Bitcoin basics

June 2017  |  EXPERT BRIEFING  |  BANKING & FINANCE

financierworldwide.com

 

There are many different digital currencies, also known as crypto-currencies, with names like Bitcoin, Ethereum, Darkcoin, Litecoin, Primecoin and Dogecoin. This article discusses only bitcoin, which is the most mainstream and widely recognised virtual currency. Bitcoin is accepted at big retailers like Amazon, Target, Sears and other companies such as the Chicago Sun Times and Virgin Airlines, as well as many smaller companies. Because of the ‘pseudonymous’ – almost anonymous – online nature of bitcoin and the fact that it has been exempt from most regulation since its inception in 2009, it is also used to make online purchases of drugs, stolen goods and other criminal enterprises.

Bitcoin is a virtual currency, basically digital money. Bitcoin is also the network where the virtual currency is exchanged in a decentralised, peer-to-peer payment network that operates without the aid or cost of a third party, such as a bank or credit card company, to hold and transfer virtual currency. These transactions occur without the oversight of regulatory bodies or basic fraud protections, in most cases.

You are probably already using something similar to ‘virtual currency’ every day, but you may not think of it as such. If you have a bank account, the bank does not keep an actual box of cash with your name on it in their vault; instead, your money is stored on the bank’s computers as little 1’s and 0’s of computer code. When you wire money, or use your debit or credit card to pay for something, nobody sends currency from one party to another, but transfers virtual money instead.

As long as the bank is solvent, you can go to a branch and withdraw your money, and when you do, they’ll subtract the value from your account and give you cash. This works because we all agree that the little 1’s and 0’s in the bank’s computers are worth real cash, and can be redeemed for real currency anytime. It is a bit of an oversimplification, but if you think of bitcoin as similar to that ‘virtual currency’ that transmits via electronic wire transfer, then it will help make sense of the theory behind bitcoin as a decentralised digital currency.

Bitcoin is different than the money in your bank account, in that bitcoins are really in the virtual world, and they stay there, unless you specifically pay a vendor to exchange them for a government bank currency. Bitcoin works because users on the network all agree that it has value, even in its virtual state, and other users agree to accept it in exchange for something of value.

Bitcoin is extremely volatile, and acts something like a stock, in that the value changes in accordance with the market. People invest in bitcoin, betting that the value will go up over time; however, nothing guarantees it will have any future value at all. The US District Court of the Eastern District of Texas held in August 2013 that investments in bitcoin or investments purchased with bitcoins are securities (SEC v. Shavers, No. 4:13-CV-416). Other courts have issued rulings contradicting that case. The governments of many countries are unsure how to handle bitcoin.

Bitcoins have been worth as little as $10, in November 2012, to over $1200 a year later. But as of the time of writing, one bitcoin is worth $1,198.92, an increase of over $900 over the same period last year. The volatility of bitcoin is one of the things that make it unique as a currency. The price of bitcoin increased dramatically after the recent US election, from an average of $250 to its current price, amid concerns about the stability of government backed currency worldwide.

Users acquire bitcoins by purchasing them at a bitcoin exchange, exchanging them online or in person, or by accepting them as payment for goods or services. You can see who buys or sells bitcoins in your area online, but obviously, there are inherent risks in meeting personally with strangers to conduct financial transactions. In fact, ‘bitcoin robbery’ is becoming very common, particularly in large metropolitan areas. Typically, people meet on a bitcoin networking site and agree to meet to exchange currency for bitcoins. Sometimes, instead of making an exchange, one person forces the other to transfer their bitcoin and, typically, makes off with any cash as well. Once transferred, even when stolen, bitcoins are gone forever, just like lost or stolen cash.

Bitcoins can also be obtained by ‘mining’ them. Bitcoin miners use computers to competitively solve special math problems, and the first computer to solve a particular problem is issued bitcoins in exchange for this work. The bitcoin network is using this computer power to securely function as these problems are being solved, so the bitcoin is paid as reward for miners doing this work. As bitcoin’s value changes and more bitcoins are issued, the computer problems get harder to solve. It is believed that this function was ostensibly designed to take the place of government oversight to stabilise monetary value, as well as to ensure that the supply of bitcoins never runs out. However, it is predicted that bitcoins will all be mined by 2140, and it remains to be seen what will happen to bitcoin at that point.

Bitcoins are stored in a ‘virtual wallet’, and one user can send coins to another user by using their ‘public key’, much like anyone who has your bank account number can deposit money into your account using the night deposit drop at your bank. Unlike credit card charges, which can be reversed, or checks which can be stopped by the bank, an exchange of bitcoins is irreversible. Users can also transfer bitcoins using a programme on their smart phone with QR codes, and transfer value with a single click. Users tend to print their virtual wallets as a backup, or have them stored on their computer, which then makes them vulnerable to theft.

Bitcoin transactions are completely open to public inspection, with every transaction visible on the ‘Blockchain’, a permanent public ledger that anyone with internet access can freely download and review. Even though bitcoin is completely open to public view, it is also somewhat anonymous; more accurately, it is pseudonymous. Bitcoin users have a pseudonym linked to their public wallet, rather than a real name, and so as long as their real name is never linked to their pseudonym, they are truly anonymous. However, keeping that pseudonym separated from one’s real identity is extremely difficult, and once the linkage is made between real identity and the public key, everything is open to public view.

Government and regulatory agencies have struggled to define and deal with bitcoin and fit it into regulations designed to deal with fiat currency. For some time, bitcoin was completely unregulated, but recently the US Financial Crimes Enforcement Network (FinCEN) has ruled that while Bitcoin users are not subject to regulation generally, businesses that exchange and convert bitcoins to real currency, as well as some ‘virtual wallet’ providers, are considered a money service business (MSB) under the Bank Secrecy Act and must follow a host of anti-money laundering (AML) regulations, including the filing of currency transaction reports (CTRs). Some countries have attempted to outlaw bitcoin, but with limited success. The virtual nature of bitcoin makes it more difficult to control and regulate, however bitcoin has a market capitalisation of over $17bn and is unlikely to simply ‘go away’, as many government regulators have hoped.  

Many merchants who accept bitcoin choose to avoid the volatility of bitcoin by accepting it and immediately exchanging the accepted bitcoin into fiat currency, similar to credit card services. Bitcoin service providers do this for a fee of about 1 percent, which is generally less than credit card merchant fees.

Ultimately, bitcoin is very similar to cash, and yet lives only in the virtual world. Bitcoin is no more or less of a mystery than what happens to your money when the bank stores monetary value as computer code. Businesses accepting bitcoin avoid the hassle of dealing with exchange rates for difference currencies and pay lower fees than for credit cards. Bitcoin’s value has been rising in response to uncertain world conditions, and it will be interesting to see the value of bitcoin change in the future.

 

Beth A. Mohr is a managing partner at McHard Accounting Consulting LLC. She can be contacted on +1 (505) 554 2968 or by email: bmohr@themchardfirm.com.

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BY

Beth A. Mohr

McHard Accounting Consulting LLC


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