Bitcoin – an audacious, innovative and 'mathematically fantastic' virtual currency, or an unregulated, volatile and opaque money channel? The Banker puts that question to banks, regulators and technology experts to get their take. 

Bitcoin, a virtual equivalent to real money but without a central authority governing it, has been heralded by devotees as a trustworthy alternative to existing payment infrastructures, independent of their government and rules. But beyond the world of tech-savvy online denizens, Bitcoin remains an obscure system for regulators and financial institutions. Now they are looking at Bitcoin more closely to figure out what role, if any, they can play in its payment systems.

 

What is Bitcoin mining?

With paper money, a government decides when to print and distribute it, and regulates its use. Bitcoin, however, relies on peer-to-peer collaboration to issue new Bitcoins and validate transactions. Nobody is in charge.

But if nobody is in charge, how can more Bitcoins be issued? And how can users ensure the coins are not copied illegitimately or counterfeited?

This is achieved by Bitcoin mining. Payments are validated, cleared and settled by peers in the network. These peers are called miners and in theory anyone can be a miner.

A miner solves maths problems, which validate transaction data, and they receive Bitcoins in exchange. This process gives a financial incentive for validating transaction data and also serves to issue the currency into circulation. Miners essentially ensure the fairness and security of Bitcoin transactions, keeping the network stable.

The network automatically changes the level of difficulty of the maths problems, depending on how quickly they are solved. With more and more miners joining the network, the problems become more difficult to solve. Nowadays it is no longer feasible to use a regular computer to mine as more computer power is needed and ‘pools’ of miners work together to solve the problems.

Miners receive 25 Bitcoins for each problem they solve, but the figure is halved every four years. By about 2140, there will have been 21 million Bitcoins issued and then there will be no more.

Bitcoin is an online currency; effectively, just data. This data can be traded against fiat currencies. Its decentralised model relies on peer-to-peer collaboration to issue money, validate, and clear and settle transactions, thereby circumventing the systems of central banks, clearing houses and banks. It is governed by software rules set by the peer-to-peer network and not by financial regulation.

A system of trust

Using Bitcoins does not require personal information as card networks do, thanks to the deployment of asymmetric cryptography in transactions. Instead of banks and payment systems, users trust the mathematics of Bitcoin and the consensus among peers that Bitcoins are actually worth something, says Mike Hearn, a Google software engineer who in his free time works as a Bitcoin developer.

When Bitcoin was first created, “it was priceless”, he says. Then on May 10, 2010, someone who called himself Laszlo on a Bitcoin forum offered to pay 10,000 Bitcoins to anyone who ordered him pizza. Someone did, received the 10,000 Bitcoins and price discovery took place, says Mr Hearn. Nowadays, 10,000 Bitcoins are worth far more than a pizza. As of July 14, 2013, 1 Bitcoin was worth just over $96. But its price is volatile. It peaked at more than $230 in April and plunged soon after.

Today, there are several ways to get Bitcoins, including trading them on an exchange, buying them online (for example, on eBay), buying them directly from another person, or ‘mining’ (earning Bitcoins by verifying and collating transactions, see box). Some merchants are even starting to accept Bitcoins as payments, including a pub in East London.

Start-ups serving the Bitcoin community in various ways are emerging; and some high-profile investors believe in the concept, too. Silicon Valley Bank in the US plans to hold deposits for Coinlab, a Bitcoin exchange, although it will not insure deposits. And the Winklevoss twins, who sued Facebook founder Mark Zuckerberg for allegedly stealing their idea for the social network, filed with the US Securities and Exchange Commission to list a Bitcoin trust fund in July.

The old and the new

The question is, how does a virtual, decentralised and peer-controlled currency fit into the traditional payments world?

Jon Matonis, executive director of the Bitcoin Foundation, which promotes the use of Bitcoin, believes there could be a new revenue stream from using Bitcoin for foreign exchange conversion or escrow services. “That is one area [the banks] can get involved in and make a lot of money [from. But they] don’t see it like that because it’s not a political currency. There has to be a change in thinking,” he says.

Bitcoin transactions bypass the conventional payment schemes or traditional clearing and settlement systems. Understandably, this makes most financial institutions nervous. “Banks have no control over [Bitcoin],” says a senior bank manager. 

Unlike in the real world, where clearing houses act as an accounting mechanism between banks and where the central bank settles payments, Bitcoin transactions consist of moving data around – transferring ownership of Bitcoins to someone else.

“When you have to convert those tokens into real money, it touches the banking infrastructure. [That’s] where regulation needs to bite,” says Chris Dunne, payment services director at VocaLink, which operates the UK’s national payments infrastructure.

Converting Bitcoins happens at Bitcoin exchanges, where users can redeem Bitcoins for real money or set up a Bitcoin account. The majority of these exchanges are not regulated and there is a risk that this may lead to non-compliance with money laundering and other regulatory concerns. Citing last year’s money laundering issues at Standard Chartered and HSBC as an example, Garrick Hileman, an economic historian at the London School of Economics, says banks have money laundering concerns even without Bitcoin, which makes tracing people difficult. “Some banks don’t want to go anywhere near it,” he says. Mr Matonis agrees: “Banks don’t really move if the regulation isn’t clear. That’s the case [with Bitcoin] now.”

