Daniela Sonderegger. Washington University Journal of Law & Policy. Volume 47, Winter 2015.
[T]here is something special about Bitcoin that makes it inherently resistant to government control. It is built on code. It lives in the cloud. It is globalized and detached from the nation state, has no own institutional owner, operates peer to peer, and its transactions are inherently pseudonymous. It cannot be regulated in the same way as the stock market, government currency markets, insurance, or other financial sectors. — Jeffrey Tucker
Introduction
Set aside all of the legal and regulatory parameters and simply take a moment to imagine a world that functions on a single digitalized currency, regulated not by a central authority, but rather by the individual users who take part in the system. Imagine being a businessperson, with back-to-back meetings across the globe. Wouldn’t it be nice if instead of stopping at the currency exchange in each country or having to notify your bank of your travels, you could simply walk off the plane and go to your favorite coffee shop or restaurant and pay by having the storeowner scan a code on your phone? Bitcoin, a new decentralized peer-to-peer digital currency, aspires to achieve this kind of borderless world.
More than a technological innovation or a view of the future, Bitcoin is poised to threaten the very foundation upon which fiat currency and monetary policy rest: centralized control. Bitcoin is unnerving precisely because “a world where it [is] used for all transactions is one where the ability of a central bank to guide the economy is destroyed, by design.”
Bitcoin was developed during a time in which the Federal Reserve plunged into an unprecedented period of monetary intervention to stave off a financial crisis that many argue was brought about by risky, unregulated investments; a world in which the Cyprus banking crisis propelled that country into a deep recession; and a world where Greece, Spain, and Italy have fallen into economic misery. It is this mistrust of governmental authorities during these unprecedented times that has spurred interest in Bitcoin.
Bitcoin has essentially turned the mistrust of existing financial institutions into a philosophy. It is the first decentralized digital currency (meaning it has no central regulatory entity). Hailed the ultimate alternative to the global banking system, Bitcoin is a payment system that allows international transactions to take place at any hour, in any place, at a very low cost. Politically, Bitcoin seeks to separate money from the state’s regulatory power. Elizabeth Ploshay, a writer for Bitcoin Magazine describes it as “‘[A] movement’—a crusade in the costume of a currency. Depending on whom you talk to, the goal is to unleash repressed economies, to take down global banking or to wage a war against the Federal Reserve.”
Others have described Bitcoin as a victory for individuals who seek payment transactions without barriers and surveillance. Bitcoin represents an opportunity for countries without a developed financial sector to send and receive payments without barriers and excessive remittance fees. These reduced transaction costs can encourage small value transactions that will aid in the development of small businesses and can provide financial access to nations with underdeveloped financial sectors.
Skeptics see Bitcoin as a questionable economic scheme wrapped up in a of libertarian political agenda. They think Bitcoin users and believers are disconnected from the world’s financial problems and lack an understanding of the central bank’s role. What is worse is that many view Bitcoin as a safe-haven for criminal activity.
The truth may lie somewhere in between. The fact of the matter is that Bitcoin has evolved into a powerful, disruptive payment system. Governments around the world, threatened by Bitcoin’s ideological underpinnings but awed by its technological potential, find themselves in somewhat of a dilemma On the one hand, regulation seems necessary. On the other, Bitcoin rejects centralized control and exists exclusively on the Internet, meaning that true, effective regulation can exist only through worldwide cooperation, which is costly, not to mention highly complex.
Presently, many merchants around the world accept Bitcoin as currency. Furthermore, the US government has not prohibited the currency and some within the government have recognized the value of the technology. Despite wider acceptance, Bitcoin is not yet fully understood and continues to exist under extreme regulatory uncertainty.
This Note analyzes Bitcoin and ultimately proposes a short-term solution to Bitcoin’s regulatory uncertainty: one that aims to balance the government’s interest in regulation and Bitcoin’s very rejection of central authority. Part I of this Note introduces Bitcoin, including an analysis of Bitcoin’s strengths and weaknesses for mainstream adoption. Part II presents the current regulatory landscape and analyzes the possible classifications and regulations under which Bitcoin could potentially fall. Finally, Part III of this Note proposes that the US government’s best alternative to regulating Bitcoin is something shy of full-fledged regulation. Instead, this Note argues that Bitcoin should be allowed to function within a loosely defined legal framework and permitted to develop with only a minimal degree of governmental intervention.
I. History
A. Bitcoin and the Future of Digital Currencies
Bitcoin is the world’s first decentralized currency that is not linked to any real world currency or commodity. Bitcoin refers both to the Bitcoin Payment System (Bitcoin), which is a peer-to-peer network that does not rely on any central government authority to function, as well as the denomination of the currency (bitcoin). The Bitcoin payment system relies on a collective network that issues, transacts, processes and verifies all bitcoin transactions. This process is termed a “proof-of-work system.” Each time a transaction occurs, users must solve a mathematical puzzle to verify the transaction. Once it is verified, the transaction is recorded within the network on what is called a “block-chain.”
