Published: October 30, 2013
Bitcoin offers a path to lower payment processing and more secure transactions. Instead of using bitcoin to buy illegal guns in the recesses of the web, ordinary consumers will use it to buy legal goods from legal retailers — and as easily as they now swipe their credit cards or exchange paper bills.
One potential obstacle to mainstream acceptance of bitcoin is the sometimes wild fluctuations in its value, which makes it alluring to currency speculators but could scare off ordinary consumers. One bitcoin was worth just over $200 Wednesday afternoon. Someone who bought a bitcoin in early April paid as much as $266 for it.
Only a small and motley assortment of merchants now accept bitcoin as payment, and in many cases they do it largely as a marketing strategy.
Since bitcoin emerged in 2009, many of those who flocked to the currency celebrated it for being beyond the clutches of governments and other institutions. Until recently, the currency lubricated transactions on Silk Road, one of the Web’s biggest bazaars for drugs, forged documents and other contraband. The site was shut down in early October by federal authorities.
New bitcoin is created on computers connected through a peer-to-peer network. An algorithm controls the production of new bitcoin, which is meant to mitigate the risk of inflation.
Already, though, businesses transferring and exchanging bitcoin find themselves in regulators’ cross hairs.
In March, the Financial Crimes Enforcement Network, part of the Treasury Department, issued guidelines telling businesses involved in the exchange of digital currencies that they needed to register as money services businesses and comply with a variety of rules to prevent money laundering. New York’s Department of Financial services began an inquiry in August to determine guidelines for digital currency businesses, issuing nearly two dozen subpoenas to start-ups, investors and others involved in the emerging field.
Bitcoin advocates, and especially merchants, say one of the currency’s most enticing promises is that it could significantly lower payment processing costs.
Retailers typically pay 2 to 3 percent of the value of a customer sale when a credit card is used. Retailers have long complained about these fees and have sought other options, but without much luck. PayPal, the online payment system, typically charges merchants a fee between 2.2 percent and 2.9 percent, as well as a per-transaction fee of 30 cents.
Bitcoin (sign: ; code: BTC or XBT) is a distributed peer-to-peer digital currency that functions without the intermediation of any central authority. The concept was introduced in a 2008 paper by a pseudonymous developer known only as “Satoshi Nakamoto”.
Bitcoin is called a cryptocurrency since it is decentralized and uses cryptography to prevent double-spending, a significant challenge inherent to digital currencies. Once validated, every individual transaction is permanently recorded in a public ledger known as the blockchain. The calculations required to authenticate Bitcoin transactions are completed using a network of private computers often specially tailored to this task. As of May 2013, the Bitcoin network processing power “exceeds the combined processing strength of the top 500 most powerful supercomputers”. The operators of these computers, known as “miners”, are rewarded with transaction fees and newly minted bitcoins. However, new bitcoins are created at an ever-decreasing rate. Once 21 million bitcoins are distributed, issuance will cease. As of August 2013, approximately 11.5 million bitcoins were in circulation.
In 2012, The Economist reasoned that Bitcoin has been popular due to “its role in dodgy online markets,” and in 2013 the FBI shut down one such service, Silk Road, which allowed the sale of illegal drugs for bitcoins. However, bitcoins are increasingly used as payment for legitimate products and services. Notable vendors include WordPress, OkCupid, Reddit, and Chinese Internet giant Baidu.
Speculators have been attracted to Bitcoin, fueling volatility and price swings. In July 2013, Cameron and Tyler Winklevoss asserted that “there is relatively small use of bitcoins in the retail and commercial marketplace in comparison to relatively large use by speculators.”
Bitcoin is the first cryptocurrency, a form of money that uses cryptography to control its creation and management, rather than relying on central authorities. However, not all of the technologies and concepts that make up Bitcoin are new; Satoshi Nakamoto integrated many existing ideas from the cypherpunk community when creating Bitcoin.
- In 2008, Satoshi Nakamoto posted a paper describing the Bitcoin protocol on the internet.
- In 2009, the Bitcoin network came into existence with the release of the first open source Bitcoin client and the issuance of the first bitcoins.
- 2009-01-03 – “Satoshi Nakamoto” mines the first block of bitcoins ever (known as the “genesis block”), which had a reward of 50 bitcoins.
