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29 一月 2014

R’BIting Bitcoins

Currencies across the globe need to have universal application and acceptability and have been given sovereign validity, sanctity by the respective countries that issue them. Each country issues its own unique currency that is valid within its territory. Currencies like the United States dollar and the Euro are accepted in many countries and are freely convertible in almost all countries. The dawn of digital era has introduced a new form of currency i.e., virtual currency/ digital wallet that is gaining increasing acceptability and availability across many jurisdictions including India. The RBI has, recently, visualised potential risks that may arise while dealing with these currencies and issued a Press Release on 24 December 2013 cautioning users, holders and traders of virtual currencies while assuring that it is examining the legality of bitcoins under the present legal and regulatory framework. Consequently, almost all websites that had earlier allowed buying or selling the bitcoins have temporarily suspended their operations. It may therefore be apposite to comprehend this novel idea and its operational dynamics before delving into the apprehensions of the RBI.

 

What is a bitcoin?

The evolution of bitcoin can be attributed to distrust in the extant banking system. Bitcoin is a digital or virtual currency which is somewhat similar to traditional currencies but contrary to such currencies it has nothing to do with ATM cards or credit cards issued by the banks. Unlike a traditional savings account, these virtual currencies are saved in digital wallet(s) - a software application downloaded and installed on a computer system or a mobile phone. Just like using a physical wallet, one can buy or sell bitcoins from websites which are called Online Exchanges, by making payment from the digital wallet. Since there is no central regulating authority (or) clearing house, all the transactions involving bitcoins takes place on a P2P (peer-to-peer i.e., one-to-one) basis in a decentralised manner outside the global banking system and is controlled only by its users with no regulatory oversight.

 

Background mechanics

The digital wallet of the user works on a public key infrastructure i.e., wallet address - a public key available to the outside world while the private key is held by the user to protect his coins inside. This is also called ‘crypto-currency’ meaning that it relies on cryptographic software protocols to generate the currency and validate transactions.

New bitcoins are generated by a process called ‘mining’. A miner is a person who, with the use of software and specialised hardware, performs task of recording and validating transactions happening between P2P. For the services rendered by miners, they earn transaction fee and newly created bitcoins. Each digital transaction constitutes a ‘block’ and various blocks form a ‘blockchain’. This blockchain tracks the flow of a bitcoin. This provides transparency and ensures safety of a transaction. For operational convenience, each bitcoin can also be sub-divided upto eight decimal places.

 

Payment advantages

Recently, Virgin Galactic announced accepting of bitcoin as the payment for its commercial space flight venture. A few business outlets in India have started accepting bitcoins as currency to replace the rupee. India has approximately 50,000 bitcoin fraternity. By and large the transactions in bitcoins appear to be for speculative purposes. There are some merits in the bitcoin usage. For example, a blockchain can be clearly tracked for ensuring validity of the payment. A merchant accepting bitcoins as consideration for goods sold/ services rendered is assured of the safety of bitcoins and can avoid the risk of being cheated by counterfeit currency. Further, the transaction costs are very minimal. There is also flexibility in dividing the bitcoins upto eight decimal places.

 

The issues

Whether legal or not, virtual currency is evolving in different countries such as US, EU, China, Japan, Germany, India, etc. Specific apprehensions or potential risks associated with this business are, whether it pegs black money; facilitates money laundering and criminal activities; helps in financing of terrorists; and taxation of e commerce .

 

Scenario in the US

In USA, the Department of Treasury’s Financial Crimes Enforcement Network’s (FinCEN) regulations define currency as fulfilling triple determinants namely (a) designation of the coin or paper money as legal tender (b) circulation and (c) use as a medium of exchange in the country of issuance. Virtual currency is a medium of exchange that operates like real currency but does not have legal tender status in any jurisdiction. In addition, the Final Rule [see end note 1] made by FinCEN has extended the application of the Prepaid Access Rules to ‘administrators’ and ‘exchangers’ to register as ‘money transmitters’ [see end note 2], who are required to register, report and maintain records.

The US Treasury has been warning bitcoin businesses since March 2013 that they must comply with “Know Your Customer” (KYC) laws that require stringent identity checks, monitoring of accounts and reporting of suspicious activity. This effort would de-anonymize the bitcoin. To comply with federal regulations surrounding financial fraud, money laundering, identity theft, and financing of terrorism, Bitcoin companies are required to verify their customers by instituting policies on customer transactions.