The purpose of the Bitcoin payment system, according to the founder of Bitcoin, Satoshi Nakamoto, is to overcome today’s “trust based model.” Nakamoto authored a paper when he launched Bitcoin describing the weaknesses of today’s so-called “trust model,” which relies on trusted third party financial institutions to process payments. Inherent in Nakamoto’s argument is a critique of the reversibility of current transactions. Trusted third parties are unable to avoid mediating disputes or guarantee finality in each payment, which inevitably increases users’ transaction costs. The possibility of reversal heightens the need for trust and causes a certain level of fraud to become acceptable in the system.
A better system, Nakamoto argues, is based on cryptographic proof that allows any two parties to transact with each other without the need for a trusted third party.” Transactions that are computationally impractical to reverse, Nakamoto argues, will protect sellers against fraud and eliminate the need for third parties. Bitcoin, at its core, is therefore a payment system or a platform through which payments can be made.
The Bitcoin system overcomes a need for third party intervention mainly through a combination of a process called mining and a shared public ledger (the block-chain). The shared public ledger is a block-chain, which chronologically records every transaction in the system, and forms the backbone of the Bitcoin verification network. Every time a transaction is confirmed, it is included in the blockchain and recorded on every node, or in other words, on every computer, in the Bitcoin network.
To ensure both privacy and validity, each Bitcoin user has a secret private key used to sign the transactions. Each user also has a public key or account number that is visible to other users. The signature provides a mathematical proof that the transaction has come from a particular Bitcoin user, and it prevents the transaction from being altered once it has been issued. Each transaction, as briefly mentioned above, is verified through a distributed consensus system (or proof of work system) called mining.
Mining essentially entails solving a series of complex mathematical puzzles that create additional blocks in the blockchain. Because Bitcoin is decentralized and lacks a verifying centralized authority, Bitcoin transactions are confirmed through this mining process. In order to incentivize the verification process, which is costly because it requires a lot of computing power, those who participate in the verification process and who first successfully solve the mathematical puzzle are rewarded with a certain amount of bitcoins. The system therefore protects the neutrality of the network by allowing different computers to agree on the state of the system and also making repudiation of transactions impossible. Therefore, Bitcoin relies on the public network to circumvent the use of third party financial institutions.
B. Bitcoin Advantages
As a form of new and innovative digital currency and payment system, Bitcoin presents a number of attractive features both for its users and for potential mainstream adoption.
First, Bitcoin excels at addressing counterfeiting. In the digital currency environment, counterfeiting is known as the double-spending problem, which means using the same currency twice. Financial intermediaries have been set up to guarantee that no party will attempt to double spend a currency. Bitcoin, however, has successfully circumvented this intermediary through its blockchain. The sheer computational force required to alter the blockchain, together with the chronological recording of each transaction engrained in the public ledger on each computer in the network ensures that the same coin cannot be spent twice.
Because costs associated with currency exchange rates and other governmental barriers are avoided, Bitcoin enables small value transactions, which facilitate e-commerce and international trade. These reduced costs mean the currency can be used in any transaction around the world to encourage the development of small businesses and allow very small-scale payments to become prominent. The Bitcoin’s design makes it ideal as the lingua franca of commerce conducted online. Bitcoin’s global reach could potentially aid developing markets by connecting people without access to bank accounts to the world economy.
Moreover, some have argued that Bitcoin is particularly appealing because the value cap, set at twenty-one million, prevents inflation. When that amount is reached, no more bitcoins will ever be created. Theoretically, this should keep inflation low and thereby place investment and spending on surer ground. Furthermore, if Bitcoin were to be widely accepted, its capping mechanism would prevent governments from saturating financial markets with bitcoins simply because they think the market needs more money.
C. Challenges For Mainstream Acceptance
Although Bitcoin has increasingly become an attractive alternative to legal tender currencies, it suffers from fundamental flaws that are detrimental to its widespread adoption. First and foremost, governments are highly concerned about Bitcoin’s susceptibility to criminal activity. Because Bitcoin offers varying degrees of anonymity to its users, digital currencies have been increasingly associated with money laundering and other criminal activities. One of the most prominent examples is Silk Road, a digital black market where Bitcoin was used exclusively to buy and sell illegal drugs. Prior to the website’s shut down, the market used a combination of anonymity enhancing technology and sophisticated user-feedback to enable its users to freely buy and sell illegal drugs.
The price volatility of Bitcoin also raises concerns. For example, its value ranged significantly from the beginning of 2013, priced at $13.28 per bitcoin to $1,147 in early December 2013. The inability to convert bitcoins into any specific basket of physical goods or commodities could be a factor affecting its price volatility. Bitcoin’s volatility is particularly problematic because it makes pricing goods and services in bitcoins difficult; this exposes Bitcoin users to substantial exchange rate risks that make the currency less attractive for widespread use. Nevertheless, some have argued that Bitcoin is not inherently volatile, but rather, that its volatility is a product of its newness. If that is the case, then Bitcoin’s volatility will decrease with its increased use and popularity.
