Bitcoin’s promise lies under the hood

Bitcoin has been under the spotlight over the past year, in part because of the volatility of the dollar-to-bitcoin exchange rate. Its reputation for seemingly facilitating illicit activities as well as several high-profile arrests in the Bitcoin universe has added to its notoriety. So has security and technological problems that led to the collapse in February of the world’s largest bitcoin exchange, Mt. Gox, after an attack by hackers, resulting in an estimated loss of approximately US$500-million. Closer to home, a self-styled bitcoin bank in Edmonton shut down in March after hackers made off with $670,000. “It’s sort of two steps forward, one step back in terms of the scandals,” says Stuart Hoegner, an international gaming lawyer and accountant who is general counsel for the Bitcoin Alliance, an advocacy group.

While the scandals have bruised Bitcoin’s image and elicited growing calls for government intervention, it has done little to mask the potential of virtual currencies and the promise behind Bitcoin’s underlying technology. Bitcoin, the most popular among 200 or so other virtual currencies created since 2009, is an ingenious computer code that has monetary value controlled and stored entirely by computers. It is essentially a peer-to-peer cash system, a form of e-money, valued in units of Bitcoin divisible much like the Canadian dollar into pennies. It is not, however, connected to any physical commodity, state or central banking authority.

A payment system

But more importantly, Bitcoin is also a payment system, a peer-to-peer network that allows for the proof and transfer of ownership without the need of a trusted third party like a bank. The implications are enormous, particularly for the financial sector, with a growing number of observers going so far as to describe the technology behind Bitcoin as disruptive as the personal computer was when it surfaced in 1975 and the Internet in 1993. “This is the true technological innovation behind Bitcoin, its ability to cut out the traditional middlemen – including governments by the way – that have traditionally played a role in the payment system by performing functions as verifying payments, determining money supply and creating rules of use,” noted David Murchison, director of the financial sector division at the Department of Finance Canada, before the Standing Senate Committee on Banking, Trade and Commerce, which is now examining digital currency and expected to pen a report by June 2015. “These middlemen typically add to the cost of payments, so by eliminating the middlemen, decentralized virtual currencies can lower the payments and their costs.”

A report by Goldman Sachs, the New York investment bank, predicted that Bitcoin would force banks and other traditional financial players to compete by lowering their costs and streamlining their systems. “If I were a payment processor like PayPal or Moneris, I would be very worried about the rise of virtual currencies and how they are going to affect my business,” says Michael Citrome, a tax litigator with Spiegel Sohmer. “Anybody who transfers money on the Internet for goods or services is likely to be affected by the technologies that virtual currencies rely upon.”

Others go even further, suggesting that it is nearly impossible to even imagine the impact the technology will have. “People know it’s huge,” says Hoegner. “People know it’s going to be very important but people don’t know what is going to look like yet.”

It’s no wonder, then, that developers, entrepreneurs and investors are flocking to the virtual currency market in droves, with Canada proving to be a choice location. In fact, Canada is currently a hotbed for innovation and growth for virtual currencies, largely because Bitcoin enthusiasts mistakenly believe they will have a free pass here because there are no laws and regulations that specifically target virtual currencies. “People think it is a tax free zone, and a law free zone where no laws apply,” says Christine Duhaime, a partner at Duhaime Law and a certified anti-money laundering specialist.

That’s about to change. The 2014 Budget Implementation Bill makes it clear that the application of Canada’s money laundering and terror financing laws will be applied to dealers of virtual currencies, and the Department of Finance is now in the midst of drafting regulations expected to be in force next year. It is an important exercise that will spell out how the federal government views virtual currencies, something that nations around the world are now grappling with. Indeed, a report by the Law Library of Congress that surveyed 40 jurisdictions and the European Union revealed that there does not exist a clear definition or consistent treatment of digital currencies. “The debate over how to deal with this new virtual currency is still in its infancy,” noted the report. Defining what virtual currencies like Bitcoin are is a crucial first step towards delineating policies, particularly since there are so many conflicting views. Basic fundamental questions such as whether virtual currency is money, a currency, or a commodity need to be addressed. As points out John Jason, OF Counsel at Norton Rose Fulbright, “It’s hard to regulate that which you can’t identify. The first thing that needs to be done is to figure out what it is that you’re trying to regulate.”

Law firms too are finally beginning to take note, often at the behest of clients. “Many of our clients have been asking what virtual currencies are, what are the current rules that apply to it, where do we think it’s going, and does it or will it impact their businesses?” says Olivier Fournier, a tax lawyer with Davies Ward Phillips & Vineberg LLP. “This is really the hot topic in the business world.” There’s another reason why lawyers should begin paying attention to the world of virtual currencies: the Bitcoin protocol may affect the legal profession.

