FOCUS: Virtual currencies have existed before but few have captured the imagination of the public and the financial services world like bitcoin. But is it money? Is it regulated? Will it help e-commerce? We look at the answers to these pressing bitcoin questions. 10 Feb 2014

To discuss bitcoin properly we need to distinguish between a bitcoin, and the bitcoin system which gives each ‘coin’ its value. They are intertwined, but distinct.

The ‘coin’ is essentially the result of a chain of digital signatures wrapped up in encrypted code. The bitcoin system is a decentralised virtual payments system that enables transactions to be made. It is the public storing of the signature chains that in theory protects the integrity of each coin by ensuring that it can’t just be duplicated, multiplied or double spent. This is vital because, unlike traditional currencies, the bitcoin is not underwritten by any government or bank.

Is bitcoin money?

Bitcoin isn’t the same as national currencies and the ‘coins’ cannot be equated to physical coins or paper notes (fiat money). No institution ‘prints’ bitcoins and no single organisation controls its distribution.

It’s not money in the traditional sense because there is no institutional guarantee underpinning it. The Bank of England stands behind the pound, the European Central Bank behind the euro. Laws then regulate ‘other means’ of money creation and the issuing of ‘electronic money’ (e-money).

‘Electronic money’ mostly refers to the digital representation of fiat money. Of course, there are many reasons why fiat money needs to be represented digitally, for example, to be stored in bank accounts accessible digitally or used in conjunction with card payment systems. But this is still part of the fiat money system in a way that bitcoins are not.

Bitcoins can perform the same the function as money – transferring value between people. They can be exchanged for goods and services and can be transferred into fiat money in exchanges that, to the user, are almost identical to normal foreign currency exchange.

So is bitcoin money? Not in a formal, philosophical, or currently in most places regulatory sense. Some countries may move towards introducing laws which consider it ‘private money’. Germany for instance, has recognised it as a private ‘unit of account’, according to Der Spiegel .

Private money systems are not new. At times private banks, online platforms, retail stores and others have sought and been permitted to issue ‘private money’, ‘credits’, ‘vouchers’ and other forms of value transfer. But these systems are in themselves distinct forms of transferring value and should not be confused with ‘money’ as backed by a central monetary authority.

Is it a digital asset?

One way in which governments might regulate bitcoin is to treat it as simply a digital asset, in the same way that laws are enacted to protect and regulate other digital items such as mp3s, e-books and games.

The UK is in the process of passing a new Consumer Rights (CR) Bill into law. It defines ‘digital content’ as ‘data which are produced and supplied in digital form’. While digital content is distinguished from goods and services by the CR BiIll, it is also given a similar status in the sense that specific rules apply to the supply of it in a commercial context.

Bitcoins fit the description of ‘data which are produced and supplied in digital form’ as they are ‘mined’ digitally and have commercial relevance only in the context of a supply that takes place at least in part digitally. They therefore fit the description of a digital asset, even if this is not what is being intended by the UK Parliament in the context of the CR Bill.

Viewing bitcoins as digital assets may also be in line with The People’s Bank of China’s (PBC) views on bitcoins. According to reports. The PBC has referred to bitcoins as ‘virtual goods’.

How is bitcoin regulated?

How bitcoin is regulated in most places remains unclear, as until recently, the only major attention it seemed to have received had been from criminal law enforcement agencies rather than regulators of traditional financial systems. The online market Silkroad.com raid by the FBI in 2009 and the confiscation of 144,000 bitcoins, then worth US$28.5 million, was the key example.

In the UK not much has changed. In recent weeks, the Financial Times has reported that the Financial Conduct Authority (FCA) has not stepped in with any formal regulation of bitcoin because it does not believe the system is in wide enough usage to merit regulation.

The European Central Bank (ECB), however, has reviewed the use of Bitcoins and concluded that it and other similar virtual currencies pose price stability, financial stability and payment systems stability risks. The ECB has said that . the lack of a proper legal framework substantially exacerbates [these] other risks.

But the ECB has also said that as most virtual currencies work on a prepaid basis, i.e. the issuance of virtual currency takes place when real money is exchanged and, in the same vein, virtual currency is absorbed (withdrawn from circulation) when exchanged back to real money. the net effect should, in theory, be limited. In other words, bitcoins behave more like assets than currency.

