Now that we’ve learned the basics of money in part 1 of this primer and how bitcoins and Bitcoin work in part 2 it’s finally time to talk about the problems and legal risks facing bitcoin adoption.
Which are significantly more serious than issues surrounding Cabbage Patch Kids adoption.
The Downside Of Bitcoin As Currency
There are plenty of potential downsides to using bitcoins as a virtual currency and these could be insurmountable obstacles in terms of its future. Here are some of the big ones.
While speculators may love the idea of buying bitcoins today and reaping a huge profit tomorrow, that isn’t the kind of thing you look for in currency. For example, this primer took a while to write (longer than it’s taken you to read this far and man, hasn’t that felt like forever?). When I wrote the section about bitcoins being worth around $515 that was true when I was writing it (March 28, 2014). Today, as I write this section (March 31) the value is around $460. That kind of huge fluctuation isn’t what people look for in terms of a currency–they may look for huge swings for other types of investments but that won’t make bitcoins succeed as a currency. You don’t want both sides of a transaction trying to figure out how much the money will be worth by the time the transaction is done–then it turns into a complicated bartering system.
To some extent, this is a hurdle that any new currency will face. As long as the currency doesn’t have widespread adoption then it will be valued mostly by its conversion to other forms of currency. But without some kind of longer-term stability, it will be difficult for a true bitcoin economy to emerge as the amounts charged for goods and services will fluctuate too wildly.
The 51% Attack
One of the greatest strengths of the Bitcoin network is also its greatest weakness. Bitcoin was created to replace those trusted, proprietary third parties that verify transactions. To do so, the Bitcoin network was created with a complicated transaction ledger (the Block Chain we discussed in part 2) and mining system. For those transactions to be verified, the majority of Bitcoin miners have to agree that the latest batch of verified transactions are correct–this process not only verifies the Block Chain but also sets to reward the miner that first solved the mathematical problem.
Verifying the solution requires agreement by at least 51% of Bitcoin miners. That distribution built into the Bitcoin network is designed to make it so that no single party is taking over verification and leading to them increasing transaction costs (leading them to increase transaction costs closer to the 2.9% being charged by most third parties today). But that distribution comes with a significant disadvantage: at any time someone can come up with enough hardware to make themselves 51% of the Bitcoin mining network and suddenly they can rewrite all the rules. They could move bitcoins to their own accounts or issue all remaining bitcoins to themselves. It’s possible that these changes could be undone, but that could be difficult.
It’s also an attack unique to Bitcoin–51% of the world’s nations could decide the US dollar is worthless and that wouldn’t impact our ability to use the dollar here in the US. The 51% attack on Bitcoin could completely destroy the system.
Like this almost killed Superman.
While the deeds that could be accomplished by someone in the 51% position are hypothetical, the actual ability is not. In January of 2014, one network of Bitcoin miners accounted for more than 42% of the network. A deliberate push by that network could have easily tipped it over the 51% number–fear of that takeover made many miners leave the network but it does reveal an actual, serious threat.
Current Third Party Protections
We discussed earlier how US retailers could save $11.7 billion a year if they moved to bitcoins given the reduced transaction fees. But one thing that should be considered is how credit card companies and others provide valuable services in exchange for those higher transaction costs. In addition to your losses being capped for fraudulent charges with credit cards, most third parties will also have reward programs and dispute resolution processes that could make the extra transaction fees worthwhile.
Forget all the bonus miles and extra hotel nights for now–those dispute resolution processes are very important. If you have a fraudulent charge on your credit card today you can contact the credit card and dispute it. They will have their own process for deciding the issue but you have a good chance of getting the issue correctly resolved. (I’ve had to do this maybe a dozen times over the past decade, every one resolved in my favor. That’s not to brag but to highlight an actual need.)
Bitcoin has no dispute resolution process. A completed bitcoin transaction, once verified into the Block Chain, cannot be undone. A reverse transaction could be completed if both parties agree to transfer the money back, but that is a new transaction and not removing an earlier one and is completely subject to the whims of the new bitcoin owner.
Private Keys Lost
Earlier we learned that having money in the Bitcoin network really means you have two things: the public address of that money (which anyone could have) and the private key that allows you to control where that money can be moved. If you lose that private key then you have lost the money.
