Bitcoin Basics: A Primer on Virtual Currencies

In the past five years, virtual currencies, or 'cryptocurrencies' have evolved tremendously and are quickly establishing themselves as a payment system. Today, virtual currencies are a multibillion-dollar venture with dual potential as both an investment and an electronic medium of exchange.* 1 2 3 Increasingly, mainstream retailers are announcing plans to accept Bitcoins, Bitcoin ATMs are growing in prominence,' the first Bitcoin debit cards have been delivered ' and the first Bitcoin derivative transactions have been executed on a US-regulated exchange.4 Yet, there remain numerous risks and challenges associated with virtual currencies. In addition to experiencing significant volatility in exchange rates and susceptibility to attacks from and illicit use by cybercriminals, the virtual currency marketplace remains largely unregulated. Governments around the globe are taking widely divergent actions-or taking no action at all - to define and regulate virtual currencies. This article will provide an overview of the virtual currency landscape, including legislative, regulatory and law enforcement developments.What are virtual currencies?Virtual currencies are decentralised peer-to-peer payment systems that are digital representations of value and can be transferred, stored and traded electronically. At their core, they are distinct from other digital payments (eg, PayPal, Facebook credits, airline miles, etc) because they provide a means to transfer value between two parties without needing an intermediate party. They do not have legal tender status; they operate with no central authority or banks, and their issue is carried out collectively by a distributed network. While the transaction between buyer and seller is direct, the identities of the parties are encrypted and therefore no personal information is transferred. However, virtual currency transactions such as Bitcoin transactions are not fully anonymous. A transaction record of every Bitcoin and every Bitcoin user's encrypted identity is recorded on a public ledger. As a result, it is most appropriate to characterise Bitcoin and many other virtual currencies as 'pseudonymous' as opposed to anonymous. This pseudonymity, combined with its efficient and decentralised nature, makes it appealing to both consumers and criminals alike.''Virtual currencies have grown exponentially in recent years. Today, there are several hundred virtual currencies in existence with a market capitalisation of over $5.75bn.n The Bitcoin system is the most prominent, with an estimated market capitalisation of over $5bn.' The exchange rate of dollars to Bitcoin soared to more than $1,200 at its peak last November, although it has since retreated and was recently less than $400 per Bitcoin.s Ripple, which recently outpaced Litecoin as the virtual currency with the second-largest market capitalisation, has a market capitalisation of over $140m and an exchange rate of about $0.0049.9 Other mineable virtual currencies with a sizeable market capitalisation include BitSharesX, Peercoin and Dogecoin. However, as Bitcoin is the dominant virtual currency, this article (and the attention of regulators and policy-makers) focuses primarily on it.While these descriptions provide a helpful understanding of what a virtual currency is and some of the different virtual currencies in existence today, they do not clarify the role of virtual currencies in the modern financial system. Are they a commodity, a currency or a medium of exchange? Can they be more than one of these? As will be discussed in more depth in the following sections, policy-makers and regulators are still trying to answer these questions. The Department of the Treasury's Financial Crimes Enforcement Network (FinCEN) has defined virtual currency as a 'medium of exchange that operates like currency in some environments, but does not have all the attributes of real currency... [including that it] does not have legal tender status in any jurisdiction'. …