Bitcoin’s particular characteristics have also incentivized users to hoard the coins, thereby treating Bitcoin as an investment rather than as a means of exchange. This incentive to hoard results from the future limited supply of bitcoins, which is due to the system’s capping mechanism. Bitcoin’s limited supply helps it improve its stored value, but people may predict that the price will continue to rise, giving them an incentive to hold the coins instead of spending them in the market. As such, Bitcoin behaves more like a highly-volatile commodity.
Bitcoin has also been criticized for its lack of security and users’ inability to bring claims against the wrongdoing party. Bitcoins, stored in ones’ personal wallet or in a third party wallet service, are subject to hard drive failures, malware, and user errors. Holding bitcoins requires a strong encryption scheme and good backup system. One small error could wipe out a user’s bitcoin holdings overnight. Users relying on a third party wallet service must also be aware of its shortcomings and potential for fraudulent use. Given the lack of a Federal Deposit Insurance Corporation (FDIC) equivalent for Bitcoin, users who have lost coins have no means of redress.
Additionally, Bitcoin’s adoption as a mainstream currency is hindered because storing and acquiring the coins requires great computational capacity. Every node in the network must download a copy of every transaction that has taken place, so that as more people join the system, every transaction becomes more resource-intensive. To prevent transactions from becoming too large, Bitcoin limits the size of each block. Currently, Bitcoin transactions are far below the limit, but as the network grows, it will have difficulty effectively dealing with such volume.
Moroever, given Bitcoin’s decentralization, all those using the system need to agree on any change by voluntarily updating their software. This is relatively unproblematic so long as the network remains small and focused, yet presents a concern for further development and improvement of the currency.
Some have argued that Bitcoin’s biggest detriment is conceptual, in that its success is closely tied to its potential failure. That is, Bitcoin’s value depends on a network; the more people who join the network, the higher the value of the Bitcoin, but the more prone it is to hyperdeflation. If Bitcoin succeeds, an increasing number of goods and services will be traded in Bitcoin, but the increase in Bitcoin demand will outpace the rate of increase in the supply of bitcoins given their limited supply, causing Bitcoin’s value to rise. Therefore, the number of bitcoins per each unit of goods and services will fall, triggering deflation. Felix Salmon, a prominent early adopter and commentator on Bitcoin, has claimed that because Bitcoin cannot achieve monetary growth, it cannot sustain an economy and therefore cannot become a widely used currency.
Ultimately, however, what will truly define Bitcoin’s future is a clarification of the legal and regulatory framework surrounding it. Legally categorizing Bitcoin will have substantial ramifications on the future use of digital crypto-currencies.
II. Regulatory Landscape
A. FinCEN Regulations
On March 18 2013, the Financial Crimes Enforcement Network (FinCEN), a branch of the US Department of the Treasury, issued guidelines regarding the administration, exchange, and use of virtual currencies. FinCEN’s Virtual Currency Guidance clarifies the applicability of the existing Bank Secrecy Act (BSA), in particular regarding Money Services Businesses regulations, to “persons creating, obtaining, distributing, exchanging, accepting or transmitting virtual currencies.” The guidelines declare these entities to be subject to the rules governing money transmission. The guidelines did not, however, specify how the currency itself should be classified. Rather, they clarified the regulatory atmosphere for those specifically transacting in Bitcoin.
FinCEN’s guidance is cause for concern for some Bitcoin users because the guidelines subject Bitcoin exchangers and administrators (defined as those who put bitcoins into circulation as well as withdraw them from circulation) to the increased costs of compliance associated with money transmitting regulations. Exchangers are subject to both state and federal licensing requirements. On the federal level, registration requires only filing an application. On the state level, however, the process is infinitely more complex. Moreover, because Bitcoin functions on the Internet and is accessible in every state, a Bitcoin exchanger must register with all those states requiring licensing in order to comply with the regulations, further adding to the cost of doing business.
B. Defining Bitcoin’s Classification and Future: District Court Judge Concludes that “Bitcoin is Money”
In SEC v. Shavers, a Texas federal judge recently declared that Bitcoin is in fact money. The question was introduced to a Texas federal district court in a case regarding a Bitcoin ponzi scheme run by an individual named Trendon Shavers. The issue arose as the court questioned its jurisdiction in the case under the Securities Act of 1993 and the Securities Exchange Act of 1934. Resolution of the jurisdictional question rested upon whether the Bitcoin investments constituted an investment of money.
In order to have jurisdiction under the Securities and Exchange Acts, the court had to conclude that Bitcoin was in fact a security. The court defined a security as “any note, stock, treasury stock, security future, security-based swap, bond [or investment contract ….” It specifically defined an investment contract as “any contract, transaction, or scheme involving three factors: (1) an investment of money; (2) in a common enterprise; and (3) with the expectation that profits will be derived from the efforts of the promoter or a third party.”
