Is Bitcoin legal?

Could the next revolution in payment systems be already here? Bitcoin is a non-fiat cryptographic electronic payment system that purports to be the world’s first cryptocurrency. In other words, it is a peer-to-peer, client-based, completely distributed currency that does not depend on centralised issuing bodies to operate, the value is created by the users, and the operation is distributed using an open source client that can be installed in any computer running Windows, Mac or Linux (see a good article about the new currency here). So, is Bitcoin legal? To answer that, we must first know a little bit about currencies in general, and electronic currencies specifically.

Currency basics

Payment systems in general, and currency specifically, depend on value. What is value? When you think about it, value is simply the desirability that someone allocates to something. Under normal circumstances, we value material things according to our needs, such as food and shelter, or according to their scarcity, such as gold. We also give value to energy in the shape of labour. Finally, we value intangibles, such as experience, knowledge, creativity and know-how.

Currencies were invented as a means to transfer value. Initially, this was done through barter, then we used coins in metals that were considered valuable for their scarcity. At some point we invented paper money to make transactions easier, as carrying gold and silver around was insecure and expensive. The first paper notes used to be a promise to give the bearer the equivalent value in metal. Money therefore relied on the idea that the issuer had metal reserves that could be redeemed at any time, hence giving value to the currency. The problem with this system, called the gold standard, is that it placed a limit on the amount of money that could be issued to that which could be allocated to metal reserves. There would be situations when a country would need to issue more money, such an during time of war, but this would result in heavy devaluation, as people would not trust that there were reserves that supported the money. During the 20th century, the gold standard was abandoned, and a new monetary system was put in place. This is what is known by some as fiat money.

Modern fiat currencies have value based on the economic strength of the issuer. In some libertarian and anarchist circles, it is said that fiat money does not have any inherent value, but this fails to recognise that neither does the gold standard. Gold does not have intrinsic value, under the right circumstances gold could be valueless. In fact, there is no such thing as inherent value, all value is dependent on circumstances. Having said that, the value in fiat money arises from the law, the currency has the backing of the government behind it, and therefore, it is supported by the economy of the territory where it is accepted.

Bitcoin as currency

Bitcoin is advertised as a non-fiat currency, in other words, its proponents claim that it has “real” value. The value arises from computing power, that is, the only way to create new bitcoins is by allocating distributed CPU power through computer programs named “miners”; the miners create a block after a period of time that is worth 50 bitcoins. The idea is that the computing power and electricity used to create the currency are what give each bitcoin its value. I have a huge problem with this from both a practical and conceptual point, as what the Bitcoin proponents are doing is simply allocating value arbitrarily to a little program that performs the mathematical equations necessary to support the creation of a bitcoin. It’s self-referential and circular currency, and its only value is that which is given by the people who buy into the idea… just like fiat money. Under this theory, many other online currencies, particularly in-game currencies, would be non-fiat money. Heck, I think I may have 25,000 gold resting in several World of Warcraft servers, maybe I could try to see if I can exchange it into BTCs, after all, that gold was mined by killing monsters using electricity, time and computing power.

Another problem that I have with Bitcoin is that mining for coins becomes more difficult as time goes by and the market grows. The algorithms that produce new coins increase the amount of processing power necessary to create each new block, so producing new money is more difficult as time goes by, and this difficulty is built into the system to try to keep the total amount of Bitcoins at a maximum of 21 million. So, the first block “mined” by BTC creator Satoshi Nakamoto (probably a pseudonym) was done at difficulty 1, at the time of writing there were 131301 blocks, making a total BTC of 6.56 million, and a difficulty of 877,227. That means, making a new block will be more than 800 thousand times more difficult than it was for the initial block. This difficulty will only go up, so an individual cannot hope to have the processing power to develop new coins, and this can only be done currently through pool mining CPU resources. This model is trying to replicate scarcity in the market, but it acts as a punishing disadvantage for late adopters, and means that early adopters have too much power if they hoarded coins early. More than anything else, this would lead me to be very sceptical of Bitcoin, the whole scheme screams Ponzi, but I am willing to be proven wrong.

Another practical concern is that while I found it easy to install the client, once it is open it is not very clear what to do with it. Bitcoin has reached a point where it is very difficult to create new coins, so their value has gone up considerably. I found the mining instructions difficult to follow, but was able to get a miner registered and working, although this was not easy to achieve. I would like to think of myself as a person with above-average technical skills, so I do not see the scheme catching on, particularly to a wider audience. It is possible to buy BTCs with real money in exchanges, but this didn’t strike me as straightforward either, and I did not feel inclined to invest in this currency (maybe I will regret it in the future, who knows?) The fact that the mining business seems to be a very closed niche would mean that newcomers would have to part with their hard-earned cash to acquire a virtual currency. At the time of writing, the exchange rate of $19 USD per 1 BTC seems ludicrously inflated.

There is something else bothering me, and it is the fact that Bitcoin seems to be a big hit with the libertarian fringe in the United States. There is a very strong anti-government and anti-taxation slant in the forums, and there were too many mentions of Ayn Rand for my liking. Libertarians, particularly of the Tea Party ilk, think that fiat money is going to collapse any minute, and that those surviving are going to be the ones holding “real” currencies. Bitcoin seems to have been erected into that small category. So there is certainly a rabidly loyal element which lends some value to the currency.

