Bhumesh
Decoding the Bitcoin Conundrum
Bhumesh Verma 30 Jan 2018

Decoding the Bitcoin Conundrum

Introduction

There are currencies and currencies in the world, and there is bitcoin.

The rise of bitcoins has excited public imagination today in much the same way the first transatlantic flight had ignited global fascination and fears. The next great revolution in IT is finally here. Bitcoin, Ethereum, Token, Litecoin, BBQCoin, SolidCoin and many more names have become far too common all across the internet. If not the other less known rivals, almost every internet user has come across the term bitcoin, especially since word spread out worldwide that value of the bitcoin unit has exceeded $16,000 USD or Rs 14,00,000 INR.[1] The newspapers and websites are full of daily news as to which celebrity made or lost how much in bitcoins yesterday.

The bitcoin, along with multiple other cryptocurrencies, is shaking up global businesses and Governments alike. It is not surprising if reactions to these cryptocurrencies has been mixed. While many experts, including Goldman Sachs CEO Lloyd Blankfein, have asserted that the rise of the bitcoin bears resemblance with the greatest bubble of all times[2], techno-enthusiasts such as Balaji Srinivasan of affirm that the bitcoin is the rational byproduct of the global development of internet.[3]

Worldwide, regulators have genuine concerns that the bitcoin is a dangerous and unreliable technology which is helpful for circumventing established laws, especially those relating to money laundering.[4] As a competitor to regular currencies it could jeopardise economies the way the housing bubble led to the financial crisis of 2008.

As far as India is concerned, Reserve Bank of India has time and again reiterated that bitcoins operate outside the purview of established laws and that those trading in bitcoins are doing so at their own risk.[5] Techno-enthusiasts have however hailed the arrival of blockchain technology, the driving force behind bitcoin, as the next logical step in the development of the internet—decentralised, efficient and dehumanised payment systems.[6] Blockchain expert Balaji Srinivasan affirms that cryptocurrencies and blockchain open the horizon for a new world where dissenters can “log off” from the establishment and assert absolute economic autonomy.[7]

Let us make an effort to learn about the technology behind bitcoins, its benefits and pitfalls for businesses and economies, and the distinct features which make bitcoins unlike any “security”, “instrument”, or “currency” ever traded in modern times. While regulatory solutions are difficult to evolve, a minimalist regulatory regime can be devised as hedge against the elusiveness and anonymity afforded by bitcoins.

What is bitcoin

The answer is not simple. It is reasonable to grudge that defining bitcoin is a task that every expert has done in a manner different from the other. In fact, even Alibaba’s founder Jack Ma has publicly expressed his ignorance of bitcoin and its underlying technology.[8] The generally available answers have been affected by the media hype over the bitcoin’s recent rise in value and have been extremely diverse. As recent developments have shown us, people across the world have paid no mind to Warren Buffet’s famous advice to avoid investing in anything we do not fully understand.[9]However, leaving aside the technicality of pure computer code, bitcoins can be defined and explained in terms of their method of operation and functionality.

A celebrated bitcoin expert Andreas M. Antonopoulos has said that bitcoin is digital money.[10] It is money just like euros or dollars, only it is not owned by a Government. Bitcoin is not a company.[11]It is not an organisation.[12] It is a standard or a protocol just like TCP/IP, or the internet.[13] It is not owned by anyone.[14] It operates by simple mathematical rules that everyone who participates in the network agrees on.[15] This currency is the brainchild of Satoshi Nakamoto who in his research paper[16] in 2008 posited that he had found a way to create a decentralised computing network to form consensus about exchange of things without any central controlling authority.[17] He builds upon a mathematical concept known as the Byzantine Generals’ Problem[18] which Nakamoto claims to have solved, and with it created his own bitcoin transaction network. As Antonopoulos explains:

… bitcoin is able to allow a completely decentralised network of computers to agree on what transactions have occurred on a network, essentially agreeing on who currently has the money. So, if I send money from my account to somebody else’s account in this peer-to-peer, completely decentralised network, it is just like sending an e-mail. There is no one in the middle. Every ten minutes, the entire network agrees on what transactions have happened, without any centralised authority, by a simple election that occurs electronically.