The court concluded that Bitcoin “can be used as money” because goods and services can be purchased with bitcoins, it can be used to pay living expenses, and it can be exchanged for conventional currencies. The court recognized, however, that Bitcoin’s acceptance in only a handful of places limits its use as money, but determined that Bitcoin was nonetheless a “currency or form of money” because it can be exchanged for conventional currencies.
After concluding that Bitcoin is an investment of money, the court analyzed the remaining elements of an investment contract, finding that Bitcoin investments “meet the definition of investment contract, and as such, are securities.” It determined that a common enterprise existed because the investors depended on Shavers’ expertise in the Bitcoin market, and he promised a substantial return on their investments as a result of his trading of bitcoins. Moreover, the court also found that the plaintiff met the third factor: expectation of profit. During the venture, Shavers promised interest between 1 percent to almost 4 percent, from which it is clear that the investors were expecting profits from Shavers’ efforts.
The Shavers decision shows one court’s initiative in further delineating Bitcoin’s regulatory landscape, but its ruling warrants a word of caution. The court’s holding that bitcoins are money and that Shaver’s scheme is an investment contract is somewhat limited. As Judge Mazzant acknowledged, bitcoins are not yet widely used as a medium of exchange. Perhaps bitcoins can be classified as money only in the particular circles that take them as payment and in circumstances such as Shavers’ Ponzi scheme.
More importantly, it is not quite clear why bitcoins are a store of value. The economist, Paul Krugman argues that a reliable store of value is a currency that is either backed by a central authority, like the dollar, which is backed by the US Treasury, or has some form of intrinsic value, such as gold being made into jewelry. Krugman has expressed skepticism that a currency that is neither backed by a central authority nor holds intrinsic value will retain its value over time. Bitcoin also does not make interest payments and no investment interest is denominated in Bitcoin at the moment, which also seems to suggest that its role as a store of value is somewhat limited.
Furthermore, there are those who have argued that Bitcoin should not be considered a currency. To be a currency, Bitcoin must be a store of value and a means of exchange. Commodities historically backed most currencies (commodity-currency) but now state governments almost exclusively back currencies (fiat currency). The Supreme Court of the United States has recognized that currency is defined as “the coin and currency of the United States or of any other country, which circulate in and are customarily used and accepted as money in the country in which issued.” Opponents of Bitcoin as a currency reason that it is not backed or issued by any government, unlike the US Dollar, which is backed by the US Treasury’s ‘full faith and credit’, and no one is legally required to accept Bitcoin. Further, its value rests only on perception.
Despite possible shortcomings, the Shavers decision illuminates Bitcoin’s potential uses and possible classification schemes. More importantly, the decision is the first to have determined and clarified the nature of the use of Bitcoin in a Ponzi scheme scenario. It is not unfathomable that based on this decision, broader and more sweeping regulatory declarations may occur in the future.
C. Bitcoin as a Security
Furthermore, although the Shavers decision indicates that in one particular instance, Bitcoin can be used as a type of security, the court failed to address whether Bitcoin itself could be a security. Although in the United States a security instrument is broadly defined, Bitcoin in and of itself fails to clearly fall within this broad definition.
If Bitcoin were classified as a security, it would likely be analyzed under the Howey Test detailed below. What makes classifying Bitcoins as a security complex, however, is that many of its characteristics point in either direction. For instance, the test’s first prong, investment of money, is easily satisfied if one views it as a user purchasing bitcoins on an exchange. On the flip side, bitcoins are also acquired through mining and therefore only require an investment of computer processing power rather than money If this is the case, Bitcoin would fail the first prong of the test. Furthermore, Bitcoin users do not gain profits from a single promoting entity because the system lacks a central authority, however, users do enter the network with the common goal of continuing the block chain. Moreover, whether there is a common expectation of profits also depends on whether Bitcoin is used as a payment mechanism or system of exchange, or rather, as a speculative vehicle. The latter would satisfy the Howey Test, while the former would fail it. Finally, the last prong may actually be the most certain in indicating Bitcoins non-classification as a security. That is, the Howey Test requires an expectation of profits derived from the efforts of another. Bitcoin’s very framework prevents any one person from exercising managerial control over the entire system.
Consequently, Bitcoin’s status as a security remains unclear, but will likely continue to be a source of potential regulation depending on Bitcoin’s further development.
D. Bitcoin as a Commodity
So far, the US Commodity Futures Trading Commission (CFTC) has not issued any ruling or guidance regarding Bitcoin as a commodity, yet the regulatory entity is currently considering whether Bitcoin falls under its jurisdiction. At the moment, most Bitcoin transactions currently do not fall within the CFTC’s purview. However, given Bitcoin’s volatility, there is great interest in using various forms of financial instruments, particularly a variety of derivative contracts, such as swaps, as a way of hedging those risks.
