Everything You Need to Know About Bitcoin For Now

September 12, 2014

Bitcoin advocate Charlie Shrem’s guilty plea last week to federal charges of aiding and abetting the operation of an unlicensed money transmitting business turned the spotlight back on Bitcoin, the emerging online “currency.” Shrem’s plea was particularly notable because of his status as both a founding member of the Bitcoin Foundation and co-founder and former CEO of BitInstant, a Bitcoin exchange company that made it possible to purchase Bitcoins at retail establishments like Walgreen’s. Shrem’s arrest and guilty plea may seem to cast a shadow over the entire Bitcoin infrastructure—but in fact, the legal issues involved are narrow, and the conduct is actually not reflective of a general legal problem for the use of Bitcoin.

This week, both eBay announced that PayPal will be embracing Bitcoin, and Overstock.com added Bitcoin as a payment option. In a few years, it seems, Bitcoin will be a seamless part of the Internet landscape, another payment option next to the MasterCard and Visa buttons on every virtual checkout.

For the uninitiated, Bitcoin has been called a “digital currency,” though in fact it’s more like a payment system than conventional money issued by governments. Bitcoin relies on a public ledger showing transactions executed on a peer-to-peer basis without a central authority. Bitcoins may be purchased with regular money and exchanged for goods and services like any currency, with access to one’s Bitcoins restricted by the use of a private encryption key. The primary benefit to merchants accepting Bitcoin is the avoidance of the fees charged for credit card processing – typically something like 2-3% of each transaction, which is not insignificant. Some portion of those savings, in turn, would be passed on to customers paying with Bitcoin.

Of course, there is another benefit to users of digital cash like Bitcoin—for some, a pretty major one. Transactions can, with a little effort, become virtually anonymous. Although the public transaction ledger is central to Bitcoin’s functioning and the ledger does show the flow of Bitcoins from address to address, the addresses are represented in the ledger by random numbers. Anonymity can be created by creative use of multiple addresses and encryption keys. That, in turn, raises the possibility that Bitcoin can be used to support illegal transactions. If Bitcoin can truly function like cash, it can then be abused for money laundering and a host of other questionable activities.

As it turns out, that’s exactly what happening and why Charlie Shrem is facing a federal prison term. Apparently, in 2011, a guy named Ross William Ulbricht decided to capitalize on the obvious and create a Bitcoin-based online marketplace for drugs, paraphernalia and anything else you can’t buy on eBay. The resulting site, dubbed Silk Road, became the go to destination for buyers and sellers in need of secrecy and anonymity.

The availability of contraband for purchase with Bitcoin led inevitably to individuals urgently and anonymously needing to convert their currency, a service which a guy named Robert Faiella was happy to provide. He did so with the knowing assistance of Charlie Shrem, who provided Faiella with the necessary connection to Bitcoin through his company BitInstant. It was their “deliberate and knowing” involvement in illegal transactions via Silk Road that put them on the wrong side of the law, not their involvement with Bitcoin, generally.

Bitcoin is no different from any “currency” or medium of exchange – in itself, it is neutral. Its legal standing really depends on how it’s used. The concept of anonymous virtual cash instantly creates a mental association with illegal activity—we don’t assume those citizens waiting on line at the ATM are withdrawing cash to buy cocaine, and we also don’t assume anyone has any ability to track our shopping habits when we buy fruit at the corner market with a $20 bill, but we do assume that anyone who wants to conduct untraceable online transactions is probably hiding their behavior for a reason. This isn’t necessarily true, though. Just because it’s anonymous doesn’t mean that’s why people seek it out or want to use it, and just because it’s online doesn’t make it dicey.

The seamy connotation of anonymous online cash will fade as the use of Bitcoin grows. One third of Americans and half the world’s population live without bank accounts, cashing paychecks or benefit checks and paying their bills with cash. These “underbanked” individuals, who are currently disenfranchised from the world of online transactions by their dependence on the cash economy, can buy (and sell) online without a bank account by using Bitcoin. However, the growth of virtual currency is not without risks, and the current “wild west” environment is giving way as governments have taken an interest in the exchange of Bitcoin and regulations have begun to emerge.

New York’s Department of Financial Services, for example, has proposed a license requirement for “all companies that store, control, buy, sell, transfer, or exchange Bitcoins.” In addition, the proposed regulation would require digital currency companies to maintain records of their customers’ identities and transactions, to report transactions in excess of $10,000, to inform customers of the risks associated with Bitcoin, to provide strong cyber-security and to hold as much Bitcoin as they owe. Or, to put more simply, New York wants to treat companies handling digital currency the same way it treats companies handling the old-fashioned stuff. New York’s proposed regulations follow on the heels of the Treasury Department’s inclusion of digital currency exchanges in its definition of money services business as well as scrutiny by the SEC and tax guidance on Bitcoin-related businesses from the IRS.

Part of the initial attraction of Bitcoin was the absence of government regulation, and naturally many Bitcoin proponents have argued against regulation.

On the other hand, these regulations do seem to have grown out of legitimate concerns. Bitcoin anonymity was used to shield the illegal Silk Road activity. In addition, a number of digital currency companies have reported significant thefts of Bitcoin – in the case of Japanese currency exchange Mt. Gox, Bitcoin with a value of $477 million was stolen, resulting in a subsequent bankruptcy filing.

Some degree of regulation of digital currency is inevitable. Our government won’t leave a potentially risky and profitable financial service alone, and the policy basis for regulation is solid provided the regulations are designed to protect consumers from predatory, risky or careless practices. The use of digital currency is growing rapidly and, with PayPal on board, is likely to explode. The law is already adapting to encompass its use and we should expect that trend to continue as more legislators turn their eye to this emerging technology and judges are increasingly faced with litigation involving digital funds.

To put it simply, Bitcoin is here to stay, and as the real world catches up with the virtual one, it’s worth putting some digital currency in your wallet.