Legal, Regulatory Implications of P2P Currency System Said Unclear

Bitcoin has many properties that could make it an ideal currency for mainstream merchants and consumers, Yale Law School student Reuben Grinberg said in an April 21 preliminary draft paper on the subject. Compared to most currencies or online payment services such as PayPal, bitcoins are highly liquid, have low transaction costs and can be used to make micropayments, he said. They may also hold the key to enabling organizations such as WikiLeaks, “hated by governments,” to receive donations and conduct business anonymously, he said.

As of March 2011, a bitcoin was worth about $1, there were about $5 million worth of bitcoins in circulation, there were anywhere from 5,000-30,000 users and around $150,000 in bitcoins was traded daily, Grinberg wrote. But while its economy is flourishing, “Bitcoin users are anxious about Bitcoin’s legal status,” he said. Some worry the currency will facilitate money-laundering, tax evasion, trade in illegal drugs and child pornography, he said. Many fear governments will crack down, particularly the U.S., which shuttered the creators of e-gold, a digital currency backed by gold, for conspiracy to commit money-laundering and credit card and investment fraud, he said.

Money in the digital age has moved from being largely anonymous to being “increasingly laden with tracking, control and regulatory overhead,” Electronic Frontier Foundation Activism Director Rainey Reitman wrote in a Jan. 20 blog. Cold, hard cash now goes through a series of regulated financial institutions such as banks, credit unions and lenders, she said. Bitcoin’s goal is to let individuals and traders generate and exchange modern money directly, she said.

The system is particularly interesting in the wake of events such as the decisions by PayPal, Visa and others to cut off services to WikiLeaks, Reitman said. If Bitcoin lives up to the dreams of its creators, she wrote, it might “offer the kind of anonymity and freedom in the digital environment we associate with cash used in the offline world."

Bitcoin is “the most dangerous project we've ever seen,” Launch Media founder Jason Calacanis wrote May 15 on the organization’s website. Launch’s website says it helps entrepreneurs roll out new inventions. His research found that Bitcoin is technically sound, and “unstoppable without end-user prosecution,” he said. It “may be the most dangerous technological project since the internet itself,” he wrote. It’s a “political statement by technotarians (technological libertarians)” and bitcoins will “change the world unless governments ban them with harsh penalties,” he said.

Bitcoins will be used to buy drugs online and to purchase cash and casino chips in Las Vegas, Calacanis said. He predicted governments will starting banning them in the next 12-18 months, and that speculation and hoarding will cause their value to soar, enticing a “crush of folks” to flood the system and start using them. There will be “massive “breakage” as laptops are stolen or crash without the currency being backed up, he said. “This is about to get interesting, everyone,” he wrote.

Although Bitcoin may be more resistant to government attack because it’s decentralized, many consumers and business users “are anxious about its legal status,” Grinberg wrote. “That it may exist in a legal grey area” could hamper demand for bitcoins, he said. The U.S. Constitution says nothing about private parties creating money, but the 1862 Stamp Payments Act and federal counterfeiting statutes may be implicated, he said. Moreover, a bitcoin may be a “security” within the meaning of federal securities law, subjecting the system to “a vast regime of regulations, including general antifraud laws,” he wrote. His paper didn’t analyze other potentially significant legal issues such as tax evasion, banking without a charter and money-laundering.

Back when the patents for Digicash, an anonymous payer scheme, were for sale, many companies considered entering into e-cash minting but were deterred by regulatory risks, University of Miami Law Professor Michael Froomkin said. At the time there were few overt regulatory hurdles to electronic cash, and financial institutions that did some bank-like business but weren’t regulated as tightly as banks were common, said Froomkin, author of a 1996 paper, “Flood Control on the Information Ocean: Living With Anonymity, Digital Cash and Distributed Databases,” published in the University of Pittsburgh Journal of Law and Commerce.

But U.S. and EU regulators made it clear privately and publicly that they were “prepared to amend their rules rapidly to make anonymous e-cash much more difficult to issue,” Froomkin told us. It was unclear whether this was a threat to make e-cash essentially illegal or, more likely, to bring the activity under a level of supervision comparable to that of banks, or even to limit it to banks only, he said. In any of these cases, the probable compliance costs would have been high enough to make the system unattractive, he said. In the end, the major e-cash experiments were run by banks or other financial institutions familiar to regulators, he said.

Bitcoin has an “unorthodox approach to fraud prevention,” Reitman wrote. All transactions are public, she said; every coin has a digital signature attached for every transaction that occurs. But the individuals tied to the activities are anonymous, she said. This is akin to how the stock exchange makes stock values public without disclosing individual owners, she said.

It’s too early to say whether Bitcoin will succeed, Reitman said. “Any new currency faces an uphill battle, both technically and legally,” she said. The worth of bitcoins, if the system is ever widely adopted, will be based on a fluctuating market value, she said. Merchants will need to accept bitcoins as a placeholder for goods and services, just as they do any other form of currency, she said. This has been a barrier to other forms of digital cash, so it’s not clear whether Bitcoin will fare better, she said. But many believe there’s a need for a decentralized currency system and Bitcoin is certainly “a step toward censorship-resistant digital currency,” she said. EFF accepts donations in bitcoins, she said.

But Wayne State University Law Professor Jonathan Weinberg said he doesn’t understand Bitcoin’s value proposition. Bitcoins only have worth to the extent there are enough other people out there willing to provide goods and services in exchange, he said in an email. Bitcoins have many disadvantages compared with conventional money instruments and only one advantage, anonymity, he said.

This suggests that the regime will only be adopted by “libertarians who are doing it for The Principle of the Thing and by people who want to engage in specific anonymous transactions,” Weinberg wrote. Put another way, he said, “my drug dealer won’t want to accept bitcoins from me in exchange for giving me drugs, because he won’t be able readily to exchange those bitcoins for clothes or cars or iPods.”