In the United States a commodity is understood to be a “useful thing; an article of commerce; a moveable and tangible thing produced or used as the subject of barter or sale.” In this sense, bitcoins are clearly commodities because they are useful articles of commerce that are capable of being possessed. Bitcoins are traded online for goods and services, and even though every node on the Bitcoin network is knowledgeable of the bitcoins contained in each wallet, the individual user is the only one capable of distributing the coins within his or her particular wallet.
Furthermore, the CFTC, under the Commodities Exchange Act (CEA), classifies commodities in three different categories: (1) agricultural commodities, which, as the name indicates, include a number of agricultural products, such as wheat; (2) excluded commodities, which refer to a number of financial interests including interest rates, currencies, price indices, etc.; and (3) exempt commodities, which encompasses everything not covered by the other two categories and includes metals, and energy. Bitcoins certainly fall under one of these three classifications and are consequently commodities under the CEA; however, which category they belong to (excluded commodities—as bitcoins can be viewed as a currency, or exempt commodities—as bitcoins may meet the definition of a metal and anything that does not fall under the first two categories, may fall under this category) is debatable.
The CFTC has “exclusive jurisdiction [over those] transaction[s] commonly known to the trade as, an ‘option,’ … ‘bid,’ ‘offer,’ ‘put,’ ‘call,’ and transactions involving swaps or contracts of sale of a commodity for future delivery.” Despite this definition, the CFTC has specified that the term “future delivery” does not include commodities futures contracts. This exclusion refers specifically to forward contracts. That is, the CFTC does not regulate forward contracts, but rather, regulates speculative investments, including futures contracts and options. Moreover, under the CEA, “options on commodities fall within the definition of a ‘swap,’ and are consequently usually regulated as such. The key is to determine whether Bitcoin transactions are either forward contracts or option contracts subject to the CFTC’s jurisdiction.
The first step in deciding whether a contract is a forward contract or an option hinges on whether the parties had a general expectation of delivery of the underlying commodity. In most Bitcoin transactions, the buyer intends to accept delivery of the bitcoins sold.
Currently, there are a few websites that sell Bitcoin forward contracts; yet, they do not have any of the characteristics of an options contract. In order for the CFTC to have jurisdiction over the transaction, there must be trade in the contract, and the seller accepts a cash settlement over physical delivery. Currently, these Bitcoin transactions are physically settled, meaning the buyer must receive the bitcoins bargained for, and the price of the contract is the price of the bitcoins and not a premium for the option to buy bitcoins at some later time. Additionally, profit is realized when bitcoins are received and exchanged, not when the rate increases beyond the strike price and the paid premium. Consequently, most Bitcoin transactions do not currently fall under the CFTC’s purview.
It is possible, however, that Bitcoin future contracts sold by large mining pools, where individual miners pool their computational strength together to mine for bitcoins, may become standardized. These contracts, where the sellers are primarily miners or mining pools, are not likely to fall under the CFTC’s regulatory authority for the reasons previously mentioned. However, if a market emerges where buyers may resell the contracts, or use swaps as a means of hedging foreign exchange risks, those transactions will certainly fall under the CFTC’s jurisdiction because, in such an event, the buyer will not take delivery of the commodity. So long as buyers take delivery of the commodity and do not become sellers, then the main prong distinguishing a forward contract from an option contract is satisfied, rendering these transactions outside of the CFTC’s regulatory purview.
E. Other State and Federal Regulations
At the moment, other federal regulatory entities as well as state governments are analyzing how to regulate Bitcoin. For its part, Janet Yellen, the chair of the Federal Reserve, has said that the Federal Reserve does not have the ability to supervise or regulate Bitcoin given that there is no intersection between Bitcoin and banks. On the other hand, earlier this year, the Internal Revenue Service (IRS) issued a notice about the treatment of Bitcoin for tax purposes. The IRS said that it will treat payments made with bitcoins, Bitcoin investments, and income derived from mining, as property, and they will be taxed accordingly. The Federal Election Commission has also considered regulating Bitcoin in the realm of campaign contributions. Finally, New York recently issued proposed regulations for a “BitFicense” plan which would be applied to companies that store, maintain, or secure virtual currencies on behalf of customers, and which would be intended to create a comprehensive framework to ensure consumer protection, particularly with respect to money laundering and cybersecurity.
