Bitcoins: A Techno-Legal Perspective
This article is divided into two parts: Part I will explain the technical aspects of bitcoins and Part II will explain the legal issues around bitcoins.
Before we go into a discussion of bitcoins, it is important to understand what digital cash is.
What is Digital Cash?
Digital cash aims to duplicate the functionality of paper cash, by providing it with properties of anonymity and transferability of payment. Digital cash is intended to be implemented data which can be copied, stored, or given as payment (for example, attached to an email message, or via a USB stick, Bluetooth, etc). Just like paper currency and coins, digital cash is intended to represent value because it is backed by a trusted third party (namely, the government and the banking industry). Most money is already paid in electronic form; for example, by credit or debit card, and by direct transfer between accounts, or by on-line services such as PayPal.
Ideal properties of Digital Cash
- Secure. A should be able to pass digital cash to B without either of them, or others, able to alter or reproduce the electronic token.
- Anonymous. A should be able to pay B without revealing her identity, and without B revealing his identity.
- Portable. The security and use of the digital cash is not dependent on any physical location. The cash should be able to be stored on disk or USB memory stick, sent by email, SMS, internet chat, or uploaded on web forms. Digital cash should not be restricted to a single, proprietary computer network.
- Off-line capable. The protocol between the two exchanging parties is executed off-line, meaning that neither is required to be host-connected in order to proceed. Availability must be unrestricted. A can freely pass value to B at any time of day without requiring third-party authentication.
These are the ideal properties, and no known system satisfies them all. It is important to note here that Paypal is not "digital cash", because it doesn't attempt to provide properties similar to cash (anonymity, off-line usage). Instead, it aims to replace credit cards, and is much more secure. In contrast with credit cards, Paypal payees do not have to have merchant status.
What is Bitcoin and how the technology works?
It is a digital currency that is created and exchanged independently of any government or bank. Bitcoin is generated through a computer program and can be converted into cash after being deposited into virtual Bitcoin-wallets, which is created when one downloads a bitcoin open-source program. When one runs the open source client, it connects to the Internet and links the user to a decentralized peer-to-peer network of all bitcoin users. The user has to create a bitcoin wallet in order to start doing business with bitcoins, much like an online account or e-cart. The program generates a pair of keys, a public and a private key, which is used while sending and receiving bitcoins over the network. The Private is always hidden. The public key is like an address to identify the key holder. Each Bitcoin address has its own Bitcoin balance. Every time a transaction is made, the public address of each user is made public to the entire network. The process of generating Bitcoins is through a complex algorithm which mines a unique number representing a bitcoin. The algorithm can be assumed to be a worker in a gold mine who is searching for a slab of gold. In this case, the algorithm is searching for an available bitcoin. The upper limit to the number of bitcoins is about 21 million. Bitcoins are used for electronic purchases and transfers. One can use bitcoins to pay other people. Each and every transaction is logged digitally on a transaction log that tracks the time of purchase and who owns how many bitcoins. This ensures that a bitcoin cannot be duplicated. This digital transaction log is called 'block chain'. The block chain records every single transaction and the ownership of every single bitcoin in circulation. Making payments with bitcoins is easier than using credit cards. If one has a wallet, one only has to enter the recipient's address, the amount of bitcoins to be sent, and click ok. The recipient will then simply receive the request for bitcoins in exchange for what he is offering (goods, services, or perhaps a currency).
What is the difference from ordinary e-cash?
Bitcoin has a completely distributed architecture, without any single trusted entity. Bitcoin assumes that the majority of nodes in its network are honest. In contrast, most e-cash schemes require a centralized bank who is trusted for purposes of e-cash issuance, and double-spending detection. This greatly appeals to individuals who wish for a freely-traded currency not in control by any governments, banks, or authorities—from libertarians to drug-dealers and other underground economy proponents (note that apart from the aforementioned illegal usages, there are numerous legitimate uses as well, which will be mentioned later). In a spirit similar to the original motivation for a distributed Internet, such a purely decentralized system guarantees that no single entity, no matter how initially benevolent, can succumb to the temptation or be coerced by a government into subverting it for its own benefit.
