Bitcoin is a commodity based on the exchange of a tokenised security issued as a payment to the “miners” or nodes in the system for a right to have an “immutable” entry saved to the ledger. The miners or nodes are paid in multiples of the base unit of Bitcoin that is known as a “satoshi”. This unit is a small indivisible value that is worth a small fraction of a cent on today’s markets.

The commodity used by Bitcoin is based on the right to have an entry written into the ledger for an amount of exchanged tokens that are mutually swapped from the user to the miner. The miners run the nodes that validate these entries and ensure that these are valid and cannot be replayed or “double-spent”. Hence, the miners who run nodes accept fees in exchange for the provision of a service.

This is in effect an arrangement under contract. The users of the system make an offer to all miners. The miners accept this offer by including the transaction into a block. Mining is a competitive industry. Any miner can choose to accept or reject a transaction knowing that another miner could take the payment in a transaction. As more transactions are included, the cost of processing a block increases. This leads to a natural block-size equilibrium based on the utility and external use value in the blockchain.

The exchange of trade in “writing” an entry into the Bitcoin ledger is based on the payment of a mining reward that is formed using an integer value of tokens. There is only a whole number exchange in tokens. There are no fractional satoshi. 100,000,000 or 10⁸ satoshi are represented using the nominal designation of 1 bitcoin. The system does not allow the exchange of 0.1 satoshi for instance.

Mining as a contract

Contractual negotiations are the result of a series of communications that create a legally binding agreement[1]. Miners can risk creating larger and more complex blocks than a “consensus” of miners will agree to process, but suffer the risk of being orphaned. When this occurs, some transactions will be included by all miners, and some may be left to expire as the miners do not see value in the transaction fee when compared to the size or complexity of the transaction.

Orphaning occurs when the majority of miners build on a separate fork. In this scenario, two miners solve a block at around the same time, or one miner or group does not agree with the format selected by another. If the transaction is included by one miner in a block and excluded in another, it will have further opportunities to be included into a later block or to expire if no miner is willing to incorporate the transaction into a block for the attached fee.

A Bitcoin transaction never truly expires. If a transaction is processed by miners and is not accepted into a block (such as for the reason that the block reward is too low), it can be sent over and over, until it is accepted or the transaction is replaced with one that is accepted. Most miners will drop a transaction from memory after 72 hours. This does not stop the user from re-sending the transaction and seeking to try and have it accepted again. This could lead to a scenario where low-fee and less important transactions are included into blocks in “off” periods, when the volume of transactions are low, and the exclusion in peak or high-use times.

As long as a transaction has not been included into a block, it remains feasible for a user of the system to create two transactions that are mutually exclusive. If this is done in order to defraud a merchant, the act will be a form of larceny. Generally, what will happen is that a transaction that incorporates the minimum fee required by the consensus of miners will be accepted and processed into the next block. If a conflicting transaction is seen in this time it will be rejected. As such, a transaction will only be replaceable when it expires. This can occur, if most nodes (miners) do not accept the transaction (the fees are too low), or it is not considered valid for some other reason by the consensus of miner nodes.

Where a merchant processes a transaction that has a miner fee under the minimum “safe” level, they are effectively assuming a risk of a double spend. When a set of miners have agreed on a consensus minimum transaction fee, the inaction of miners to orphan an intentional double spend, isolating the “dishonest” miner that has aided in the commission of a larceny or other fraud and theft, should result in actions in negligence.

In the use of a double spend to defraud a merchant where the standard minimum fee has been included in a transaction, inaction from miners is risky. The most effective enforcement framework involves enforcement from the least-cost provider as proposed by Mann & Belzley[2]. There are various kinds of services connected with Bitcoin mining, and the liability of the miner as a service provider may depend on what form of transaction verification is being provided. At one extreme, a simple validation of a transaction would mirror the liability framework of long-distance telecommunications providers, at the other there are Internet publishers when it comes to the proposed incorporation of OP_Codes that are specifically designed to facilitate illegal activity.