This is true for currency as well. If you stand at the top of a mountain and wave a $20 bill around and the wind rips the bill out of your hand, you don’t have that $20. If someone walks up to you with a gun and demands the $20, same thing.
Unless you’re Chuck Norris. Chuck Norris makes money when he gets mugged.
The concern here is that private keys are not designed to be remembered by human brains. So you need some kind of storage method to intervene. Wallet programs or websites are the easiest place to store them, both for their ability to remember long strings of numbers and because they can be utilized to complete bitcoin transactions in the future. But programs and websites can be hacked. Or a virus on your hard drive can detect wallet programs, deduce that you have bitcoins, encrypt all of your files, and demand a bitcoin ransom or it will delete the key and you lose everything. That’s not a hypothetical risk, that’s a real virus.
As an additional method of security, some people place private keys in what is called cold storage. This means the files are removed from an Internet-connected device. They may be printed to paper and deleted from online records or they are placed on a USB drive that is placed in a secure location like a bank safety deposit box. This certainly makes the keys less susceptible to an online attack but they are still subject to the same limitations as physical currency (loss, theft, damage). If you wanted to have a physical stockpile of currency, there are easier ways. But security around private keys is vitally important since if you lose the keys you lose your money.
The problems with losing a private key, losing your money, are not unique to the bitcoin economy. The same thing could happen to your bank accounts if they were hacked. But there are a lot more safeguards in place and laws to help you in that event. The bitcoin economy has not matured enough to address these risks, giving you virtually no recourse if you lose your keys.
Other Technical Issues
The 51% attack is the easiest technical issue to understand but there are several other that can impact bitcoin transactions. One which has gained some attention is called transaction malleability (very technical article on how it works can be found here). Understanding this attack is a bit difficult–just know that an attacker can modify transactions before they are entered into the Block Chain. The modified transaction is seemingly innocent–it doesn’t change where the bitcoins were transferred. But it does modify the final verification hash and since there is no standard way for wallet programs to operate, some wallet programs would see the modified hash as proof that the first transaction failed and the wallet needed to send bitcoins again. The result is that a nefarious seller could trick a wallet into spending twice as many bitcoins as it should–and like we discussed before, there’s no recourse.
When one of the larger bitcoin exchanges, Mt Gox, announced it had lost several hundred thousand bitcoins it claimed this was due to transaction malleability. While that cause has been questioned, it is also true that in the days following Mt Gox’ announcement this attack was found to be responsible for double charging over 300,000 BTC’s worth of transactions.
Plus we were really, really sure we knew the Ace was in the middle.
There are several other potential weaknesses and attacks with the Bitcoin network and to some extent that should be expected with a new technology. It’s also true that our current third party verification systems have also been subject to attacks and data breaches. We just have a lot more experience dealing with the technology that has been around for decades.
Bitcoin Legal Issues
Beyond facing technical issues and obstacles to having bitcoins adopted as officially recognize currency, the Bitcoin network and bitcoin transactions also face significant legal challenges in the near future. Here are some of the most important.
Currency Or Commodity?
The IRS recently issued guidance that bitcoins will be treated as commodities rather than currency under US law. Brazil has just done the same and other countries will determine their own treatment. This triggers certain legal treatments that differ from currency–if someone pays you in bitcoins then it is like you were paid with gold bars rather than Euros. This not only requires you to figure the amount you were paid in terms of how much those bitcoins were worth when you received them, but if the value of those bitcoins change by the time you use them then you also need to record that amount. And if the new amount is higher than you can be taxed under capital gains.
Tax treatment depends on your overall income situation and I’m not a tax expert, so take this all with a grain of salt. But short-term capital gains (for commodities or investments held for under a year) you will be taxed 35% of the gain. If you held that commodity for over a year then that falls to 15%. Let’s see that in action.
Say I agree to pay you $25 in bitcoins (BTC, if you recall) if you hold my place in line at Franklin BBQ on one dreary day in January. Leave aside the ethics and propriety of such a transaction. In June, Franklin BBQ adds pork loin to the menu. You are eager to try the latest BBQ awesomeness, especially because Franklin is now taking BTC as payment. Pork loin is being sold for $12.50 a pound, quite a deal, and you decide to order 4 pounds.
This shall now be called your bitcoin pork loin.