Some US authorities have also been willing to discuss the ways in which bitcoin could be regulated. Bart Chilton, Commissioner of the US Commodity Futures Trading Commission (CTFC), for example, has said that the CFTC could regulate it if it could be characterised as a commodity that is being used as a derivative.

So if somebody’s buying it and holding it for the future, then it’s something that we at least could regulate, squarely, Chilton said, according to a Nasdaq report.

Further, a principal deputy assistant attorney general in the US has reportedly indicated that there is a . recognition that online payment systems, both centralized and decentralized, offer legitimate financial services and that treatment of virtual currencies will be guided by this recognition.

Last month at the World Economic Forum, JP Morgan Chase and its chief executive James Dimon said that bitcoin would be regulated like currencies, but that this will probably be the end of [bitcoin and its competitors]. However, Dimon’s comments at the forum in Davos need to be viewed in the context of JP Morgan’s own activities. JP Morgan has recently made patent applications for a bitcoin competitor, according to a number of reports .

The Russian Central Bank has warned against virtual currencies being used as ‘money surrogates’, according to RT.com in the context of money laundering, while The People’s Bank of China has restricted its transfer and exchange for yuan, as reported by the BBC amongst others. Further reports surfaced over the weekend suggesting concern in Russia over the use of money substitutes.

Current governor of the Australian Federal Bank Glenn Stevens has taken a more relaxed approach. In an interview with the Australian Financial Review he said: “You can hold US dollars or euros or whatever in Australia completely freely if you want to and there would be nothing to stop people in this country deciding to transact in some other currency in a shop if they wanted to. There’s no law against that so we do have competing currencies.”

The most positive support a regulator has provided for bitcoin may be the comments of Benjamin Lawsky, the superintendent of financial services in New York. Lawsky told the Financial Times recently that Bitcoin has reached a ‘tipping point’ where its potential benefits outweigh the risks of illegal activity.

Regulators in many other countries, including France, Finland, Sweden, Norway, India, Thailand, Israel and Canada have all been reported as also providing public comment on the question of regulation.

Where does bitcoin leave mainstream financial systems?

Bitcoin transactions are totally decentralised – they happen outside of the extensive and highly regulated payments systems set up by banks, regulators and governments. Since banks have no role in the processing of bitcoin transactions arguably they have no opportunity to earn revenue from providing many of their normal services, and their existing systems are at risk.

If you pay in bitcoin the person you paid can verify from the bitcoin system that you have paid and will not have to wait on further authorisation or confirmation of payment. In this sense virtual currencies may introduce efficiencies into the financial system that are otherwise not possible.

But in some ways, a bitcoin transaction is more closely related to paying with physical cash than it is to an e-money transaction that relies on a bank transfer. If your password is hacked and your bitcoins are stolen you may have as little recourse as you would if someone had stolen twenty pound notes from your pocket.

What does it mean for e-commerce?

Even in the pre-dot-com boom days in the late 90s, lawmakers could foresee the need to establish laws that would regulate contracts made online, where parties contracted with each other at a distance, perhaps never seeing or even speaking to one another. Their first thoughts were to deal with the question of authenticating signatures. Electronic signature laws therefore came into effect in a number of jurisdictions for this purpose.

However, the need to verify the identities of the persons signing electronically posed a problem. For this reason, a complex system for verifying signatures by trusted third parties was built into European laws.

Virtual currencies like bitcoin do not address the issue of authenticating identities of the persons transacting online. They do however tackle the problem from another angle. Like hand-to-hand cash transactions, the identity of the persons making the transfer is not always as important as ensuring that currency of genuine value is being exchanged.

Bitcoin places the emphasis on the security of transactions to ensure that genuine value within the framework which it operates is being exchanged. It also enables transactions to be made anonymously. In this context, whether ‘money’ has been transferred is not in issue, only the identity of the person who has transferred it – a matter than can be dealt with by theft laws rather than ones governing payment processes.

Accordingly, despite the legal uncertainties that remain and the caution expressed by regulators and others, we do not think that virtual currencies, whether bitcoin or a successor, are going away.

Luke Scanlon. technology law specialist at Pinsent Masons, the law firm behind Out-Law.com