Air Guitars and Bitcoin Regulation

Originally published at The Monetary Future on November 25, 2011.

No one really sends or receives bitcoin. They merely transfer their ownership and specific control rights to the block chain on the giant public ledger in the cloud. It’s like an air guitar. The bitcoin itself exists because we all say that it exists.

The same can be said of bitcoin’s exchange value — it has value because we all say that it has value. That is both its weakness and its brilliance. Its intangibility prevents its confiscation. Where are your bitcoins Mr. Anarchist? Well sir, they are right over there stacked next to my new air guitar. What, you don’t see them? I swear that they are there. I don’t think governments will ever declare that they can see them too! Because if governments did see them, then bitcoin would be imputed with tremendous legal monetary value and they don’t want to do that. Governments will want to diminish the credibility of bitcoin — not enhance it.

Now, to the exchanges. This is where the enforcement and regulations will hit first. Trading bitcoin in and out of national currencies is currently necessary because many transactions still have to be settled in that manner. Of course, this will adjust over time as more and more bitcoin value can remain in the bitcoin ecosystem for necessary daily transactions. But in the meantime, regulation is increasingly possible in this area due to exchanges requiring a certain degree of jurisdictional presence and centralization. As with buying and selling air guitars on eBay, regulators can exert influence because there is a centralized point of exchange. It matters not what is being exchanged.

Regulatory Bias With Some in the Bitcoin Community

“We are working with the government to make sure indeed the long arm of the government can reach Bitcoin.”
— Jeff Garzik, Bitcoin Developer

“Regulation would allow the proper authorities to find and charge those who use bitcoins for illegal activities.”
— Amir Taaki, Co-founder of Bitcoin Consultancy

“Norman is pushing to bring Bitcoin away from its roots and closer to a traditional currency — he is reaching out to regulators, looking to get legislation to oversee the system.”
— CNBC on Donald Norman, Co-founder of Bitcoin Consultancy

These are the big three bitcoin regulatory proponents within the bitcoin community. There are certainly many more outside of the community. Now, let me see if I can summarize their rationale because these quotes are not isolated incidents and they are not taken out of context. I believe that the rationale is twofold: (1) a reaction to the anonymous online drug company Silk Road tainting the fledgling currency; and (2) a belief that bitcoin exchanges given a regulatory blessing will be in a position of strength for customers exchanging in and out of national currencies.

Both of these rationales are misguided, especially when bootstrapping a decentralized P2P cryptocurrency. Bitcoin was designed from the outset to route around centralized, authoritarian interference. Bitcoin’s designer(s) anticipated regulatory termination and asset confiscation because bitcoin itself is a direct challenge to the privileged money monopoly of the sovereign. The issue is not whether bitcoin as a digital currency embodies libertarian political and economic beliefs — it was simply designed to survive. However, it is supremely naive and daft to think that a government will not soon erect laws and regulations to prevent anonymous and untraceable transactions. Additionally, government tends to tax that which it regulates and a sanctioned bitcoin will soon be transformed into an ‘approved’ and useless digital currency.

Bitcoin exchanges are constantly under attack in various parts around the globe and even with partially-regulated exchanges, laws can always be modified to accomplish the aims of the State. The solution is to create decentralized exchanges and to promote business models and closed-loop paradigms that make fitting into the current institutional structure irrelevant. It is a perpetually losing battle to seek minor legal victories within the confines of an arbitrary, subjective court system.

In differentiating between the fear of punishing coders and the fear of punishing the consumers and merchants that openly choose to transact in bitcoin, James Westlock summed it up nicely in his comment to the “Bitcoin and Agorism” article:

“Everyone here understands that a Bitcoin exchange is nothing to do with Bitcoin clients and the source code that is compiled into them. The imbeciles who run exchanges in police states like the USA will be scrupulously avoided by anyone with a brain cell, and those who set up exchanges in free(er) countries will reap the benefit. Anyone developing a Bitcoin client cannot be charged with conspiracy with regard to the uses that the client is put to, in this case exchanges. The client is neutral, just as browsers are neutral. You can use a browser to commit a crime, but culpability for that criminal act cannot be passed to the people who code the browser (Mozilla, Google, Apple).”

To be sure, David Norman and Amir Taaki have many more pro-regulation references and citations available at their website. For instance, Taaki gives a radio interview with the Katherine Albrecht Show in the U.S. Then, reporting in the Independent, Stephen Foley quotes David Norman on the hackers that brought down the largest bitcoin exchange:

“In the UK, supporters of Bitcoin made an urgent appeal to the Financial Services Authority to regulate the largest London-based exchange, so as to reassure people that using Bitcoin is safe. ‘Unregulated businesses don’t usual cry out for regulation,’ said Donald Norman, co-founder of the exchange Britcoin. ‘But because we are unusual, and because we are dealing with people’s money, and because of all the scary stories around Bitcoin, we would like nothing more than to have a government authority looking into our accounts — especially now.’”