Despite my misgivings, there is little doubt that BTCs have been gaining value. They are not accepted at any major retailer (but they can be used to purchase alpaca socks, yay!), but can be used in a growing number of websites. It seems to me that the increase in value is that it has become a supposedly good investment at the moment, and with larger press presence comes increase in value. In fact, Bitcoin has been a lot in the news recently because it is being accepted as means of payment in some of the less savoury corners of the Internet. The fact that the coins are anonymous and supposedly untraceable mean that they are allegedly being used to pay for porn and drugs.

Moreover, a big security problem has been uncovered recently, as a user had 25,000 BTC stolen from his wallet. A hacker got into his system and removed the un-encrypted file, which seems to be a major issue with Bitcoin. Because it is possible to see which wallet holds what, similar attacks may happen more and more in the future if the value continues to increase.

Legalities

But now to the real question, is Bitcoin legal? There are generally two types of currency from a legal perspective, there is legal tender and legal currency. Legal tender is simply currency that cannot be refused in the fulfilment of a debt. Legal currency is currency that is recognised by the government as a legitimate manner to pay for goods and services. In most countries legal currency and legal tender are one and the same, but there are some exceptions. For example, in the most of the UK the Bank of England notes are legal tender, but in Scotland only coins are legal tender, there are notes issued by several banks, which act as legal currency. The same applies for Northern Ireland. It is also common to see economies with a weak local currency to accept international money as legal currency.

In the United States, where most of the BTC action seems to be taking place at the moment, only the US Dollar is legal tender (31 U.S.C. § 5103). Similarly, only the Mint and the Federal Reserve can produce coins and currency, which are the only means of legal tender. Title 31 of the US Code does not seem to make the distinction between legal currency and legal tender, so to me both are one and the same (please comment if this is not the case). This is corroborated by several official documents that indicate clearly that only the USD is allowed as the official currency of the United States. According to the FBI “it is a violation of federal law for individuals, […] or organizations,[…] to create private coin or currency systems to compete with the official coinage and currency of the United States.” I am no securities expert, but it would seem that Bitcoin would not fall under definitions of securities and commodities either(see here for a discussion on these). So in my humble opinion Bitcoin is not legal currency in the United States.

The picture is clearer in the European Union. Unlike the United States, the EU has implemented a legal framework for the regulation of electronic money. The Electronic Money Institutions Directive 2009/110/EC defines electronic money thus (paraphrased for clarity):

1. electronically, including magnetically, stored monetary value;
2. as represented by a claim on the issuer which is issued on receipt of funds for the purpose of making payment transactions;
3. the transaction is an act, initiated by the payer or by the payee, of placing, transferring or withdrawing funds, irrespective of any underlying obligations between the payer and the payee;
4. which is accepted by a natural or legal person other than the electronic money issuer.

If a payment system fulfils these requirements, then it is considered electronic money, and only electronic money institutions can issue electronic value. There is a high threshold for an electronic money institution, as the EMI would have to fulfil quite a lot of requirements. The idea behind this stringent regulation is evident, as what is taking place is the issuing of value into the economy. In my opinion, Bitcoin would definitely meet the legal definition, which would mean that in order to work in Europe it would need to be declared an electronic money institution, otherwise it is operating outside of the regulatory framework.

It seems like it is only a matter of time before regulators come knocking on the doors of Bitcoin. However, part of the appeal of the system is that it is completely decentralised. Just as it happens with P2P file-sharing, you could shut down the entire Bitcoin operation tomorrow and the network would still run because it does not depend on a central system. So, while Bitcoin may very well be illegal, it may also be almost impossible to shut down in any efficient manner, that is the beauty of distributed networks.

However, this point may be moot. Regulators only need to be involved if Bitcoin becomes a large source of value in a national economy. At the moment, there are 6.5 million BTCs in circulation, with a value of almost $130 million USD at today’s prices. This is no small change, and would seem to prompt some form of involvement from governments. However, I think that the value of Bitcoins may be a bubble as a result of hoarding from early adopters. Once newcomers realise that it is very expensive to enter the market, prices may drop. However, investors only invest if they see room for growth, it is perfectly possible that speculation will continue to drive prices up, therefore prompting regulation by the government. Catch 22 in my opinion, Bitcoin is better off remaining small.

I’m off to see if I can produce some more WoW gold, it makes more sense to me to kill monsters and get gold in return.

ETA: Just in case, here is my purse address if anyone feels like proving me wrong 1F9arzFyYFXTEd2FEjiRxHuyTSGNxehwEt

ETA2: There are lots of other interesting considerations, such as money laundering and the use of the currency in black markets. I will touch on those subjects in the next couple of weeks.

ETA3: Mt.gox, the largest Bitcoin exchange, has been hacked exposing usernames, emails and encrypted passwords. I’m looking at the list of 61,020 accounts right now. I would say that this could be a fatal flow for BTC, and no regulators had to get involved.

Final Edit: EFF has removed Bitcoin donation support fearing negative legal repercussions.