SSRN-id1817857

Electronic copy available at: http://ssrn.com/abstract=1817857   1   Bitcoin:  An  Innovative  Alternative  Digital  Currency     (PRELIMINARY  DRAFT)  Apr.  21,  2011  Reuben  Grinberg1      IMPORTANT:  This  is  a  first  draft  that  is  missing  a  discussion  of  a  number  of  important  legal  issues,  particularly  money  laundering  and  what  the  e-­‐gold  saga  means  for  Bitcoin,  taxes,  etc.  Some  or  all  of  my  conclusions  may  change  in  later  drafts.  I  am  posting  this  publicly  to  get  early  feedback  from  the  Bitcoin  community.  Please  feel  free  to  email  me  your  comments  at  reuben.grinberg+bitcoin@gmail.com.  In  the  spirit  of  bitcoin,  donations  can  be  sent  to  1Het2qD6Yab9vaLUs3JrM1aYMXNSJ42Rdc.     Introduction  ..............................................................................................................................  3   I.  Bitcoin  Primer  .......................................................................................................................  5   II.  Bitcoin  Ecosystem  ..............................................................................................................  8   III.  Comparing  Bitcoin  to  its  Competition  .....................................................................  11   a.  Facilitation  of  e-­‐commerce  .....................................................................................................  12  1.  Traditional  ecommerce  .........................................................................................................................  12  2.  Micropayments  .........................................................................................................................................  14  3.  Virtual  World  and  Game-­‐Related  Commerce  ..............................................................................  14   b.  Gold-­‐Backed  Currencies  ..........................................................................................................  16   IV.  Is  Bitcoin  Sustainable?  ..................................................................................................  18   a.  Iraqi  Swiss  Dinar  ........................................................................................................................  18   b.  Confidence  ....................................................................................................................................  19  1.  Improper  Use  of  Discretionary  Authority  .....................................................................................  19  2.  Superior  Competing  Currency  ...........................................................................................................  20  3.  Government  Crackdown  .......................................................................................................................  21  4.  Deflationary  Spiral  ..................................................................................................................................  21   c.  Potential  Technology  Failures  ...............................................................................................  23  1.  Anonymity  Failure  ...................................................................................................................................  23  2.  Theft  ..............................................................................................................................................................  23  3.  Denial  of  Service  .......................................................................................................................................  24   V.  Legal  .....................................................................................................................................  25   a.  Federal  Government’s  Monopoly  on  Issuing  Currencies  ..............................................  26  1.  The  Stamp  Payments  Act  of  1862  .....................................................................................................  27  2.  Prohibition  on  Coining  Current  Money  and  the  Liberty  Dollar  Saga  ................................  31   b.  Securities  Regulations  ..............................................................................................................  35  1.  Note  or  Stock  .............................................................................................................................................  36                                                                                                                  1  Yale  Law  School,  J.D.  expected  May  2011.  I  thank  professor  Jonathan  R.  Macey  and  my  wife  for  their  time  and  insights.  I  also  thank  AUSA  Jill  Westmoreland  Rose  and  Bernard  von  NotHaus,  opposing  parties  in  the  Liberty  Dollar  cases  who  took  the  time  to  answer  my  questions.   Electronic copy available at: http://ssrn.com/abstract=1817857   2   2.  Investment  Contract  ...............................................................................................................................  37  3.  Commodity  .................................................................................................................................................  