The first Congressional Hearing on Virtual Currencies [see end note 3] had expressed concerns over websites like ‘SilkRoad’ which used bitcoins in transaction of illegal goods and services. However it eventually did not ban it but expressed the desire to regulate the sector to combat any potential threat considering that the legitimate use would far outweigh the malicious use of bitcoins. Thus the US regulator is not averse to dealing with virtual currencies as long as there is assurance that it is used for legitimate transactions and will eventually be brought into the purview of mainstream financial operations.

 

Scenario in other countries

The European Banking Authority has also sounded a note of caution to parties to the bitcoin transaction that users should be aware of the risks of such transaction before going ahead. It expressed concerns over the effect of hacking of exchange platforms or its seizure by government order for money laundering or terrorist financing investigations which could jeopardize the users and the money that they have invested [see end note 4]. Of late, Swiss Parliament has considered a postulate for treating bitcoin as a foreign currency [see end note 5]. However, Chinese government has banned financial institutions from trading in bitcoin [see end note 6]. Germany recognises bitcoin as “unit of account” and treats it as a financial instrument.

 

Legality in India

Transactions in bitcoins are not illegal in India stricto sensu. However users need to be very careful while dealing with this type of virtual currency. The RBI in its advisory opinion has clearly expressed its concern over the P2P anonymous/pseudonymous systems that could lead users to breach, even if unintentionally, the anti-money laundering laws or combating financing of terrorism laws. It has categorically warned about virtual currencies being prone to losses arising out of hacking, loss of password, compromise of access credentials, malware attack etc. The users need to treat their e-wallets with the same care as their physical wallets and must compulsorily conform to the KYC norms followed by the bitcoin exchanges. Since they are not created by or traded through any authorised central registry or agency, the loss of the e-wallet may result in permanent loss of the currencies held in them. Additionally, in the absence of regulatory authority to oversee the payments, there is no framework to address customers’ problems, disputes, chargeback, etc. The Enforcement Directorate (ED) is also involved in series of raids on bitcoin traders, probing for financial crimes and money laundering transactions. This warning coupled with ED’s actions has led to the virtual closing down of the bitcoin exchanges in the country. It remains to be seen whether the bitcoin community will grow or die out after an initial flutter like many other earlier attempts for a single global currency.

 

Way forward

Today the reliability of fiat currencies is a point of concern. In an economic downturn with currency fluctuations and increasing unemployment, virtual currencies provide a more prudent investment opportunity for knowledgeable users. Moreover, with the developments in the field of cryptology, encryptions of commercial transactions prove a more feasible option that guarantees safety of an investment. It is therefore pertinent for governments to consider the US model and attempt at regulating the sector rather than letting it be held ransom by hackers. It might also be pragmatic to put in place appropriate security systems to plug any loop holes and avoid hacking. Before recognising bitcoins as private currency, it is important for the government to intervene and devise policies. It must be kept in mind that the purposes for which the bitcoins are used have to be regulated and not the business per se. The government may initially allow the business in a limited way under a centralised repository system before opening up the business fully in a decentralised way. This may be easier said than done but may pose many pertinent questions such as its treatment in foreign exchange dealings, taxation, etc.

As far as the users are concerned they should have the appetite for risk. As there can be no efficacious way to prevent hacking, it is advisable for users choose their passwords and access credentials with utmost care to avert the loss of digital money. Nevertheless, with the recent introduction of the one-time password (OTP) card, the potential risk to one’s account from a malicious party could be significantly mitigated [see end note 7]. They must also adhere to the AML/KYC norms at the respective bitcoin exchanges and avoid using technologies to hide their IP addresses to ensure greater transparency.

[ The author is a Principal Associate, Corporate Practice, Lakshmikumaran & Sridharan, Hyderabad ]

 

End Notes:

  1. On Definitions and Other Regulations Relating to Prepaid Access.
  2. Guidance on Application of FinCEN’s Regulations to Persons Administering, Exchanging, or Using Virtual  Currencies by Department of Treasury, Financial Crimes Enforcement  Network
  3. Held on 18-11-2013
  4. http://www.eba.europa.eu/documents/10180/16136/EBA+Warning+on+Virtual+Currencies.pdf
  5. http://www.coindesk.com/swiss-lawmakers-bitcoin-foreign-currency/
  6. http://www.reuters.com/article/2013/12/05/chinabitcoinidUSL4N0JK1KZ20131205
  7. https://www.mtgox.com/press_release_20131120.html

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