How to trade Bitcoins?
Exchanges provide a place for people to trade Bitcoins for other types of currency. Payments to a merchant who accepts Bitcoins are made from the wallet application, either on the computer or smart-phone, by entering the recipient's address, the payment amount.
What gives a bitcoin its value?
This is the most contentious of all questions. In the first year of bitcoin, there were almost no transactions, but people were spending their energy on generating bitcoins. This is possibly because bitcoins have:
1. Value as a collectible, in a similar manner to people collecting rare metals, stones, shells, postal stamps, paintings and baseball cards.
2. Value from betting that other people may find these collectibles valuable and thus would have to buy some of them from earlier collectors, thus making them richer.
Gold is valuable for the same reason. Not because it’s shiny but because it’s rare, durable and mobile, and thus can be collected. And once collected, it can only increase in value when more people want it. In case of bitcoins, the value can appreciate or depreciate in the expectation of investors, buyers, sellers and speculators that bitcoins is a “thing of the future”. One must not be under the impression that the peer-to-peer network is responsible for any single price that people put on bitcoin. There’s clearly no rational way to tell how much money bitcoin “should be worth” today or tomorrow. Pure demand and supply for bitcoins is what determines its price. There may be no demand and hence the bitcoin can become junk. Additionally, frequency of transactions is independent from the total value of the supply. The value of a bitcoin is constantly changing, and there is no centralised exchange for it. Thus each time a bitcoin changes ownership, the two parties need to agree on its price. There is no fixed price. Also the difference between bitcoins and other currencies is that there is no centralised bank that prints the currency and sets relative values.
This part deals with the legal issues around bitcoins. The principal question that comes to mind is that what exactly the definition of bitcoins in legal sciences is. While the law in this field is yet to take shape, some of the existing definitions can be explored to see where this fits.
Is it Currency?
Reserve Bank of India Act defines "Currency" to include all coins, currency notes, banks notes, postal notes, postal orders, money orders, cheques, drafts, traveller's cheques, letters of credit, bills of exchange and promissory notes.
In economics, a currency is a system of money (monetary units) in common use, especially in a nation. Under this definition, British pounds, U.S. dollars, and European euros are different types of currency, or currencies. Currencies in this definition need not be physical objects, but as stores of value are subject to trading between nations in foreign exchange markets, which determine the relative values of the different currencies. Currency must not be perishable, should be a medium of exchange and should have a stable store of value. This is reason why wheat or jute cannot be treated as currency because they do not have stable store of value and are perishable. That is also why the world moved away from the pre-historic barter system.
Bitcoins are not perishable, they are a medium of exchange but they have no stable store of value. No entity or assets back up Bitcoin value. Bitcoin value is entirely virtual—a Bitcoin is only worth what another person thinks it is worth. This is different than currency issued by countries. A country’s currency is backed by that country’s government. This backing can either be by fiat (government regulation or law) or by commodity (such as the gold). Bitcoin value is not based on government regulation or law mandating its use in a country. Similarly, it is not backed by gold. Bitcoin can be used to purchase goods or services, used to pay for individual living expenses but it is limited to those places that accept it as currency.
Is it Security?
"Securities" include- (i) shares, scrips, stocks, bonds, debentures, debenture stock or other marketable securities of a like nature in or of any incorporated company or other body corporate; (ii) Government securities; (iii) rights or interests in securities.
A security is an instrument that is secured against something else. A security represents a right in something else. For example, the value of a bond, note or a promise to pay depends on the financial condition of the promisor. A share is secured against the equity interests of a company. Therefore by owning a share, the shareholder owns an interest in the company. The market value of a share depends on what the buyer is willing to pay, given the profitability conditions of the underlying assets. In case of bonds, debentures, a security creates an obligation on one party to pay another party. Now, a bitcoin is not a security because there is nothing underlying in it. It is not creating an interest or right in any asset or anything else for that matter. Nor is it creating an obligation on one party to pay another party.