39  4.  Currency  ......................................................................................................................................................  40   Conclusion  ...............................................................................................................................  43           3   Introduction    Bitcoin  is  a  digital,  decentralized,  partially  anonymous  currency,  not  backed  by  any  government  or  other  legal  entity,  and  not  redeemable  for  gold  or  other  commodity.    It  relies  on  peer-­‐to-­‐peer  networking  and  cryptography  to  maintain  its  integrity.2  Bitcoin  has  many  properties  that  could  make  it  an  ideal  currency  for  mainstream  consumers  and  merchants.  Compared  to  most  currencies  or  online  payment  services,  such  as  PayPal,  bitcoins  are  highly  liquid,  have  low  transaction  costs,  and  can  be  used  to  make  micropayments.  This  new  currency  could  also  hold  the  key  to  allowing  organizations  such  as  Wikileaks,  hated  by  governments,  to  receive  donations  and  conduct  business  anonymously.3      Amazingly,  as  of  March  2011,  a  bitcoin  (currency  ticker  “BTC”)  is  worth  about  the  same  as  a  U.S.  Dollar  (“USD”),  there  are  about  $5  million  worth  of  bitcoins  in  existence,4  there  are  probably  somewhere  between  5,000  to  30,000  Bitcoin  users,  and  about  $150,000  worth  of  bitcoins  are  traded  every  day.5                                                                                                                  2  See  http://en.wikipedia.org/wiki/Bitcoin;  Satoshi  Nakamoto,  Bitcoin:  A  Peer-­‐to-­‐Peer  Electronic  Cash  System  (2009),  http://www.bitcoin.org/sites/default/files/bitcoin.pdf;  Bitcoin  FAQ,  http://www.bitcoin.org/faq.  3  See  Keir  Thomas,  Could  the  Wikileaks  Scandal  Lead  to  New  Virtual  Currency?,  PC  World:  Business  Center  (Dec.  10,  2010),    http://www.pcworld.com/businesscenter/article/213230/could_the_wikileaks_scandal_lead_to_new_virtual_currency.html;  Rainey  Reitman,  Electronic  Frontier  Foundation,  Bitcoin  –  a  Step  Toward  Censorship-­‐Resistant  Digital  Currency  (Jan.  20,  2011),  https://www.eff.org/deeplinks/2011/01/bitcoin-­‐step-­‐toward-­‐censorship-­‐resistant  (“Bitcoin  is  particularly  interesting  in  the  wake  of  recent  events  that  demonstrated  how  financial  institutions  can  make  political  decisions  in  whom  they  service,  showcased  by  the  decisions  of  PayPal,  Visa,  Mastercard  and  Bank  of  America  to  cut  off  services  to  Wikileaks.”).  In  fact,  Anonymous,  a  loosely  organized  group  of  hacktivists  that  have  attacked  Wikileaks’  foes,  among  others,  The  Week,  Anonymous:   The  secret  group’s  5  biggest  hacks  (Mar.  7,  2011),  http://theweek.com/article/index/212846/anonymous-­‐the-­‐secret-­‐groups-­‐5-­‐biggest-­‐hacks,  accept  donations  in  Bitcoins  on  their  anonymous  news  site,  AnonNews.  AnonNews  –  Everything  Anonymous,  Donating  through  Bitcoin,  http://www.anonnews.org/bitcoin.html  (last  visited  Mar.  7,  2011).  4  See  Page  Indicating  USD-­‐Bitcoin  Exchange  Rate  Provided  By  “Mt.  Gox,”  http://bitcoincharts.com/markets/mtgoxUSD.html.  Mt.  Gox  is,  according  to  the  Bitcoin  wiki,  “the  most  widely  used  bitcoin  currency  exchange  market.”  https://en.bitcoin.it/wiki/MtGox.  5  Gavin  Andresen,  Video,  Making  Money:  creating  a  decentralized  electronic  currency,  Ignite  Amherst  (2011),  available  at  http://blip.tv/file/4771178  [hereinafter  Andresen  Video];  see  http://bitcoinwatch.com/  (last  visited  Mar.  28,     4    Although  the  Bitcoin  economy  is  flourishing,  Bitcoin  users  are  anxious  about  Bitcoin’s  legal  status.6  Some  believe  that  governments,  particularly  the  U.S.  government,  are  likely  to  crack  down  on  Bitcoin.  Some  point  to  Bitcoin’s  ability,  like  all  digital  and  anonymous  currencies,  to  facilitate  money  laundering,  tax  evasion,  and  trade  in  illegal  drugs  and  child  pornography.7  Indeed,  the  U.S.  government  prosecuted  and  shut  down  the  creators  of  e-­‐gold,  a  digital  currency  backed  by  gold,  under  state  and  federal  laws  for  conspiracy  to  commit  money  laundering,  and  also  for  providing  services  to  those  involved  in  “child  exploitation,  credit  card  fraud,  and  wire  (investment)  fraud.”  8  Alternatively,  others  point  to  governments’  purported  interests  in  protecting  their  economies  and  monopolies  on  minting  new  money.9  These  individuals  point  to  the  successful  prosecution  and  conviction  of  the  creator  of  the  Liberty  Dollar,  a  paper  and  coin-­‐based  currency  backed  by  gold,  silver,  and  copper.10    Part  I  explains  how  Bitcoin  works  and  Part  II  describes  its  nascent  ecosystem  of  websites  and  services.  Part  III  compares  Bitcoin  to  its  competition,  including  payment  processors  like  PayPal  and  digital  gold  currencies.  