In many cases, liability will depend upon how a court faced with a case of first impression analogises a particular miner when applied against more conventional categories of information providers. For example, should the miner as a service provider be viewed as the equivalent of the telephone company, purely a conduit for information? This might be the right analogy for the telecommunications-link provider, but clearly does not fit the publisher. On the other hand, if the miner is viewed as analogous to a publisher of a printed publication, there is a much greater exposure to liability[3].

The consensus agreement deployed is such that miners could be deemed to comprise a common-law partnership. The failure of one miner to intercept and reject the actions of another miner would in this model be analogous to the partners of a firm failing to take action to restrain the negligent or illegal acts of a rogue partner.

In some scenarios, the provider of a host computer for the validation of transactions could be compared to a printer or perhaps a distributor of printed publications. It could also be argued that a Usenet group or bulletin board is analogous to a library, so that the provider should be treated as the librarian. Where it is clear that a transaction is specified for a known illegal purpose or where the transaction is clearly being used for a fraudulent double spend, the miners are open to liability for not taking action.

When a transaction has been sent, and a later one that replaces the output comes from a limited set of miners, the ability to determine a fraudulent double spend is simple. The miner who accepts and processes such a transaction would be aiding the commission of a means to defraud others. Miners would need to be vigilant against the actions of such miners or they could be held liable to the loss of the merchant or another recipient.

The miner could choose to act in a multitude of ways to mitigate this liability. The simplest would be to orphan blocks that contain the double-spent transaction. Alternatively, the miner could refund the losses sustained by the merchant as a recompense for their negligence. Either path is a viable method, but the recompense of other miners for a fraudulent transaction would lower trust in the system and allow for more invalid transactions to occur.

There are in effect three primary classifications and ways of distinguishing Bitcoin businesses and validators. It is likely that any bitcoin-based transaction will follow through a path of user wallet, backbone providers such as miners, and propagation networks, and arrive at a merchant wallet or PoS (point of Sale) system where both the user wallet and merchant wallets are effectively endpoints. Backbone providers include the class of telecommunication carriers who deal solely with the transmission and routing of transactions across the Bitcoin provider networks and the miners who validate and aggregate transactions into a block. For purposes of liability in the original Bitcoin protocol, backbone providers offer little more than a conduit for contractual loss from other providers that they deal with. Backbone providers are unlikely to have the capabilities or capacity that will allow them to distinguish between data, traffic, or protocol content making the ability to filter illicit activity next to impossible at this level[4]. Source and destination wallet providers are in effect similar in many ways. In particular, any endpoint merchant wallets will at some stage act as either and both source or destination transaction providers.

The alteration of the Bitcoin protocol to incorporate additional code designed with the predominant purpose of simplifying the provisioning of illegal activities would create a direct liability to the miners as validators. The common-law partnership of mining entities opens liability for the actions of any one miner in allowing such a transaction to apply equally to all. As a common-law partnership, a negligence suit for example could be conducted against any miner who continues to mine a fork of a blockchain that incorporates a transaction using a system that is designed to facilitate an illegal activity. In the case of OP_DATASIGVERIFY, the use is clearly designated for the provision of bucket shops and a Silk-Road-version-2.0 drug market.

This easily determined use case differs from a more generalised exchange of money or contracts. In the validation of an exchange on a ledger, the miner cannot determine the use and thus cannot be expected to “rule” on the validity of a transaction. In a manner analogous to a common carrier, the miner of a simple transaction using the original Bitcoin scripting language simply processes the sale of ledger space with no liability for the use of the ledger. The alternative incorporation of easily determinable use that is illegal in nearly every country would open the miner to liability. Not through their own actions, but in aiding and facilitating as a common-law partner in the overall mining system.

