Understanding Bitcoins and other forms of virtual currencies

SUITS THE C-SUITE By Ken Meissner

Business World (10/13/2014 – p.S1/5)

IN THE PAST FEW YEARS, the idea of virtual currencies — systems of digital money created and maintained via the internet without the intervention or backing of any country’s government — has attracted a great deal of attention and varying degrees of enthusiasm and alarm from all sorts of people, including financiers, investors, merchants, central bankers, financial regulators, tax authorities, law enforcement officials, academics, and ordinary people looking for convenient ways to transfer funds to vendors, service providers, friends, and relatives.

There is a long way to go before Bitcoins and similar currency can achieve the widespread acceptance given to traditional currencies, such as the US dollar, Euro, and Swiss Franc. Nor is there any assurance this goal will ever be reached. But the possibilities are intriguing and, in some ways, troubling. There is the prospect of quick, low-cost money transfers, with fewer middlemen, and greater privacy. But there are obvious potentials for abuse, including tax evasion, money laundering, and financing of illegal activities, including terrorism.

In addition, the value of Bitcoins has varied widely as indicated by the price charts on sites such as coindesk.com and bitcoinhelp.com, often in response to negative news about various organizations and individuals involved in the Bitcoin ecosystem. As of early October, the price chart history in bitcoinhelp.com indicates that Bitcoins were generally trading at about $325 to $330 per unit, a sharp drop from the $620 to $625 price range they were trading in early July.

If one is to think about it, money is essentially a faith-based way for humans to buy and sell goods and services, store and conserve wealth, and keep track of the value of the transactions we engage in and the wealth we hold. A given unit of currency is worth only what people generally agree it is worth. When trust is lost, as happened with the German Mark in the 1920s, the results can be disastrous for individuals and for societies.

Originally, paper currency was based on faith that each note could be exchanged for a certain amount of a precious commodity, such as gold or silver. Following World War II, most of the world’s currencies were pegged to the value of the US dollar, while the value of the dollar was sustained by a promise to redeem US Treasury notes for a certain amount of gold.

In the 21st century, the emergence of the internet has laid the foundation for new forms of digital or “virtual” currencies to emerge. As reported in the Taxpayer Advocate Service 2013 Annual Report to the US Congress, one type of virtual currency — Bitcoins — has gone from a theoretical concept outlined in a 2008 white paper, to a dynamic financial ecosystem with bricks and mortar currency exchanges, automated teller machines (ATMs), dedicated venture capital funds, networks of merchants willing to accept payments in Bitcoin, and nearly 13 million currency units in circulation at an estimated value of more than $8.3 billion.

Every Bitcoin transaction is recorded in a sort of open ledger maintained on servers linked together in a peer-to-peer network, known as the BlockChain. These ledgers are maintained by semi-volunteers, known as miners. Miners are rewarded for their work with an opportunity, once they have verified a certain number of transactions, to solve a unique, complex mathematical puzzle. Twenty-five newly created Bitcoins are awarded to miners who successfully solve such a puzzle. Thus, both the maintenance and expansion of the Bitcoin money supply depend on the efforts of these miners. As time has passed, the mathematical complexity and the necessary computing power have increased dramatically. By now, only large consortia with specialized equipment can mine Bitcoins and hope to earn more value than the cost of the equipment and electricity they use. Ultimately, only 21 million Bitcoins can ever be issued, due to limitations built into the original design.

MoneyTalksNews, a US-based TV show that offers financial advice, explains that there are just three ways to obtain Bitcoins:

· Earn them via mining, which creates new Bitcoins;
· Buy them from an individual either directly or through an exchange, which enables conversion of Bitcoins into other currencies; or
· Engage in a Bitcoin-denominated transaction, selling goods or services for Bitcoins.

Once you have Bitcoins, you need to store them. This requires a piece of software known as a wallet. You can store your wallet offline, on a hard drive or other storage medium that is not connected to the internet. This protects you from hackers. But you should have multiple copies, in case your hard drives fails or becomes corrupted.

Or you can store your Bitcoins in an online wallet, which may be a wallet-only Web site, or may be an exchange. However, online news sites (such as weusecoins.com) report that there have been a number of troubling instances in which exchanges sustained large losses by hackers.

This highlights the continuing problem of Bitcoin price volatility. It is almost astonishing how Bitcoins have persisted and survived a series of events that one would have expected to shake public confidence in Bitcoins.

For example, in the early days, Bitcoins were often associated with illicit activities, such as trading in drugs, stolen goods, and other contraband via underworld “dark” Web sites such as Silk Road. The Federal Bureau of Investigation arrested the operator of Silk Road in 2013 and seized servers on which Bitcoins were stored. Early this year, the US government moved to formally seize those Bitcoins and auction them off for approximately $28 million. A successor Web site, Silk Road 2, had nearly $3 million of its customers’ Bitcoins stolen. Based on their statements released on the internet, administrators of Silk Road 2 claim to have paid back over 80% of what was stolen and promise to pay the rest back shortly.

As of now, the legal and tax status of Bitcoins varies enormously. Some jurisdictions have sought to outlaw them. Forbes magazine reported that in China, for example, individuals may own Bitcoins, but financial institutions may not handle them.

In the US, the Internal Revenue Service (IRS) has ruled that Bitcoins are a form of property. So if the value of a Bitcoin changes between its acquisition and sale, you are liable to have a taxable capital gain or a loss which you may or may not be able to deduct. If you are paid in Bitcoins for services rendered, the value you receive is considered ordinary income.

And in the Philippines, the Bangko Sentral ng Pilipinas (BSP) has announced that the exchange of virtual currencies, such as Bitcoins, is not locally regulated, and has warned consumers from potential financial losses. In fact, last March, the BSP released a warning to the public about the volatility of virtual currencies and the lack of assurance that there will ever be stability.

It remains unclear how the marketplace for Bitcoins or other forms of virtual currency will evolve. Government and industry leaders will need to work out a balance between know-your-customer banking laws and individuals’ desire for privacy. Standards and mechanisms, whether governmental or industry-voluntary, will have to evolve to protect small participants in the marketplace. But given how quickly virtual currencies like Bitcoin have grown and been embraced by a wide range of stakeholders, it seems likely that they may endure in some form.

Ken Meissner is a Tax Senior Director of SGV & Co.