What Bitcoin and the Blockchain are and their legal risks

By Christine Duhaime

Bitcoin, Blockchain and Other Digital Currencies

In the past few weeks, mainstream media from around the world have zeroed in on the exponential growth of digital currencies, and in particular, Bitcoin, but none of that focus has been on the legal implications of the phenomenal advent of a crypto currency like Bitcoin and on the potential risks, if any, to anti-money laundering and counter-terrorist financing initiatives. So here is our take on the legal issues surrounding digital currencies and the platforms from which they are operated, the Blockchain or distributed ledger technology.

At its most basic level, Bitcoin is unregulated although some aspects of its existence are controlled by its users on the Blockchain. And it is that fact – the unregulated nature of Bitcoin – that makes it both fascinating and attractive to users and at the same time may make it risky as a vehicle for crime.

What is Bitcoin? 

Bitcoin is operated on a a protocol called the Blockchain, a public distributed ledger technology, and is a type of digital currency. It was invented before 2009 and made available in 2009 by an unknown person, or persons, known only by the pseudonym Satoshi Nakamoto.

As a currency, it operates peer-to-peer (P2P) and essentially machine to machine (M2M). Unlike traditional fiat currencies that are issued and controlled by central banks, Bitcoin has no central monetary authority and is not backed by any central bank, authority or government. Likewise, the supply of Bitcoin is not controlled by any central authority, and is not legal tender in any jurisdiction.

There are several types of digital currencies. Bitcoin is a digital currency with a bidirectional flow. Currencies with bidirectional flow allow users to buy and sell virtual currency according to the exchange rates with their own national currency and to purchase virtual and real goods and services.

Digital currency with unidirectional flow allow users to buy digital currency according to the exchange rates with their own national currency but it cannot be exchanged back to original form. An example of a unidirectional flowing virtual currency is Facebook credits.

Users buy Bitcoin online with real monetary instruments and use them to buy goods and services globally and as a result, Bitcoin competes with official currencies. The exchange rate for Bitcoin is determined by supply and demand in the Bitcoin market. The transactions for those goods and services are not processed through a centralized authority, or clearing house. Like the purchase and sale of Bitcoin itself, the purchase and sale of goods and services using Bitcoin is unregulated, somewhat anonymous, and usually low fee.

It has Clever Mensa & Mimetic Side

Bitcoin has a charming Mensa and Girardian mimetic principle side – users can earn Bitcoin by solving complex mathmatical problems using computer programs, a process known as “mining” and that is also how the supply of Bitcoin is increased on the Blockchain. Miners execute algorithms to agree on a single history of transactions that, over time become more and more complex, to acquire new blocks of Bitcoin. Bitcoin was designed with this control function in place deliberately so that it would become more difficult to mine for Bitcoin and limit its ultimate final supply to 21 million units, which is nowhere near enough for its survivability, hence the mimetic component. There are approximately 11 million Bitcoins in ‘circulation’ today.

How is Bitcoin Used?

To use Bitcoin, a user downloads and installs Bitcoin software which uses a public key cryptography that automatically generates a Bitcoin address where the user can receive payments that are stored on the user’s wallet on their local computer. To send Bitcoin, users input the target user’s address and the amount of Bitcoin they would like to transfer. The user’s computer then digitally signs the transaction and sends the information M2M to the distributed P2P Bitcoin network. The P2P network verifies the owner of the Bitcoin and once validated, the Bitcoin is transferred. It takes about ten minutes, can be completely anonymous, and is not reversible.

If a Bitcoin user is prepaying for a hotel in Seattle via Bitcoin, for example, once the financial transaction is completed, the hotel has its Bitcoin payment immediately and ‘off the books’. There is no paper trail to evidence that transaction and it cannot be reversed.

What are the legal risks with Bitcoin?

There are several legal risks with Bitcoin that derive from its unregulated status.

The most obvious is that it is not subject to the laws of any one jurisdiction and each court will have to take jurisdiction for every litigation situation de novo, and some of the concerns flowing from that are:

  • There is no consumer protection for users and that means they are exposed when buying and selling Bitcoin and when using them for goods and services, and in fact minors can engage in the transactions without comprehending the consequences of Bitcoin losses;
  • It may be considered illegal to acquire, sell, possess or use  Bitcoin in some countries under their laws that govern the coining of currency and its usage as a form of legal tender;
  • There are no dispute resolution mechanisms governing it in the event of a dispute associated with its acquisition, disposition or use or storage;
  • It can operate as an underground economy with all of the attendant characteristics associated with underground economies, the constitutive elements of which typically include tax-evasion through unreported transactions; unreported income; and under-utilization of the labour force;
  • Some organizations are selling shares of Bitcoin-related enterprises. The trade of units or shares of such Bitcoin-related entities may, according to securities lawyers, be a violation of securities laws of some jurisdictions which may expose sellers of Bitcoin to securities laws violations;
  • Deposits (holdings) of Bitcoin are not protected by bank deposit insurance and as a result, there is nothing to protect minimum amounts of Bitcoin holdings held by digital currency exchanges; and
  • There are no systems or safeguards required to be in place to make it reasonably safe from theft or hacking.

These legal risks do not make Bitcoin undesirable or necessarily problematic.

Indeed, it is no different from cash transactions and the same risks apply to all cash transactions and to transactions involving gold or diamonds. To the extent Bitcoin may be an underground activity, the reality is that underground economies have existed since the beginning of time and continue to exist all over the world, including in industrialized states. Illegal gambling is an obvious example of a fully-functioning and long-standing component of the underground economy that shares many of the same legal risks as those facing Bitcoin in the infant state of its development.

But the difference for Bitcoin is that it is a financial product and as a society, we have come to expect, and in some respects demand, the complete regulation of financial products and services.

Terrorist Financing & Money Laundering Risks?

It is not disputed that cybercriminals have used electronic payment systems and digital currencies as a way to launder money and possibly even fund terrorism.

Bitcoin, however, poses a unique risk because it is the only decentralized P2P and M2M digital currency that opens up a new channel for potential money laundering and terrorist financing with no easy way to detect suspicious activity, identify users and traders, obtain transaction records and trace money flows from and to criminals and terrorists unless you know who owns or controls each and every wallet tied to the Blockchain.

Without being able to obtain transaction records and follow financial transactions, it is virtually impossible for law enforcement worldwide to prevent terrorist financing from occurring on the Blockchain, or to monitor it to prevent terrorists from purchasing the tools, equipment and supplies they need to carry out attacks.

Like all currencies, Bitcoin may inevitably be used by factions of extremists and money launderers to move money globally, except in this case, without easy detection unless all wallet holders are identified.

And that’s the fear for law enforcement.

Much as we may not like some of the invasive components of modern anti-money laundering and counter-terrorist financing legislation, and the attendant monitoring and reporting to government agencies, it is effective in stopping terrorists and protecting society.

The very thing that makes Bitcoin attractive to some users – anonymity – may make it dangerous for society because it can be used for terrorist attacks that threaten our way of life and seek to destroy the fundamental values to which we ascribe that form the basis of our constitutional democracy.

@2013, Christine Duhaime.