F. Regulatory Reactions to Bitcoin in Other Countries
Bitcoin has been received with mixed enthusiasm by governments around the world. Some have welcomed Bitcoin with open arms. For example, Belgium’s government has not specifically regulated Bitcoin, and its Minister of Finance has indicated that at the moment regulation seems unnecessary. Further, the United Kingdom’s Financial Conduct Authority has told Coinfloor, a Bitcoin exchanger, that it has no plans to regulate Bitcoin exchanges. Germany declared Bitcoin to be private money, meaning it could be used for tax and trading purposes in the country. Finland has said Bitcoin is a commodity and not a currency. However, Finns can use the commodity as a means of exchange and to make payments. Similarly, the Japanese government has stated that Bitcoin is a commodity, but disallowed financial institutions and banks from handling Bitcoin trades. On a similar note, The People’s Bank of China has essentially disallowed financial institutions from handling Bitcoin transactions. China’s treatment of Bitcoin is particularly important because China has rapidly become one of Bitcoin’s biggest markets.
In December 2013, the Chinese government issued a statement regarding Bitcoin. It found: (1) Bitcoin is not a currency, but rather will be treated as a virtual asset/digital commodity; (2) financial institutions and payment companies may not engage in Bitcoin related businesses; (3) buying and selling of online commodities is allowed and people are free to do so (i.e., exchanges are legal), but goods and services cannot be priced and paid for in bitcoins; (4) the government will exercise increased oversight of Bitcoin-related websites and it will act to prevent money laundering risks associated with Bitcoin; and (5) the public must assume Bitcoin’s risk since it is a speculative asset. The Chinese government’s policy implements “broad restrictions from a very macro-level, not blindly try to regulate a market in its infancy.”
G. Implications of Current Regulatory Framework
Although the Bitcoin market is still small, it is clear that there is little consensus as to how to regulate Bitcoin. In the United States, regulation has focused on money laundering and money transmission, and less so on consumer protections and the Bitcoin system’s actual classification. If Bitcoin continues to grow, clearer regulatory guidelines may be necessary, particularly with regard to its classification as a currency, a commodity, or some other kind of asset.
III. Analysis
Based on Bitcoin’s uncertain nature, governments could develop a host of regulations. Nevertheless, it would be unwise for them to implement strict regulations at this time. Rather, the US government should emulate some elements of the Chinese policy, with one major distinction; goods and services should be priced in Bitcoins, and users shall be permitted to use Bitcoin as a payment mechanism. As such, this note advocates for the United States to adopt a mixed policy incorporating elements of both the Chinese and Finish/models with respect to Bitcoin. Such a combined model would allow Bitcoin to mostly self-regulate within a vague framework that both legally defines Bitcoin while ultimately allowing it the regulatory freedom it requires to fully develop.
Bitcoin is ultimately a self-regulated system based on a mathematical peer-to-peer network that exists on the Internet, and it can continue to fully develop only if permitted this regulatory freedom. Nonetheless, Bitcoin will never reach its full potential if lawful businesses fail to see it as legitimate. The US government should take a hands-off approach to Bitcoin, while keeping a close eye on the criminal activity, regulating and prosecuting only when absolutely necessary. Self-regulation within this vaguely defined legal framework is the preferred path because: (1) Bitcoin is already a self-regulated system; (2) harsh regulation could send Bitcoin overseas, leaving the United States out of the regulatory discussion; and (3) Bitcoin may come crashing down in an instant. Such a modified self-regulating framework will allow the government to monitor Bitcoin developments, while giving the market the confidence it needs to allow Bitcoin to follow its true course.
A. Bitcoin is Inherently Self-Regulating
Bitcoin was conceived as system that is distrustful of central authority. More than a medium of exchange or a possible currency, Bitcoin is an open source protocol that can be molded and built upon by its users, thereby exhibiting self-regulating qualities. Bitcoin users must consent to system changes, as the system is regulated in a formulaic and mathematical fashion. These particular qualities, based on network acceptance and adoption of change, make Bitcoin an inherently self-regulated system.
Because the system is flexible and based on community adoption, it is unlikely that a government will be successful in implementing regulation. Bitcoin thrives on its strong network effects, meaning the currency with the largest user base is the most useful one and therefore it entrenches its position as the most popular. This means more processing power is dedicated to the system, thereby increasing security and making it difficult for regulators to intervene with the process. Even if the US government could implement regulation, the simple fact that Bitcoin exists on the Internet means that the rest of the world can ignore US imposed regulation, cutting the United States off of the Bitcoin economy.
B. Consequences of the Current Regulatory Environment in the United States
If Bitcoin is self-regulated, there are valid concerns regarding the criminal activity underlying many Bitcoin transactions. To ameliorate these concerns, the Bitcoin community has attempted to find code-based solutions to the problem. Currently, however, the Bitcoin system is unable to prevent small-scale criminal activity from taking place, as evidenced by numerous hackings of bitcoin wallets, large-scale sale of drugs, as well as other illegal activity.
Nevertheless, Bitcoin’s strength lies in the system’s ability to adapt and become increasingly secure with time. Assuming that more and more users on the network routinely use Bitcoin for legitimate purposes, it is fathomable (based on the network effects just described) that the system will become stronger and code based changes addressing these criminal concerns will be widely accepted.