In order to gain legitimacy for a decentralized P2P cryptocurrency that comes with user-defined anonymity and user-defined traceability, the Statist apologists have gone out of their way to seek clear and concise guidelines from the government on what will and will not be permitted with respect to bitcoin activity. They may soon get their wish.

UK Financial Services Authority on Bitcoin Regulation

A response purporting to be from the FSA appeared recently in the Bitcoin Forum. In reading the well-referenced text, it appears obvious that bitcoin itself cannot be regulated as money but that exchangers would fall under the guidelines of FSA regulation because they are deposit takers and holding balances in national money before and after the bitcoin exchange takes place. A bitcoin service that simply provided a matching service, such as bitcoin-otc, where buyers and sellers settled on their own would not therefore fall under the regulation.

This is important because of various claims circulating that there is a coordinated effort on the part of EU-based financial institutions to freeze or impede bank accounts that are acting as agents for bitcoin exchanges or bank accounts of bitcoin exchanges themselves. In August 2011, the French bank CIC froze MtGox client funds and closed the bank account paving the way for a court case and final decision on October 18th, 2011. Then on October 21st, 2011, MtGox released this statement:

“While Bitcoin at a European level is so far not directly impacted by this decision, the Bank de France (France’s central bank) has confirmed that because of European banking rules, monetary transfers (deposits and withdrawals) through a single entity are subject to financial regulation and therefore can only be performed by licensed financial institutions such as banks or Payment Service companies (the European Equivalent to a Money Service Business). This decision has forced us to find other payment processing partners within Europe that will allow us to quickly resume all EUR transactions for our European customers soon.”

Seeking legal opinions and regulatory clarification will only result in more disappointments. Therefore, in order to obtain the ruling that the bitcoin regulation proponents seek, bitcoin exchanges and bitcoin merchant applications will have to be adapted to support the enforcement of AML rules regarding money service businesses and identity verification for prepaid access products, such as the recent FinCEN regulatory changes from the United States.

In the future, we are likely to see regulations and enforcement against the bitcoin exchange infrastructure as well as restrictions on bitcoin transactions at the large online and offline merchants subject to establishment transactional reporting requirements. Both enforcement avenues will be deployed in an effort to undermine the usefulness and acceptance of bitcoin, because quite frankly that will be the only option available to authorities.

Cryptocurrencies are Not Virtual Goods

Vili Lehdonvirta works as a researcher at the Network Society research programme at Helsinki Institute for Information Technology in Finland and he is Visiting Scholar at the Interfaculty Initiative for Information Studies at the University of Tokyo. His research examines the social and economic impact of new information technologies, especially online games, social networks, virtual currencies, and virtual taxation.

He believes that the bitcoin currency goes way too far in providing user-defined anonymity and user-defined transaction traceability. Although he doesn’t mention how the transition to a digital cash society can justifiably deny the very same attributes enjoyed with physical paper cash today, he seems to promote his own “ideal” vision of how the future cashless society should be constructed. This is the most dangerous type of thinking when discussing a cashless society because we are at a critical nexus that will define our relationship with money in the cyberspace frontier. Either we respect individual financial privacy or we restrict it and pave the way for an even more frightening and suffocating vision of the future.

Quoted on the Bitcoin Forum,Vili had this to say:

“I am fascinated by Bitcoin, and I also think I have something of value to contribute to the Bitcoin community. The first is that as a researcher, I have studied payment and digital currency design and user adoption issues, and I think this is an area where the Bitcoin ecosystem could do better. The second is that as a long-time member of Electronic Frontier Finland, I have spent a lot of time thinking and publicly debating about privacy and digital freedom issues. I am worried that Bitcoin is a step too far as it leaves no possibility for even democratic governments to enforce their laws. This is a topic I would love to debate with the community and hear opposing views. I think the end result could be a better understanding for me, but also a better understanding for the Bitcoin community on how to live in harmony with democratic authority.”

In the co-authored 2010 landmark paper, “A New Frontier in Digital Content Policy: Case Studies in the Regulation of Virtual Goods and Artificial Scarcity”, Vili Lehdonvirta states:

“The law has commenced its long course to recognize digital goods as a form of property. One finds it in court decisions concerning the interpretation of criminal law and related damages. The behavior of gamers and other online users has, both in quantity and quality, exceeded the limits of contract law (Fairfield 2008). Other areas of law, including but not limited to those of criminal law, law of damages, defamation, and law of property, will slowly step into play. But the natural inertia of law can sometimes be a good thing in creating the rules that shape behavior (Bohannan 1965).”