Part  IV  explores  whether  Bitcoin  can  be  a  sustainable  currency  and  why  individuals  would  trust  a                                                                                                                                                                                                                                                                                                                                            2011)  (approximately  120,000  bitcoins  transacted  in  last  24  hours  at  an  exchange  rate  of  approximately  0.8  USD/  BTC).  6  See,  e.g.,  epii,  How  long  until  governments  outlaw  bitcoin  usage?  (Mar.  29,  2011),  http://www.bitcoin.org/smf/index.php?topic=5110.msg74627#msg74627  (“I  think  that  illegalization  is  Bitcoin's  most  likely  mode  of  failure.”).  7  See,  e.g.,  id.  (“Considering  how  quickly  services  like  Silk  Road  [an  anonymous  marketplace  for  illegal  drugs]  have  sprung  up,  and  the  fact  that  the  demographic  of  people  who  seem  most  interested  in  Bitcoin  at  this  point  tends  to  overlap  with  the  demographic  of  likely  tax  evaders,  I  am  afraid  that  this  illegalization  might  just  be  a  matter  of  time.”).  8  See  Peter  C.  Tucker,  The  Digital  Currency  Doppelganger:  Regulatory  Challenge  or   Harbringer  of  the  New  Economy?,  17  CARDOZO  J.  INT’L  &  COMP.  L.  589,  590-­‐92  (2009)  (citations  omitted).  9  See,  e.g.,  Glass,  Re:  How  long  until  governments  outlaw  bitcoin  usage?  (Mar.  29,  2011),  http://www.bitcoin.org/smf/index.php?topic=5110.msg74713#msg74713.  10  See,  e.g.,  id.;  Dept.  of  Justice,  Press  Release,  Defendant  Convicted  of  Minting  His  Own   Currency  (Mar.  18,  2011),  available  at  http://charlotte.fbi.gov/dojpressrel/pressrel11/ce031811.htm  (“[The  defendant]  intended  for  the  Liberty  Dollar  to  be  used  as  current  money  in  order  to  limit  reliance  on,  and  to  compete  with,  United  States  currency….  It  is  a  violation  of  federal  law  …  to  create  private  coin  or  currency  systems  to  compete  with  the  official  coinage  and  currency  of  the  United  States….  “Attempts  to  undermine  the  legitimate  currency  of  this  country  are  simply  a  unique  form  of  domestic  terrorism,”  U.S.  Attorney  Tompkins  said  in  announcing  the  verdict.  “While  these  forms  of  anti-­‐government  activities  do  not  involve  violence,  they  are  every  bit  as  insidious  and  represent  a  clear  and  present  danger  to  the  economic  stability  of  this  country,”  she  added.).     5   currency  not  supported  by  any  legal  institution  and  not  redeemable  for  any  commodity.  Part  V  will  explore  a  few  of  the  many  legal  ramifications  of  Bitcoin,  including  statutes  supposedly  aimed  at  enforcing  the  federal  government’s  monopoly  on  issuing  currency  and  securities  regulation.     I.  Bitcoin  Primer    Julian  Assange  was  probably  not  surprised  when  PayPal,  a  corporation  with  large  market  share  susceptible  to  government  pressure,  stopped  processing  donations  to  his  whistleblowing  organization,  Wikileaks,  due  to  what  Paypal  deemed  “illegal  activity.”11  In  the  1990s,  Assange  was  a  member  of  the  cypherphunks  mailing  list,  a  group  that  discussed  achieving  privacy  and  libertarian  ideals  by  using  cryptography.  In  1998,  another  member  of  the  cypherpunks  proposed  a  digital,  distributed,  anonymous  currency  called  “b-­‐money”  that  would  allow  “untraceable  pseudonymous  entities  to  cooperate  with  each  other  more  efficiently,  by  providing  them  with  a  medium  of  exchange…”  12  About  ten  years  later,  Satoshi  Nakamoto13  figured  out  how  to  implement  such  a  currency,  publishing  a  description  of  his  invention14  and  also  releasing  software  to  make  it  work.15      Bitcoin  is  a  “fiat  currency,”  like  the  U.S.  Dollar,  because  it  is  not  redeemable  for  a  certain  amount  of  a  commodity,  such  as  an  ounce  of  gold.  Unlike  the  U.S.  Dollar,  Bitcoin  is  not  backed  by  the  U.S.  Government  –  or  any  legal  institution  for  that  matter  –  and  is  a  digital  rather  than  paper  currency,  storable  on  electronic  media  and  transferable  over  the  internet.16      Individuals  who  want  to  own  or  transact  in  Bitcoins  can  either  run  a  program  on  their  own  computer  that  implements  the  Bitcoin  protocol  (a  “Bitcoin  client”17),  or                                                                                                                  11  PAYPAL,  Paypal  statement  regarding  Wikileaks  (Dec.  3,  2010),  https://www.thepaypalblog.com/2010/12/paypal-­‐statement-­‐regarding-­‐wikileaks/  12  Wei  Dai,  b-­‐money  at  para  13  (1998),  http://weidai.com/bmoney.txt  13  The  name  is  almost  certainly  a  pseudonym.  See  https://en.bitcoin.it/wiki/Satoshi_Nakamoto;  Andresen  Video,  supra  note  5.  14  Nakamoto,  supra  note  2.  15  See  bitcoin,  https://github.com/bitcoin/bitcoin  (current  repository  for  the  official  Bitcoin  program  code).  16  See  William  Hett,  Digital  Currencies  and  the  Financing  of  Terrorism,  XV  RICH.  J.L.  &  TECH.  4,  7  (2008),  http://law.richmond.edu/jolt/v15i2/article4.pdf  (describing  how  digital  currencies  generally  work).  17  The  Bitcoin  developers  publish  an  “official”  Bitcoin  client  for  Windows,  Mac  OS  X,  and  Linux,  with  an  ugly,  confusing,  but  usable  graphical  user  interface.  See  Bitcoin,  http://www.bitco