As followers of trends in e-commerce, our firm takes a keen interest in new e-payment methods. Last year, we predicted the Bitcoin would emerge as an innovative mode of currency for online transactions. When Bitcoin – an alternative virtual currency – first appeared in the mainstream media, it was largely portrayed as a wonky, nerdy counterculture experiment in decentralized wiki-currency. Reports explained that it was based on digital cryptography, but few if any people actually understood the math and even fewer could explain it in language that was comprehensible to most of us. But things have changed, and it is a whole new Bitcoin world.
Recent reports actually treat Bitcoin like a part of the mainstream economy. Government officials testifying on Capital Hill warn legislators not to underestimate the value that Bitcoin brings to the economy. Even leaving aside the federal shutdowns of illicit sites like Silk Road (an eBay-like marketplace for illegal drugs), ever-growing numbers of businesses are accepting Bitcoin as payment. Online market Overstock.com and social gaming site Zynga.com have both indicated their intent to accept Bitcoin. The owner of the Sacramento Kings has announced that fans will soon be able to buy tickets and hot dogs using Bitcoin. And it even appears that it will be possible to make political contributions using Bitcoin – doubling down on the whole issue of transparency versus anonymity in campaign contributions.
So if your organization considers using or accepting Bitcoin, there are some significant considerations:
1. The value of Bitcoin is extremely volatile.
Individuals can exchange national (fiat) currencies for Bitcoin through a variety of exchanges that have popped up in response to the demand for such services. The prices on these exchanges vary considerably among themselves at any particular time, and the price of Bitcoin has fluctuated wildly over the course of the past year. One Bitcoin was worth about $13 a year ago (in January 2013); in November 2013, the price surged over $1000 per Bitcoin. For a period of time, people in China were reportedly using Bitcoin as a means to avoid currency restrictions in that country; when China issued a ban on Bitcoin, the price swooned, although it later recovered much of that value.
The volatility of Bitcoin obviously poses challenges for businesses that accept them. Some address the issue by setting prices in national (fiat) currencies, accepting payments in Bitcoin but exchanging them on a regular basis. Other businesses have proposed engaging in sophisticated hedging transactions to address this risk.
2. Bitcoin has regulatory uncertainty.
To even talk about regulations and Bitcoin feels like it cuts against the entire vibe of this alternative currency, but there is little doubt that it is coming. The Financial Crimes Enforcement Network (FINCEN) has stated unequivocally that Bitcoin exchanges (which exchange Bitcoin for fiat currencies) and most Bitcoin “miners” (which process Bitcoin transactions) must register as Money Services Businesses (MSBs) under Department of the Treasury regulations. And legislators in the U.S. Congress are unquestionably considering what regulations can and should be imposed on the currency in order to safeguard against abuses without extinguishing the innovation to which it is so closely tied.
3. Bitcoin is anonymous – sort of.
When Bitcoin first emerged in the public eye, it was ballyhooed – and demonized – because of its supposed anonymity. The belief that its users could indeed remain anonymous gave rise to marketplaces for drugs and murders for hire paid in Bitcoin. The rub is that Bitcoin is not entirely anonymous: The digital framework of the currency is that each transaction is recorded in the cryptography itself (preventing fraud such as spending the same Bitcoin twice), and it is possible in some cases to use that information to find one’s way back to a Bitcoin user. The combination of a belief in anonymity and the ability of law enforcement to identify users obviously poses risks related to anti-money laundering obligations of which businesses must be aware.
4. Bitcoin still has security issues.
The last, but possibly most serious, consideration about accepting Bitcoin is lingering questions about security. Bitcoin are balances (credits) assigned to “addresses” (random strings of letters and numbers) that are publicly available. To spend the balance associated with a particular “address,” a user must have the corresponding “private key” (a slightly longer random string of letters and numbers) and apply a digital signature that allows some portion of that balance to be transferred to another address. Thus, the security of Bitcoin relies entirely on the security of “private keys”: Anyone who gains access to a private key gains access to the Bitcoin balance associated with that key. Given the recent headlines about data security breaches, it is not hard to understand why there might be concerns about accepting a virtual currency that can be purloined simply by stealing digital data from a computer.