For the most part, I respect Vili Lehdonvirta’s academic work on virtual goods ownership, but he harbors confused thoughts on the broader acceptance of bitcoin through dilution of its most beneficial properties, because he mistakenly extends the notion of virtual goods legal recognition to virtual currency legal recognition. While this might be appropriate for a virtual currency that evolved out of a virtual commodity within a proprietary gaming environment, it is wholly inappropriate for a decentralized P2P cryptocurrency that does not depend upon physical property rights for its valuation.

Lawyers’ Take On Bitcoin Regulation

Just as the economics profession, the legal profession is still struggling to catch up with bitcoin. I expect much more detailed legal research in the coming months. One of the lawyers in the forefront, John William Nelson, had this to say in his article, “Extending real-world laws to virtual worlds is a terrible idea”:

“Government regulation, either directly or indirectly by forcing common law theory into a virtual world setting, will destroy the ability of virtual worlds to create these fundamental characteristics. The game conceit — the imaginative construct upon which the world is based — will, as Dr. Bartle says, ‘evaporates upon contact with . . . reality.’ The world will no longer be free to evolve — its evolution will be constrained by the laws injected into its sphere. The world’s support for the hero’s journey will be conditional upon the rules and regulations of laws from the outside — laws from the real world.”

In a follow-up piece, “Bitcoin Isn’t a Security”, Nelson also concludes that bitcoin in-and-of-itself is not a security that can be regulated under U.S. federal securities law:

“But if currency can be a security, then Bitcoin is a security because it’s a type of currency, right?

Wrong. Bitcoin is not really a type of currency, at least not of the type recognized as securities. No entity or assets back up Bitcoin value. Bitcoin value is entirely virtual — a Bitcoin is only worth what another person thinks its 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 standard the U.S. used to use). Some compare Bitcoin’s value to the value of fiat money, because like fiat money it is not backed by a commodity, but this is where the similarities between Bitcoin and fiat money end.

Bitcoin is backed by no entity, no commodity, no organization. Bitcoin value is not based on government regulation or law mandating its use in a country. Similarly, it is not backed by a whole bunch of gold sitting in Fort Knox.”

In answering the question of whether bitcoin investors should worry about securities regulations or laws, Nelson emphasizes that securities law is generally broad enough to capture any enterprise where investment for profit is involved, because a common economic scheme exists where a profit is expected based on the efforts of a third party. In “Bitcoin Isn’t a Security”, Nelson states:

“Bitcoin investors should absolutely worry about securities laws. The securities definitions outlined above might not apply to Bitcoins themselves, but they are flexible enough to apply to Bitcoin exchanges that convert a Bitcoin to real-world currencies. Securities law might even apply to exchanges converting Bitcoin to other virtual currencies such as Lindens.”

Ultimately, laws erected to protect the State’s coveted monopoly over the issuance of money will not be slayed through a minor technicality nor will bitcoin suddenly be blessed by a newly-converted regulatory regime. At Yale Law School, Reuben Grinberg writes in “Bitcoin: An Innovative Alternative Digital Currency”:

“Most importantly, Bitcoin currently operates in a legal grey area. The federal government’s supposed monopoly on issuing currency is somewhat narrow and statutes that impose that monopoly do not seem to apply to Bitcoin due to its digital nature. However, a bitcoin may be a ‘security’ within the meaning of the federal securities laws, subjecting bitcoins to a vast regime of regulations, including general antifraud rules. Furthermore, other legal issues that have not been analyzed in this paper are probably significant, including tax evasion, banking without a charter, state escheat statutes, and money laundering.”

The great promise of a nonpolitical bitcoin lies in what its decentralized nature immune to shutdown actually enables — the ability to maintain financial privacy and to transact with entities that may be despised by the government.

This article was also reprinted by the Ludwig von Mises Institute of Canada and Center for a Stateless Society.

For further reading:
“Why the quoted price of Bitcoin doesn’t matter”, Blogdial, October 17, 2011
“WikiLeaks and the protect-ip Act: A New Public-Private Threat to the Internet Commons”, Yochai Benkler, September 15, 2011
“Precursors to Bitcoin legislation emerge”, Blogdial, September 2, 2011
“On the virtual money?”, Charis Palmer, Banking Review, August 7, 2011
“Bitcoins are Baseball Cards”, Blogdial, August 3, 2011
“Bitcoin: A Bit Too Far?”, Edwin Jacobs, Journal of Internet Banking and Commerce, August 2011
“Innovation and Legal Panic — Bitcoin”, Joseph Skocilich, June 27, 2011
“Is Bitcoin Legal?”, TechnoLlama, June 16, 2011
“Bitcoin exchanges offer anti- money-laundering aid”, Reuters, June 15, 2011
“The Coming Attack On Bitcoin And How To Survive It”, Anthony Freeman, June 7, 2011
“Money Transmitter Legislation and Bitcoin’s Legal Status”, Bitcoin Money, June 2, 2011