Shrouded in mystery

The origins of Bitcoin are shrouded in mystery. Born out of a mistrust in the international financial system following the near collapse of the world economy, the new technology emerged in 2008 as a research paper conceived by a programmer or group of programmers under the pseudonym Satoshi Nakamoto. A year later, Nakamoto launched software that created the first Bitcoin network and bitcoin unit of currency.

The math-based currency was quickly embraced by libertarians seduced by its professed promise as an alternative to fiat currency, by geeks who gleamed at the possibilities the technology had to offer, and by cryptographers who marveled at its feat of solving a long-standing conundrum that stumped previous efforts at creating a viable virtual currency — Bitcoins prevents users from spending the same unit of digital currency over and over in spite of the absence of government oversight or a central database.

Bitcoins are essentially long digital addresses and balances. They are created – or mined in bitcoin parlance – by a global network of computers who have to solve increasingly complex computer algorithms. Each time a miner solves one of these cryptographic puzzles, the miner is rewarded with new bitcoins. Bitcoin’s algorithms dictate 25 new bitcoins get added every 10 minutes for a total of 21 million bitcoins, about half of which are now in circulation. What’s more, every time a transaction is made, it is recorded on a public ledger called a block chain, which is broadcast to anyone running open-source Bitcoin software. Miners keep track of all the bitcoin transactions and add them to the block chain ledger, and in exchange, they get the privilege every so often of awarding themselves a few extra bitcoins.

In an intriguing twist, while all transactions occur in the open by being recorded on the block chain, it provides a high degree of privacy, not anonymously as is commonly held. “There is more transparency in the bitcoin transaction than in most other types of payments, and certainly much more than cash payments,” remarked Murchison, the federal Department of Finance official, before the Banking Committee. Another distinguishing feature is that, unlike bank transactions, bitcoins transfers are irreversible. “This allows crypto-currencies to look more like cash and allows merchants to accept payments for transactions without the risk that these transactions will later be reversed,” testified Lukasz Pomorski, assistant director, funds management and banking with the Bank of Canada before the same hearing.

There are signs that the virtual currency is gaining traction, even though it is plainly evident that Bitcoin is still in the earliest phases of industry development. At present, the Bitcoin market capitalization is estimated $8.4 billion, big enough to be listed on a senior exchange if it were a company, according to the Bank of Canada. While in the first few years of Bitcoin effort was spent building infrastructure such as setting up mining services, it now appears that Bitcoin is entering the investment phase, where venture capitalist, hedge funds and other financial firms are starting to invest capital in the new technology. Bitcoin ATMs have been cropping up across North America, with the first one established in Vancouver, joined by Ottawa, Toronto and Montreal. Bitcoin exchanges, most of which emulate either stock or currency exchanges, are too growing in numbers, providing consumers with yet another way of purchasing or selling bitcoins. All told, there are currently about 100 exchanges globally, 10 of which are located in Canada. And that’s besides the proliferation of virtual currency-related businesses, including processing services, consultants, legal services and special interest groups promoting virtual currency usage.

Bankers giving bitcoin business a hard time

But many in Canada’s small but fast growing Bitcoin business community are now facing an unexpected hurdle that is making it difficult to do business in the country. It is proving to be a daunting challenge for Canadian crypto-currency businesses to obtain a regular commercial services bank account. While it may appear to be incongruous that a business operating an alternative currency may require banking services, the reality is that they are constantly swapping back and forth in fiat currencies. One bitcoin business who did not want to go on record is on to his third bank after two financial institutions closed his bank account ostensibly for no reason.

“I think they still haven’t really wrapped up their minds around what this technology is, what is going to happen with it, where it’s going to go, and how to deal with it since it could arguably compete with the bank’s own existing services and products,” says Matthew Burgoyne, a Calgary lawyer with McLeod Law LLP, who has numerous Bitcoin entities as clients. Burgoyne also suspects that banks are also apprehensive in taking new Bitcoin clients because the Department of Finance has yet to introduce regulations that specifically target virtual currency operations.

Matthew McGuire, an anti-money laundering expert, believes that banks are apprehensive about taking on bitcoin businesses because of anti-money laundering concerns. “There are three things in a transaction that are necessary if you are trying to be fraudulent or you want to conduct money laundering,” says McGuire who has a fair number of clients who are Bitcoin entities. “You want anonymity, though within the Bitcoin community it is argued that it’s not at its core anonymous as you could determine (someone’s identity) through the block chain. You want to be able to get your money in, and you want to be able to transfer money to other jurisdictions. All of those things are present within the Bitcoin structure now.”