The likelihood is that it is simply too early to judge whether Bitcoin is simply a fad or a harbinger of a sea change in our notion of what constitutes money and currency in a global digital world. Businesses who are early adopters may garner significant gains – or they may get burnt by early “learning experiences.” Inside counsel are wise to advise their clients about the risks and benefits of Bitcoin so that business leaders may make wise choices about the decision to accept them.
By: Karl Smith and Casselle Smith
The value of Bitcoin, the hottest and most widely traded virtual currency, plunged a little over a week ago, after China’s central bank issued a statement that the government is banning financial institutions from trading in the virtual currency.The price of a single Bitcoinfell from roughly $1200 on December 5th to less than $600, early morning December 8th. Thereafter it recovered somewhat selling for around $700 as of December 16. At the time of this posting (12/18), the price had fallen once again to $571.
This time last year, Bitcoin were selling for roughly $13 apiece. Economists and financial experts have struggled to explain the meteoric rise price to investors and to a public increasingly interested in the virtual currency. In many ways, the soaring price for Bitcoin looks like a classic bubble: Speculators pay out of the nose for Bitcoin, hoping to unload them to an “even greater fool” who will come along later with the same plan. At first blush, this type of bubble appears to resemble a pyramid scheme that must inevitably collapse once all potential speculators have bought in.
Bitcoin, however, has important features that differentiate them from other bubble-prone assets. The fact that the crash coincided with a change in policy from the Chinese government makes it even more likely that the special features of Bitcoin have played an important role in their use.
The design of Bitcoin allows for almost completely secure and anonymous transactions. Users don’t have to trust that a bank or other financial intermediary will keep their information secret. For the most part, the very nature of a Bitcoin transaction does this. Consequently, the currency has attracted substantial interest from users engaged in illicit transactions. Some of these are of the kind familiar to American readers. The website Silk Road, for example, specialized in selling narcotics and accepting Bitcoin as payment; it has been shuttered by U.S. law enforcement.
The Chinese government’s ban on Bitcoin arose from a different sort of illicit transaction that is less familiar to Americans because it are designed to get around regulations that the United States does not impose… Here’s the rub: the Chinese government limits its citizens’ ability to invest outside of the country because it wishes to provide a large pool of capital available to Chinese industries. Since Chinese investors have limited choice, Chinese banks can offer them paltry rates of return that guarantee that the value of their investments will fail to keep up with inflation. Naturally, Chinese investors wanted a way out, and many of them turned to Bitcoin.
Chinese investors would buy Bitcoin using the local currency, the Yuan. They would then transfer the Bitcoin to a bank or other financial institution outside of China and have that institution sell the Bitcoin and invest the proceeds outside of China. When the investor was ready to cash in, she would simply instruct the financial institution to sell the foreign investments, use the proceeds to buy Bitcoin, and then transfer the Bitcoin back to her.
This loophole allowed Chinese investors to earn higher rates of return without being caught by the authorities. For a time, the Chinese government allowed the loophole to remain open. On Wednesday, however, the Chinese government banned financial institutions and, importantly, online platforms like Biadu.com, from doing any business in Bitcoin. Baidu is a Chinese search engine that, like Google,forms the backbone of how users connect online. Without Baidu’s help,finding someone to buy or sell Bitcoin in the first place becomes exponentially more difficult.
Fear that the Chinese market for Bitcoin would dry up seemed to lead speculators to dump the currency following the announcement. It also exposes the fundamental weakness of Bitcoin: while they allow enormous anonymity for users, connecting with a broadbase of other users requires using a platform which almost necessarily does not seek anonymity. If it did, potential users would not know of their existence.
Regulators don’t have to crackdown on users themselves but simply on the websites and platforms that connect them.
There is no readily apparent US or European analogue to the Chinese monetary policy that motivated the country’s crackdown. Hence, China’s stance does not necessarily indicate that an international sea change is afoot with respect to the legal nature of Bitcoin and other emerging virtual currencies. Nonetheless, to the extent that Bitcoin’s surge in value was precipitated by Chinese investors’ thirst for international investment capabilities, the recent crash highlights the currency’s deep vulnerability to changes in financial regulation around the world.
Karl Smith is the Creator and Chief Curator of Modeled Behavior, a leading international finance and economics blog currently hosted on Forbes. He blogs mostly on macroeconomics, rationality, philosophy, and futurism.