Lucky for you, BTCs have doubled in their US dollar conversion since January so you are able to use the exact amount of bitcoins I paid you to purchase your $50 of sweet, smoky BBQ. Because you received $25 in a commodity (BTC) and were able to turn it in for $50 in goods you have now realized a gain of $25. Since this was based on something you held for under a year you now owe 35% of the gain, or $8.75. If you had been able to hold on until January, and assuming BTCs are still worth double compared to when you received them, then you would only pay 15% of the gain, or $3.75. But, really, who can wait that long?
The good news is that technically you still made out pretty well–you were able to get $50 in goods for the equivalent of $33.75. But the bad news is that you have to keep track of all your transactions, when you got BTC, how much they were worth, how much you got for them when you exchanged them for something else, or else the IRS may take issue with your filings. And that’s never a good thing.
It’s also bad news when you compare to a standard currency exchange. People make investments in foreign currency just like they can buy stocks and bonds or gold or collectible Elvis plates.
Fact: the Fat Elvis plate can hold six full-size pork loins.
When you make money off a currency investment you are typically taxed 23% of the gain (they use a 60/40 rule to determine the amount, 60% taxed at long term 15% rate, 40% taxed as short term at the 35% rate). Just the fact that the IRS is treating BTC like stocks or other commodities puts it into a category different from, and less advantageous than, other forms of foreign currency.
Although the US has determined that BTC can be used for transactions and just has a specific way of dealing with the tax implications, other countries have declared bitcoin transactions to be illegal or placed restrictions on their use. Bitcoins cannot be used in Iceland and their use has also been restricted in Taiwan, India, Japan, and China, among others. This is still an emerging technology so it would be in your best interest to look into bitcoins’ legal standing in a country before you embark on transactions with them.
Anonymity And Money Laundering
Anonymity and Bitcoin is a fascinating issue. On the one hand you have people claiming that bitcoin transactions are completely anonymous and this makes it attractive to criminal elements. On the other hand you have people claiming that bitcoin transactions are publicly trackable and that you can follow every bitcoin from person to person which is something you can’t do with cash currency today, making it even more secure than cash.
Who’s right? They both are.
Although every bitcoin transaction is public knowledge, what is known is the amount that was transferred and the address to which the amount was transferred. If you can determine who owns or controls that bitcoin address then you know how much they received. But there is nothing that compels bitcoin addresses to be identified, unlike many countries which have laws that require bank accounts to be registered in people’s/companies’ names.
If a bitcoin is ever stolen (through a technical attack or someone stealing the password) then you can absolutely know where the bitcoins were transferred–but that may not help you. Especially if the destination was some large bitcoin transaction site that you then lose in the shuffle. Perhaps the thief takes 5,000 BTC from your account and then start sending out batches of 100 BTC now and then. It would be impossible to say that those were your BTC and not someone else’s.
The identification of bitcoin transactions doesn’t necessarily make it more secure, but it also could make it easier to follow. Like a double-edged sword, it cuts both ways.
Double edged swords: as awesome to look at as they are to use in analogies.
Another way bitcoin transactions are like a double-edged sword is that the person handling it may face the most risk. We’ve already seen one example of an entrepreneur arrested on money laundering charges for providing a service to convert bitcoins to cash faster than the Bitcoin network allows and we could see more actions like this in the future. Even though bitcoins are treated as commodities, money has its own set of regulations and new companies rising to meet the gaps in the Bitcoin economy could run up against this highly regulated space.
The Future Of Bitcoin(s)
Where does this leave bitcoins and Bitcoin moving forward? While there are significant challenges to bitcoins being adopted as an actual currency there is a degree of interest in the technology that could keep it alive long enough to be accepted. This could change in an instant if the Bitcoin network is compromised or a few large countries declare it completely illegal, but for now it has a chance to be adopted if it can deliver on the promise of reduced transaction fees.
Of far more interest, I think, is the Bitcoin network itself and the idea that you can securely transfer unique codes from person to person. If the Bitcoin network becomes more refined and then modified to use more than bitcoins, it’s entirely possible that other, actual forms of currency could be exchanged on the network. That could be an interesting application of the technology and its promise of cheap, efficient transfers without the downside of a new, unregulated (by a traditional authority) currency.
Whatever happens with bitcoins and Bitcoin, hopefully by reading this primer you’ll understand what’s at issue. But if you do have suggestions for refining the primer, please contact me and let me know.