If all this explanation is not intelligible, another way to understand bitcoin may be to rethink how real world exchange works. In the real world, we regularly deal with the known fact of limited resources and scarcity of things. If Bhumesh has a pen, it means Somashish may not have one. If Somashish has a ten rupee note, Bhumesh may not have one. Thus, an exchange takes place. Generally, we are able to buy and sell by means of an intermediate mechanism, namely, the monetary system having a currency which is a promissory note having the watchful sanction of the State. All of us believe it to be valuable to the extent stated in the note because the power of the State enforces it.

Thus, in the real world currency helps buying and selling based on the value of each unit of such currency which people trustingly believe to be inter alia genuine and containing inherent value. Bhumesh, while selling his pen, need not bother about the currency so long it is the one which RBI regularly prints with all the regular legally prescribed and popularly known features. Bhumesh sells the pen and Somashish tenders the note without any worry as to the genuity and inherent value of the note. In the cyberspace it was hitherto thought impossible to replicate a similar exchange facilitating scenario before Nakamoto invented the bitcoin computing network/decentralised digital ledger called the blockchain.

While in the real world, it is the central bank of the country which ensures the authenticity and reliability of the currency, the same function is performed in the cyberspace by a set of well-defined codes called the blockchain held in consensus by a network of millions of servers and computers in the internet.[19] The unique codes i.e. the genuine bitcoins are auto-verified and auto-accepted as per the set rules of the game.[20] There is no central server or central system which operates the rules.[21] The rules of the game self-operate.[22] This network also keeps a decentralised digital ledger which debits and credits for every transaction that takes place.[23] The blockchain is the automatic processor and recorder of all transactions with the bitcoins.

In the scheme of things, the bitcoin/cryptocurrency are unique codes with public and private digital keys along with a value in terms of any one of the given national currencies. Each time a subscribing individual buys a bitcoin, he pays the given value in the national currency through a bank account.[24] In return for subscription of the bitcoin a unique programme code is obtained, being the private key underlying the bitcoin of the subscriber.[25] If one loses a LinkedIn password, it can be reset. With this private key underlying a bitcoin, reality is that if one loses it, all the bitcoins are lost — as good as losing an entire wallet full of money.[26] The computer network has an inherent public key which has to merge with the private key for bitcoin ownership.[27]

Once a subscriber is part of the computer network, the transactional possibilities are unlimited. Automated smart contracts, bitcoin futures, bitcoin exchange, buying merchandise or making donations—all kinds of valuable transactions can be effected across the globe seamlessly, anonymously and immediately.[28] There is no identity that gets recorded. What is recorded in the blockchain is that a certain subscriber node transacted with another subscriber node, without in anyway giving away locational or personal details of either transacting parties.[29] The value of the bitcoin itself can be transferred to different pay wallets as well as to the bank account of the subscriber.[30] Owning a bitcoin has till now paid off well. Investors who owned even a single bitcoin since 2014 have seen an over 800 per cent increase in bitcoin value which now stands at $16000 USD as against $234 USD in 2014.[31]

The attraction of bitcoin is quite self-evident. Bitcoin is used in transactions worth $2 billion per day, a 10 times annual increase in 2017.[32] The user base has surpassed 100 million last year.[33] The sheer scale of transactions means the blockchain now keeps unlimited amounts of transaction data, all of it being decentralised through the entire network. Is the blockchain susceptible to being hacked? Is the data susceptible to stealing? Well at this point, the answer is that it could be done but only at an astronomical expense for the blockchain to be brought to a standstill.[34] Attempts at hacking the blockchain find stiff resistance due to the decentralised storage of the data and stealing from the entire network is impossible only because of this reason.[35] The existing codes on which the blockchain operate cannot be totally subverted due to the massive extent of the computing network.[36]

The real innovation lies in the underlying technology—the blockchain. The blockchain is a decentralised public ledger that is transparent and trustless—in the sense that it enables people to cooperate in a distributed manner, and to transact with one another, without the need for any trusted authority or centralised clearinghouse.[37]

As an important accounting innovation, it can lead to more efficiency and transparency in the field of many financial applications.[38] It can reduce the cost of regulatory compliance, by means of multi-signatures and other technical mechanisms such as proof of solvency which can be used to increase the transparency and accountability of traditional fiduciary institutions.[39] Similar claims have been presented into the IMF report on virtual currencies.[40]