Although Bitcoin may evolve into a stronger, more protected system in the future, criminal activity is nonetheless taking place now. This makes a strong argument against self-regulation. What is more, Jerry Brito, a senior research fellow at the Mercatus Center at George Mason University, has noted that due to the way bitcoins are created, “there is no Bitcoin company to raid, subpoena or shut down.”
Yet, evidence seems to suggest that this threat is overstated. As previously discussed, Bitcoin transactions are not completely anonymous because they exist on a public ledger. Furthermore, law enforcement personnel have the tools to trace these transactions and capture the wrongdoing party.
Even if Bitcoin may not be the tool of choice for many criminals, crime through Bitcoin has undeniably occurred. Exchangers have been targeted as a means of regulating this criminal activity. Exchangers, unlike other aspects surrounding Bitcoin transactions, are real business entities, incorporated in the United States, where digital currency is exchanged for fiat currency. The United States has proven it has the power to control and regulate this aspect of the Bitcoin industry, yet it should continue to do so cautiously, implementing only that regulation necessary to protect consumers and further help delineate the regulatory framework. Furthermore, lawmakers have expressed that the US Department of Justice has the tools to prosecute criminal Bitcoin transactions under the current regulatory framework.
Exclusively regulating Bitcoin exchangers strikes a sufficient balance between the need to protect Bitcoin users from criminal activity and ensuring the freedom Bitcoin requires to properly grow and develop. Nevertheless, some Bitcoin exchangers have responded to regulation by blocking US users from their system. If the United States is not careful in the way it regulates and prosecutes Bitcoin criminal activity, it may be shut out of the Bitcoin regulatory discussion. Regulation that is too strong will only send Bitcoin users overseas, further removing it from the reach of US regulation. Given these risks and Bitcoin’s ability to adapt, the United States should interfere only when absolutely necessary to safeguard the public’s interests.
C. Bitcoin’s Possible Failure
Bitcoin should also be permitted to self-regulate because of the threat that the system may collapse in the near future. There are a number of potential failures that could occur in the foreseeable future. First, Bitcoin has no guaranteed demand. Second, Bitcoin could become vulnerable as a result of over-speculation which could ultimately cause an irrecoverable crash. In addition, Bitcoin could be threatened by the emergence of a new currency making it obsolete, or users abandoning it for some other reason. Opponents argue that Bitcoin is in a bubble from which it will not recover once the bubble bursts, and the computational power required to support the system is currently straining at the seams. Should this be true, the cost of regulation far outweighs the costs of self-regulation. If Bitcoin faces an inevitable demise, there is little point in investing resources and efforts in devising sophisticated regulations only to see the system entirely collapse.
However, even if Bitcoin is in a bubble the entire system may not collapse. It can still be a useful store of wealth or medium of exchange. Experts have said that it fills a market need by facilitating e-commerce as a payment method. If, or until the bubble bursts, however, Bitcoin will continue to be a speculative investment, and it is only once the market crashes that “we’ll see whether it [Bitcoin] has legs.” The way Bitcoin may be used after its potential crash, if at all, will help regulators further define the appropriate legal framework. Until then, or until there is some sign Bitcoin has become more stable, governments should mostly sit tight and allow Bitcoin to develop.
D. Ideal Regulatory Solution: Adoption of a Combined Regulatory Model
Finally, this Note proposes that self-regulation in the world we currently live in cannot fully function without some regulatory guidance. As such, this Note proposes that the US government may benefit from emulating some elements of China’s current regulatory approach as well as incorporating aspects of the Finnish model. As described above, by defining Bitcoin as a commodity rather than a currency, the Chinese policy implements a vague legal framework that gives Bitcoin users a workable legal definition of the technology. However, this Note advocates that unlike the Chinese model, the US should by no means restrict goods and services from being priced in Bitcoin and should allow use of Bitcoin similar to that the Finish and model has permitted.
With respect to the Chinese policy, the US government should emulate the following elements: (1) provision of a vague legal framework by defining what Bitcoin is, namely, a commodity and not a currency; (2) removal of financial intermediaries from participating in the Bitcoin economy; (3) transfer of risk to those directly participating in the Bitcoin economy, i.e., the users themselves; and, (4) the government’s maintenance of power to track and protect against money laundering or other Bitcoin related criminal activities. Nevertheless, emulating the Chinese approach to its full extent would completely stifle Bitcoin innovation and development. Emulating the Finish model which classifies Bitcoin as a commodity, but allows goods and services to be priced in Bitcoin, is therefore of fundamental importance.
Such a framework would allow the government to monitor Bitcoin activity, while at the same time allow the system to continue to develop relatively freely. By not defining Bitcoin as a currency, the Chinese government restricts it from being used as a payment mechanism, but avoids having to define it within current currency control regulations. What is more, by defining Bitcoin as a commodity but prohibiting financial intermediaries from meddling with Bitcoin, the Chinese government diverts Bitcoin’s risks to the users themselves. However, by restricting merchants from pricing goods and services in Bitcoin, the Chinese policy completely restricts Bitcoin from being used as a payment mechanism and instead pushes it into the realm of a speculative commodity. Consequently, permitting the pricing of goods in Bitcoin, as the Finish policy suggests, is necessary for Bitcoin to achieve its full potential as a payment mechanism.
