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By Mary Grams, Senior Marketer at Thomson Reuters

 

 

Overview

One of the most intriguing recent developments in financial instruments is the rise of Bitcoin. Its brief history is the stuff of legend: payment of record for the Silk Road, dubbed the "wild west" of financial products by the Consumer Financial Protection Bureau, and it even has its own pirate, Dread Pirate Roberts. Bitcoin poses serious risks for inexperienced investors, but Bitcoin also promises a simpler, cheaper, private way to transact online, and advocates argue that Bitcoin can be a democracy and economy builder.

This Top Ten will cover questions and issues surrounding this trendy virtual currency.

1. What is Bitcoin?

Bitcoin is a peer-to-peer financial transaction network and protocol. It is a virtual currency, and was first mentioned in a 2008 white paper by someone using the name Satoshi Nakamoto. Nakamoto's identity has sparked worldwide speculation, but remains a mystery. The Bitcoin Foundation is the principal advocacy group for Bitcoin.

Bitcoin is defined as a cryptocurrency. Users' computers compete to solve complex math problems and the winners are rewarded with bitcoins. A finite number of bitcoins exist - roughly 21 million bitcoins may be mined by 2040, at which point bitcoins can no longer be mined.

No central government backs or controls Bitcoin, making it attractive to many users. Bitcoins only exist in virtual marketplaces and virtual wallets, and unlike funds deposited in FDIC-insured back accounts, Bitcoin users usually have no recourse if their wallet is hacked or stolen.

2. Mining for bitcoins and other ways to acquire the currency.

As Bitcoin miners obtain bitcoin, the transactions are tracked on a public ledger called a block chain, showing time-stamped transactions as the bitcoin is moved from one IP address to the next. They may take wild and circuitous journeys being exchanged or bought on virtual exchanges, taken in payment for goods or services on online marketplaces like the Silk Road or everyday retailers like Overstock.com and Expedia, or simply traded between users.

3. It's the "Wild West" of financial products.

Director Richard Cordray of the Consumer Financial Protection Bureau recently eviscerated Bitcoin claiming that "consumers are stepping into the Wild West when they engage in the market." Bitcoin's lack of fraud protection and irreversibility of transactions are frequently cited as the most dangerous elements for consumers.

Hacking and extortion threats also loom for Bitcoin users as they are not guaranteed against loss, and many virtual currency companies have been little help in previous Bitcoin wallet hacks.

Solvency and longevity of virtual currency exchanges is also a concern. Mount Gox, a Bitcoin virtual exchange, filed for bankruptcy late last year after losing about $650 million in bitcoins. Investors are trying to claw back their holdings in bankruptcy.

Bitcoins have become a favored currency for drug traffickers and others pursuing illegal activity. Recently, a Bitcoin promoter and a virtual currency exchange operator pleaded guilty on separate charges involving a conspiracy to sell bitcoins to users of the Silk Road, which is frequently used for illegal drug trafficking.

Ross Ulbricht, also known as "Dread Pirate Roberts," was indicted in federal court early this year as the owner and operator of the Silk Road. Ulbricht is alleged to have built the Silk Road on the Tor network, a network designed to hide the IP addresses of networked computers. He incorporated a Bitcoin payment system for the Silk Road, allowing users to conceal their identities during transactions. His trial is scheduled for November 2014.

4. Counterpoint: Bitcoin makes transactions easy, private and cheaper.

With all the splashy headlines on illicit underground marketplaces, dread pirates, and drug trafficking, Bitcoin's positive attributes can get lost behind the headlines. David Cohen, undersecretary of Terrorism and Financial Intelligence, spoke of the "promises and pitfalls of virtual currency," in March 2014. He acknowledged that Bitcoin and other virtual currencies have the potential to "empower users, lower transaction costs, increase access to capital, and bring financial services to many unbanked individuals all around the world." The undersecretary also noted the innovative value of virtual currencies as a tool for entrepreneurs and businesses.

Along with those advantages, users do not need to disclose private information such as credit card numbers, which allows for greater privacy and data security. Though transactions and identities are encrypted, Bitcoin transactions are transparent and can be confirmed by smartphone or computer.

