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A Primer on Bitcoin

Bitcoin is a relatively new 'cryptocurrency' in which in which encryption technology enables consumers and businesses to exchange goods for currency over the Internet without having to rely on the element of trust in order to ensure payment.  Users buy Bitcoins and load them onto a virtual wallet, which they can then use to transfer Bitcoins instantly and anonymously to other users anywhere in the world.  As such, there are significant cost savings and efficiency benefits associated with the use of Bitcoin as a method of currency.  As Venture Capitalist Marc Andreessen explained on the New York Times' Dealbook, "Bitcoin is the first Internetwide payment system where transactions either happen with no fees or very low fees (down to fractions of pennies)."(1)  Many vendors are starting to consider Bitcoin in part to combat the large fees charged by credit card companies which cut into sales margins.  However, no central bank exists to regulate Bitcoin, and it entirely relies on peer-to-peer transactions and largely unregulated exchanges.

The appreciation in value of Bitcoin has been staggering since its introduction in 2009.  A Bitcoin is produced through a complex technological process known as mining.  One Bitcoin (BTC) was trading for less than a penny in early 2010, but as of late 2013, the value of one BTC fluctuated between $500 and $1,000.  In January 2014, Bitcoin made headlines when a major online retailer, Overstock.com, and an NBA franchise, the Sacramento Kings, announced that Bitcoins would be accepted for purchases.(2) 

Nevertheless, Bitcoin is a very young software technology, and carries significant risks not faced by holders of traditional currency.  The market for Bitcoin is highly volatile, and prices can fluctuate wildly due to occasional illiquidity and a variety of other factors.  In early 2014, Tokyo-based MtGox.com was the largest online Bitcoin exchange market.  In early February 2014, MtGox.com announced that a Bitcoin software glitch was allowing hackers to steal customers' Bitcoins, and MtGox.com froze customers' accounts and ceased allowing cash withdrawals.  Bitcoins on MtGox.com started trading at a deep discount in response: as reported by CNN.com on February 20, 2014, "the rights to MtGox bitcoins were selling for around $118 each.  On well-functioning exchanges, the price was around $570 per bitcoin."(3)  On February 24, 2014, MtGox.com was taken offline overnight, and the website was left with a statement that "[i]n light of recent news reports and the potential repercussions on MtGox's operations and the market, a decision was taken to close all transactions for the time being in order to protect the site and our users. We will be closely monitoring the situation and will react accordingly."(4)

U.S. regulators are striving to catch up to the rise of Bitcoin as a viable currency over the past few years.  Bitcoin virtual wallets are not insured by the Federal Deposit Insurance Corporation (FDIC) or other countries' similar regulatory organizations, and users who lose Bitcoin on exchanges such as MtGox.com are currently left without recourse to regain their funds in the event of a security breach or crash.  Benjamin Lawsky, New York's Superintendent of Financial Services, has announced that New York will issue Bit Licenses to companies utilizing Bitcoin, and may also issue additional rules regarding required disclosures and procedures.(5)
   
U.S. courts are just beginning to confront alleged crimes and lawsuits dealing with Bitcoin.  Last year, the U.S. Securities and Exchange Commission (SEC) brought an enforcement action against Trendon T. Shavers and his company Bitcoin Savings and Trust for his alleged operation of a Ponzi scheme in which he obtained Bitcoin from investors with a promise of paying 1% interest on a daily basis by reselling Bitcoin to local investors in Texas.(6)  Shavers did not live up to his promises to pay his investors at the agreed-to rate.  Shavers asserted that Bitcoin did not qualify as a security under federal law.  United States Magistrate Judge Amos Shazzant rejected that premise, noting that "the only limitation of Bitcoin is that it is limited to those places that accept it as currency. However, it can also be exchanged for conventional currencies, such as the U.S. dollar, Euro, Yen, and Yuan. Therefore, Bitcoin is a currency or form of money, and investors wishing to invest in BTCST provided an investment of money."(7)  As a result, the Court found that Bitcoin investments met the definition of investment contracts and qualified as securities under federal law, allowing the SEC enforcement action to move forward.(8)

While investors can take heart from the ruling in Securities & Exchange Commission v. Shavers in the case of broken promises to repay Bitcoin, market crashes and technological theft are largely unregulated and potentially fraught with peril for investors.  Fitch Law Partners LLP will continue to monitor developments in this rapidly changing field.

For more information about our banking law practice, please visit our banking law page.

(1) Marc Andreessen, Why Bitcoin Matters, N.Y. Times Dealbook, Jan. 21, 2014, available at http://dealbook.nytimes.com/2014/01/21/why-bitcoin-matters/?_php=true&_type=blogs&_r=0.
(2) See Darren Rovell, Sacramento Kings to Accept Bitcoin, ESPN.com, Jan. 16, 2014, available at http://espn.go.com/nba/story/_/id/10303116/sacramento-kings-become-first-pro-sports-team-accept-bitcoin.
(3) James O'Toole, Speculators Look to Cash in on Bitcoin Crisis, CNN Money, Feb. 20, 2014, available at http://money.cnn.com/2014/02/20/technology/innovation/bitcoin-mtgox/index.html?iid=EL.
(4) www.mtgox.com, accessed Feb.25, 2014. 
(5) Jose Pagliery, Bitcoin Regulation Coming This Year, CNN Money, Feb. 12, 2014, available at http://money.cnn.com/2014/02/12/technology/bitcoin-regulation/
(6) Sec. & Exch. Comm'n v. Shavers, 4:13-CV-416, 2013 WL 4028182 at *1 (E.D. Tex. Aug. 6, 2013.     
(7) Id. at *2. 
(8) Id. at *2.

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