Bitcoin: What it is and the legal concerns it inspires.

General

All currencies require some sort of foundation that serves as a backing for the currency. In the United States it used to be silver and/or gold, now it is simply trust in the “credit”[i] of the United States government that offers security in investing in the U.S. Dollar. Enter Bitcoin, which is an electronic currency that was created to operate without a central authority and which creates value in itself by using “cryptographic proof [of transactions] instead of trust” in third parties such as a government or financial institution.[ii] Bitcoin achieves this proof by using software of the same name[iii] that creates a de-centralized network of computers which tracks the chronological history of every individual bitcoin and requires confirmation from each computer in the network of the veracity of that history in order to approve that bitcoin’s next transaction.[iv] This creates a unique framework of transparency, security, and legitimacy that offers the currency a reason to be trusted and thus valued.[v]

Technical

It is helpful to have a distilled picture of the complicated process that makes up the Bitcoin network in order to understand the promises it offers and the problems associated with it.[vi] Bitcoin relies on public/private-key cryptography, a peer-to-peer network, and proof-of-work to process and verify payments.

When a bitcoin is sent to another party it is transferred from one cyber address in the Bitcoin network to another. This transaction is broadcast to the entire network and each node in that network logs and begins to verify the transaction. The unique attribute is that each bitcoin holds a record of its transactional history and the network must verify this history. Thus a bitcoin cannot be spent twice by the same owner for the network will not approve the second attempt.

The cryptography that protects an individual’s bitcoin “wallet”[vii] is vital to the security of the network. There are two keys associated with the wallet – a private and public one. The public one is associated with receiving any transaction and is public knowledge, while the private key is used to sign and send money. For example, if Jane wants to send a bitcoin to Moe then Moe must give Jane his public key and then Jane attaches Moe’s public key to the bitcoin and signs the transaction with her private key and public key. The private key cannot be deduced in the transaction and thus the transaction is only tied to the two public keys.

The Bitcoin network also regulates the amount of bitcoins in existence with a max amount of bitcoins of around 21 million expected to be created by around the year 2033[viii]. The software achieves this regulation though the process of “mining” bitcoins.[ix] This is the process by which nodes in the Bitcoin network add and verify transactional data to the public ledger. The process was designed to be highly resource-intensive (GPU and electrical requirements) and was inspired by the mining of other commodities such as gold. Thus when a node successfully completes the extremely difficult mathematical problem to solve a transactional history a certain amount of bitcoins are created. With each new transaction these problems get harder to solve and thus bitcoins are harder to create. This makes the creation of new bitcoins relatively stable and with inflation control inherently built in.

Bitcoins can be used to purchase goods and services virtually or even physically, but they can also be traded in for a fiat currency such as the U.S. dollar. It is this aspect of Bitcoin that the first and only third party is required for the system. There has to be a third party involved to translate and exchange the digital-to-physical transaction of the currencies.[x]

Finally, the process of using bitcoins creates a relatively anonymous transaction.[xi] Each bitcoin is tied to the public keys it has been associated with and those keys are not attached to any individual person. Furthermore, users can have any number of addresses and thus could use a different one for each transaction. Since the network only cares about the chronological record of a bitcoin’s transactional history there is no reason to tie the bitcoin to any individual person. As you will see, it is this aspect of the Bitcoin network that seems to constitute the greatest concern.

The Promise of Bitcoin

Bitcoin promises a global currency that is not beholden to the “inherent weaknesses of the trust based model” of relying on governments or third parties to safeguard monetary transactions.[xii] It is a fiercely democratic tool to transfer monetary power from concentrated authorities directly into the hands of the people. Furthermore, it has inherent inflation resistance built into its framework and a relative amount of privacy from intrusion by third parties. Thus, Bitcoin furthers democracy by protecting itself from politically motivated micro and macro economic policies, censorship, and by creating what can only be called a truly objective currency.

The Problems of Bitcoin

However true and grand these promises may be, Bitcoin is destined for legal battles that will threaten its survival. One author aptly described Bitcoin’s problem: “Any technical development that grew out of a distrust of regulation and central control ironically places itself in line for regulation and central control.”[xiii]

First, it is safe to assume that government’s rarely like to give up control. Thus, it is likely, simply from this assumption, that Bitcoin will be seen as a threat to governments and that they will seek to claim as much control as they can, even to the degree of making it illegal. With that being said there are more specific issues that are garnering legitimate attention by scholars, corporations and governments alike.