There are ways around the problem, such as opening a bank account abroad or resorting to merchant payment services, adds McGuire, who is assisting the Department of Finance with drafting the new regulations aimed at virtual currency dealers.

Another solution frequently used by Bitcoin businesses is to implement an anti-money laundering program and register with the Financial Transactions and Reports Analysis Centre of Canada (FinTRAC) even though many Bitcoin entities are under no legal obligation to do so. In fact, FinTRAC has so far taken the position that bitcoins are not “funds” within the meaning of the Proceeds of Crime (Money Laundering) and Terrorist Financing Act (PCMLFTA) and its regulations. In other words, FinTRAC will not regulate many Bitcoin exchange functions under money services business rules in Canada. “Thus far Canadian banks have been very hostile, which has been a problem,” says Hoegner. “That’s unfortunate because I think the risks can be managed and mitigated. The hope is that financial institutions are going to have less hesitation once and if the 2014 Budget Implementation Act and its provisions are passed and the regulations come online.”

Bankers under fire

Bankers came under fire at a recent hearing of the Banking Committee under pointed questions by Senator Paul Massicotte, a chartered accountant, who suggested that the Royal Bank of Canada (RBC) was closing down bank accounts of Bitcoin businesses because “this is a competitor of yours, you protect your own turf and therefore you will prejudice yourself and make sure you get an advantage over any competitor.” Carolyn Burke, an RBC vice-president, international cards and Canadian regulatory payments said that “currently bitcoin is unregulated and the government has also said there are concerns around the source of funds. It is not something that a bank can put through the normal processes that we have.”

While not exactly jumping on the bitcoin bandwagon, the head of a major Canadian bank reportedly said that the Bank of Montreal would be open to dealing in bitcoin transactions as long as the virtual currency becomes regulated. The Canadian Bankers Association, though it has taken no official position on Bitcoins as they operate outside of the banking system, echoed that stance. Before the Banking Committee, Darren Hannah, acting vice-president, policy and operations testified that users, consumers and firms that “deal in bitcoin or any other payment form” would benefit from a robust, regulatory framework so “that everybody understood the rights, responsibilities, safety, soundness and security associated with the payment mechanism.” Senator Pierrette Ringuette, a member of the Banking Committee for the past years, replied that “this is the first time that the Canadian Bankers Association has appeared before us asking for regulations.”

The Office of the Superintendent of Financial Institutions (OSFI), an independent agency of the Government of Canada that regulates and supervises financial institutions, and private pension plans subject to federal oversight, has not issued guidance related to dealing in virtual currencies. While it does not prohibit the use of virtual currencies, it does expect federally regulated financial institutions to be aware of the risks and consequences of engaging in any financial activity, including activity that may be linked to virtual currencies, said OSFI in an email message.

Sparse official guidance

Scant official guidance is available so far to bitcoin entities from Canadian policy makers, regulators and overseers, with the possible exception of the Canadian tax authority. But that doesn’t mean that people transacting in bitcoins are not subject to regulation, says Hoegner. Securities regulators such as the Autorité des marchés financiers have by and large limited themselves so far to issuing warnings to consumers about the dangers of becoming involved with virtual currencies. The Ontario Securities Commission followed suit (OSC). All virtual currencies should be approached with “extra caution,” says the OSC. Recent events, from software glitches, hackings and exchange shutdowns to cases of outright fraud, “highlight the speculative and risky nature” of virtual currency, adds the OSC. “At this point securities regulators in Canada have been less instructive than tax authorities have been,” observes Elliot Greenstone, a partner in the capital markets, M&A, life sciences, and technology practices with Davies Ward Phillips & Vineberg LLP. “That’s partly because it really depends on the instrument and how the instrument is being used, the purpose for which it is being used, and is it really an investment. At this point it’s really a case by case basis of the particular investment.”

The taxman had no such hesitation. The Canada Revenue Agency (CRA) issued a fact sheet plainly stating that tax rules apply when digital currencies are used. In fact, two separate tax rules apply to the virtual currencies, depending on whether they were merely bought and sold for speculative purposes or were used as money to buy things. When bitcoins are bought or sold like a commodity, any resulting gains or losses could be income or capital for the taxpayer depending on the specific facts – a position that did not take tax lawyer Fournier by surprise even though it could be problematic given the volatility of bitcoins. “Because of the high volatility, the valuation of bitcoins may not be as simple as taking the price at the exchange that day because there are quite a high number of exchanges and they have different prices for the same bitcoin at the same time every day,” says Fournier. He suggests that a proper valuation of the bitcoin may be to take the average price of the virtual currency over a number of days as opposed to the spot rate.