Contractual liability

Any end-user transaction exchange in Bitcoin can be served by a destination wallet directly using a P2P exchange where a template is swapped and signed or sent to a known (even offline) address by sending directly to a node. A source wallet is the system that supplies access to the keys and systems where the initiation of an exchange (both lawful and illicit) is presented or created[5]. There are two significant differences involving the source wallet and the destination wallet when viewed under a regulatory framework. Firstly, the destination wallet serving ordinary end users is most unlikely to have any direct association with or precise information concerning the primary malfeasor, unless the wallet is involved with illegal activity (such as the Silk Road wallets), in which case it provides law enforcement with a source of all illegal transactions that can be traced. Any logs or materials that may be maintained are unlikely to hold the level of detail necessary to prove malfeasance from a merchant wallet that has recieved bitcoin that may have come from a “tainted” source. A source wallet conversely is likely to maintain logs and track access to the content that it maintains. It is necessary to weigh any process of assessing how “fair” it would be to “hold responsible” the merchant wallet for the misconduct of its clients or other parties and also in determining how successfully a wallet-service provider could serve as a regulator in controlling misconduct against a variety of factors. In many cases, the merchant wallet may be located in a jurisdiction without reciprocal regulations, thus preventing prosecution. Next, the merchant wallet may itself be a victim of illicit activity.

In the instance that a merchant wallet supplies both the host that contains content and also the access to that material, it is likely to be able to more effectively monitor and control the activity of its users than a provider would that provides only access to the material. A user wallet cannot readily remove itself from the authority of the regulatory regime in whose jurisdiction the users are situated. To do so would result in also removing its ability to serve those end-users. A merchant wallet and the content it hosts, if desiring to make possible prohibited conduct, can move itself to an alternate jurisdiction that does not disallow the illicit conduct. For instance, a merchant wallet that wishes to implement access to Internet gambling can locate itself in a jurisdiction where these activities[6] are legal and thus legitimised. This in effect places these organisations beyond the jurisdiction and capability of the majority international legal edicts and the related enforcement capabilities[7]. The user wallet and system, though, are not beyond this reach. A user wallet that is accessed and/or located in London with local clients that allows its clients to connect after exchanging payment to a child pornography site in Nigeria links to the user in London and can be used to trace this activity. The miner is unable to determine this level of transaction use, whereas a wallet provider and others could limit such access, as can intermediary ISPs who provide the conduit.

A wallet supplies an end user with the data that they have requested from the blockchain. As the administrators of systems that link disparate networks and the Bitcoin backbone, and encapsulate application data into an arrangement that may be broadcast along the backbone, miners are capable of averting selected attacks through the blocking of attempts to censor sites, hosts, or even selected data available on standard Bitcoin transaction templates. Miners can also aid in mitigating the incorporation of known scripts designed to facilitate crime.

Merchant and retail wallets need to integrate to present the end user with details of the contract terms (including minimum mining fees) and the related services[8] that the merchant provides. It is possible to consider their functions to be either integrated or disintegrated based on the circumstances.

Where legislation is focused on stopping selected uses of transactions within Bitcoin, it is fitting to concentrate on those wallet systems dealing directly with those affected by the legislation. Legislation mandating Bitcoin-address filtering (such as to block access to selected script templates) is better directed to wallet services and merchants, as they can process the details of the exchange[9]. Ideally, it is beneficial to consider a single entity mining partnership formulated from a collaborating consensus miner group — those who act within the basic script constructs being equal to a common carrier and those seeking to add methods to bypass the legislative limits being more akin to a publisher and incorporating the liability frameworks for such a change.

Subsidising mining

The present mining market subsidises transaction validation using the allocation of additional tokens to the operators of the validation nodes (miners). The mining reward is constructed to issue 50 bitcoin each block, halving approximately every four years.

The reward schedule for Bitcoin

At present, the mining reward returns 12.5 Bitcoin every block with a small additional component from the fees. In under two years this will be 6.25 Bitcoin a block. This will be followed in 2024 by a reward of only 3.125 Bitcoin, and the fees at this point will be critical to the continued existence of the system. As such, we can see that the transaction validation is incentivised early to enable the creation of a diversified infrastructure designed to allow for a constantly incremented transaction limit.

