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What Is Bitcoin and How Is It Regulated and Treated by the U.S. Government?

  • Nov 15, 2018
  • Donnell C. Much
  • By Donnell C. Much

Many consumers and investors have recently heard about, followed, or even traded in the crypto-currency called Bitcoin. Bitcoin is a decentralized, peer-to-peer virtual currency used like money and was created in 2009 by an individual or individuals using the alias “Satoshi Nakamoto.” Bitcoin can be exchanged for traditional currencies such as the U.S. dollar, or used to purchase goods or services, usually online. Presently, PayPal, Overstock.com, Expedia.com, Subway, OKCupid, WholeFoods, Bloomberg.com and Microsoft all accept Bitcoin as a form of payment. As I write this blogpost, Bitcoin is trading at approximately $6,397.00, however, the crypto-currency is volatile. For example, on November 5th of last year, Bitcoin was trading at $7,389.55. The next day it closed at $6,959.23.

People can purchase Bitcoin on Bitcoin exchanges such as Coinbase, Changelly, Binance, GDAX, XAPO, Kraken and Bittrex or “mine” them using powerful computers that solve highly complicated math algorithms whereby the Bitcoin miner is awarded small amounts of the crypto- currency through their computer’s hard work and use of electricity. Once an investor purchases Bitcoin, or an individual or business is awarded Bitcoin, the crypto-currency is deposited and maintained in a “digital wallet,” which exists in the cloud or on a computer hard drive. The Bitcoin “mining” function is critical because it creates the Bitcoin blockchain, which verifies Bitcoin transactions. The “block award” is achieved by placing a new block on the blockchain, which acts as an on-going public ledger of verified Bitcoin transactions. This is an essential function for the crypto-currency, as the blockchain allows it to be securely and predictably created without centralized regulation or the assistance of a sovereign. Furthermore, Bitcoin was developed by its creators to continue to release itself (or continue to half itself) until 21 million is achieved. At that time, no more Bitcoin will be released.

A significant aspect of Bitcoin is that the currency is exchanged without an intermediary, government or central bank. Consequently, merchandise and other items can be purchased anonymously because there is not a country or sovereign’s central bank involved in the transaction. As stated, Bitcoin is not backed by a central bank or government and, therefore, is not insured by any central government or by any arm of a central government. Specifically, here in the U.S., neither the Federal Deposit Insurance Corporation (“FDIC”) nor the Securities Investor Protection Corporation (“SIPC”) insures Bitcoin transactions or the location of their maintenance. Accordingly, if a digital wallet or Bitcoin exchange is hacked and the crypto-currency stolen, the Bitcoin is gone forever. Not surprisingly, because there is no sovereign backing nor insuring the Bitcoin and the location of its maintenance, it is a risky investment for any investor or user of the crypto-currency.

Another important component of Bitcoin is that each transaction involving the crypto- currency is recorded in a public ledger or “blockchain” where the names of the buyers and sellers of Bitcoin are not revealed, only their digital wallet’s identities or aliases, and the actual Bitcoin transaction. Not surprisingly, because an owner of Bitcoin’s real name is not associated or not mandated to be associated with each transaction, some transactions include the purchase and/or sale of illegal goods and services such as drugs, prostitution, illegal pornography and hacking for hire.

As an investor in Bitcoin, a user of the crypto-currency, or as a practitioner representing investors who have purchased, sold or invested in Bitcoin, it is critical to understand how certain U.S. agencies and bureaus of U.S. agencies treat and attempt to regulate crypto-currencies, including Bitcoin.

