Introduction
Bitcoin, a creation of
a computer programmer under the pseudonym Satoshi Nakamoto is an immensely
popular decentralized virtual currency. In this post we seek to present a brief
overview of such currency and its legal classification. We will however discuss
the issues in detail in subsequent posts.
Bitcoins are referred
to as cryptocurrency. The system basically uses encryption to validate
transactions as well as for the production of the currency. Unlike other
currencies either real or digital, there is no central bank or other central
controlling authority. Bitcoin’s
decentralized system depends purely on an algorithm to regulate the currency
thereby excluding human involvement in the production or distribution of the
currency.
Bitcoin’s popularity
lies in the fact that it works on a peer-to-peer basis. Hence it eliminates the
need of a third party which significantly lowers transaction costs. There is a
common presumption that transactions relating to Bitcoins are anonymous. However,
one must take into account that Bitcoin system records all transactions on a
public ledger referred to as blockchain.
The transactions are not completely anonymous but allow for the use of
pseudonyms. The public ledger is part of a highly cost-efficient design. The
public ledger addresses two major problems. Firstly, since each Bitcoin and
each user is given a unique digital identity the risk of forgery or
counterfeiting is mitigated. Secondly, the public ledger eliminates the need to
include a third party to verify transactions since the public ledger itself verifies
the transfer of Bitcoins to the seller from the buyer.
In general there are
three modes in which Bitcoins can be procured.
Users can exchange conventional money to procure Bitcoins. Typically
there is a 0.5 per cent or lower exchange fee in such transactions. Bitcoins are sold at prices determined on the
basis of supply and demand. The price of
Bitcoin is prone to severe volatility with prices fluctuating by a few hundred
dollars within a month.
The second method of
procuring Bitcoins is by accepting the same as exchange for sale of goods or
services. The third method is called mining.
Users solve a complex math problem to discover new Bitcoins. Typical home
computers will generally not enjoy much success in solving the problem. It is
so designed that Bitcoins will be discovered at a limited and predictable rate.
Bitcoins are immune
from the monetary policy of the Central Bank of a country since neither its
velocity (rate of exchange) or the amount of money is directly under the
supervision of the bank determining monetary policy in a country.
Another unique feature
is that only 21 million Bitcoins will ever be created. One Bitcoin can be
divided up to 8 decimal places. When the maximum limit of Bitcoins are reached,
will be traded without addition in number of Bitcoins,
the trades will be likely to be in fractions of Bitcoins such as transactions
of 0.10 Bitcoins down to 0.000 000 01 BTC.
Commercial
Advantages with Bitcoins
The use of Bitcoins has
attained a fair amount of popularity. The widespread use may be attributed to
the following:
1. Transaction costs are significantly reduced
for electronic payment.
2. Transactions using Bitcoins provide a
great amount of privacy and perhaps a complete protection from identity theft.
3.Immunity from inflation is another
complex advantage over conventional currency. Once value stored in conventional
currency is converted into Bitcoins, a reduction in relative value of
conventional currency has no effect on value stored in Bitcoins.
Concerns
with use of Bitcoins
The extent of
regulation of Bitcoin remains unclear, especially in the Indian context. In December last year, the RBI released a
press note warning users of Virtual Currencies against Risk posed by such
currencies including Bitcoins and litecoins. The regulation does not prohibit
the use of Bitcoins, instead it declares that the creation of Bitcoins and
their trading is not regulated under the auspices of the Central Bank or
monetary authority. The concerns
highlighted in the press note are that
i. Virtual Currency (VC) is stored in
electronic form carried in electronic wallets. They therefore become vulnerable
to hacking and loss of password.
ii.
There is no established framework for
consumer dispute redressal.
iii.
The value of VC has been subject to
great volatility in the recent past.
iv.
VC may be used for illicit
transactions. Further, in view of the
limited anonymity this could lead to unintentional breaches of the Anti Money
Laundering and CFT(combating the financing of terrorism) regulations.
As a caveat the RBI has
stated it is currently examining the issues associated with the usage, holding
and trading of VCs under the extant legal and regulatory framework of the
country, including Foreign Exchange and Payment Systems laws and regulations.”
Its concerns are well
founded in the wake of instances of hacking of VC systems in specific Bitcoins
since well known Bitcoin Exchanges like Mt. Gox and Bitfloor have been subject
to hacking attacks resulting in great theft of Bitcoins.
Legal
status of Bitcoins
Recently the United
States District Court of Eastern District of Texas sought to define the term
and stated that a bitcoin is an electronic form of currency unbacked by any
real asset or without specie, such as a coin or precious metal. In simple
terms, Bitcoins are currencies which are intangible and are not issued by the
Central Bank. They are generated by a specific community and are definite
mediums of exchange in those communities which accept the same. In its
judgement the court stated that:
“It is not regulated by a central bank or any other form of governmental authority; instead, the supply of Bitcoins is based on an algorithm which structures a decentralized peer-to-peer transaction system.”
The legality of
Bitcoins was discussed elaborately in the same case. The
point taken into consideration was whether Bitcoins are securities.
This question was
answered in the affirmative by the Court. In this case Shavers, the founder of Bitcoin Saving & Trust (BTCST)
solicited the sale of Bitcoins to investors. The investors suffered losses due
to a fraudulent transactions and misrepresentations. The first question the Court considered was whether Bitcoins are securities under 15 U.S.C. § 77b. Determination of this issue was
relevant to assess whether the SEC had subject matter jurisdiction over the
dispute.
Shavers contended that
a Bitcoin is not a currency regulated in the United States of America. Further
no ‘money’ had been exchanged in these transactions. Therefore SEC does not
have the jurisdiction. The SEC on the other hand argued that the BTCST
investments are both investment contracts and notes, and, thus, are securities.
The term “security” is
defined as “any note, stock, treasury stock, security future, security-based
swap, bond…[or] investment contract…” [1] An
investment contract is any contract,
transaction, or scheme involving (1) an investment of money, (2) in a common enterprise, (3) with the expectation
that profits will be derived from the efforts of the promoter or a third party.[2]
By relying on the above
definition, the court concluded that a Bitcoin can be used as money as it can
be used to purchase goods or services. The only limitation being that the same
is used only in places where the currency is accepted. Therefore Bitcoin was
held to be security.
While the SEC has at
least preliminarily found to have standing to regulate Bitcoins, the Treasury
has declined from exercising jurisdiction in relation to investments and
trading in Bitcoins.
In subsequent posts, we will discuss in detail
the regulatory issues out of use and trade of Bitcoins and similar currency
with a special focus on India.
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