- The prices for the first bitcoin transactions were negotiated by individuals on the bitcointalk forums. One notable transaction involved a 10,000 BTC pizza.
- On 6 August, a major vulnerability in the Bitcoin protocol was spotted. Transactions weren’t properly verified before they were included in the transaction log or “block chain” which allowed for users to bypass Bitcoin’s economic restrictions and create an indefinite number of bitcoins.
- On 15 August, the major vulnerability was exploited. Over 184 billion bitcoins were generated in a transaction, and sent to two addresses on the network. Within hours, the transaction was spotted and erased from the transaction log after the bug was fixed and the network forked to an updated version of the Bitcoin protocol. This was the only major security flaw found and exploited in Bitcoin’s history.
- In June 2011, Wikileaks and other organizations began to accept bitcoins for donations. The Electronic Frontier Foundation temporarily suspended bitcoin acceptance, citing concerns about a lack of legal precedent about new currency systems, and that they “generally don’t endorse any type of product or service.” The EFF’s decision was changed in 17 May 2013.
- In late 2011, the exchange rate of bitcoin crashed from over $30 in June to below $2 in October.
- In January 2012, Bitcoin was featured as the main subject within a fictionalized trial on the CBS legal drama The Good Wife in the third season episode “Bitcoin for Dummies“. The host of CNBC‘s Mad Money, Jim Cramer, played himself in a courtroom scene where he testifies that he doesn’t consider bitcoin a true currency, saying “There’s no central bank to regulate it; it’s digital and functions completely peer to peer.”
- In October 2012, BitPay reported having over 1,000 merchants accepting Bitcoin under its payment processing service.
- The Bitcoin-based payment processor Coinbase reported selling $1 million in bitcoins in a single month at over $22 per bitcoin.
- The Internet Archive announced that it is ready to accept donations as bitcoins and that it intends to give employees the option to receive portions of their salaries in Bitcoin currency.
- The Bitcoin transaction log or “block chain” temporarily forked into two independent logs with differing rules on how transactions could be accepted. The Mt.Gox exchange briefly halted Bitcoin deposits and the exchange rate briefly dipped by 23% to $37 as the event occurred before recovering to previous level of approximately $48 in the following hours.
- In the US, the Financial Crimes Enforcement Network (FinCEN) established regulatory guidelines for “decentralized virtual currencies” such as Bitcoin, classifying American “Bitcoin miners” who sell their generated bitcoins as Money Service Businesses (or MSBs), that may be subject to registration and other legal obligations.
- Payment processor BitInstant and Mt.Gox experienced processing delays due to insufficient capacity.
- On 10 April, the bitcoin exchange rate dropped from $266 to $76 before returning to $160 within six hours.
- Bitcoin gained greater recognition when services such as OkCupid and Foodler began accepting it for payment.
- On 15 May 2013, the US authorities seized accounts associated with Mt. Gox after discovering that it had not registered as a money transmitter with FinCEN in the US.
- The US-based bitcoin company Coinbase announces a $5 million Series A investment, the largest funding round for a bitcoin company.
- A project under way in Kenya is linking Bitcoin with M-Pesa, a popular mobile payments system, in an experiment designed to spur innovative payments in Africa.
- July 30, 2013—The Foreign Exchange Administration and Policy Department in Thailand stated that Bitcoin lacks any legal framework and would therefore be illegal, which effectively banned trading on Bitcoin exchanges in the country. According to Vitalik Buterin, a writer for Bitcoin Magazine, “Bitcoin’s fate in Thailand may give the electronic currency more credibility in some circles.” But he was concerned it didn’t bode well for Bitcoin in China.
- As of July 2013, BitPay handled bitcoin transactions for more than 4,500 companies.
- Federal Judge Amos Mazzant of the Eastern District of Texas of the Fifth Circuit ruled that bitcoins are “a currency or a form of money” (specifically securities as defined by Federal Securities Laws), and as such were subject to the court’s jurisdiction. The case, brought by the U.S. Securities and Exchange Commission, is ongoing.
- Germany’s Finance Ministry subsumed Bitcoins under the term “unit of account”—a financial instrument—though not as e-money or a functional currency, a classification nonetheless having legal and tax implications.