Here come the regulators

Now regulators are now looking into Bitcoin. The issue is that existing laws are not easily applicable to it. In Europe, for instance, the European Central Bank (ECB) in a 2012 study found that neither the Payment Services Directive (PSD), nor the Electronic Money Directive (EMD) apply fully. “These were written with traditional electronic payment schemes in mind, where an issuer guarantees processing of a transaction,” says Christoph Sorge, assistant professor at the department of computer science at the University of Paderborn in Germany.

In the case of the EMD, the ECB concluded that “Bitcoin probably complies with the first and the third criteria, but not with the second”. The first criterion says e-money is stored electronically, the third says it is accepted as a means of payment by those other than the issuer. The second criterion, however, considers something to be e-money if it is issued on receipt of funds, which does not happen when Bitcoins are mined.

Regarding the PSD’s application to Bitcoin, the ECB stated in the paper: “This directive lays down rules on the execution of payment transactions where the funds are electronic money, yet it does not regulate the issuance of electronic money, nor does it amend the prudential regulation of electronic money institutions as provided for in the EMD. Therefore, the new category of payment service provider it introduces – payment institutions – should not be allowed to issue electronic money... Bitcoin clearly falls outside the scope of the PSD.”

In the US, the Treasury’s Financial Crimes Enforcement Network (FinCEN) has defined as ‘money transmitters’ any persons and organisations that accept and transmit anything of value that substitutes for real currency under the US Bank Secrecy Act. Those who accept real currency for Bitcoins and vice versa will be considered to be money service businesses and will have to comply with relevant regulation, says Micah Willbrand, director of risk and payments for Europe, the Middle East and Africa at BankersAccuity, a data service provider.

Regulation bites

What this means in practice became clear in mid-May when the US Department of Homeland Security seized the bank account of Mutum Sigillum, the US-subsidiary of Mt Gox, the world's biggest Bitcoin exchange, which operates out of Japan. Mark Karpeles, CEO and owner of Mt Gox, had not declared that he was running a money remittance business when he had opened a bank account with Wells Fargo in 2011. “Many exchanges, including Mt Gox, are now beginning to enact some regulatory controls such as Know Your Customer, and account opening and transaction monitoring,” says Mr Willbrand. Mt Gox registered as a money services business at the end of June.

If a bank wants no association with an exchange due to (a perceived) lack of regulatory compliance, Mr Sorge suggests that they could blacklist an exchange, or cancel or refuse to open accounts linked to Bitcoin.

Such regulatory attention helps Bitcoin acquire some legitimacy, says Mr Hileman. He says the ECB study and FinCEN’s guidance especially played an important role as they made clear that Bitcoin has become “important enough” to gain the attention of the US treasury and other regulators. “FinCEN’s announcement... brought some transparency, where previously there was a lot of vagueness and uncertainty,” he says.

Disruptive innovation

While regulatory concerns remain, Bitcoin’s model has been praised, even by those outside the Bitcoin community. “It’s the sort of disruptive innovation that the industry needs to allow society to become more digital and to create more value. While it may bring new or changed inherent risks, this should also be a catalyst to drive innovation in regulation, control and conduct,” says KPMG’s head of payments in the UK, Mark Hale.

But Alaric Gibson, research analyst at JWG Group, a think tank for financial services regulation, warns: “[Regulators need] to be careful not to regulate innovations too early. There’s value in trying new technical approaches, which can be destroyed without understanding the real consequences of the innovation.”

Meanwhile, financial institutions are standing back and watching. At Innotribe, an initiative by financial transactions network Swift to encourage collaborative innovation in financial services, “we’re trying to figure out what significance it represents to banks”, says Kosta Peric, the network's head of innovation and communication. “[Bitcoin] poses a potential influence on the future evolution of currencies, shows banks and payment networks there’s a need for very cheap, fast and international money transfers. The industry needs to realise something is changing in the requirements for payment services, of people’s views on banks,” he adds. 

Mr Dunne, who considers Bitcoin’s infrastructure “mathematically fantastic”, agrees, admitting that money transfers in banking can be more difficult than need be. Why? “Because we need to abide by a bunch of regulations. [But] when innovations such as Bitcoin come along, it shows what you can achieve with technology,” he says.

Issues to solve

But there are issues to solve before Bitcoin can go mainstream. The lack of a central authority is one, says Mr Hileman. There is no mechanism to adjust the supply. There will only ever be 21 million Bitcoins (although they can be broken up into hundred-millionths), which encourages hoarding. Since Mt Gox started its Bitcoin exchange in July 2010 until May 2013, 73% of Bitcoins have accumulated at addresses that only receive and never send Bitcoins, according to a study by the Weizmann Institute of Science in Israel.

Dormant Bitcoins could be “simply abandoned or lost by users who experimented with the system in its early days, when it was very difficult to buy anything or to exchange Bitcoins into dollars”, the researchers concluded. If someone loses access to their app, they lose their Bitcoins, unless they back up their private key somewhere. For Jon Matonis, executive director of the Bitcoin Foundation, this is no different from cash.

Will Bitcoin ever play a meaningful role in payments? There is potential for it in future, says Mr Dunne, “but only once it’s regulated”. Even so, he doubts it will enter banking directly because “it’s not a real currency”.

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