5. Another counterpoint: Bitcoin can be a democracy and economy builder.

Advocates also argue that Bitcoin can support budding democracies, businesses and economies. Bitcoin transactions provide anonymity for democratic agitators in oppressive regimes to fund democratic activities or to donate to controversial charitable organizations. For unbanked individuals and small businesses, the ability to transact without a bank account or credit card and with low or no transaction fees increases the flow of commerce. Bitcoin is especially useful for micropayments (typically defined as payments less than $1 USD), which help small entrepreneurs grow their businesses without paying fees to third parties.

6. Bitcoin for wages?

Might employers pay their employees' wages in bitcoins in the near future? In a recent Q&A on Thomson Reuters' Corporate Counsel blog, David Prather noted that the federal Fair Labor Standards Act (FLSA) requires employers to pay a minimum weekly standard wage. While meals and lodging or fair market value of facilities may be considered part of a wage under certain circumstances, the FLSA does not permit other forms of payment or currency to be considered as part of the minimum weekly wage. Second, state laws frequently have similar minimum pay and currency requirements.

But the question of whether bitcoins may be paid out for wages beyond the minimum weekly standard wage is still open so employers and employees may soon be seeing Bitcoin in paychecks.

7. What does the I.R.S. have to say about Bitcoin?

The Internal Revenue Services released Notice 2014-21, which treats bitcoins as property with corresponding federal tax implications. Public comments showed the varied opinion and depth of emotion of Bitcoin users. As noted above, employees who are paid with bitcoins are subject to federal income tax withholding and payroll taxes, and employers must report income paid in bitcoins. Bitcoin payments to independent contractors and other service providers are taxable and self-employment tax rules apply.

8. Federal regulators and Bitcoin

Along with the I.R.S. and the DOJ, other federal agencies have waded in. The U.S. Treasury's Financial Crimes Enforcement Network (FinCEN) released guidance that virtual currency exchanges would be considered "money transmitters" with record-keeping and recording obligations as required by existing anti-money laundering regulations. Exchanges that allowed users to buy or sell bitcoins in exchange for real currency would be required to file as money services businesses.

The Securities and Exchange Commission has also taken a corner on Bitcoin in a ruling that any investment in securities in the United States is subject to the SEC's regulation regardless of whether the investment is in U.S. dollars or virtual currency. To that end, the SEC has exercised jurisdiction in a Bitcoin Ponzi scheme.

FINRA has also issued an investor alert on the "significant risks" of Bitcoin investments. But recently, Bitcoin got a shot in the arm from the Commodity Futures Trading Commission. The CFTC approved the first derivative tied to the Tera Bitcoin Price Index, which allows a Bitcoin user to lock in a dollar value on their bitcoin providing some protection against the pendulous price swings that have been associated with Bitcoin.

9. State regulators and Bitcoin

The New York Department of Financial Services indicated that it would begin requiring "bit licenses" for virtual currency operators serving customers in the state. California's money transmitter laws require that domestic and international money transfer operators be licensed, and the California Assembly recently passed legislation legalizing the use of virtual currency in all transactions occurring in California. Other states like North Carolina have indicated that Bitcoin and other virtual currencies already fit within the ambit of existing money transmitting laws.

10. Bitcoin as a global currency?

Bitcoin has had tepid reception around the globe. China banned financial institutions and payment companies from dealing in bitcoins in December 2013, causing the currency's value to plummet. Chinese citizens are still permitted to buy and sell bitcoins. Shortly thereafter, the central banks of India, Australia, and New Zealand also issued warnings on the risks of Bitcoin.

UK authorities have given the cold shoulder with the Bank of England warning that a take-off in Bitcoin's popularity could jeopardize the financial stability of the U.K's banking system. The Russian Prosecutor General banned use of any monetary substitute for the ruble, but the Bank of Russia and central government have stated they might reconsider the ban.

Conclusion

Could employees be paid in Bitcoin instead of U.S. dollars someday? Could bitcoins be a hedge for gold or stocks? While government regulators have begun to consider Bitcoin, it remains to be seen whether Bitcoin will grow from its shadowy beginnings to a respectable and reliable financial instrument in the marketplace.

Region: United States
Interest Area: Financial Services
The information in any resource collected in this virtual library should not be construed as legal advice or legal opinion on specific facts and should not be considered representative of the views of its authors, its sponsors, and/or ACC. These resources are not intended as a definitive statement on the subject addressed. Rather, they are intended to serve as a tool providing practical advice and references for the busy in-house practitioner and other readers.
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