The CRA’s application of barter transaction rules when bitcoins are used to purchase goods or services makes little sense to tax litigator Citrome. Barter is the exchange of one good for another good without the use of cash. Under Paragraph 3 of the CRA’s Interpretation Bulletin IT-490, in a barter transaction between arm’s-length persons, “we generally consider that the value of whatever is received is at least equal to the value of whatever is given up.” “Commercially this is a problem because if the purpose of a bitcoin is to allow frictionless transfers of money over the Internet, and you have to account and pay taxes every time you use a bitcoin, then it makes very complicated,” says Citrome. He says that CRA would do well to emulate the lead set by the United Kingdom, which announced that value-added taxes do not apply to bitcoin transactions. Under the Excise Tax Act, the legislation that governs the GST and provincial sales taxes, supplies and financial services are exempt. In other words, the CRA could easily adopt a liberal interpretation and consider bitcoins as a financial instrument “because it is just not appropriate to tax bitcoin transfers for sales tax purposes,” adds Citrome.

Hearings at the Banking Committee yielded tell-tale glimpses on how institutions like the Department of Finance and the Bank of Canada view digital currency. Testimony provided by Department of Finance at the Banking Committee should quell fears that it was going to take a heavy-handed approach and stifle the virtual currency sector with onerous legislation. Au contraire. “We would aim, in these regulations, to cover virtual currency exchanges, but not individuals or businesses,” said Murchison before the Banking Committee. “We think this approach will allow for financial innovation, which we see to be one of the interesting markers behind this.” Jason believes that it will be “super important” for Ottawa to be mindful of international legislation and regulations on virtual currencies. “The world as we know it is super connected and linked, and you really need to have consistent regulation, particularly since these virtual currencies are primarily designed to facilitate international payments,” says Jason. “So there’s no point in passing a bunch of laws in Canada that is inconsistent with the laws in other jurisdictions.”

Bitcoin falls short of being a currency

The Bank of Canada too provided a revealing peek on its take on virtual currencies. Money serves three functions: it’s a generally accepted medium of exchange; it serves as a unit of account so that it helps consumers to compare the value of different goods like comparing the cost of a Tim Hortons coffee with a Starbucks coffee; and it can be used as a store of value. “We would argue that bitcoin and other crypto-currencies fall short of a definition of money and do not satisfy the functions of money, at least at present,” said Grahame Johnson, chief, funds management and banking at the Bank of Canada. “First, for bitcoin to be a currency, it would need to be generally accepted and it would need to be a medium of exchange. While there may be some potential, it’s not quite there yet.”

Thanks to its volatility, it also falls short of being able to be considered as a store of value, adds Johnson. A recent report estimates the volatility of the value of bitcoin is about 108 per cent per year or about 40 times greater than the volatility of the real value of a U.S. dollar. In more vivid terms, a bitcoin traded at a third of a cent per bitcoin in 2010. Last December it reached a high of $1,200 before diving to $430 in early April. “The volatility of bitcoin means that customers who store value in bitcoin are exposing themselves to a lot of variability and a great deal of risk in terms of what the savings could be worth, even in a relatively short period of time, like a week,” said Johnson. That’s why there are some who would describe crypto-currencies such as bitcoins as speculative investments. Others like the Bank of England and the Bank of Finland suggest that bitcoin is more similar to a commodity than a currency.

That does not detract from the value of crypto-currencies. Even if bitcoins or similar crypto-currencies ultimately fail, Johnson believes that other payment innovations will rise to replace them. Jean-Pierre Lam, a University of Waterloo professor and former economist at the Bank of Canada agrees. “It’s about the technology, and not about bitcoins itself. It is the technology that is going to grow. It’s in its infancy. That’s where we will see this thing take off,” says Lam.

The underlying technology behind Bitcoins may quite possibly have a notable impact on the legal profession, predicts Hoegner. Future iterations of crypto-currency will likely have the possibility to embed instructions or algorithms in a block chain or some kind of distributed ledger that allows for some functions of a contract. Another possibility may be that one or more block chains could be used to create and administer arbitral proceedings and establish intellectual property rights. “We’re only really now starting to scratch the surface of what that can mean, and what that means for lawyers and what means for consumers,” says Hoegner.