The anonymity of Bitcoin transactions creates immediate issues of money laundering and funding of illegal activities[xiv], such as terrorist organizations.[xv] The FBI has Bitcoin on their radar and an leaked, unclassified document expressed the “distinct challenges [in] deterring [such] illicit activity.”[xvi] The FBI currently assesses these activities with “low confidence” because they lack “current reporting specific to Bitcoin” and are simply basing the query on what is happening in other electronic currencies, such as web-money[xvii] and their understanding of human nature in general.

Senator Charles Schumer has expressed outrage at the hubris of a website found in the similarly anonymous and de-centralized TOR network[xviii], called the Silk Road, and has asked federal authorities to shut it down.[xix] The Silk Road is a forum where drugs are freely offered up for purchase with bitcoins. The fact that bitcoin transactions are merely the swapping of data between two electronic addresses removes any potential oversight of the transactions by banks or regulatory bodies. Basically, the transaction is analogous to a real world transaction of cash between two individuals in the privacy of a home while wearing masks; they are virtually untraceable. Because the bitcoin transaction happens virtually, it is easier to sell and obtain such illegal items and to avoid the dangers of searching them out in the real world, thus, as the argument goes, encouraging greater consumption of illegal drugs.

Another concern is with the theft of bitcoins. Assuming that bitcoins are considered a legal currency, there is a concern of criminal activity stealing or creating bitcoins fraudulently. Such instances have already taken place. In 2011 malware software surreptitiously installed on various computers was blamed for stealing $300,000 bitcoins.[xx] Because Bitcoin is electronic it is susceptible to electronic attacks. In the original paper that outlined the Bitcoin system, the author Satoshi Nakamoto noted, “The system is secure as long as honest nodes collectively control more CPU power than any cooperating group of attacker nodes.”[xxi] However, Bitcoin was created with these exploits in mind and was structured to make them very hard to execute.[xxii]

Finally, the government does have the ability to apply regulations and police the use of bitcoins as they are converted to physical money. In 2011 the Financial Crimes Enforcement Network (FinCen) “redefined the definition of ‘money transmission service’ to mean ‘the acceptance of currency, funds, or other value that substitutes for currency from one person and the transmission of currency, funds or other value to another location or person by any means.’”[xxiii] This new definition seems to include any transaction on the Bitcoin network. However, the de-centralized aspect of Bitcoin makes it nearly, if not entirely, impossible to regulate. So the government will probably focus their energy on regulating third party bitcoin exchange companies as well as businesses that except bitcoin as payments.  

Conclusions

The concerns of Bitcoin do not strike me as substantially different from concerns of existing money. Money can currently be laundered through sales of art work and other methods. Terrorist organizations are funded through cash donations and other financial loopholes. White collar crimes existed before the internet and will continue. The development of a currency designed to keep up with technology and to disperse control across de-centralized network is too important for the future of our global reality. Like it or not, the world is homogenizing and a global currency is often a subject of economic scholarship. Bitcoin could be the answer as it does not discriminate against any nation, person, or ideal; it is an objective, democratic, technologically advanced currency ready to usher in a new world order. Ok, maybe I am extrapolating a little too much. In the end, it seems Bitcoin will have to weather some serious interests by powerful legal entities as well as continue building a base of clientele that actually uses and accepts the currency. Only time will tell if Bitcoin is strong enough to survive and adapt to what the future holds.


[i] U.S. Const. art. I, § 8, cl. 2

[ii] Satoshi Nakamoto, Bitcoin: A Peer-to-Peer Electronic Cash System, at http://bitcoin.org/bitcoin.pdf (last visited Sept. 30, 2012).

[iii] “Generally accepted practice is to use Bitcoin (singular, with upper case letter b) to describe the protocol, network, and software, and bitcoin(s) (singular or plural, with lower case letter b) to describe actual bitcoins, as generated by computers.”  https://en.bitcoin.it/wiki/Introduction (last visited Sept. 30, 2012).

[iv] Id.

[v] Bitcoin Virtual Currency: Unique Features Present Distinct Challenges for Deterring Illicit Activity, April 24, 2012, Unclassified FBI Intelligence Assessment p. 4, found at http://www.wired.com/images_blogs/threatlevel/2012/05/Bitcoin-FBI.pdf (last visited Sept. 30, 2012).