Satoshi Nakamoto is a pseudonym for the unknown person or people who designed the original Bitcoin protocol in 2008 and launched the network in 2009. Nakamoto was responsible for creating the majority of the Bitcoin software and was active in making modifications and posting technical information on the BitcoinTalk Forum.
Investigations into the real identity of Satoshi Nakamoto have been attempted by The New Yorker and Fast Company. Fast Company’s investigation brought up circumstantial evidence linking an encryption patent application filed by Neal King, Vladimir Oksman and Charles Bry on 15 August 2008, and the bitcoin.org domain name which was registered 72 hours later. The patent application (#20100042841) contained networking and encryption technologies similar to Bitcoin’s, and textual analysis revealed that the phrase “…computationally impractical to reverse” appeared in both the patent application and bitcoin’s whitepaper. All three inventors explicitly denied being Satoshi Nakamoto. In May 2013, Ted Nelson speculated that Japanese mathematician Shinichi Mochizuki is Satoshi Nakamoto.
The fork of March 2013
On 12 March 2013, a Bitcoin miner running version 0.8.0 of the Bitcoin software created a large block that was incompatible with earlier versions of the Bitcoin software due to its size. This created a split or “fork” in the block chain since older versions of the software did not accept this block as valid. Computers with the recent version of the software accepted the block and continued to build on the diverging chain, whereas older versions of the software rejected it and continued extending the block chain without the offending block. This split resulted in two separate transaction logs being formed without clear consensus, which allowed for the same funds to be spent differently on each chain. In response, the Mt.Gox exchange temporarily halted Bitcoin deposits. The exchange rate fell 23% to $37 on the Mt.Gox exchange but rose most of the way back to its prior level of $48.
Developers at bitcoin.org resolved the split by recommending that users downgrade to “version 0.7”, which utilized the oldest transaction log in the split. User funds largely remained unaffected and were available when network consensus was reached. The network reached consensus and continued to operate as normal a few hours after the split.
On 18 March 2013, the Financial Crimes Enforcement Network (or FinCEN), a bureau of the United States Department of the Treasury, issued a report regarding centralized and decentralized “virtual currencies” and their legal status within “money services business” (MSB) and Bank Secrecy Act regulations. It classified digital currencies and other digital payment systems such as Bitcoin as “virtual currencies” because they are not legal tender under any sovereign jurisdiction. FinCEN cleared American users of Bitcoin of legal obligations by saying, “A user of virtual currency is not an MSB under FinCEN’s regulations and therefore is not subject to MSB registration, reporting, and recordkeeping regulations.” However, it held that American entities who generate “virtual currency” such as bitcoins are money transmitters or MSBs if they sell their generated currency for national currency: “…a person that creates units of convertible virtual currency and sells those units to another person for real currency or its equivalent is engaged in transmission to another location and is a money transmitter.” This specifically extends to “miners” of the Bitcoin currency who may have to register as MSBs and abide by the legal requirements of being a money transmitter if they sell their generated bitcoins for national currency and are within the United States.
Additionally, FinCEN claimed regulation over American entities that manage bitcoins in a payment processor setting or as an exchanger: “In addition, a person is an exchanger and a money transmitter if the person accepts such de-centralized convertible virtual currency from one person and transmits it to another person as part of the acceptance and transfer of currency, funds, or other value that substitutes for currency.”
In summary, FinCEN’s decision would require Bitcoin exchanges where bitcoins are traded for traditional currencies to disclose large transactions and suspicious activity, comply with money laundering regulations, and collect information about their customers as traditional financial institutions are required to do.
In its October 2012 study, Virtual currency schemes, the European Central Bank concluded that the growth of virtual currencies will continue, and, given the currencies’ inherent price instability, lack of close regulation, and risk of illegal uses by anonymous users, the Bank warned that periodic examination of developments would be necessary to reassess risks.
In June 2013, Bitcoin Foundation board member Jon Matonis wrote in Forbes that he received a warning letter from California’s Department of Financial Institutions accusing the foundation of unlicensed money transmission, Matonis denying the foundation is engaged in money transmission and saying he viewed the case as “an opportunity to educate state regulators.”
In late July 2013, the industry group Committee for the Establishment of the Digital Asset Transfer Authority began to form to set best practices and standards, to work with regulators and policymakers to adapt existing currency requirements to digital currency technology and business models and develop risk management standards.[