Whether/how can bitcoins be regulated

Regulating bitcoins could be a nightmare for Governments. It is not surprising if some of the extraordinary features of the cryptocurrencies like bitcoin cause foreheads to fold. A man fears what he knows the least. Bitcoins make for fast and anonymous payments across borders.[41] However, the most negative aspect of bitcoins is that they can be fully understood and run only by minds exceptionally genius in coding.[42] In fact, it is also questionable whether the scale of blockchain systems is good enough to securely cater to the fast increasing number of subscribers.[43]

In blockchain’s scheme of things two entities play a pivotal role in ensuring that the network keeps generating maximum efficiency for subscribers— the open source software developers and the miners.[44] The developers make, improve and repair the software underlying bitcoin. The miners are the entities causing the deployment of the software in the network and new issues of bitcoins for initial subscribers. Functionally they are significant for providing the ignition to the network which thereafter runs on the strength of the ever-expanding network of subscribers. Their role is also important for plugging security gaps and performance improvement/upgrades in the software.

Miners seek maximising the transaction fees that could be gained for each transaction through the blockchain. In such a scenario, the transactions which are of higher value are processed on priority. Disputes on the best way of upgrading the scale of bitcoins have already cause divisions in the bitcoin fraternity.[45] The issues of lowering transaction fees and blockchain size increases which could have forced system upgrades for miners (with wide disparities in terms of hardware and software) have led to one division of bitcoin, creating the bitcoin cash on 1st August this year.[46]

The bitcoin has continued with a comparatively less increase of the blockchain size but with a new offering that all low price payments have been made totally free.[47] On the other hand, bitcoin cash makes use of slightly greater blocks in its blockchain network. Bitcoin cash makes for greater volume of bitcoin transactions which are processed quicker than the previously used blockchain network.[48] Clearly this is a better product than original bitcoin. However, this also requires greater hardware and software upgrades for bitcoin subscribers to be able to stay on the network. Greater subscriber investment can only mean greater sunk costs which in turn make subscribers dependent and vulnerable to the miners of the currency, in case the miners successfully collude adversely. Thus, abuse of dominance related issues could creep into the bitcoin industry as greater differentiation of the bitcoin is likely to take place in the near future.[49]

An even greater development is the untapped potential that blockchain/bitcoin technology has for facilitating tech startup funding. Tokens, a variant of bitcoin, which operate on a different blockchain network but on largely similar principles as bitcoins have been explored for their potential to fund tech projects.[50] Capable of gathering funding at an unprecedented pace and quantum, the investment can be potentially sought from every user participating in the token’s blockchain. An example is how the Brave Browser developer team raised $30 million from its initial coin offering of its own attention token.[51] The time within which the said investment was garnered was astounding to say the least. It was mere 24 seconds.[52]

Product Hunt also engaged in a similar exercise called KittyCoins to finance its operations directly from the community.[53] It needs a special kind of audacity to drop funds for such activity. It must be noted that the token is not an equity. The investors do not get any guaranteed return. The only way for them to redeem their investment is to wait their turn for the value of the token to rise sufficiently high for them for a comfortable sale in the future. The bottom line is that these new ways of finance, now termed “Kickstarter on steroids”, have the potential of fundamentally changing the way we might think about financing startups in the future. Daimler AG has even gone on to issue corporate bonds to the tune of €100 million in a blockchain trail.[54]

Blockchain technology must find its own niche place in the legal regimes of each country for making economically efficient and sound regulation possible. From the perspective of securities law, bitcoin technology finds its closest analogy with participatory notes in terms of the anonymity of the subscribers. However, given the vast uses of this technology it may not be fair to bring it under the purview of securities law. Needless to add, bitcoin itself does not carry a right to any underlying assets of any kind. It also needs to be emphasised that bitcoins may have a lot to do with information technology but their functions go beyond the realm of software and hardware services. While it has all features of currencies, it is in fact heavily dependent on national currencies for the determination of its value.

Blockchain technology is to money and finance what Napster was to the music industry — a new paradigm. Napster had raised a debate whether listeners sharing music over P2P networks are outlaws. World has moved a long way since then. Today number of YouTube clicks on advertisement sponsored and freely-aired music videos have become the benchmark for marketing music albums. Standing at this crucial juncture, Governments need to make a policy choice.