However it may be argued that a bitcoin can be a security if someone is purchasing bitcoins as a speculative investment and intending to profit off of a future sale of those bitcoins, then that purchase would be an investment of money. Some uses of Bitcoin may not be an investment of money (such as using Bitcoins to purchase a good). However, people are certainly speculating on the price of Bitcoins, as can be seen by the emergence of Bitcoin investment vehicles. Further, the investment rules and requirements of Bitcoin exchanges which are already in existence can classify a bitcoin as a security and a transaction as a securities transaction, even if bitcoins are not security in itself. In US, the SEC has authority to regulate securities, like stocks, in the United States. In Securities and Exchange Commission v. Trendon T. Shavers, the United States District Court for the Eastern District of Texas was concerned with the question whether Bitcoin-related investments were “securities” and hence subject to the jurisdiction of the Securities and Exchange Commission (SEC). The defendant, Shavers, was the founder and operator of Bitcoin Savings and Trust (BTCST) and solicited Bitcoin in principal investments from BTCST investors. The investors suffered losses and hence the SEC brought an action against Shavers and BTCST on the ground that they have made misrepresentations regarding the nature of the investments and had defrauded the investors. Shavers adopted the argument that SEC had no jurisdiction because the investments were not “securities” because Bitcoin is not money, and is not regulated in the US. He also argued that no money changed hands. The court did not accept Shavers’ arguments and instead ruled in favour of the SEC.
But so far, the agency has not determined whether Bitcoin itself can be categorized as a security, making it hard for it to crack down on trading fraud.
Is it ‘Goods’?
‘Goods’ means every kind of movable property, other than actionable claims and money; and includes stocks and shares, growing crops, grass and things attached to or forming part of the land which are agreed to be severed before sale or under the contract of sale. Intangible things like Trademarks, patents, copyright, goodwill, water, gas, electricity are all goods. Further, the Supreme Court has held in TCS v. State of AP (2004) that the test to determine whether a property is ‘good’ is not whether the property is tangible or intangible or incorporeal. The test is whether the concerned item is capable of abstraction, consumption and use and whether it can be transmitted, delivered, stored, possessed etc.
Bitcoins do resemble goods. It is movable, it is not money, it is not an actionable claim because it does not impose a claim on anybody or anything against which an action can be taken, it can be abstracted by a computer program (within a certain limit placed by the algorithm, and hence it is countable and finite), it is being used and consumed by peopled dealing in bitcoins, it can be transmitted, delivered over a network, stored in a wallet and in USB drives. Bitcoins are an abstraction, much like a painting or a song, for which any price can be paid. There is no prohibition on much price one can pay for a painting or a song. A can pay Rs. 1 crore, whereas B can pay Rs. 1 lac for the same painting.
More precisely speaking it is an online commodity. Section 4 defines a contract of sale as “a contract whereby a seller transfers or agrees to transfer the property in goods to the buyer for a price.” The consideration in a contract of sale has necessarily to be ‘money’. Thus, if bitcoins are sold for money, then Sale of Goods Act will be applicable. But if bitcoins are used an exchange medium for goods, then Sale of Goods Act will not apply. Chinese authorities announced that Bitcoin was a “virtual commodity that does not share the same legal status of a currency.” In the United States, that classification could put Bitcoin under the Commodity Futures Trading Commission. But that agency has not assumed responsibility.
There seems to be no reason to consider bitcoins as illegal if they are considered as goods.
Other legal issues to consider: A trader cannot export goods from India and receive payment in Bitcoins. Under FEMA Act, such export proceeds must be repatriated to India in terms of foreign exchange through normal banking channels. Similarly importation of Bitcoins would pose legal difficulties if transactions are not carried out through legitimate banking channels.
Further legal issues involve lack of consumer protection in any sector of the Bitcoin economy. Anyone could be a victim of theft or malpractice. In the immediate future, the most likely source of enforcement may be the Federal Bureau of Investigation’s cybersecurity team.