Bitcoin, even classified as a commodity, as done in Finland and Japan, can be used as a payment protocol or a means of exchange. Users pricing goods in bitcoins and accepting the commodity are put on notice of the commodity’s risk but can also take measures to avoid that risk simply by using the software as a means of exchange. Users can accept bitcoins at the current exchange rate and immediately convert the bitcoins received into their preferred fiat currency. At the moment, companies exist that will price in US currency, and when they receive payment in bitcoins, they deposit an equivalent amount into the depositor’s bank account. As a consequence, it is these companies (and not the government or federal entities) as well as the user’s themselves that are accepting Bitcoin’s volatile exchange rate, which currently comes at a cost of a 1 percent transaction fee.
I would argue that a regulatory approach combining these two models is temporarily beneficial in the United States, as it will allow users to continue using Bitcoin at the cost of assuming the risks of its volatile nature until Bitcoin becomes more stabilized. As Nassim Nicholas Taleb has phrased it, “Light control works; close control leads to overreaction.” Once Bitcoin becomes much more stable, further regulation and inclusion of financial institutions and banks in the equation may be advisable. At this point, however, Bitcoin is much too young and risky for regulated financial institutions and banks to become involved. China’s solution, to the extent described, together with the Finnish model’s pricing of goods and services in Bitcoin is preferable at the moment because it gives Bitcoin the freedom it needs to develop and stabilize, prior to the government intervening and having to assume the risks.
Taking such a combined regulatory approach will give the United States a tighter reign on the entire Bitcoin system. The government will have increased monitoring power. And it will have the regulatory authority it needs if and when it becomes necessary to exercise full-fledged regulatory power, because it will already have established a working framework. Because the regulation is designed to be vague, regulatory entities that may have authority to the authority to regulate Bitcoin (like the Securities Exchange Commission or the CFTC) are not excluded from the debate but are not forced to act immediately either. More importantly, this vague legal framework will continue to allow Bitcoin technology to freely develop without isolating it to unknown parts of the world.
Regulating Bitcoin as a digital commodity unfortunately restricts its use as a full-fledged currency and likely subjects it to the CFTC’s regulations, when Bitcoins begin to be traded as options or futures contracts in the United States. Nevertheless, the proposed solution is proper because it does not fully inhibit the system’s development. Even as a commodity, the Bitcoin protocol can be used as a method of exchange. Furthermore, Bitcoin is currently utilized more as a speculative tool rather than a currency. Presently, its high volatility, resulting from speculative activity, has hindered Bitcoin’s general acceptance as a means of payment for on-line commerce, but it is also this high volatility that has spurred interest in using Bitcoin as a commodity to hedge those risks.
By defining Bitcoin as a commodity, the government will help steer Bitcoin’s course, and perhaps allow its price and use to stabilize within a specific setting. The proposed solution is obviously a short-term solution and fails to determine what will happen in the long-term. However, the beauty of this framework is that it allows both Bitcoin and the government the necessary flexibility for future development.
This proposal assumes Bitcoin will continue to be used as something like a currency or commodity rather than as a purely speculative instrument. At the moment, Bitcoin’s price volatility together with other risks inherent in the system makes the use of financial instruments, such as derivatives, to hedge against these risks, highly appealing to Bitcoin users. But, these very same arguments support exclusion of financial institutions and banks from participating in Bitcoin, at least for the time being. As a consequence, China’s regulatory model, together with the Finish model’s modifications, is suitable for current Bitcoin development in the United States.
Conclusion
Given the major developments that need to be made to further understanding Bitcoin, it is uncertain whether one day you will be able to universally purchase your daily coffee in bitcoins. What is certain is that Bitcoin is an innovative technology that has caught the world’s attention, and has, if nothing else, become a highly disruptive technology. Sitting at the crossroads between political ideology and financial reform, Bitcoin begs regulators to question the very foundation upon which the current financial and economic systems rest.
Regulation is a necessary friction, and given the potential disruption Bitcoin may cause, governments around the world will logically want to regulate it. But, given Bitcoin’s ideological and technological underpinnings, the success of the system requires a degree of regulatory freedom. Proper regulation will not stifle innovation but will allow the Bitcoin system to self-regulate within a vaguely defined regulatory framework.
Numerous questions will remain and will arise as Bitcoin continues to develop, but given Bitcoin’s infancy, it is advisable the government not fully jump into regulation until Bitcoin is better understood. What is more, Bitcoin is a truly global phenomena. Its development and regulation will not take place domestically but will be fully realized only when the world comes together to define its status.