[vi] I must disclaim here that my understanding of the technical aspects of Bitcoin is couched in, at best, an amateurish understanding of computer technology in general. I have tried to relay the technical aspects of Bitcoin to the best of my understanding, but I am the first to say I do not fully appreciate how “mining”, “blocks”, “proof of work”, or cryptography specifically functions.

[vii] A “wallet” is the file on your hard drive where your bitcoin “money” is stored.

[viii] http://bitcoin.org/about.html (last visited Sept. 30, 2012).

[ix] https://en.bitcoin.it/wiki/Mining (last visited Sept. 30, 2012).

[x] Bitcoin Virtual Currency: Unique Features Present Distinct Challenges for Deterring Illicit Activity, April 24, 2012, Unclassified FBI Intelligence Assesment p. 8, found at http://www.wired.com/images_blogs/threatlevel/2012/05/Bitcoin-FBI.pdf (last visited Sept. 30, 2012).

[xi] Id.

[xii] Satoshi Nakamoto, Bitcoin: A Peer-to-Peer Electronic Cash System, at http://bitcoin.org/bitcoin.pdf (last visited Sept. 30, 2012).

[xiii] Zack Bastian, Bitcoins and Prepaid Access Rules: Headed for a Collision (Feb. 29, 2012), http://lawofthegame.blogspot.com/2012/02/bitcoins-and-prepaid-access-rules.html (last visited Sept. 30, 2012).

[xiv] Associate Press and NBC New York, Schumer Pushes to Shut Down Online Drug Marketplace (June 5, 2011), http://www.nbcnewyork.com/news/local/123187958.html (last visited Sept. 30, 2012).

[xv] John Solomon, Trends in Terror Finance, Part 2: The unregulated Sector, http://www.c-cft.org/publication/pdf/TrendsinTerrorFinancePart2.pdf (last visited Sept. 30, 2012).

[xvi] Bitcoin Virtual Currency: Unique Features Present Distinct Challenges for Deterring Illicit Activity, April 24, 2012, Unclassified FBI Intelligence Assessment, found at http://www.wired.com/images_blogs/threatlevel/2012/05/Bitcoin-FBI.pdf (last visited Sept. 30, 2012).

[xvii] Id. at 2.

[xviii] “Tor is free software and an open network that helps you defend against a form of network surveillance that threatens personal freedom and privacy, confidential business activities and relationships, and state security known as traffic analysis”. https://www.torproject.org/ (last visited Sept. 30, 2012).

[xix] Associated Press and NBC New York, Schumer Pushes to Shut Down Online Drug Marketplace (June 5, 2011),  http://www.nbcnewyork.com/news/local/123187958.html (last visited Sept. 30, 2012).

[xx] Peter Cohan, Are Bitcoins Worth Their Weight in Gold? (June 20, 2011), http://www.forbes.com/sites/petercohan/2011/06/20/are-bitcoins-worth-their-weight-in-gold/ (last visited Sept. 30, 2012).

[xxi] Satoshi Nakamoto, Bitcoin: A Peer-to-Peer Electronic Cash System, at http://bitcoin.org/bitcoin.pdf (last visited Sept. 30, 2012).

[xxiii] Bitcoin Virtual Currency: Unique Features Present Distinct Challenges for Deterring Illicit Activity, April 24, 2012, Unclassified FBI Intelligence Assessment p. 8, found at http://www.wired.com/images_blogs/threatlevel/2012/05/Bitcoin-FBI.pdf (last visited Sept. 30, 2012).

~ by Movementry, LLC on October 2, 2012.

7 Responses to “Bitcoin: What it is and the legal concerns it inspires.”

  1. The most problematic feature of bitcoin, in my opinion, is the anonymity of its transaction. Like this post stated, bitcoin has the potential to illicit illegal activity without much prospect of identifying those behind the illegal activity. I agree that regular currency also has this problem and there have always been issues over money laundering and the funding of terrorist groups. However, one should consider the context in which bitcoin is being used. Unlike physical currency, bitcoin is traded completely online, which, like the post states, can make it easier to engage in illegal activity. Moreover, bitcoin is operating in an environment that no government, or any entity, has control over. As we’ve discussed in class on numerous occasions, our government and many other governments are slow to adapt to changes in technology and they are already having difficulty maintaining any control over online activity. Yes, this might create a fully objective and democratic currency system, but are the people of this world ready to handle that kind of government-free system? I’m curious to know what implications this could cause on the global economy and on physical currency in general (if bitcoin becomes more widely used).