Liability and securities fraud

Dr Russell Smith of the Australian Institute of Criminology[A] stated in 2000 that:

“The perpetrators of many on-line scams … are often not large corporations. They are able to close-down their operations quickly and easily, move assets to secure locations and use digital technologies to conceal their identities and disguise evidence. In such cases there is little likelihood of success whether civil or criminal proceedings are taken.”

Dr Smith noted that fraud may be committed both electronically and in paper-based payment systems by individuals opening accounts with false identification details. These individuals may then exceed credit balances, or alter instruments or messages used to authorise transactions. On the Internet, traditional methods of fraud and criminal activity have been updated such that they use this new technology capably. But, there are dilemmas other than fraud for Bitcoin miners and services. It is necessary to understand the relationship between the various parties in the Bitcoin ecosystem, and how they interact if we are to gain an understanding of the issues facing these various entities.

Notes:

[1] An electronic contract has a twofold structure. Thought of electronically, the contract is a sequence of numbers and code saved to some electronic or magnetic medium. Alternatively, the contract becomes perceptible through a transformation of the numeric code when broadcast to a computer output device such as a printer or screen . Prior to the passing of the ECA, this dichotomy exasperated the uncertainty contiguous with whether an electronic contract can be regarded as being a contract in writing.

[2] Mann, R. & Belzley, S (2005) “The Promise of the Internet Intermediary Liability” 47 William and Mary Law Review 1 <http://ssrn.com/abstract=696601> at 27 July 2007].

[3] The distributed nature of Bitcoin mining means that a publisher of a block can reach far more people. A company with a website in the UK, for instance, has direct access to the US, Canada, Australia, and many other countries with the primary limitations being language. As money, these limitations on language do not even apply.

[4].Many commentators on the nature of digital currency hold the view that the difficulty of understanding a blockchain network stems from an artefact of the distributed protocol, under which the transactions that travel over those networks are in the form of a distributed and competitive system that is composed of disintegrated ordered peer-to-peer exchanges of particular tokens. It seems that regulation at the backbone (or mining) level is likely in most cases to involve costs to all traffic that would outweigh the benefits reasonably attributed to the regulation. The error in the view many promote is seeing the system as disintermediated and not as an exchange by two (or more) contractually associated parties who use the blockchain as a validation and settlement system.

[5].This point is best made by Zittrain, (2003). Internet Points of Control, 44 B.C. L. Rev. 653.

[6].In such a structure, there is and has been an international race to the bottom to attract business to certain countries by decreasing the legal obstacles to their establishment. In the context of Internet gambling, the winner of this race has arguably been the small island of Antigua in the British West Indies. See Don Yaeger, Bucking the Odds, Sports Illustrated, Jan. 8, 2001, at 26 (“Some 850 Web gambling sites are based [in Antigua] and an estimated 80% of all gaming URLs on the Web can be traced back to servers on the 108-square-mile island.”); United States General Accounting Office, Report GAO-03–89, Internet Gambling: An Overview of the Issues 52 (2002), available at http://www.gao.gov/new.items/d0389.pdf [hereinafter GAO Report] (listing 35 of 88 Internet gambling websites as registered in either Antigua or Barbuda, but failing to report the percent of Internet gambling taking place at these sites).

[7] Indeed the United States even brought a case against the country of Antigua and Barbuda before the WTO in an effort to curtail the proliferation of Internet gambling operations on that tiny island nation. The United States lost that suit. See Naomi Rovnick, Herbies Helps Antigua in WTO Outsourcing Victory, Lawyer, April 5, 2004, at 10.

[8] Many ISPs were set up by the same kind of people who tend the carry out computer hacking, phone phreaking, or similar activities. This group of people tends to believe that any kind of property rights in information are basically wrong, particularly if that information is owned by the government or a big business, and take great pride in discovering and making available such confidential information. It is, therefore, not surprising that there have been a number of cases in the United States which involve the publication of stolen proprietary information.

[9] Many Retail ISPs maintain little or no technological capability to filter internet traffic.

[A] Smith, 2000 “Confronting Fraud in the Digital Age”