Any outright curtailment or absolute prohibition may be counterproductive. At this juncture, the uses of bitcoin are quite diverse, mixed in a vast basket of legitimate and illegitimate uses. Should the transactions be banned, bitcoin technology would be reduced to being used only by the criminal “dark web”.  So, if a curtailment or prohibition on bitcoins were contemplated, it would only be fair to ask whether the use of this technology should be relegated only to the criminal world. It would be efficient if such a revolutionary technology is instead given adequate time to be developed within a new legal framework. So, ultimately, the regulation of bitcoin must be based on its unique monetary and financial functionality. A new standalone regulatory regime which can be executed under the aegis of the various organs of the Finance Ministry would be a welcome step.

Money laundering and tax evasion are the two major concerns in India and these are two most common perceptions affecting bitcoins worldwide as well. Any attempt to insist on identity recognition mechanisms in the technology could unfairly disrupt the core principles of the technology. Investment that could be attracted towards making the network faster and efficient could unduly be wasted on trying to introduce extravagant changes in the basic framework of codes underlying the network. For good or bad, the blockchain technology is wholly incompatible with any controls/supervision pertaining to identity of transacting parties.

An efficient way to get around this problem is to monitor bank accounts which are linked to bitcoin wallets as and when money is transferred to the latter. A bank account balance is indispensable for the bitcoin subscriptions. While transactional details may remain absolutely secret due to the peculiarities of the blockchain technology, any movement of funds to and from the bank accounts may still provide ample suspicious indications for agencies concerned — taking a cue, they can initiate investigations and subsequently make a case for money laundering or tax evasion, as the case may be.

In the US, law enforcement agencies, businesses and consumers have grappled with complicated cryptocurrencies as well as the manner and extent to which they should be regulated.[55] Regulatory activity related to offering virtual currencies has come in fits and starts, with a burst of intensity in 2013 spurred by the rise of the bitcoin.[56] One of the earliest attempts at such regulation was the BitLicense which made KYC norms compulsory for bitcoin operators in New York.[57]

In the spring of 2013, the Financial Crimes Enforcement Network, under the US Department of the Treasury, issued guidance on the obligations of virtual currencies under the federal Bank Secrecy Act.[58] This announcement was quickly followed by stringent action. Law enforcement measures included seizure of assets of cryptocurrency participants held at banks in Maryland and California.[59] Additional federal indictments, accompanied by seizure orders, were imposed against Liberty Reserve, the Costa Rica-based cryptocurrency.[60] The Department of Financial Institutions in the State of California issued a cease and desist letter to the Bitcoin Foundation. The Foundation was charged with engaging in the business of money transmission without authorisation required by California’s Money Transmission Act.[61]

Thus, the US has taken the approach of allowing cryptocurrencies to operate on the condition that they must comply with the law. Registration as a money transmitter was followed by obligation on the part of the cryptocurrency network to maintain annual reports on activities and an obligation to prohibit any criminal activity on the network coming to its knowledge. India can incorporate such a legal framework (or an even better counterpart) to regulate bitcoins.

Conclusion

Bitcoins present a new challenge for lawmakers across the world. However, a kneejerk reaction is least desirable. While bitcoins may be disruptive, they are not necessarily criminal and a thorough understanding of the technology underlying bitcoin must be the basis for any legal regulation. Blockchain technology is to money and finance what Napster was to the music industry — a new paradigm. The technology may either be condemned to the underground or be sceptically welcomed by the law. Future developments in bitcoins will be heavily determined by this highly essential policy choice. Bitcoins should receive a unique standalone legal framework of their own so that they may develop in a manner which is economically efficient and in consonance with public interest.

* Bhumesh Verma, Managing Partner, Corp Comm Legal and Somashish, Fifth Year B.A. LL.B. (Hons.) School of Law, Christ (Deemed University), Bangalore

[1] Bitcoin tops record $19,000, then plunges in wild 2-day ride <https://www.cnbc.com/2017/12/06/bitcoin-tops-13000-surging-1000-in-less-than-24-hours.html>.

[2] The Bitcoin may now be the biggest financial bubble of all time <https://www.cnbc.com/2017/12/14/bitcoin-may-now-be-the-biggest-financial-bubble-of-all-time.html>.

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