  2. > “are the people of this world ready to handle that kind of government-free system? ”

    We’re about to find out. : )

    There are more nodes going the network every day:

    http://blockchain.info/nodes-globe

  3. I was curious about what constituted the “work” that the Bitcoin network is doing to create the Blocks that equate to the generation of actual Bitcoin currency. I wondered if the network was calculating a difficult mathematical problem to some purpose, like finding the next prime number, for example. Interestingly, the computational work is basically a “make-work” transaction: Each mining node collects the transaction history that has not yet been committed to a block, then looks for a random value that can be appended. For each random value it tries, it computes a Hash of the random value and the transactions and checks it to see if certain bytes in the hash equal a pre-determined value (in this case, a string of zeroes in the top of the hash). Each random value has to be tried separately and the hash computed, a process which takes a small amount of computer processing time; there is no way to know in advance which value will create the hash that is desired. All the other miners on the network are competing to find the solution to the next block.

    Once a miner has found a solution to the block which meets the criteria, it is published to the network and checked by the other nodes (an easy process to do in reverse, mathematically). Once verified, the finder gets 50 bitcoins and that becomes the opening transaction of the next block. A website out there keeps track of the progress: http://blockexplorer.com/.

    The idea, as James mentioned, is that the resource constraints of finding the next block (electricity and CPU/GPU power) act as a sort of inflation control on the creation of Bitcoins and tie the value to a real commodity, just as currencies were once based on the gold standard. Take a look at one person’s mining rig! (http://www.youtube.com/watch?v=eLt8Se3vVNg&feature=related)

  4. So let me get this straight Bitcoins are created by users. Essentially users are paid for their computing power to create the currency. If this is true and a central entity is not paying into the pool each time a coin is mined then the total value should be depleted to almost nothing. I don’t really have enough of a grasp to understand this but it sounds like the value of the currency is being kept artificially high. Furthermore, since bitcoins are not pegged against anything other than merchandise there is no way to determine their true value. This seems like a pyramid scam to me. Initial adopters stand to gain profits based off later investor’s real money investments while the original creator stands to make the most.

  5. Like Ryan, I can barely understand how Bitcoin is able to exist. Gold and silver, America’s old backing system, makes sense to me. I can see the gold, wear the gold, sell the gold. It took me long enough to figure out what the purpose of buying stock in a company was. But I still don’t think I understand why anyone would purchase Bitcoin, other than someone who was trying to anonymously trade money with someone. From this article, it seems like one of Bitcoin’s strongest benefits is its security and protection. But whatever security was used to protect the system was hacked by someone smarter than them. I am wary enough of hackers stealing my information online, but to purposely put more money onto the internet would make me feel too vulnerable. People are only getting better at hacking, and I would prefer not to be their next victim.

  6. What happens if the bitcoin limit is reached by a hacker who creates a program or bot network to continuously create fraudulent transactions? I could imagine a hacker would overwhelm and shut down future production of bitcoins. Unlike modern fiat currency where the US is not likely going to think “we’re at our limit- stop printing new bills forever.” I don’t think I saw anything in the white paper indicating Bitcoin is prepared to deal with that type of attack.

    In comparison, the maximum amount of gold a WOW avatar can have has gone from 248,000 to practically infinite. http://www.thegoldqueen.com/blog-news/world-warcraft-gold-cap-lifted/. The maximum amount of WOW gold in the universe is whatever amount Blizzard decides. I haven’t heard anything about a Diablo 3 gold cap. The nature of Blizzard’s virtual gold insulates it against an attack to reach an arbitrary limit.

  7. I agree with Amy’s post, my first thought when reading about the Bitcoin exchange process was that the anonymity feature could lead to foul play. Anonymity on the internet has already proven to be an impetus for illegal activity. Crimes of all sorts are committed via the internet because people think that they can hide their true identities and get away with it. Luckily, in many situations, law enforcement has kept up with current technology and has been able to trace crimes back to the “anonymous” perpetrators. With a virtual currency like Bitcoin, however, it seems that law enforcement is going to run into significant trouble with tracing crimes back to the source. Given that security is an utmost concern of the users and providers of Bitcoin and given that virtual currency can change hands so quickly, it seems that extra hurdles have been added when it comes to tracing illegal activity. There may have to be some exception made to the anonymity requirement solely to keep users honest.

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