In 2009, a programmer going by the pseudonym Satoshi Nakamoto introduced Bitcoin, partially in response to the financial crisis. Nakamoto wanted a currency that governments and banks could not easily manipulate. Bitcoin is defined by code and has no physical form or intrinsic value. It is completely decentralized and can be exchanged anonymously without incurring any financial service fees. These same traits have made Bitcoin attractive for criminal activities and a challenge to regulators, enforcement agencies, and tax authorities.
Prone to Cybercrime
Because Bitcoin can be used anonymously, it is attractive for illegal financial transactions such as money laundering and buying narcotic drugs online. In 2013, the FBI shut down Silk Road, an online black market best known for illegal drug trade that used Bitcoin as currency. The government seized millions of dollars’ worth of Bitcoins in the process. The U.S. Marshal later auctioned off a portion of these confiscated Bitcoins. In a 2014 Forbes magazine article, then Executive Director of the Bitcoin Foundation, Jon Matonis, said the auction proves that Bitcoin is fungible and possesses a “market-based legitimacy.”
As a currency with no physical presence that is stored online, Bitcoin is also attractive to hackers and thieves. Several Bitcoin storage and exchange companies have suffered major thefts. In early 2014, Japan-based Mt. Gox, then the largest digital currency exchange in the world, was forced to declare bankruptcy when it discovered hackers had stolen $477 million work of Bitcoins. In March 2014, a Canadian Bitcoin storage company called Flexcoin lost approximately $650,000 worth of Bitcoins.
Current Bitcoin Legal Framework
Because it is still so new, there are no international laws regulating Bitcoin. Each country regards Bitcoin differently and regulations are constantly evolving. This article focuses on the stance of U.S. financial authorities as other governments may look to the United States for precedent.
The U.S. Department of Treasury’s Financial Crimes Enforcement Network (FinCEN) issued its first guidance about digital currency in March 2013 (document) followed by another in January 2014 (document). These guidance discussed Bitcoin participants, categorizing them as users, exchangers, and administrators. FinCEN further defined exchangers and payment processors as money transmitters whose actions fall under the laws governing money services business (MSB) within the Bank Secrecy Act (document). Once any business or individual falls under FinCEN’s definition of money services business, the entity must meet registration requirements and adhere to a range of anti-money laundering, recordkeeping, and reporting responsibilities. BitPay is one of the Bitcoin-related companies already registered with FinCEN.
The number of businesses and merchants (like Overstock (OSTK), Dish Network (DISH), and Dell) accepting Bitcoin is increasing. Many merchants have expressed interest in a derivative products (and derivative markets) through which their exposure to Bitcoin price fluctuations could be hedged. Derivatives are a popular way to hedge risk through products such as futures, forwards, options and swap. Many registered trading platforms are ready to list Bitcoin derivative products. The Tera Exchange, a registered SEF (swap execution facility) with the U.S. Commodity Futures Trading Commissions (CFTC) already has a CFTC-regulated product called USD/XBT Swap. The product protects the value of Bitcoin by locking in a dollar price.
The U.S. Commodity Futures Trading Commissions held their Global Markets Advisory Committee meeting in October where it discussed various aspects of Bitcoin (though it made no formal announcement afterwards). In a December 2014 speech, CFTC Chairman Timothy Massad said that some aspects of virtual currencies will fall under the agency’s jurisdiction.
New York has taken the lead among the U.S. states to propose Bitcoin regulations. In July 2014, the New York Department of Financial Services issued a legal framework proposal (document) called BitLicense for firms dealing in virtual currency in the state. The proposal requires certain compliances for anti-money laundering, consumer protection, capital requirements, and cyber security. Here is the response by the Bitcoin Foundation on the New York proposal.
In May 2014, the Securities and Exchange Commission (SEC) issued an investor alert about Bitcoin and other virtual currency investments (document). The SEC intended to make investors aware of the potential risks involved in Bitcoin and other virtual currency‑related investments (See: The Risks Of Buying Bitcoin). There is no clear cut ruling or regulation by the SEC on Bitcoin. The Financial Industry Regulatory Authority (FINRA) also issued a similar investor alert, highlighting risks and potential scams (document). For taxation purposes, the Internal Revenue Service (IRS) treats Bitcoin as property and not currency. The transactions would include wages received in virtual currency, self-employment payments in virtual currency, and any profit or loss arising from the sale or exchange of Bitcoins (document). (See: Bitcoin IRS Tax Guide For Individual Filers)
Future Bitcoin Laws
With many prominent businesses now accepting Bitcoin, there is an increasing expectation that regulators provide security for Bitcoin use and storage and clarity on Bitcoin laws. National and international agencies may get involved in advanced tracking techniques, training, and online identification methods. Law enforcement agencies will continue to focus on the use of Bitcoin in illegal drug and money laundering transactions. Government agencies may also focus on digital currency exchange organizations (such as Mt. Gox). As the Bitcoin community expands and matures, the need for government mandated licenses, record keeping, and reporting is bound to increase.
The Bottom Line
With half a decade in existence and billions in valuation, Bitcoin and other cryptocurrencies are here to stay. The Bitcoin community is growing in size and legitimacy. For example, the ex-chairman of SEC is on the advisory board of two Bitcoin-related companies (BitPay and Vaurum). New regulations are coming to prevent criminal use, secure against hackers, protect merchants, and tax and regulate users. Until then, Bitcoin users must adhere to anti-money laundering and cyber security laws.