The Emergence of Bitcoin

By Helen Narvasa and Heather Morton | Vol . 22, No. 29 / August 2014

NCSL NewsDid you know?

  • Bitcoin is a form of digital currency—the most popular of more than 330 options available on the online market as of June 2014.
  • Political campaigns may accept small Bitcoin contributions.
  • Overstock.com, DISH Network, Expedia, 1-800-Flowers,TigerDirect, Newegg, Sacramento Kings and Zynga accept Bitcoin payments.

Of the more than 330 payment options available for Internet transactions, Bitcoin now is the most popular of available cryptocurrencies. Major online retailers Overstock.com, DISH Network, Expedia, 1-800-Flowers, TigerDirect, Newegg, Sacramento Kings and Zynga currently accept Bitcoin payments. Among issues regarding Bitcoin transactions are the facts that they are irreversible and are not insured by any entity. They also are vulnerable to loss (e.g., hard drive crashes) and to theft by hackers. State and federal officials are questioning Bitcoin taxability and regulation.

Launched in 2009 by anonymous creator(s), commonly referred to as “Satoshi Nakamoto,” Bitcoin has come under increasing scrutiny. In 2013, demand in China helped push a Bitcoin’s value to more than $1,000 (from $13 at the beginning of that year), highlighting its high-risk volatility. In October 2013, the Federal Bureau of Investigation (FBI) shut down Silk Road, an online black market for illegal drugs, guns and pornography, and seized 144,000 Bitcoins, the largest cryptocurrency seizure to date. In February 2014, Mt. Gox, the largest online Bitcoin exchange, declared bankruptcy after 650,000 Bitcoins went missing, presumably stolen by hackers.

How Does Cryptocurrency Work? The lack of a physical token to count and hold may confuse some. Rather, Bitcoin is a form of digital currency used in electronic payment transactions—no coins, paper money or banks are involved; there are zero to minimal transaction fees; transactions are fast and not bound by geography; and, similar to using cash, transactions are anonymous.

Bitcoins are stored in digital wallets, which are software or apps installed by Bitcoin users on their computer or mobile device. Each Bitcoin digital wallet contains encrypted information, called public and private keys, that is used to send and receive Bitcoins. All Bitcoin transactions are recorded in a virtual public ledger called the “block chain,” which is maintained by Bitcoin “miners.” These miners can be anyone, anywhere in the world, who is willing to invest in the specialized computer hardware needed to rapidly process complex computations. Miners are awarded Bitcoins in exchange for verifying each transaction and adding it to the block chain.

Decentralized Bitcoin mining uses increasingly powerful computers connected to each other via the Internet. Designed with a 21 million Bitcoin limit projected to be reached by 2140, miners solve progressively complex mathematical calculations as more Bitcoins are used. The limited supply of Bitcoins protects it from devaluation.

Federal Action

At the request of the U.S. Senate Finance Committee, the U.S. Government Accountability Office (GAO) issued a May 2013 report on the taxability of virtual currency transactions and urged the Internal Revenue Service (IRS) to issue guidance. In November 2013, the U.S. Senate Banking, Housing and Urban Affairs Committee held a hearing on The Present and Future Impact of Virtual Currency to further examine risks, benefits and possible industry regulation.

On March 25, 2014, the IRS issued a ruling that virtual currencies would be taxed as property and subject to capital gains tax. Further guidance issued by the Federal Election Commission on May 8, 2014, stated that political committees, including political campaigns, may accept small Bitcoin donations (valued at $100 or less) and may buy and sell Bitcoins as an investment. The U.S. Consumer Financial Protection Bureau (CFPB) also plans to focus more attention on virtual currencies at the recommendation of another GAO report.

State Action

In February 2014, the Conference of State Bank Supervisors, a national organization for state banking regulators, formed the Emerging Payments Task Force to study innovations in payment systems, including virtual currencies. The task force issued virtual currency guidelines to help state regulatory agencies disseminate consumer advisories and also held a public hearing that included overviews of current virtual currency regulations.

In April 2014, the Texas Department of Banking issued a supervisory memorandum to clarify the regulatory treatment of virtual currencies under the Texas Money Services Act. Following IRS guidance, the department determined that cyrptocurrencies do not fit statutory definitions of currency or money, but ruled that some cryptocurrency transactions would qualify as money transmissions and would be subject to the statutory provisions under the Texas Money Services Act. For example, a third-party exchanger—an intermediary similar to the failed Mt. Gox—that exchanges virtual currency for actual currency would meet the definition of money transmission. In addition, exchanging virtual currency for actual currency through an automated machine, or Bitcoin ATM, could qualify as money transmission, depending on whether the machine is configured to involve a third-party exchanger.

Two states have bills that affect virtual currencies such as Bitcoin and others. The first, California A.B. 129, repeals an existing state statutory prohibition on issuing or placing into circulation as money anything other than lawful U.S. currency. Enacted in June 2014, the law ensures that businesses and consumers who use alternative currencies, including Bitcoin, do not violate state law. The second, Illinois H.B. 5886, would provide that virtual currency does not have legal tender status. The bill would define “virtual currency” as a medium of exchange that operates like currency in some environments, but that lacks all attributes of actual currency.

PDF Version