. In addition, Bitcoin exchanges were required to file trading records and adopt measures to prevent money laundering practices.
Among the countries with relatively Bitcoin-friendly regulatory regimes are the USA, Canada, Japan and Switzerland. In the US one of the first regulatory steps towards cryptocurrencies was undertaken back in 2013 by the Financial Crimes Enforcement Network (FINCEN), which issued a guidance on digital currencies. It placed digital currency exchanges and processors within the scope of the Banking Secrecy Act by defining them as money service businesses. As a result Bitcoin exchanges in the USA need to comply with a range of registration and record-keeping requirements just as traditional financial institutions. The guidance from FINCEN however left ordinary users of virtual currencies outside the scope of regulation. Canada also provides a very interesting case study in Bitcoin regulation. Initially, the country was labelled as the “wild west” of Bitcoin due to its lack of regulation. As a result of this regulatory vacuum the Canadian Bitcoin exchanges flourished tremendously. Notably, Canada was also the home of the first Bitcoin ATM which opened back in 2013 in a coffee shop in Vancouver. Later in 2014, however, a national law (Bill C-31) was signed that imposed regulation on Bitcoin. The new law treats virtual currencies, including Bitcoin, as “money service businesses” for the purpose of anti-money laundering regulation. As a result, companies dealing in virtual currencies need to register with the Financial Transactions and Reports Analysis Centre of Canada (FINTRAC), and implement certain compliance mechanisms – retain and store records of transactions, report suspicious transactions, etc. Japan has also recently passed a bill that concerns digital currencies and digital currency exchanges. The new law defines Bitcoin and other virtual currencies as a form of payment method and not a legally recognized currency. Interestingly, the new law differentiates virtual currencies not only from traditional currency but also from electronic money. The law also adds regulatory requirements applicable to digital currency exchanges requiring them to implement IT system management policies with measures to prevent loss and damage to both funds and personal information. As for Switzerland, the financial markets regulator – FINMA, has recently approved the first Swiss private bank for bitcoin asset management, potentially incentivizing other global banks to offer digital currency products.
At the EU level, there are two significant developments in view of Bitcoin regulation that deserve to be mentioned. First, in its ruling on Case C-264/14 (Skatteverket v David Hedqvist), the Court of Justice of the European Union proclaimed that the exchange of traditional currency for Bitcoin units is exempt from VAT. Second, in 2016 the EU Commission published its Proposal for amendment of Directive 2015/849 on the prevention of the use of the financial system for the purposes of money laundering or terrorist financing. The aim of the proposed amendment is to address some existing gaps in the oversight of financial transactions including the potential use of virtual currencies for criminal activities. Recently, the EU Parliament proposed significant amendments to the text initially introduced by the Commission. First, the EU Parliament suggests that it is necessary to extend the scope of Directive (EU) 2015/849 so as to include regulation of “issuers, administrators, intermediaries and distributors of virtual currencies, and administrators and providers of systems for online payments” in addition to regulating virtual currency exchanges. The end goal of such broad regulatory reach would be for the competent authorities within the EU to be able to monitor the use of virtual currencies and identify suspicious activities. Furthermore, the Parliament suggests that “virtual currencies should not be anonymous and national Financial Intelligence Units (FIUs) should be able to associate virtual currency addresses to the identity of the owner of virtual currencies”. It remains to be seen whether such far-reaching provisions would find their place in the final text of the Directive after the legislative procedure is finalized.
It becomes clear from the presented regulatory landscape that Bitcoin (and cryptocurrencies as a whole) is still a new phenomenon in the realm of finance and a harsh regulatory response at this point could potentially kill the innovative benefits it brings. It is obvious that Bitcoin offers certain economic advantages when compared with traditional currencies and traditional payment methods and this should not be overlooked. However, its volatility is a significant setback on its track to become a mainstream currency. What could certainly be done at this point is the implementation of targeted legislation that focuses on battling the use of digital currencies for illicit schemes and criminal purposes. At the same time, if Bitcoin, or any other cryptocurrency, eventually finds its place into mainstream commerce then extensive regulatory oversight is a certainty.
At the moment of writing of this article, one bitcoin is traded for $4156.