  1. Internal Revenue Service (“IRS”): The IRS in IR-2014-36 (March 25, 2014) issued guidance stating that it will treat virtual currencies, including Bitcoin as property for federal tax purposes. Consequently, general tax principles that apply to property transactions apply to transactions using virtual currency.
  2. U.S. Commodities Futures Trading Commission (“CFTC”): The CFTC has stated that the definition of “commodity” in the Commodity Exchange Act (“CEA”) is broad and can mean a physical commodity, such as an agricultural product (soy beans, wheat, cotton, etc.), a natural resource (gold, silver, platinum, natural gas, oil, etc.), or it can also mean a currency or interest rate. The CEA definition of “commodity” includes “all services, rights, and interests…in which contracts for future delivery are presently or in the future dealt in.” The CFTC first found, in 2015,  that Bitcoin and other virtual currencies are properly defined as commodities. See, In the Matter of: Coinflip, Inc., d/b/a Derivabit, and Francisco Riordan, CFTC Docket No. 15-29, available here. The CFTC has oversight over futures, options, and derivatives contracts. Therefore, the CFTC’s jurisdiction is implicated when a virtual currency is used in a derivatives contract, or if there is fraud or manipulation involving a virtual currency traded in interstate commerce. Beyond instances of fraud or manipulation, the CFTC generally does not oversee “spot” or cash market exchanges and transactions involving virtual currencies, including Bitcoin, that do not use margin, leverage, or financing.
  3. U.S. Securities and Exchange Commission (“SEC”): The SEC has indicated that it views crypto-currencies, including Bitcoin as securities and that those companies, which sell crypto-currencies or allow the sale of them on their website must register as exchanges and follow the applicable federal and state laws associated with registration. Specifically, the SEC stated that it will apply the federal securities laws, including the “Howey Test” to everything from crypto-currency exchanges to digital wallets, and when determining whether an instrument is a security or not, “form should be disregarded for substance” so that the emphasis will be focused on the “economic realities underlying a transaction…” Tcherepnin v. Knight, 389 U.S. 332, 336 (1967); United Housing Found., Inc. v. Forman, 421 U.S. 837, 852-853. Consequently, the SEC will determine that crypto-currencies, and their exchanges and digital wallets are securities or brokers/dealers of securities if these currencies look and function as securities, or brokers/dealers of securities, and the SEC will treat them as such.
  4. Financial Crimes Enforcement Network (“FinCEN”): FinCEN, a branch of the U.S. Treasury Department, issued guidance in March of 2013, which stated that companies that exchange or transfer crypto-currencies such as Bitcoin are considered money-service businesses (MSBs) so that the companies must provide information to the government in order to prevent money laundering. Any transactions of more than $10,000 must be reported. Therefore, companies that exchange, transfer, or administer Bitcoin must register with FinCEN as Money Service Businesses (MSBs) under Treasury regulations. Ordinary users of Bitcoin, however, do not need to register. Furthermore, for the most part, FinCEN’s position is that tokens traded in Initial Coin Offerings (“ICOs”) are considered money, the equivalent to fiat currency in the traditional economic system. This is important to FinCen because it allows it to regulate financial crimes committed using cryptocurrencies in the very same way that it would investigate and respond to the same crimes committed using traditional forms of currency. This means that sales done during ICOs must adhere to money transmitter regulations promulgated pursuant to the Bank Secrecy Act (“BSA”).

Bitcoin has certainly changed the global finance and banking industries by permitting anonymous parties to purchase and sell goods and services with only their Bitcoin transactions recorded on the blockchain. Bitcoin and blockchain technology is incredibly significant because it allows individuals to engage in anonymous transactions without the assistance or permission of a sovereign or government. Bitcoin and blockchain technology, including the use of smart contracts or self-executing agreements where the terms of the agreement between parties are directly written into lines of code, essentially allow the technology itself to regulate financial transactions between two individuals or groups. As Bitcoin and other crypto-currencies become more entrenched in the U.S. and global financial systems, and the currency becomes less volatile and less associated with illegal activities and transactions, the currency could become an accepted alternative to the trusted, traditional currencies, such as the Euro and U.S. dollar.

DISCLAIMER: Although McCausland Keen + Buckman always strives to provide accurate and current information, the foregoing is intended for general informational purposes only, shall not be construed as legal advice, and does not create or constitute an attorney-client relationship.

Donnell C. Much

about the author

Donnell C. Much

Donnell guides investors in securities litigation and arbitration, and counsels and advocates on behalf of clients involved in commercial disputes.

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